How Cross Selling Of CDOs Between Banks "Created A Big Ponzi Scheme"

Two weeks ago we disclosed that a proposed amendment by Maine Republican Susan Collins would disqualify TruPS securities from bank regulatory capital, "which if passed into law, will trim about $108 billion from bank holdco Tier 1 capital, an amount which is about 13% of the "Big 4" banks' total Tier 1 capital according to Moody's." The reason for this long overdue proposal is that TruPS are nothing but a fancy way that banks bought and sold CDOs to each other in what can only be qualified as one big Ponzi scheme involving worthless assets. There are no longer just our words. Bloomberg's Yalman Onaran and Jody Shenn have written an extensive piece on the dangers facing bank balance sheets and liquidity as a result of having approximately a tenth of their capital locked into the same kinds of securities that are now the reason for Goldman's ongoing legal troubles.

From 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.

Just how big was the TruPS market? Very:

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.

And it is not like these underlying securities have much value to them. Luckily, Washington is finally realizing the huge destabilzing threat these pose should there be a modicum of realistic marking on bank balance sheets:

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.

Just what exactly are TruPS:

TruPS are securities issued after a bank-holding company sells debt to an off-balance-sheet trust, which then sells the notes. They’re considered a type of capital for regulatory purposes because they rank between common stock and senior debt in a bankruptcy. The notes allow a bank to defer making interest payments for up to five consecutive years. Unlike other types of preferred stock, they have fixed maturities, and missed dividends must be paid later. For tax purposes, they count as debt, and the interest paid out can be deducted like other interest expenses.

CDOs that bundled TruPS are similar to other complex products designed by Wall Street banks that pooled assets such as mortgage bonds and loans used in leveraged buyouts into new securities, with varying risks and ratings. CDOs were among the largest sources of the $1.8 trillion of losses suffered by the world’s biggest financial companies that required governments worldwide to bail out banks with taxpayer funds.

While TruPS have been around since the 1980s, they gained wider acceptance when the Federal Reserve, which regulates bank- holding companies, allowed them to be treated as Tier 1 capital in 1996.

Already regulators are unhappy with having banks resort to claims of solvency based on TruPS' participation as part of their capitalization:

The Office of the Comptroller of the Currency, which oversees bank subsidiaries of holding companies, wasn’t happy with the rule change and never implemented it, according to three officials with knowledge of the discussions. As a result, it was Riverside’s parent company, Riverside Banking Co., which issued the trust preferreds.

The FDIC has also objected to TruPS as being too weak for capital purposes, according to George French, the agency’s deputy director for policy in the division of supervision and consumer protection. The agency’s chairman, Sheila Bair, expressed support for the Collins amendment in a letter she sent the senator on May 7, the day it was introduced.

The agency’s view was confirmed during the financial crisis, French said. Banks couldn’t use their TruPS as capital because deferring the dividends would have been seen as weakness, which could have led to bank runs. When payments were deferred, they caused losses for the TruPS held by other banks.“It contributes to a downward spiral,” French said.

In other words, TruPS are merely another cog in the Ponzi scheme of the current Wall Street structure. To wit:

Investment bankers may have used relationships developed helping lenders issue TruPS to persuade them to buy related CDOs, said Joshua Rosner, an analyst at Graham Fisher & Co., an independent New York-based research firm, and co-author of a May 2007 report that said a collapse of mortgage-bond CDOs would roil markets.

“When they 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 said. “It created a big Ponzi scheme.”

Should politicians finally do the right thing and take even one small step in the right direction, here are the banks that would be most at risk from a capital shortfall. Not surprisingly, JPM will be the most vocal opponent of any amendment to strip the bank out of this hollow contributor to bank capitalization.

On the other hand, with Congress just as corrupt as every other aspect of the system, don't expect anyone to do the right thing here. After all, all it would take is for Jamie Dimon to come out screaming that the end of the world would occur if he were to be forced to actually mark his assets to some semblance of reality: why deal with a problem today when it can easily be pushed back to tomorrow. And as Jamie knows too well, CEO tenures are, at the end of the day, limited. This is merely one other aspect of the firm's eventual insolvency that his successor will eventually deal with. But not him, and not now.