Fed curbs could have cut small banks' ills

WASHINGTON - The Federal Reserve Board, chastised for regulatory inaction that contributed to the subprime-mortgage meltdown, also missed a chance to prevent much of the financial chaos ravaging hundreds of small- and midsize banks.

In early 2005, at a time when the housing market was overheated and economic danger signs were in the air, the Fed had an opportunity to put a damper on risk taking among banks, especially those that had long been bedrocks of smaller cities and towns across the nation.

But the Fed rejected calls from one of the nation's top banking regulators, a professional accounting board and the Fed's own staff for curbs on the banks' use of special debt securities to raise capital that was allowing them to mushroom in size.

Then-Chairman Alan Greenspan and the other six Fed governors voted unanimously to reaffirm a nine-year-old rule allowing liberal use of what are called trust-preferred securities.

The Fed allowed the banks to count the securities as debt, even while counting the proceeds as reserves.

Banks were then free to borrow and lend in amounts 10 times or more than the value of the securities being issued.

The Fed supervised about 1,400 bank-holding companies, the bulk of them parent companies of community banks.

A four-month McClatchy inquiry finds that the Fed rule enabled Wall Street to encourage many community banks to take on huge debt and to plunge the borrowings into risky real-estate loans.

In a winter 2010 Supervisory Insights report published Wednesday, the Federal Deposit Insurance Corp. confirmed McClatchy's findings.

Sandra Thompson, the FDIC's director of supervision, said that "institutions relying on these instruments took more risks and failed more often than those that did not include the use of" trust-preferred securities.

In its supervisory report, however, the FDIC didn't criticize the Fed directly.

The Securities and Exchange Commission is now investigating how securities businesses hawked some of the complex bonds in a poorly understood, $55 billion offshore market for debt issued by banks, insurers and real-estate trusts - a market that's only now becoming clear.

William Black, a former senior federal thrift regulator, blames the Fed for an overzealous free-market focus.

"The Fed desperately wanted to believe that it didn't need to regulate and could rely instead on private market discipline," meaning banks would avoid taking excessive risks, said Black, now a professor at the University of Missouri, Kansas City.

Instead, he said, the banks were "lending into the bubble" with money generated by the bonds, while other banks lacked the sophistication to assess the perils of buying the complex securities.

Fed officials declined to comment about this regulatory misfire. Greenspan didn't respond to a request for comment.

by Greg Gordon and Kevin G. Hall McClatchy Newspapers Dec. 24, 2010 12:00 AM




Fed curbs could have cut small banks' ills