June 8 (Bloomberg) — U.S. banks are fighting to preserve the use of securities that help them appear better capitalized, even as their investments in each others’ notes perpetuate what one regulator calls a “downward spiral” of losses.
The cross-ownership, largely unnoticed by bank supervisors who generally discourage the practice, was made possible by a Wall Street innovation like the ones that allowed subprime mortgages to flourish. Small lenders, such as Riverside National Bank of Florida, were able to sell trust-preferred securities, known as TruPS, because investment bankers packaged them with those issued by dozens of other financial institutions.
Riverside, which started in a trailer in 1982, bought collateralized debt obligations made up of TruPS as it grew to 65 branches and $4.8 billion assets. When real estate soured and lenders racked up loan losses, Riverside and about 400 of its peers suspended interest payments on their TruPS, causing the CDOs to default or lose value and inflicting more harm on an industry suffering from the worst economy since the 1930s.
“The industry was self-financing, using loopholes in rules,” said Joseph Mason, a professor of finance at Louisiana State University in Baton Rouge. “Regulators weren’t keeping track of ownership of the capital, which became more difficult to do with the use of CDOs. The losses fed on each other.”
Riverside, based in Fort Pierce, Florida, was one of almost 1,400 U.S. lenders that had issued $149 billion of trust preferreds by the end of 2008, according to the Federal Reserve Bank of Philadelphia. About $45 billion of CDOs filled with such TruPS were created by the time the market for securitized debt shut down that year, according to PF2 Securities Evaluations, a New York-based company that helps banks and funds evaluate CDOs.
Congress may end the use of TruPS as capital, forcing banks that issued them to replenish their coffers. Banks are lobbying to remove a provision barring their use that was introduced by Maine Republican Susan Collins and included in the financial reform bill passed by the Senate last month. The Senate version is being reconciled with one passed by the House of Representatives in December that doesn’t include a ban.
“We’re still working to try to minimize the damage the amendment would do to bank-holding company capital,” said Mark Tenhundfeld, executive vice president of the American Bankers Association, which predicts the rule could force banks to raise as much as $130 billion of new capital or curtail lending.
If the Collins provision survives, it will come too late to undo the damage caused to Riverside, which was shut by the Federal Deposit Insurance Corp. on April 16. The bank has sued the firms that sold the TruPS CDOs for not disclosing that they were marketed to other lenders and the rating firms for overstating the creditworthiness of the securities.