The financial innovation was meant to be safe by spreading risk, but it ended up magnifying losses when the economy slumped
A battle has erupted in Washington over a seemingly obscure instrument called trust-preferred securities, or TruPS. This bit of financial exotica didn't get as much attention as synthetic collateralized debt obligations or credit default swaps during the global credit crisis. Yet TruPS definitely did some damage. Now Senator Susan Collins (R-Me.) has proposed restricting them, and the banks are fighting back.
To understand what's at stake, consider the story of Riverside National Bank of Florida. Back when the industry was booming, Riverside sold at least $99 million of TruPS. The appeal for banks was that regulators counted the TruPS they issued as part of their capital—the buffer they are required to hold against potential losses. Riverside, based in Fort Pierce, Fla., was one of almost 1,400 U.S. lenders that had issued $149 billion of TruPS by the end of 2008, according to the Federal Reserve Bank of Philadelphia.
That by itself might not have become a problem. Securitization helped compound the dangers of these securities. Much as they did with mortgages, investment bankers pooled TruPS into CDOs, some pieces of which were sold to banks—including Riverside, which bought $211 million of them. When the real estate market soured and lenders racked up losses, Riverside and more than 400 of its peers suspended interest payments on their TruPS. That caused the CDOs holding TruPS to default or lose value, inflicting losses on the banks owning them. Thanks in part to those losses, Riverside, with assets of $3.4 billion, collapsed in April.
By issuing TruPS and buying CDOs containing them, the banks in effect were propping each other up. "The industry was self-financing, using loopholes in rules," says 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."
The pileup of TruPS on banks' balance sheets went unnoticed by regulators since they were grouped with other investment-grade debt, according to three banking supervisors. Only last June were banks required to disclose their holdings of TruPS CDOs in regulatory filings. They still don't have to report purchases of TruPS that are not part of CDOs. "There wasn't enough oversight of the systemic risks that the banks' ownership of these securities could create," says Mark Williams, a former Fed examiner who teaches finance at Boston University.
TruPS may have their comeuppance in Congress. A provision that would prevent them from counting as Tier 1 capital was introduced by Senator Collins and included in the financial reform bill the Senate passed last month. The Senate version is being reconciled with the one the House of Representatives approved last month, which doesn't include a ban.
While Federal Deposit Insurance Corp. Chairman Sheila Bair supports the ban, banks are lobbying hard against it because it would force those that issued TruPS to raise capital in other ways. About 600 banks with less than $10 billion in assets use the securities as Tier 1 capital, says Camden Fine, president of the Independent Community Bankers of America, who wants the amendment to be withdrawn or at least to allow existing preferreds to continue counting as Tier 1 capital. "This is a raw-nerve issue with any banker that holds trust-preferred securities," Fine says. "I guarantee you every banker who holds [them] has contacted their representatives and senators on this issue."
Those voices have been heard. Senator Collins now says that lawmakers may have to grandfather existing TruPS or phase in the ban. The FDIC also supports grandfathering or allowing a transition period.
Even if the provision survives, it will come too late to undo the damage caused to Riverside. The bank has sued the firms that sold it CDOs for not disclosing that they were marketed to other lenders and sued the rating firms for overstating the creditworthiness of the securities. In a motion to dismiss the case, the investment banks denied that they made any misleading statements and said Riverside was a sophisticated institutional investor that should have done its homework. A separate motion to dismiss made by the rating firms said Riverside had failed to identify any statement that could be considered fraudulent. Both motions are pending.
One possible reason banks ended up owning so many TruPS CDOs: Investment bankers may have used relationships developed helping lenders issue TruPS to persuade them to buy related CDOs, says Joshua Rosner, an analyst at Graham Fisher, an independent research firm. "When [those bankers] didn't find enough natural demand among only institutional investors, they could turn around and sell back to the very banks that had issued into the last one, or would be selling into the next one," Rosner says. "It created a big Ponzi scheme."
The bottom line: Securities designed to spread risk ended up magnifying losses in the banking industry when the economy slumped.