How the Fed let small banks take on too much debt, then fail

Greg Gordon and Kevin G. Hall
McClatchy Newspapers

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 mid-sized 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.

This was like a magic bullet for community banks that had few ways to raise capital without issuing more common stock and diluting their share price. 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.

Data emerging from the carnage of collapsed and teetering banks leaves little doubt that the Fed rule, and regulators’ failure to adequately police the issuance of these securities, created big cracks to the already shaky foundations of the nation’s banking system.

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