The last thing a community bank suffering from bad loans needs is a downgrade on its investments.
But that is exactly what many banks are getting, and for some of them, the downgrades are enough to threaten their survival.
Take the $525 million-asset First Federal Bankshares Inc. of Sioux City, Iowa. It might have found an investor to help boost its capital by the $5 million it needed after running into loan trouble. But in recent weeks the rating agencies downgraded all 14 of the pooled trust-preferred securities it owns, triggering a significantly higher capital requirement.
Now First Federal needs a cash infusion of about $20 million.
"The downgrade got us," said Levon Mathews, its president and chief executive officer.
Many banks have invested in such securities, but some are feeling squeezed to a higher degree than others.
The issue is particularly troublesome for those like First Federal that already had their capital thinned by deteriorating loan quality.
"As long as we continue to see downgrades on these securities, we are going to see more problems," said John Keyser, national director of financial institution services for McGladrey & Pullen LLP. "We will see more banks go from well capitalized to adequately capitalized."
The hit goes deeper than the impairment charge a company must take when writing down the securities to fair-market value, said Michael Iannaccone, the president of MDI Investments Inc. in Chicago.
"Not only are you taking the impairment hit, you need more capital to hold against it," he said.
John A. Hall, the president and CEO of the $858 million-asset Rainier Pacific Financial Group Inc. in Tacoma, said a downgrade changes how any type of investment is perceived on the balance sheet, but for pooled trust-preferred securities, the changes can be dramatic, because of how the risk-weighting formula works.
Those securities are always carried at their full value, he said, but when downgrades happen, the risk weighting increases beyond the initial value.
Rainier has $108.2 million of trust-preferred securities, all of which Moody's Investors Service Inc. downgraded in March. As a result, the risk-weighting formula requires Rainier to hold the same amount of capital against those securities as it would for $428.1 million of assets, or nearly fourfold the securities' actual par value.
"It is a difficult set of rules, and we are all working closely with the regulators on it," Hall said. "We are doing our best to address it, but it has put us in a difficult position."
Hall said he knew of at least a handful of other firms going through the same heartburn, but Iannaccone said the scope of the problem is much larger than that, because community banks have been major buyers of trust-preferred securities.
First Federal has $65 million of the securities, which had been written down to $28.3 million as of the fourth quarter.
Mathews said that the current value of the securities and any writedowns the company may need to take are still being evaluated.
But under the risk-weighting formula, the securities must be treated as if they were worth $433.8 million, or 6.5 times their initial value, according to a securities filing. This greatly impacts the amount of capital that must be set aside to cover the assets.
First Federal has spent months trying to rebuild its capital, which had been depleted by problems in its construction loan portfolio. So far it has trimmed expenses and sold a branch. It also has hired Sandler O'Neill & Partners LP to help it explore ways to raise capital, including finding private investors and selling assets and branches.
Mathews would not specify how much his company is seeking from investors. In a securities filing, it said it has a letter of intent for a "significant" infusion from a private-equity group.
The downgrades have not derailed those negotiations, Mathews said.
However, the amount of capital First Federal needs has increased. In December it signed an informal agreement with the Office of Thrift Supervision to achieve a risk-based capital ratio of 12% by Sept. 30. That would have required it to raise about $5.1 million, Mathews said earlier this year.
But last week the company reported a 5.3% total risk-based capital ratio at its Vantus Bank — a level regulators view as significantly undercapitalized.
Judging by that, Iannaccone estimated First Federal would need about $20 million.
Observers said they doubt the private-equity firm would bow out because of the downgrades, but they said the likelihood of increased regulatory scrutiny could prompt it to seek better pricing.
"Given the amount of due diligence, it is likely that the private-equity group knows about the value of those holdings, but that doesn't mean that they won't use this to drive a harder bargain," said Theodore Kovaleff, the president of Informed Sources Service Group in New York. "The question then becomes how much space does the bank's board of directors have behind them before there is a wall."
Rainier, which lost $4.6 million in the first quarter after an $8.5 million other-than-temporary impairment charge related to its securities, is also operating under a regulatory order. It has until June 19 to submit a capital restoration plan to the Federal Deposit Insurance Corp.
In April, Rainier said it intended to preserve capital by slowing loan growth, selling assets, reducing expenses and eliminating its dividend. It has hired KBW Inc.'s Keefe, Bruyette & Woods Inc. to explore capital-raising alternatives.
Hall said his company would need an infusion of $40 million to $60 million to plug its capital hole, or it would need to merge with an institution with a similar amount of excess capital.
He said he is hopeful investors will take into consideration that its trouble is with securities, not loans.
"We are not plagued by major credit problems, so they can see what they are getting because of markdowns we've taken on these securities," Hall said. "That's a distinction that investors should make. Our hope is that they can isolate out those problems and see the underlying value of the franchise."
Others voiced skepticism about whether investors would look more kindly on securities problems.
"They view it all as garbage," Iannaccone said. "It might be a better grade of garbage, but it is still garbage."
Tim Coffey, an equity analyst for FIG Partners LLC in San Francisco, was not optimistic about Rainier's prospects, either.
"They certainly have their work cut out for them," he said. "Operations are going to be challenged, to say the least."
Coffey pointed out that the issuers of the trust-preferred securities are largely banks, so any improvement in the financial services sector could result in improved valuations. However, it would then become a race against the clock for those affected.
"This could prove to be a near-term issue," he said. "But they may not be around long enough to see it resolved."