MIAMI HERALD: "SHADOW RATINGS" How rating agencies set stage for community bank failures

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 United States 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.

WORTHLESS

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.”

Wrong. Of the 324 U.S. banks that have failed since 2008, 136 defaulted on a total of $5 billion in trust-preferred securities — called TRuPS in industry parlance — that they had 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.

McClatchy Newspapers 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.

TOXIC ASSETS

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 institutions willing to take them.

One failed bank, Riverside National Bank of Fort Pierce, 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 failed and its toxic assets fell to the FDIC, which took over as the plaintiff and continued the suit.

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, 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.