It looks like some regional and smaller banks weren’t so immune to problems stemming from securities as conventional wisdom has been suggesting.

You have probably heard that the problems with the smaller banks is tied to bad loans not exotic derivatives. In general, this is probably true, but there is a subset of banks that just bought trouble from their bigger brethren.

From the WSJ:

Federal officials on Thursday were poised to seize Guaranty Financial Group Inc., in what would be the 10th-largest bank failure in U.S. history, and broker a sale of the Texas bank to Banco Bilbao Vizcaya Argentaria SA of Spain. Guaranty’s woes were caused by its investment portfolio, stuffed with deteriorating securities created from pools of mortgages originated by some of the nation’s worst lenders.

Guaranty owns roughly $3.5 billion of securities backed by adjustable-rate mortgages, with two-thirds of the loans in foreclosure-wracked California, Florida and Arizona, according to the company’s latest report. Delinquency rates on the holdings have soared as high as 40%, forcing write-downs last month that consumed all of the bank’s capital.

Guaranty is one of thousands of banks that invested in such securities, which were often highly rated but ultimately hinged on the health of the mortgage industry and financial institutions. “Under most scenarios, they were good and prudent investments — as long as we didn’t have a housing or banking crisis,” says John Stein, president and chief operating officer at FSI Group LLC, a Cincinnati company that invests in financial institutions.

There might be some hyperventilation in this report and, to be sure, the author asserts but doesn’t provide any hard evidence about the number of banks that were buying MBS. To the extent that the securities don’t comprise that big a piece of their overall assets, they can probably weather the storm with a little help from regulatory forbearance.

In the case of Guaranty, the article notes that they went all in on MBS that were primarily backed by option ARMs. All MBS are not created equal and those that have more plain vanilla products are probably not that threatened.

There is, however, another type of security that brought down a family of Illinois banks a month or so ago. They’re called trust-preferred securities and they represent a systemic problem.

Again from the Journal:

Banks also are being battered by more than $50 billion of trust preferred securities, financial instruments that are a hybrid between debt and equity. From 2000 to 2008, more than 1,500 small and regional banks issued trust preferred securities, according to Red Pine data.

In a process similar to the securitization of subprime mortgages, Wall Street brokerage firms bought the securities from individual banks and packaged them into so-called collateralized-debt obligations. The firms then sold slices of the CDOs to investors, marketing them as lucrative but low-risk.

Many of the buyers were small and regional banks, which were confident they could evaluate other banks and attracted to the interest promised by the issuing financial institution.

But as banks struggle with rising loan losses, some issuers of trust-preferred securities no longer can afford their obligations. In the first half of 2009, 119 U.S. banks deferred dividend payments on their trust-preferred securities, while 26 defaulted on the securities.

The consequences are cascading down to banks that bought the securities. One banking lawyer who asked not to be identified describes the result as a “wonderful chain of stupidity.”

What the article doesn’t talk about is that the regulators were complicit in the growth of trust-preferred securities. They pushed banks to shore up their capital earlier in the decade and turned a blind eye to the fact that by allowing other banks to invest in preferred stock of their competitors they were simply sanctioning leverage upon leverage within the system.

Effectively, a bank could issue preferred securities which counted towards its Tier 1 capital ratio and sell it to another bank that could also use the debt to satisfy Tier 1 capital ratio requirements. A daisy chain that’s now unwinding with predictably disastrous consequences.

This crisis arose from a host of sources. Among them are the federal agencies that were charged with avoiding this sort of thing.

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