Fed missed chance to slow banks' risk-taking

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 ravaging hundreds of small and midsize banks.

In early 2005, at a time when the housing market was overheated and economic danger signs were in the air, the Fed had an opportunity to put a damper on risk-taking among banks, especially those that had long been bedrocks of smaller cities and towns across the nation.

But 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 special debt securities to raise capital that was allowing them to mushroom.

Then-Chairman Alan Greenspan and the other six Fed governors voted unanimously to reaffirm a 9-year-old rule allowing liberal use of what are called trust-preferred securities.

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.

The Fed supervised about 1,400 bank-holding companies, the bulk of them parent companies of community banks.

Data emerging from the carnage of collapsed and teetering 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.

A four-month McClatchy inquiry finds that the Fed rule enabled Wall Street to encourage many community banks to take on huge debt and to plunge the borrowings into risky real estate loans.

In a Winter 2010 Supervisory Insights report published Wednesday, 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.

In its supervisory report, however, the FDIC didn't criticize the Fed directly.

Adding to the problems, investment banks aggressively pooled these community-bank securities into complex bonds — much like the complex mortgage bonds that nearly brought down the financial system in 2008.

The consequences were devastating.

As of Sept. 30, the FDIC had 860 small banks on its "watch list" for possible failure. The issuance of the special securities to boost lending helps explain the staggering 324 bank failures between 2008 and mid-December.

Of those failed banks, the parent companies of at least 136 of them issued and later defaulted on more than $5 billion of the special securities.

Worse expected

The picture is sure to grow uglier in 2011.

That's because 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.

Defaults and deferrals even contributed to at least three dozen failures by banks that bought the complex bonds — as much as $312 million by the Riverside National Bank of Florida alone.

The failures collectively have already 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.

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.

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 about this regulatory misfire. Greenspan didn't respond to a request for comment.

Bonds junk by 2007

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.

Bundling and slicing

After the Fed's 1996 vote approving their use, the special securities 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 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 heavily 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.

The Fed rejected those appeals, overrode the accountants and kept the rule essentially intact.

By 2009, the amount of the bank-issued securities had climbed to a whopping $149 billion.