Throwing Gas On The Fire

When you're a bank, it's hard to lend money when you have to hoard capital because the regulators keep forcing you to write down the value of your assets. While we've been focusing on commercial real estate loans and REO, the regulators have been throwing other assets into the write-down pile.

According to Columbus (Ohio) BusinessFirst, community bank Delaware County Bank & Trust recently disclosed that what it, and its outside auditors, thought were adequate valuations of trust preferred securities weren't conservative enough to satisfy "you-can-never-go-too-low" FDIC examiners.

Bank parent DCB Financial Corp.has disclosed that regulators told the bank the assumptions it was using to value an investment portfolio weren’t conservative enough and that it needed to reflect a greater likelihood of future problems. The new assumptions led to a bigger write-down on the value of the securities than bank executives reported in quarterly financial roundups.

“It is awkward for us to have our auditors sign off on our methodology and assumptions and then have the regulators come in later on and say, ‘No, we don’t agree with that,’ ” said CEO Jeff Benton.

The change accounted for substantially all of a $1.2 million increase in the bank’s 2009 loss to $4.2 million, from $3 million originally. The bank ended up taking $2.6 million in charges related to the securities last year, leaving the $8 million investment with a value of $2.1 million, said CFO John Ustaszewski.

[...]

The disagreement centers on the bank’s portfolio of trust preferred securities, which were issued by small banks to raise capital. Classified as collateralized debt obligations, they were popular before the mortgage crisis, when bank failures were rare and finances for most lenders were strong.

But such investments increasingly have soured as the conditions of small banks responsible for paying dividends and principal on the securities have weakened.

Delaware County Bank wrote down the value of the investments without prompting. But regulators during an examination last spring disagreed with projections the bank used to determine how deeply those investments were in trouble, Benton said.

Guess who won that "disagreement"? That was an easy question to answer, right?

According to one expert quoted in the article, trust preferred securities are "risky."

It’s no surprise regulators are taking a close look at holdings of trust preferred securities because their provisions often allow banks backing them to defer making payments for years if they get into financial trouble, said John Shaffer, a principal at Dublin-based bank consultant Keller & Company Inc.

And the odds that banks will go under have increased, raising the potential for further problems with the securities, Shaffer said.

“That’s why (the investments) are risky,” he said.

With all due respect, pools of trust preferred securities were not considered exceptionally risky a few years ago. In fact, when the FDIC authorized state banks to invest in such securities in 1999, it did so under its authority "to designate other kinds of hybrid securities as permissible investments, subject to the same 15 percent cumulative limit, if the securities have the character of debt securities and do not represent a significant risk to the deposit insurance funds." Neither the issuers nor the purchasers expected the bottom to fall out of the US economy and to plummet into the worst recession since the 1930s, anymore than the regulators did. Now that the economy has done just that, the FDIC has had second thoughts.

A spokesman for the Federal Deposit Insurance Corp. said the agency does not comment on specific banks, but provided a guidance letter the FDIC sent to banks last April imploring them to carefully evaluate trust preferred and other securities.

“Management due diligence regarding purchases of these products was often lacking,” the letter said, warning bankers that FDIC examiners could force impairments even if the securities had investment-grade credit ratings.

Yes, well after the economy crashed, the FDIC sent a letter warning banks to be careful about investing in trust preferred securities. Like similar "guidance" (such as the commercial real estate guidance we discussed yesterday), it served no practical purpose other than covering the regulators' backsides, because by the time it was issued, the critical problem was not the acquisition of new assets but the problem of dealing with the legacy assets purchased long before such guidance was issued. As has become typical, the response of the FDIC to the problem of legacy assets is to deplete capital by being more conservative than either bank management or outside auditors, which exacerbates the problems of the banks that hold the assets.

It would be interesting to see how many of the bank and thrift holding companies that issued trust preferred securities have been subjected to vigorous write downs and loss reserve requirements by regulators, which actions have led, in turn, to deterioration in the financial condition and performance of the issuers, which deterioration was used as a basis for writing down the value of the securities on the books of the banks that hold them. Obviously, the root cause of the economic problems of community banks is the economy, not the regulators' reaction to it; however, has anyone in the regulatory realm heard of the term "self-fulfilling prophecy"?

Just checking.