Banks in `Downward Spiral’ Buying Capital in CDOs Distrusted by Regulators

By Yalman Onaran and Jody Shenn June 8 (Bloomberg) — U.S. banks are fighting to preservethe use of securities that help them appear better capitalized,even as their investments in each others’ notes perpetuate whatone regulator calls a “downward spiral” of losses. The cross-ownership, largely unnoticed by bank supervisorswho generally discourage the practice, was made possible by aWall Street innovation like the ones that allowed subprimemortgages to flourish. Small lenders, such as Riverside NationalBank of Florida, were able to sell trust-preferred securities,known as TruPS, because investment bankers packaged them withthose issued by dozens of other financial institutions. Riverside, which started in a trailer in 1982, boughtcollateralized debt obligations made up of TruPS as it grew to65 branches and $4.8 billion assets. When real estate soured andlenders racked up loan losses, Riverside and about 400 of itspeers suspended interest payments on their TruPS, causing theCDOs to default or lose value and inflicting more harm on anindustry suffering from the worst economy since the 1930s. “The industry was self-financing, using loopholes inrules,” said Joseph Mason, a professor of finance at LouisianaState University in Baton Rouge. “Regulators weren’t keepingtrack of ownership of the capital, which became more difficultto do with the use of CDOs. The losses fed on each other.” Collins Amendment Riverside, based in Fort Pierce, Florida, was one of almost1,400 U.S. lenders that had issued $149 billion of trustpreferreds by the end of 2008, according to the Federal ReserveBank of Philadelphia. About $45 billion of CDOs filled with suchTruPS were created by the time the market for securitized debtshut down that year, according to PF2 Securities Evaluations, aNew York-based company that helps banks and funds evaluate CDOs. Congress may end the use of TruPS as capital, forcing banksthat issued them to replenish their coffers. Banks are lobbyingto remove a provision barring their use that was introduced byMaine Republican Susan Collins and included in the financialreform bill passed by the Senate last month. The Senate versionis being reconciled with one passed by the House ofRepresentatives in December that doesn’t include a ban. “We’re still working to try to minimize the damage theamendment would do to bank-holding company capital,” said MarkTenhundfeld, executive vice president of the American BankersAssociation, which predicts the rule could force banks to raiseas much as $130 billion of new capital or curtail lending. ‘Modifications’ Possible Collins will “support modifications to address concerns ofcommunity banks,” spokesman Kevin Kelley said withoutspecifying what those might entail. Lobbyists for theIndependent Community Bankers of America, a Washington-basedgroup representing about 5,000 smaller lenders, have met withkey lawmakers in recent weeks to discuss the capital issue. Thefinal version of the bill may provide a transition of three-to-five years to comply with the rule, people with knowledge of thenegotiations said. If the Collins provision survives, it will come too late toundo the damage caused to Riverside, which was shut by theFederal Deposit Insurance Corp. on April 16. The bank has suedthe firms that sold the TruPS CDOs for not disclosing that theywere marketed to other lenders and the rating firms foroverstating the creditworthiness of the securities. Type of Capital TruPS are securities issued after a bank-holding companysells debt to an off-balance-sheet trust, which then sells thenotes. They’re considered a type of capital for regulatorypurposes because they rank between common stock and senior debtin a bankruptcy. The notes allow a bank to defer making interestpayments for up to five consecutive years. Unlike other types ofpreferred stock, they have fixed maturities, and misseddividends must be paid later. For tax purposes, they count asdebt, and the interest paid out can be deducted like otherinterest expenses. CDOs that bundled TruPS are similar to other complexproducts designed by Wall Street banks that pooled assets suchas mortgage bonds and loans used in leveraged buyouts into newsecurities, with varying risks and ratings. CDOs were among thelargest sources of the $1.8 trillion of losses suffered by theworld’s biggest financial companies that required governmentsworldwide to bail out banks with taxpayer funds. While TruPS have been around since the 1980s, they gainedwider acceptance when the Federal Reserve, which regulates bank-holding companies, allowed them to be treated as Tier 1 capitalin 1996. FDIC Objects The Office of the Comptroller of the Currency, whichoversees bank subsidiaries of holding companies, wasn’t happywith the rule change and never implemented it, according tothree officials with knowledge of the discussions. As a result,it was Riverside’s parent company, Riverside Banking Co., whichissued the trust preferreds. The FDIC has also objected to TruPS as being too weak forcapital purposes, according to George French, the agency’sdeputy director for policy in the division of supervision andconsumer protection. The agency’s chairman, Sheila Bair,expressed support for the Collins amendment in a letter she sentthe senator on May 7, the day it was introduced. The agency’s view was confirmed during the financialcrisis, French said. Banks couldn’t use their TruPS as capitalbecause deferring the dividends would have been seen asweakness, which could have led to bank runs. When payments weredeferred, they caused losses for the TruPS held by other banks. ‘Downward Spiral’ “It contributes to a downward spiral,” French said. Proposals by the Basel Committee on Banking Supervision,which brings together regulators and central bankers of 27countries, would also eliminate TruPS for use as capital. When TruPS were first introduced, only the largest U.S.banks, such as Citigroup Inc. and Bank of America Corp., couldissue them. Smaller banks couldn’t sell in sizes large enough toattract investors, and fixed legal and other costs ate into thevalue of smaller deals for issuers. A team at Citigroup led by Josh Siegel helped change thatby coming up with the idea of pooling TruPS into CDOs andcreating the first deal in 2000, convincing rating firms andinvestors that a diverse pool of banks across the country meanta slice of the debt could be rated AAA. First Horizon NationalCorp., based in Memphis, Tennessee, and KBW Inc. in New York,two investment banks that had better relationships withcommunity lenders, followed jointly a few months later. Market Explodes The introduction of CDOs helped the market explode. Almost250 of the 459 banks whose shares were listed on major exchangesin 2002 had sold trust-preferred securities, up from about 100in 1999, according to SNL Financial, a Charlottesville,Virginia-based financial information and research provider. It also wreaked havoc on the banking sector. The pileup ofTruPS on banks’ balance sheets went unnoticed by regulatorssince they were grouped with other investment-grade debt,according to three banking supervisors who asked not to beidentified. Only last June were banks required to disclose theirholdings of TruPS CDO in regulatory filings. They still don’thave to report purchases of non-pooled TruPS. “There wasn’t enough oversight of the systemic risks thatthe banks’ ownership of these securities could create,” saidMark Williams, a former Fed examiner who teaches finance atBoston University. Enabling smaller banks to sell TruPS provided them withfunds they used to expand into construction lending, commercialmortgages and home-equity debt, fueling a real estate bubblethat burst in 2007. ‘Enticed’ by Yields “It was an extremely cheap way for the smaller banks toraise capital,” said Jeffrey Caughron, an associate partner inOklahoma City at Baker Group Ltd., which advises community banksinvesting $20 billion of assets. “The securitization processand the demand created by securitization, created an environmentwhere trust-preferred issuance became very cheap.” Banks also were “enticed” by the CDOs’ higher yields,Caughron said. One investment-grade TruPS CDO slice sold inDecember 2006 offered yields that floated 2.70 percentage pointsabove the three-month London interbank offered rate, a borrowingbenchmark, Bloomberg data show. TruPS CDOs helped banks get around restrictions on owningequity stakes in each other. Regulations force banks to deductfrom their capital the full amount of any equity holdings inother banks. Trust preferreds, since they are considered debtinstruments, carry a much smaller capital charge, similar tothat associated with corporate debt. The ownership of TruPSCDOs, if rated investment grade, carried even less capital cost,since securitized debt is deemed to be safer. Conserving Cash If a bank bought $100 of Citigroup shares, it would have tohold $100 of capital against that asset. The purchase of $100 inCitigroup TruPS would require only $8 of capital. For $100 ofAAA rated CDOs that pool bank TruPS, the amount of regulatorycapital to be set aside declines to $1.60. When the credit crisis hit and banks suspended payments ontheir TruPS to conserve cash, the value of the securitiesdropped, leading to losses for the holders. ZionsBancorporation, a Salt Lake City-based lender, saw its $2billion investment in trust preferreds of other financialinstitutions decline by a third in value, according toregulatory filings. John L. Skibski, chief financial officer of Monroe,Michigan-based MBT Financial Corp., the parent of Monroe Bank &Trust, bought about $20 million of TruPS CDOs, most of thembefore 2006. They have been marked down by about half since. “I did read through the offering statements, and thought Iunderstood all the details on how they worked and felt thatbecause it was the banking industry they would be good,”Skibski said. “In hindsight, in seeing how the industry hasgone down, I would not have bought them.” Negative Outcome Skibski’s bank, which started in 1858, didn’t invest inother securitized debt or sell TruPS. Owning CDOs that pooled trust preferreds had anothernegative outcome. The suspended payments by issuers caused CDOsto be downgraded by rating firms. When the rating dropped belowinvestment grade, as dozens of them did, the banks’ capitalcharges against the CDOs could multiply by 60 times. The CDOs made it difficult for banks to negotiate withholders of their TruPS to convert them into common stock, whichwould have been the best way to use them as capital withoutbeing stigmatized for deferring payments. While investors inhigher-rated tranches of a CDO may benefit from a conversion,holders of lower-rated slices wouldn’t, preventing an agreement,according to Andrew Silverstein, a partner at Seward & KisselLLP law firm in New York who has worked on such deals. ‘Hurting Each Other’ More than 13 percent of TruPS within CDOs had defaulted asof April, with payments suspended on an additional 17 percent,according to Fitch Ratings. Riverside’s default on $99 millionof TruPS in 10 CDOs was the largest since December, according toa report by the New York-based rating firm. The bank had haltedpayments in October 2008. The bank bought $211 million of TruPSCDOs, according to its lawsuit. “When the buyers and the sellers are the same, they starthurting each other,” said Joel Laitman, a New York-basedpartner at law firm Cohen Milstein Sellers & Toll PLLC who isrepresenting Riverside in its lawsuit. The case, filed in New York State Supreme Court inNovember, was brought against the firms that sold CDOs toRiverside, including First Horizon, KBW, Citigroup, JPMorganChase & Co., Credit Suisse Group AG and Merrill Lynch & Co. Italso named rating firms Moody’s Investors Service, Standard &Poor’s and Fitch. The FDIC was added as a plaintiff on June 3,the same day the case was moved to federal court. ‘Negative Loop’ In a motion to dismiss the case, the investment banksdenied that they made any misleading statements and said thatRiverside was a sophisticated institutional investor that shouldhave done its homework. A separate motion by the rating firmssaid Riverside had failed to identify any statement by them thatcould be considered fraudulent. Both motions are pending. “Regional and small banks weren’t aware that these CDOswere being marketed to other banks,” said Laitman. “Thiscreated a negative loop. Investment banks selling this stuffwere the only ones who knew about this.” Vernon D. Smith, Riverside’s founder and head untilretiring in 2009, who has also owned a cattle ranch, citrusgroves, radio stations and a weekly newspaper in Florida, didn’treturn telephone messages left at his house. Super Bowl Tickets TruPS CDOs are also at the heart of a series of lawsuitsbrought by the liquidation trustee for Northbrook, Illinois-based Sentinel Management Group Inc., a cash-management firmthat collapsed in 2007. The trustee sued First Horizon, KBW andCohen & Co., a Philadelphia-based securities firm affiliatedwith a family involved in almost half of such CDOs, saying theirbankers bribed a Sentinel employee with Super Bowl tickets,strip-club visits and dinners at restaurants such as Tao in NewYork to get him to buy risky low-ranking slices of the CDOs. In March, First Horizon said the Securities and ExchangeCommission told it the agency might file a lawsuit against thebank over a transaction with Sentinel. Jack Bradley, a spokesman for First Horizon, KristaEccleston, a spokeswoman for KBW, and Megan Livewell, aspokeswoman for Cohen, declined to comment. In legal responsesin the cases, the three companies denied they engaged inwrongdoing and disputed some facts. ‘On the Roadshow’ The trustee also says that the banks arranged to buy backsome of the older CDOs from Sentinel as they sold it new ones.The arrangement may have helped get deals done because investorsin new CDOs often want to know that the junior-most pieces, alsocalled equity, will be sold, said Howard Hill, a former BabsonCapital Management LLC money manager who helped startsecuritization-related departments at four banks. “When you go out on the roadshow, a question that veryoften comes up from potential bondholders is, ‘Have you sold theequity,’” he said. Investment bankers may have used relationships developedhelping lenders issue TruPS to persuade them to buy relatedCDOs, said Joshua Rosner, an analyst at Graham Fisher & Co., anindependent New York-based research firm, and co-author of a May2007 report that said a collapse of mortgage-bond CDOs wouldroil markets. “When they didn’t find enough natural demand among onlyinstitutional investors, they could turn around and sell back tothe very banks that had issued into the last one, or would beselling into the next one,” Rosner said. “It created a bigPonzi scheme.” ‘Shocked’ at Disclosures Too many banks ended up buying the mezzanine tranches ofthe CDOs, which went bust faster than the highest-rated ones,according to Siegel, who left Citigroup to co-found New York-based StoneCastle Partners LLC, which manages about $3.1billion, including TruPS CDOs. He said he didn’t realize thatwas happening as the market grew and was “shocked” atdisclosures about what banks had bought. “Smaller banks should not have been buying any kind ofstructured paper” except for simple government-guaranteedmortgage securities, Siegel said. “Unfortunately, too much ofthis paper has landed back at banks, which really wasn’t whatshould have happened.” To contact the reporters on this story:Yalman Onaran in New York at yonaran@bloomberg.net;Jody Shenn in New York at jshenn@bloomberg.net.

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