WASHINGTON – The Federal Reserve Board, chastised for regulatory inaction that contributed to the subprime mortgage meltdown, also missed a chance to prevent much of the financial chaos now ravaging hundreds of small and midsized banks.
Many of these banks had long been bedrocks of smaller cities and towns across the nation, including two in the South Sound region. Tacoma’s Rainier Pacific Bank failed in February and DuPont’s Venture Bank failed in September 2009.
A four-month McClatchy Newspapers investigation has found that in 2005 the Fed rejected calls from one of the nation’s top banking regulators, a professional accounting board and the Fed’s own staff for curbs on the banks’ use of trust-preferred securities to raise capital that was allowing them to mushroom in size.
The board’s decision to leave the rule unchanged enabled Wall Street to encourage many community banks to take on huge debt and to plunge the borrowings into real estate loans. Adding to the problems, investment banks aggressively pooled the securities into complex bonds – much like the complex mortgage bonds that nearly brought down the financial system in 2008.
The consequences were devastating.
Since 2008, 324 banks have failed across the country. The parent companies of at least 136 of them issued and later defaulted on more than $5 billion of the special securities.
As of Sept. 30, the Federal Deposit Insurance Corp. had 860 small banks on its “watch list” for possible failure. And the picture is sure to grow uglier in 2011.
Fitch Ratings, which rates the likelihood of bond defaults, said that another 380 bank holding companies that issued $7.1 billion of the securities have exercised their rights to defer paying interest to investors for up to five years. Deferrals historically have preceded defaults.
The failures collectively already have left more than $1 billion of the complex bonds on the books of the FDIC’s industry-funded bank rescue fund. McClatchy obtained this sum through the Freedom of Information Act.
Data from the banks leaves little doubt that the Fed rule, and regulators’ failure to adequately police the issuance of these securities, created big cracks to the already shaky foundations of the nation’s banking system.
In a Winter 2010 Supervisory Insights report published last week, the Federal Deposit Insurance Corp. confirmed McClatchy’s findings. Sandra Thompson, the FDIC’s director of supervision, said that “institutions relying on these instruments took more risks and failed more often than those that did not include the use of” trust-preferred securities.
The Securities and Exchange Commission is now investigating how securities firms hawked some of the complex bonds in a poorly understood, $55 billion offshore market for debt issued by banks, insurers and real estate trusts – a market that’s only now becoming clear.
The Fed first voted in 1996 to approve the use of trust-preferred securities. They were a hard sell since there wasn’t much of a track record. That changed in 2000 when the Wall Street firm Solomon Brothers came up with the idea of bundling securities from 30 or 40 banks and selling slices, or “tranches” of each bundle based on their investment grades.
By 2004, banks big and small had issued $77 billion of the securities, spurring lending that helped the economy rebound from the 9/11 terror attacks, but prompting a new regulatory challenge. The Fair Accounting Standards Board determined that banks should report the securities only as debt, not as capital. This meant that the banks couldn’t borrow against the proceeds from the issuance of the securities, curtailing banks’ growth potential.
Lobbied by community bankers to reject that conclusion, the Fed proposed a formal rule that left things as they were for banks with assets under $15 billion – the community and regional banks.
FDIC officials blanched. In a nine-page letter to Greenspan, then-agency Chairman Donald Powell argued that the policy would encourage banks to take too many risks to cover the dividends they’d be expected to pay their parent companies in return for the cash.
He lamented “the unilateral decision of an important bank regulator such as the Federal Reserve to depart from established prudential standards.”
At least one Fed official urged that community banks be held to more stringent standards.
Then-Chairman Alan Greenspan and the other six Fed governors voted unanimously to reject those appeals, override the accountants and keep the rule essentially intact.
A MAGIC BULLET
This was like a magic bullet for community banks that had few ways to raise capital without issuing more common stock and diluting their share price. The Fed allowed the banks to count the securities as debt, even while counting the proceeds as reserves. Banks were then free to borrow and lend in amounts 10 times or more than the value of the securities being issued.
William Black, a former senior federal thrift regulator, blames the Fed for an overzealous free-market focus.
“The Fed desperately wanted to believe that it didn’t need to regulate and could rely instead on private market discipline,” meaning banks would avoid taking excessive risks, said Black, now a professor at the University of Missouri-Kansas City.
Instead, he said, the banks were “lending into the bubble” with money generated by the bonds, while other banks lacked the sophistication to assess the perils of buying the complex securities.
Fed officials declined to comment for this report. Greenspan didn’t respond to a request for comment.
By 2009, the amount of the bank-issued securities had climbed to a whopping $149 billion.
‘A RISKY BUSINESS’
The demise of two banks on Sept. 11, 2009, illustrates how the community bank securities blindsided issuers and buyers alike.
Corus Bank and Venture Bank were emblematic of many banks that used these securities to feed the real estate bubble, helping to propel U.S. home construction from $257 billion in 1996 to $620 billion a decade later.
From 2003 to 2007, Chicago-based Corus Bancshares generated more than $400 million in capital by making more than a dozen offerings of the 30-year bonds, partly to fuel its Corus Bank unit’s dive into the sizzling market for condominiums, especially in Florida. The bank’s officers felt the fever, as their total condo construction loans shot up from $447.6 million to $3.46 billion.
“Everyone was making money hand over fist,” said John Barkidjija, who was promoted to serve as Corus’ chief credit risk officer months before the bank failed. “We were in a risky business. We were doing bigger and bigger loans. We were concentrated geographically, and if there was a downturn, it could be bad.”
DuPont’s Venture Bank, a lender that began as a credit union in 1932 – received a cash infusion from its parent company, which issued $21 million of the special securities. Cranking out loans to real estate developers, the bank’s assets grew from $752 million to $1.1 billion between 2005 and 2008. Venture officers commissioned the construction of a multi-story, $8 million headquarters.
But Venture also invested more than $42 million in the bank bonds that bank examiners would require them to write off. An FDIC report shows that Venture also lost $42.5 million in investments when the government took over mortgage finance giants Fannie Mae and Freddie Mac in 2008.
Washington state bank examiners in 2008 concluded that Venture had concentrated more of its investments in real estate development loans than all but 1.5 percent of the nation’s banks and thrifts.
Venture’s former chief financial officer, Sandra Sager, declined to comment about the lender’s collapse.
AT RAINIER PACIFIC
Other banks that left the FDIC with hefty portfolios of defaulted bonds when they failed included Independent Bankers Bank of Springfield, Ill., and Rainier Pacific Bank of Tacoma, each with more than $113 million, and Vantus Bank of Sioux City, Iowa, with $65 million.
John Hall, the former chief executive of Rainier Pacific, said his executive team ensured each purchase of the securities was carefully studied and structured to spread the bank’s exposure among 600 banks and insurance issuers.
The investments seemed far safer than to “go out into your local community and take a risk with 600 construction developers,” Hall said.
When the economy stalled and bank issuers exercised their option to defer paying interest on the bonds for five years, ratings agencies downgraded many of them to junk, and Rainier Pacific – like other banks – had to write them off as total losses. That threw the Tacoma bank into the red.
‘THERE’S NO MARKET’
The outlook for trust-preferred securities went dark in mid-2007, after ratings agencies put under review for a downgrade the slices of 72 offshore deals involving complex bonds that were backed by community-bank securities. This signaled downgrades that eventually reduced these bonds to junk status.
Growing nervous that summer, an officer of one community bank dialed his broker to unload millions of dollars of the complex bonds.
The reply, recalled the now-former bank officer, came as a shock: “There’s no market.”
“I didn’t know what to say,” he said, speaking on condition of anonymity because of litigation fears.
He likened it to trying to sell your house and being told: “There’s no buyer … even if you lowered it to a dollar.”
Regulators soon seized the bank.