It's hardly news that in the run-up to the financial crisis, some banks created highly-toxic collateralized debt obligations, and other banks bought those highly toxic CDOs and put them on their balance sheets. The result was that when the crisis hit, and the CDOs plunged in value, a lot of banks needed to take a lot of write-downs.
Certain banks, however, holding certain CDOs, managed to avoid taking any write-downs, and instead quietly just held on to those instruments, keeping them on their books at 100 cents on the dollar. Essentially, they bought complex financial instruments, and then treated them for accounting purposes as though they were their own loans, being held to maturity, which therefore didn't need to be marked to market. And regulators allowed them to get away with it - until now.
Nick Dunbar has a very good explainer of what's been going on with these CDOs - specifically, the ones which include obscure creatures known as trust preferred securities. And Floyd Norris has the best short description of exactly what TruPS are, and how they became CDOs:
Trust-preferred securities became popular with bank holding companies in the 1990s because bank regulators allowed them to be treated as capital by the issuing bank, just like common stock, but they were treated as debt securities by the Internal Revenue Service, allowing the issuing bank to deduct interest payments from income on its tax return. The C.D.O.'s were created to allow many small banks to issue such securities, with the buyers reassured by the apparent diversification.
These gruesome instruments actually helped some banks get through the crisis: if you issued TruPS, then you could (and almost certainly did) suspend interest payments for as long as five years, without penalty. But we're now getting to the end of that five-year period, and, as Norris says, "it is unclear how many of them will be able to make back payments before the periods end this year and in 2015." Which means that TruPS CDOs, like many other financial innovations of the 2000s, have notably failed to bounce back to their pre-crisis valuations.
As Dunbar says, these things have no place on banks' balance sheets. And, gloriously, the Volcker Rule has ensured that they're being kicked off those balance sheets. (Better late than never.) Under the rule, CDOs of TruPS are categorized as a "covered fund," which banks aren't allowed to own.
The problem is that certain banks, most notably Zions Bancorp (NASDAQ:ZION), still own billions of dollars of these things, and have never written them down. If and when they do so, they're going to have to take hundreds of millions of dollars in losses. And so out come the lobbyists - and out come the silly pieces of legislation, seeking to create a massive carve-out from the Volcker Rule, which would allow Zions and others to hold on to these TruPS CDOs indefinitely.
Even if your goal is to keep the TruPS CDOs on banks' balance sheets, this legislation is a dreadful way of doing so - since, as Norris notes, the proposed law goes much further than that, and effectively allows banks not only to hold the old instruments, but even to create brand-new ones. Talk about not learning our lesson. But in any case, Zions and the other banks which bought these instruments should, finally, be forced to rid themselves of them. Zions is never going to be happy about taking a loss, but now's not a bad time for banks in general to be taking losses. And frankly, all of these gruesome CDOs should have been jettisoned from banks' balance sheets years ago. Let's hope this legislation goes nowhere, and that these ugly reminders of pre-crash "financial innovation" finally start being held by buy-siders who mark to market, rather than by banks claiming that they're worth 100 cents on the dollar.
Disclosure: No positions.