In New Phase of Crisis, Securities Sink Banks

By ROBIN SIDEL U.S. banks have been dying at the fastest rate since 1992, mainly because of bad loans they made. Now the banking crisis is entering a new stage, as lenders succumb to large amounts of toxic loans and securities they bought from other 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, and broker a sale of the Texas bank to Banco Bilbao Vizcaya Argentaria SA of Spain. 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. View Full Image The Dallas Morning News Texas-based Guaranty Financial Group was crippled by investing in securities issued by other lenders. Guaranty owns roughly $3.5 billion of securities backed by adjustable-rate mortgages, with two-thirds of the loans in foreclosure-wracked California, Florida and Arizona, according to the company's latest report. 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. "Under most scenarios, they were good and prudent investments -- as long as we didn't have a housing or banking crisis," says John Stein, president and chief operating officer at FSI Group LLC, a Cincinnati company that invests in financial institutions. The specter of a systemic collapse in the U.S. banking system has faded, largely because the government has shored up the industry with $250 billion in taxpayer-funded capital since last fall, most of it going to big banks. But more than 20% of all banks reported a net loss in the first quarter, the latest period for which the Federal Deposit Insurance Corp. has figures, and problems are now building in small and medium institutions. Mortgage-delinquency rates and losses on credit cards are at all-time highs. The accumulating bad assets and need for capital mean few banks are lending aggressively, creating a drag on the economic recovery. 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. "There is no question that these securities will be...for some of these banks the straw that breaks the camel's back," says Cassandra Toroian, founder and chief investment officer of Bell Rock Capital LLC in Rehoboth Beach, Del., which manages money for financial-services companies and wealthy individuals. 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." Red Pine Advisors LLC, a New York firm that helps small banks value illiquid investments, is picking up about 25 new clients per quarter as banks scramble to assess what they own. "Some of these banks that made these investments didn't know what they were buying. Others just bought too much," says Wade Vandegrift, a principal at Red Pine. Last month, dozens of small and regional banks said their financial results were bruised by a deterioration in their securities portfolios. Riverview Bancorp, of Vancouver, Wash., eked out a $343,000 profit, but the 18-branch bank took a $258,000 charge on a pool of securities it holds. First Defiance Financial Corp. had a write-down of $874,000 on four investment pools valued at $2.3 million. Officials at the Defiance, Ohio, bank with 35 branches said it owns even more of those kinds of securities, but their performance is holding up so far. 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. During the buoyant housing market, many of those securities earned top-notch grades from major rating agencies, giving bank CEOs, finance chiefs and treasurers comfort. "A lot of community banks are located in communities that weren't growing, and there wasn't a lot of loan opportunity. They needed some place to invest their money," says J. Stephen Skaggs, president of the Bank Advisory Group LLC in Austin, Texas. So, they snapped up securities. 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. In a process similar to the securitization of subprime mortgages, Wall Street brokerage firms bought the securities from individual banks and packaged them into so-called 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, 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." Related Article FDIC Set to Loosen Rules to Buy Failed Banks Huge holdings of trust-preferred securities doomed six family-controlled Illinois banks that collapsed last month. Their capital ratios tumbled below minimum requirements when regulators forced the banks to write down the value of the securities, says Lyle Campbell, who ran the family's banking business. The six failed banks, three of which opened in the Civil War era, had about $1.38 billion in combined assets. Their collapse is expected to cost the FDIC's strapped insurance fund $267 million. "A lot of these banks had no business buying this stuff," says Ms. Toroian, a former bank analyst. "These are banks that survived the Great Depression, and now they can't survive this financial crisis because they made some bad mistakes in their investment portfolios." Guaranty's push into mortgage-backed securities underscores how easy it was for regional and small banks to double down on their real-estate bets when times were good. Founded in 1938 as Guaranty Building & Loan in Galveston, near the Gulf of Mexico, the institution had swelled to $2 billion in assets and about 30 branches when the Texas real-estate bubble burst. In 1988, regulators declared Guaranty and more than 100 other savings and loans insolvent. Guaranty was brought back from the dead by Temple-Inland Inc., a conglomerate that owned timberland, paper mills, a railroad and a small mortgage company. With government help, the Austin company combined the S&L and two other failed Texas thrifts into a new thrift that was twice as big. By 2005, Guaranty had $18 billion in assets and 150 branches in Texas and California. That year, Guaranty bought nearly $3 billion of triple-A-rated mortgage-backed securities, according to company filings. Its holdings ballooned to $3.2 billion from $420 million a year earlier. A Guaranty spokesman declined to comment. Under pressure from shareholders such as billionaire Carl Icahn, Temple-Inland spun off Guaranty in 2007. The housing market was sliding, but Guaranty didn't waver from its self-confidence. "While the deterioration in the housing and credit markets is clearly significant, and could continue, it is important to note that we did not originate or purchase subprime loans, we have very few 2006 and 2007 vintage single-family mortgage loans, we buy straightforward structured mortgage-backed securities, and lending to home builders is a long-time core competency for us," Guaranty President and Chief Executive Kenneth R. Dubuque wrote in his first shareholder letter. Mr. Dubuque, who stepped down from Guaranty in November, couldn't be reached for comment. All of the mortgage-backed securities Guaranty bought from 2005 to 2007 were created from option adjustable-rate mortgages, which let borrowers decide how much to pay each month. And of the 45 private-label mortgage-backed securities in Guaranty's investment portfolio at the end of 2007, at least 26 were created from loans made by American Home Mortgage Corp., Countrywide Financial Corp., IndyMac Bancorp or Washington Mutual Inc. All of those lenders have since collapsed or been sold because of massive loan losses. Delinquency rates on Guaranty's portfolio jumped to as much as 40% last fall from a range of 4% to 22% in 2007. Last month, banking regulators forced the company to write down the mortgage-backed securities by $1.45 billion, or more than a third of their value in November. The write-downs plunged Guaranty's total risk-based capital ratio, a measurement of its ability to absorb future losses, to negative 5.5%, classifying the bank as "critically under-capitalized." The Office of Thrift Supervision took over Guaranty's board, and the FDIC rushed to find a buyer. Write to Robin Sidel at robin.sidel@wsj.com