The problems with hybrids - a boom time favorite - come home to roost

The Wall Street Journal notes that these securities, a blend of equity and debt, helped fell six family-owned Illinois banks last week, leaving the Federal Deposit Insurance Corp. on the hook for an expected $267 million.

The rationale for investing in hybrids - or in this case sliced and diced hybrids packaged into collateralized debt obligations - is painfully familiar: a high credit rating, attractive returns, and the belief that any lingering risk had been sufficiently dispersed through the miracle of securitization.

In hindsight, it’s easy to see what went wrong and wag fingers at the misguided investment strategy of some regional banks. But when taxpayer money is on the line, something more radical is needed to ensure that the next newfangled financial product doesn’t require the FDIC, and by extension the taxpayer, to swoop in and save the day.

The answer? Make banking boring, very boring.

The FDIC insures deposits at more than 8,000 banks, and its reassuring presence has prevented depositor panics, even though 52 banks have failed this year alone. But it hasn’t prevented banks from making some bad investment decisions.

Take the hybrids, known more formally as trust preferred securities. The six failed Illinois banks and two others owned by the same family started gobbling up hybrids in 2005, according to the Journal, as a means of juicing profits. They weren’t alone.

These securities were championed by a host of investment banks as a safe way to boost returns at a time when the premium on other conservative investments like bonds hovered around its historical low.

The catch with hybrids is they are part stock and therefore more vulnerable than debt to losses should the issuers (largely bank holding companies) get into trouble. They also allow the issuing banks to suspend the dividend.

This little detail, while known by all during the boom years, was downplayed, since few thought the issuing banks would ever run into serious trouble. This was another widely held assumption the credit crisis quashed.

If deposits are protected by the federal government, then the banks using those deposits to turn a profit should be required to invest them in easy to understand and relatively safe assets. That means nothing more exotic than Treasuries, or government agency securities, or the billions of dollars worth of other debt backed by Washington.

It would at least help solve the issue of moral hazard that has cropped up with all FDIC-insured banks, not just the “too big to fail’’ ones, and give the federal government breathing room to concentrate on the much more complicated issue of fixing large banks that could take years to sort out.

Agnes T. Crane is a Reuters columnist.