Banks phasing out 1990s risky securities

In the arcane world of finance, trust-preferred securities were one of the shiny tools of the 1990s that investment bankers once loved before the securities fell into disrepute, just like the subprime-mortgage-backed securities that helped wreck the housing market.

Banks created and sold trust-preferred securities to raise capital without diluting the value of existing stock, with the added bonus that interest payments on the securities to investors would be tax-deductible, unlike dividends that are paid to shareholders.

But now financial reform regulation requires larger banks to phase them out, and a lengthy article for regulators by the Federal Deposit Insurance Corp. notes that the securities did not function well as bank capital, so banks were weaker than they appeared.

"It really is just debt," Tom O'Brien, chief executive of Jericho-based State Bank of Long Island, said of trust-preferred securities. "But you don't mix up debt and equity -- they're two different things."

The Federal Reserve first allowed banks to count trust-preferred securities as the highest form of capital in 1996, and many seized on them as a way to fuel growth.

"This was a cheap way for banks to raise capital," said Mark Curtis, chief financial officer of First National Bank of Long Island, based in Glen Head.

"It always seemed odd to me," Curtis said. "We bought a piece of one issue about five years ago. We held it for about two weeks, and I had buyer's remorse and got rid of it. It's really not capital to me."

But to some, it is. Astoria Federal Savings & Loan, based in Lake Success, has about $128 million of trust-preferred securities on its books as capital.

"I don't know what the problem is with trust-preferred securities," said Monte Redman, Astoria's president. He expressed annoyance that the securities would no longer count as core capital in three years, but he said Astoria had plenty of capital without them. "Trust-preferreds did not cause problems."

Although there's no hard evidence that trust-preferred securities brought down any banks, the FDIC noted that banks that relied on them to raise capital tended to fail more often than those that didn't. That's most likely because such banks didn't use the securities to bolster existing capital as anticipated, but instead used the money to fund ill-advised growth, the FDIC said.

If the Bank of Smithtown hadn't been taken over in November by Connecticut-based People's United Bank, it likely would have been one of those. Shortly before it was bought, Smithtown suspended interest payments on its trust-preferred securities.

"They issued trust-preferred securities to fund excessive growth," O'Brien said. "They didn't use it to build capital."

Because banks were the main buyers of trust-preferred securities, when banks that issued them had problems, they rippled through the industry. If a bank that issued the securities failed, the banks that bought them then had worthless securities.

"A bank failure or default hurt other banks" in such cases, Curtis said.

"I do think the FDIC and the Federal Reserve learned the lesson of unintended consequences on these," O'Brien said. "It's never quite as good as you think it is."