Critically Under-Capitalized Banks Direct Result of “Wonderful Chain of Stupidity”

Last week the Wall Street Journal ran an article about how trust securities sank Guaranty Financial Group and six family-controlled Illinois banks in early July.

Please consider In New Phase of Crisis, Securities Sink Banks. 

Federal officials on Thursday were poised to seize Guaranty Financial Group Inc., in what would be the 10th-largest bank failure in U.S. history. Guaranty’s woes were caused by its investment portfolio, stuffed with deteriorating securities created from pools of mortgages originated by some of the nation’s worst lenders.

Delinquency rates on the holdings have soared as high as 40%, forcing write-downs last month that consumed all of the bank’s capital.

Guaranty is one of thousands of banks that invested in such securities, which were often highly rated but ultimately hinged on the health of the mortgage industry and financial institutions.

Many analysts and bankers are increasingly worried that the boomerang effect that killed Guaranty will cripple many small and regional banks already weakened by losses on home mortgages, credit cards, commercial real-estate and other assets imperiled by the recession.

Thousands of banks and thrifts scooped up securities tied to the housing market or other financial institutions in the past decade. Such investments were alluring because they seemed certain to outperform Treasury bonds, municipal bonds and other humdrum holdings that dominated the securities portfolios at most banks for generations.

As of March 31, the 8,246 financial institutions backed by the FDIC held $2.21 trillion in securities — or 16% of their total assets of $13.54 trillion.

The problems also underscore how the boom in securitization of loans instilled a belief that risks could be controlled, an idea embraced first by financial giants like Citigroup Inc. and Merrill Lynch & Co. and then smaller institutions reaching for higher profits.

"We saw them as a safe investment, and now we wish we didn’t have them," says Robert R. Hill Jr., chief executive of SCBT Financial Corp, a Columbia, S.C., bank with 49 branches. The bank has less exposure than some other small institutions, with the crippled securities representing about 10% of its investment portfolio.

The overall impact on the U.S. banking industry’s second-quarter results isn’t clear, because disclosure of losses and even the types of securities owned vary widely from bank to bank. Some obscure their troubled holdings in a vague line item titled "other" in financial statements.

"The very depth of the problem is very difficult for us to get our hands on," says Jim Reber, president of the ICBA Securities, the brokerage unit of the Independent Community Bankers of America, a trade group of 5,000 small banks and thrifts. "These securities have declined in value, and it is not clear when they are going to come back in value, if at all."

The sickened securities fall into two categories. Guaranty is among nearly 1,400 banks that own mortgage-backed securities that aren’t backed by government-related entities such as Fannie Mae and Freddie Mac. Such "private issuer" and "private label" securities are carved out of loans originated by mortgage companies, packaged by Wall Street firms and then sold to investors.

Small and regional financial institutions own about $37.2 billion of private-issuer and private-label securities, Red Pine estimates. But regulators are pressuring banks to write down the value of their mortgage-backed securities, now being downgraded as more borrowers fall behind on payments for the underlying loans.

Banks also are being battered by more than $50 billion of trust preferred securities, financial instruments that are a hybrid between debt and equity. From 2000 to 2008, more than 1,500 small and regional banks issued trust preferred securities, according to Red Pine data.

Many of the buyers were small and regional banks, which were confident they could evaluate other banks and attracted to the interest promised by the issuing financial institution.

But as banks struggle with rising loan losses, some issuers of trust-preferred securities no longer can afford their obligations. In the first half of 2009, 119 U.S. banks deferred dividend payments on their trust-preferred securities, while 26 defaulted on the securities.

The consequences are cascading down to banks that bought the securities. One banking lawyer who asked not to be identified describes the result as a "wonderful chain of stupidity."

Under-Capitalized Banks And FDIC

On August 19, in Emails from a Bank Owner regarding FDIC and Under-Capitalized Banks I posted some interesting comments from a bank owner on capitalization.

I have a few more emails to share, one of them written on July 4th after the six Illinois bank failures.

On July 4, 2009 ABO (A Bank Owner) wrote:

Mish,

As you may have noticed the FDIC closed seven banks on Thursday. Six of the banks were in Illinois and one was in Texas. The Texas bank appears to have been closed by the FDIC after loan losses depleted capital. However, the six bank’s in Illinois were all closed after SECURITY LOSSES depleted their capital. Each of the banks had massive losses on their March 31, 2009 call report in the category securities gain(losses). Security losses are a non-operating item and are listed after pre-tax operating income on the call report. This is very unusual and possibly reveals another cancer hiding on many banks balance sheets. The cancer appears to be OTHER DOMESTIC DEBT SECURITIES. If you go the call reports available on the FDIC web site and go to schedule RC-B- Securities you will find these assets listed as other domestic debt securities. By definition other domestic debt securities are either;

1) Bonds, notes, debentures, equipment trust certificates and commercial paper issued by US-chartered corporations and other U.S. issuers.

2) Preferred stock of U.S.- chartered corporations and business trusts that by its terms either must be redeemed by the issuing corporation or trust or is redeemable at the option of the investor, including trust preferred securities subject to mandatory redemption.

It is quite possible that what caused the failure of these six banks in Illinois were investments in trust preferred securities. Trust preferred securities are basically an unsecured loan to a bank holding company using a creative structure. Trust preferred came out of nowhere about 10 years ago and took the place of banks stock loans. A banker could borrow money on a LIBOR basis and only be required to pay interest for up to 30 years. Because of the unique structure the Federal Reserve blessed it and allowed banks to count a portion of the debt as equity. In other words the debt was not really debt by definition. Originating investment banks would take a large fee and originate the loan or trust preferred and sell the security into the market. If a bank bought the security as an investment it would be shown as an asset on the call report under the name of other domestic debt securities.

My point here is that I have not seen seven banks closed in one day in a long time. Most disturbing is that six of the seven were from one state, were small and apparently closed as the result of investments made in other banks via trust preferred. If this is the case how many other banks are exposed to the same risk and how much is their exposure? No decent banker would have invested in these assets unless the potential loss was somehow limited. A bank is limited by law as to how much it can loan one borrower. The law is called the legal lending limit. The amount varies by state but is usually no more than 15% of capital. Additionally, most banks have an in-house limit that is much less. Why did the regulators allow this scheme in the first place and why did they not impose any restrictions on exposure? If I am correct 6 banks were just wiped out in one day as a result of this investment.

I did not have permission to share that email at the time, but as you can see, ABO was correct.

Hiding The Losses

A few days ago ABO had a few more comments about how FDIC was handling these situations.

ABO Writes:

Take a look at how the FDIC is selling failed banks. It is a little different than in the past. The FDIC is using a loss sharing agreement that is usually around 80-20 and has certain guidelines on timing of the losses. I would guess that the losses on the failed banks are dragged into the future somewhat rather than being recognized at the time the bank is closed. This method would be less of an immediate hit to the fund and would probably create a contingent liability rather than a direct one. The banks that agree to this loss sharing plan are relying on the promise of the FDIC to make good on future guarantees for losses. The losses are not backed by the full faith of the government.

The Fed and FDIC always want to delay addressing the problems, hoping they will go away. Such structural problems seldom do.

Amazingly Financial Group was considered "well capitalized" right up to the brink of failure. When the bank did fail, the hit to FDIC was not immediately taken but stretched into the future.

The WSJ article notes ‘There are 1,400 banks that own mortgage-backed securities that aren’t backed by government-related entities such as Fannie Mae and Freddie Mac." What we don’t know is how many of those banks are levered up enough in garbage mortgages to fail.

Note too that those garbage trust-preferred securities problems are on top of the widely expected fallout from commercial real estate problems affecting small to medium-sized regional banks. Thus, banking woes are much deeper in many areas than either the FDIC or Fed is admitting.

Mike "Mish" Shedlock