On the advice of its auditors, First Federal Bankshares Inc. in Sioux City, Iowa, took a $4.6 million charge on its pooled trust-preferred securities investments in the fiscal year that ended June 30, but chief financial officer Michael Moderski still is not sure it was the right move.
True, the securities had declined in market value — one pool of investments includes trust-preferreds issued by the since-failed IndyMac Bancorp as well as others that are on ratings agencies' watch lists — but Mr. Moderski questioned why a charge was necessary when the bonds are still paying principal and interest to investors. The $565 million-asset First Federal would only see a loss on the securities if it sold them, he said, and it plans to hold them to maturity.
"I have done the cash-flow analysis," Mr. Moderski said. Though yields on certain tranches of investments are not what they once were, "there is enough overcollateralization and principal that we will get our money back. We feel the bonds are being priced as if it was a forced sale and do not [reflect] the true intrinsic values of the cash flow."
Trust-preferred securities are popular capital-raising vehicles for community banks, and since investment banks eight years ago started pooling them with securities from other banks, thrifts, and financial institutions, community banks have been active investors in the bonds.
However, the credit crisis brought on by turmoil in the housing market has roiled the trust-preferred market of late, and one result is that banking companies nationwide are sparring with their auditors over when and by how much they should write down the value of their trust-preferred investments.
So far, only a handful of publicly traded banking companies have taken charges against earnings, but industry watchers expect more will be forced to do so as auditors take into account ratings agency downgrades.
"I think this whole thing is coming to a head, and the auditors are going to be much more difficult in the third-quarter valuations," said Matthew Kelley, an analyst at Sterne, Agee & Leach Inc. "Clearly there will be many more other-than-temporary impairments taken during the third quarter, and this will start to" affect banks' capital ratios "as balance-sheet adjustments become income statement realities."
Banks that have written down the securities are doing so because their auditors determined that they would fetch far less than what the banks what paid for them if they were sold today.
On Aug. 13 Provident Bankshares Corp. in Baltimore revised its second-quarter results to include a $16.7 million charge that auditors determined it should take on pooled trust-preferred securities. The charge reduced earnings from $15.1 million to $10.2 million for the quarter.
In a press release, Provident chairman and chief executive officer Gary N. Geisel called the revision "frustrating" because "substantially all of the issuers in these securities are paying principal and interest and are expected to do so until maturity."
There is no disputing that market values of pooled trust-preferred securities are declining. This is because some banks have failed and defaulted on payments and other issuers — banks, thrifts, insurance companies, and real estate investment trusts — have deferred payments to preserve capital. (Issuers typically have the option to defer payments for five years.)
Sterne Agee's Mr. Kelley pointed to a report from Fitch Ratings Inc. that showed double-digit deferment rates in some tranches, including one in which 18% of the underlying securities were in deferment.
Still, bankers are at odd with auditors over how much these securities' values have actually declined.
Donna Fisher, the senior vice president of tax and accounting at the American Bankers Association, said a conversation she had with one banker illustrates how far apart they are on the issue.
"The facts are different for all of them," she said, "but this particular bank said cash flows were 95 cents on the dollar but the value the audit firm wanted to use was 50 to 60 cents on the dollar."
Two steps determine the amount of a charge, Ms. Fisher said. First, a bank must determine that a security is impaired, then it must decide how badly it is impaired. The second step is creating the difficulty.
"Some of the audit firms are saying you have to use broker quotes, even if the securities are in illiquid, thinly traded markets," she said. Bankers and auditors "may be getting a broker quote that is trash, [but] you have to use that number."
Other industry watchers agreed that determining what is or is not impaired is tricky because so many factors are relevant, including cash flow, cash-flow modeling, ratings, and trading prices. Complicating matters is that the securities are so rarely sold — especially in the last year as demand has dried up — that it is hard to put a value on them.
"It is sort of gray about what entails 'other-than-temporary'," said Thomas Alonso, an analyst at Fox-Pitt Kelton Cochran Coronia Waller.
Dorsey Baskin, a partner in the professional standards group at Grant Thornton LLP, said auditors could determine a securities tranche to be impaired even if it were still generating interest payments to investors. Banks often do this with their own loan portfolios, he said, when they start reserving for losses on loans that are performing but have the potential to go sour.
"I don't think making payments is sufficient," he said. "You have to look beyond what they have done and look at what you expect it can do in the future. You don't have to wait for the default to know there is an impairment."
Indeed, even if securities are meeting performance expectations now, they could falter as more banks struggling to raise capital opt to defer payments.
"A bank might still be getting cash flow on the principal and interest in August, but another bank could go into deferral, hitting a trigger on the overall pool, and then they don't get a payment in September," Mr. Kelley said. The threat of more deferred payments — not to mention more failures of banks with outstanding trust-preferred securities — caused Moody's Investors Service to downgrade 77 tranches this month to several notches below investment-grade, said Jim Brennan, a senior credit officer. Fitch and Standard & Poor's have not downgraded any tranches but have several on watch lists.
Jeff Davis, an analyst at First Horizon National Corp.'s FTN Midwest Securities Corp., said it is inevitable that more tranches of trust-preferred securities will be downgraded, and that banks will try to hold out before taking charges — if their auditors will let them.
"Banks don't want to take the impairment because it costs capital," he said. "We'll see a number of banks take charges this quarter, but more will take them in the fourth quarter."