NEW YORK — Billions of dollars in top-rated bonds backed by community banks have gone bust, debunking the defense offered by credit-rating agencies that wildly inaccurate ratings were limited to risky mortgage bonds that imploded and then triggered the U.S. financial crisis.
Government regulators and lawyers across the country are examining how credit-rating agencies came to bless as "investment grade" the now-toxic bonds made up of special securities issued by community bank holding companies.
During the go-go years preceding the December 2007 start of the worst modern recession, more than $50 billion of these special securities were floated by community banks and pooled into complex instruments called collateralized debt obligations, or CDOs.
From 2000 to 2008, Moody's Investors Service rated at least 103 of them, valued at $55 billion, issued by banks, insurance companies and real estate investment trusts.
Today, many of these securities are virtually worthless.
Questioned by the Financial Crisis Inquiry Commission on June 2 in New York, Moody's Chief Executive Raymond McDaniel insisted that "the poor performance of ratings from the 2006-2007 period in residential mortgage-backed securities and other related securities, housing-related securities, has not at all been replicated elsewhere in the business."
Of the 324 U.S. banks that have failed since 2008, 136 of them defaulted on a total of $5 billion in trust-preferred securities — called TRuPS in industry parlance — that they'd issued to raise capital.
These securities were popular because their issuance didn't dilute an issuer's share price, unlike preferred stock. And the dividends paid on the securities were tax deductible for the issuer.
Through the Freedom of Information Act, McClatchy learned that at least 36 failed banks have transferred more than $1 billion in bonds backed by trust-preferred securities to the Federal Deposit Insurance Corp.
And with small 860 banks on the FDIC's "watch list" as of Sept. 30, indicating risk of failure, it's clear that even more of these toxic assets may flow to the FDIC, which is unable to find other institutions willing to take them.
One of the failed banks, Riverside National Bank of Fort Pierce, Fla., brought a suit against Moody's and its two competitors, alleging that Moody's as a result of "undisclosed conflicts of interest fraudulently and/or negligently assigned inflated 'investment grade' ratings to the CDOs" that are worthless today.
Riverside eventually failed and its toxic assets fell to the Federal Deposit Insurance Corp., which in an unusual move took over as the plaintiff and continued the suit.
Moody's declined to comment.
Previous reporting this year by McClatchy revealed how the Moody's board of directors asked little about the business division that drove profits and eventually destroyed the company's reputation. A McClatchy report in late 2009 revealed how executives in charge of rating structured finance products — those involving sliced up, pools of loans, bonds or securities — took control of Moody's executive suite.
During several public hearings this year, former analysts at Moody's, which dominated the business of rating complex bonds, testified that they were pressured by superiors to maximize their revenues, even if it meant providing dubious ratings.
It's why McDaniel's testimony is so damning in its assertion that ratings problems were limited to mortgage bonds, and brought by outside factors.
"This (collapse in trust-preferred CDOs) has nothing to do with mortgages at all, and yet you still have had this massive impact and this massive failure," said a former Moody's senior analyst who alleges he was pressured to provide inaccurate ratings.
The analyst, who insisted on anonymity for fear of litigation, said there's a fundamental flaw in the way these securities were rated. Moody's provided what were called "shadow ratings," one-time ratings issued about the health of the bank that weren't continually monitored and instead represented a snapshot in time.
Armed with these "shadow ratings," investment banks then pooled the securities into different layers of risk, offering investors slices of the pooled securities broken down into differing risk levels. Hedge funds and big pension funds often took the portions rated highest and thus perceived to be of least risk.
Less sophisticated buyers took out the riskier portions, which offered the higher returns.
"There are small banks who are buying some of the most sophisticated and difficult to analyze securities. Many of our clients didn't seem to have clear appreciation for the risks they were assuming," said Gene Phillips, the director of PF2 Securities Evaluations Inc., a New York firm that provides independent valuation of complex financial instruments. "And yes, the only thing they're relying on is the rating and perhaps the promises made to them by the" investment bank salesperson.
A former high-level Moody's executive involved in the "shadow ratings" process, who requested anonymity to protect his new job outside Moody's, acknowledged that the "shadow ratings" enabled Wall Street to aggressively market the securities as safe bets.
Community banks began issuing trust-preferred securities in earnest in 2002, but there wasn't much of a track record. To guard against risk, rating agencies, which worked side by side with Wall Street banks to develop the pool of securities, insisted on geographic diversity.
The thinking was that if pools contained securities issued from a mix of banks across the country, there'd be less risk involved.
It proved to be a fatally flawed logic, since so many of the community banks made poor lending decisions or overextended themselves on construction loans that eventually blew up their banks.
"I have no idea how the rating agencies were ever able to get comfortable not only putting a rating on it, but calling it AAA," said a former top executive at a now defunct Wall Street investment bank that was a big promoter of these complex CDOs.
Speaking to McClatchy on condition of anonymity to protect his reputation, this executive said that investment banks and raters were both chasing profits.
"Moody's was like every other business. They were put under tremendous pressure to do this business because it was by far their highest margin business," the executive said.
The investment-grade rating provided by Moody's and its smaller competitors was an essential element in the boom, and later bust, of trust-preferred securities.
One former chief financial officer of a failed Midwest community bank sunk more than $50 million of his bank's investment portfolio into CDOs backed by the special securities.
Demanding anonymity for fear of litigation, this official told McClatchy the ratings were a key reason he bet so heavily on a product that seemed safe because they involved securities issued by community banks like his.
"We relied on a lot of the stuff that they were providing us in terms of who the issuers are, their analysis in terms of loss rates. I wasn't cranking cash flows but was relying on their information," said the former finance chief, adding there was a limited amount of due diligence he himself could do on a complex bond.
Investors in the bonds didn't know who else bought into these complex securities or how big a slice they took.
"It was heavily weighted on the rating agencies," said the official, who bought into securities with an investment-grade A rating though that turned out to be junk, bringing down his small bank. The rating "definitely helped. That was definitely one of the facts that made us comfortable with the (securities) that we had."
The finance chief of a South Carolina community bank also got burned by CDOs containing pools of trust-preferred securities. Around 2005, he invested in the securities as a way to raise capital for future lending, and he's lost about $7 million on the bets.
"They were perceived to be very safe instruments, and it was a way to diversify your investment portfolio," said the executive, who asked that his name not be used because he didn't want to attract negative attention to his healthy bank.
In hindsight, he now thinks the ratings provided a false comfort level.
"I think once you started digging down into the banks, I think that's where it was the eye opener. For your investment portfolio, it was just too complex," the banker said.
And that's why the battle is now in the courtroom.
Moody's and its competitors have traditionally escaped liability for failed ratings on the grounds that they enjoy First Amendment rights that protect free speech. They provide an opinion to investors, thus it amounts to exercising protected speech.
On Dec. 11, a California state judge reaffirmed those rights in a case brought by the California Public Employees Retirement System involving a different complex financial product.
But in a move that heartened other potential litigants, the judge left the door open for CALPERS, the largest U.S. pension fund, to continue portions of the suit alleging illegal behavior. It allows CALPERS attorneys to seek some potentially key documents and information from Moody's.
The scope of lawsuits is likely to only widen because buyers of complex securities aren't taking their losses lightly.
For example, insurance giant Allstate is reviewing all of its purchases of complex financial instruments with an eye toward litigation. From 2001 to 2005, it bought eight trust-preferred CDOs — a fraction of Allstate Investment's total portfolio — that have gone bad despite being given AAA or AA investment-grade ratings.
"There are people lining up to start suing," said Tom Wilson, Allstate's chief executive, told McClatchy. "I don't think we're alone."
MORE FROM MCCLATCHY
For more McClatchy politics coverage visit Planet Washington
McClatchy Newspapers 2010