Hybrid Securities Doomed Six Banks

By DAVID ENRICH and DAMIAN PALETTA The six family-controlled Illinois banks that collapsed on Thursday were doomed by massive holdings of trust preferred securities, Wall Street instruments that came into vogue during the industry's boom but are now battering a growing number of small banks. In 2005, the failed banks and two others owned by the Campbell family of Illinois started snapping up trust preferred securities, which are a hybrid between debt and equity, in an attempt to fuel earnings growth. Demand was sluggish for loans in the small Midwestern towns where the family's banks were based. When the credit crisis hit, the values of the securities and pools into which they were packaged rapidly lost value, partly because some banks stopped paying dividends on the securities. Under accounting rules, the banks were required to write down the securities to market value. That forced the banks to absorb big losses, winnowing their capital cushions. The six failed banks, some of which were founded in the Civil War era, had about $1.38 billion in combined assets. While the Federal Deposit Insurance Corp. found buyers for the banks' branches and some of their loans, the failures are expected to cost the agency's strapped insurance fund roughly $267 million. A total of 52 federally insured banks and savings institutions have gone bust this year. The Campbell family still controls three banks that remain in business. Two are based in Illinois and also have been battered by investments in trust preferred securities. A third bank, in Scottsdale, Ariz., steered clear of the securities because it had plenty of growth opportunities through lending. It is now suffering from a wave of souring loans to finance commercial real-estate projects. Lyle Campbell, the 73-year-old patriarch of the family's banking business, said in an interview on Monday that he is scrambling to raise as much as $25 million from private investors to bolster capital at his three surviving banks. "The appetite is not large," he said. One of the three banks, First National Bank of Gilman, Ill., which was founded in 1869 and has about $44 million in assets, last week reached a preliminary deal to sell itself to an unidentified Illinois bank. "We weren't as bad as those that went down, but we needed capital," said Dale R. Warmbir, who is First National's president and has run the bank since 1977. That was three years before Mr. Campbell and a partner bought a controlling stake. "It's a relief that it's over, but we're all angry that it had to happen," Mr. Warmbir added. Mr. Campbell, who oversaw the failed banks with his three sons, instructed executives at institutions owned by the family to buy trust preferred securities. In a process similar to the securitization of subprime mortgages, Wall Street brokerage firms bought the securities from individual banks and packaged them into collateralized-debt obligations. The firms then sold slices of the CDOs to investors, marketing them as lucrative but low risk. Many of the buyers were small and regional banks. Mr. Campbell, who also races planes and helicopters and collects antique Lincoln Continental cars, said the CDOs were rated as investment grade and included securities issued by hundreds of U.S. banks. "They were so widely dispersed that we thought they'd be safe," he said. Regulators didn't object to his investments at the time, he added. As of March 31, 2007, the six failed banks were holding about $439 million of securities in their available-for-sale portfolios, according to a review of regulatory filings by The Wall Street Journal. That included trust preferred shares and other securities. Mr. Campbell said he spent much of the past year urging the FDIC, Office of the Comptroller of the Currency and the Illinois Department of Financial and Professional Regulation to not force the banks to take painful write-downs. "We lost that argument," he said. As of March 31, 2009, the six banks' available-for-sale portfolios had declined by 33% to about $296 million. As a result of the write-downs, capital ratios at the six banks fell below the levels required by regulators. Mr. Campbell and his sons spent months unsuccessfully trying to drum up outside capital. An FDIC spokesman said it was the Illinois regulators' decision to close the banks. Susan Hofer, a spokeswoman for the Illinois banking regulators, said: "We don't tell banks how to run their businesses, but if their investments go south or their business model stops working, it is our job to act decisively to protect their customers from undue risk." Write to David Enrich at david.enrich@wsj.com and Damian Paletta at damian.paletta@wsj.com