25 May 2010

Toxic CDOs Beset FDIC as Banks Fail

The Wall Street Journal

The FDIC has inherited hundreds of potentially worthless bonds that have come back to haunt the Wall Street firms that sold them, the credit-rating firms that graded them and the hundreds of small banks that bought them.

The Federal Deposit Insurance Corp., and by extension the U.S. taxpayer, owns more than 250 collateralized debt obligations that were purchased by small institutions that later failed. Although the bonds have a book value of more than $400 million, they are a headache for the agency as it grapples with the toxic assets flowing from many banks around the country.

"We're getting more of [the CDOs] all the time," said Miguel Browne, an assistant director in the FDIC's division of resolutions and receiverships. The agency has inherited such securities from about two dozen banks that have failed in the current crisis, including Omni National Bank in Atlanta, Venture Bank in Lacey, Wash., and San Diego National Bank.

The FDIC's mountain of bad securities has grown even bigger in recent weeks following the failure of Riverside National Bank of Florida, a small firm that had stuffed its investment portfolio with 27 CDOs known as trust preferred securities. Although it was a community bank with 58 branches in Florida, its pile of CDOs has almost doubled the notional value of bonds owned by the federal agency.

Now, in an unusual move, the FDIC may be preparing battle back directly. It has asked a New York court for permission to replace Riverside as plaintiff in a six-month-old lawsuit in which the bank accused more than a dozen financial firms of misrepresenting the value of the CDOs.

The FDIC's focus on CDOs comes at a time when the financial instruments are being scrutinized by regulators and prosecutors. Several Wall Street firms, including Goldman Sachs Group Inc. and Morgan Stanley, have attracted particular attention in recent weeks for what they told investors about the nature of the CDOs when the initially sold them.

The problem is that it is difficult to pin down the value of something for which there may be no market. According to FDIC estimates, that the book value of the CDOs that the agency now holds is more than $400 million. But "a lot of these things will have little or no market value," Mr. Browne said.

The agency hopes to auction off any CDOs that have value this summer. If it can't unload them, the FDIC could be forced to write off their value, saddling taxpayers with the losses.

Many of the 200 bank failures since the beginning of 2009 have been accelerated by losses in trust preferred securities, which are a hybrid between debt and equity. More than 1,500 banks issued such securities between 2000 and 2008 after regulators ruled that they could be counted as capital, making their balance sheets appear healthier.

Wall Street brokerage firms then bought the securities from individual banks that had issued them and packaged them into CDOs. The brokerage firms then sold slices of the CDOs to other small banks. Community banks bought roughly $12 billion of these trust preferred CDOs between 2000 and 2008, according to Red Pine Advisors LLC, a New York firm that values illiquid investments.

Riverside, based in Fort Pierce, Fla., bought 27 trust preferred CDOs with a book value of $211 million between 2005 and 2007. Only two of those CDOs revealed the underlying collateral the investments relied upon, according to a lawsuit that Riverside filed last year in New York Supreme Court. It bought the securities from Wall Street firms, including Merrill Lynch, which is now owned by Bank of America Corp., FTN Financial, a unit of First Horizon National Corp., and boutique financial-services firm Keefe, Bruyette & Woods Inc. Defendants also include McGraw-Hill Cos., which owns credit-ratings firm Standard & Poor's, and Moody's Corp.'s Moody's Investor Service; the suit says that the credit raters determined the CDOs to be investment grade when they weren't.

When the financial crisis struck, the banks that issued CDOs couldn't afford to make interest payments on them. Credit-rating firms then downgraded the securities, battering their value.

That dealt a blow to Riverside, which was already stumbling under the weight of soured loans. Its CDOs dropped an average of 11 rating levels within four years. Its portfolio of trust preferred securities dropped more than 60% to $79 million by the end of 2009, according to the lawsuit.

Riverside has sued more than a dozen firms that sold it the trust preferred securities, saying they were "based on inflated investment-grade ratings, undisclosed material conflicts of interest," among other misrepresentations, according to the lawsuit.

"We believe we have meritorious defenses in this matter and intend to defend ourselves vigorously," said a spokesman for First Horizon. Representatives of KBW and Merrill declined to comment.

"We believe the claim has no legal or factual merit," said an S&P spokesman. A Moody's representative declined to comment.

But in a motion to dismiss the case, the defendants said Riverside's losses "result from the risks it knowingly assumed and from the unprecedented market cataclysm, rather than any flaw in the specific CDOs at issue here."

When Riverside failed last month, Toronto-Dominion Bank of Canada acquired the most valuable pieces, including its branches, $2.76 billion in deposits and most of its $3.42 billion of assets. The Canadian bank left the trust preferred securities to the FDIC, which also inherited Riverside's lawsuit.

Earlier this month, the FDIC filed a motion to replace Riverside as plaintiff in the case. The agency also is seeking a 90-day stay in the case as it tries to determine what the CDOs are worth.

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