Turns out mortgages weren’t the only toxic assets Wall Street decided to package into CDOs. Small community banks issued billions of dollars in trust preferred securities before the credit crunch as a way to prop up their capital cushions. Problem was, the only way they could sell the so-called TruPS to investors was to combine them with other trust-preferreds in CDOs.

Now, those CDOs, which were purchased by some of the same small banks that issued them, are beginning to default, leading to a downward spiral of losses for banks. A provision in the new financial reg bill passed by the Senate forbids counting TruPs as Tier 1 capital. If it passes, smaller banks could be forced to raise $130 billion to meet capital requirements or sharply curtail lending. (Big banks like Citigroup have issued trust preferred's for a long time, but most of those were not packaged into CDOs.)

Not surprisingly, the banking lobby is fighting the provision. But that could be tough given the FDIC and Sheila Bair support the proposal. There’s also this:

TruPS CDOs are also at the heart of a series of lawsuits brought by the liquidation trustee for Northbrook, Illinois- based Sentinel Management Group Inc., a cash-management firm that collapsed in 2007. The trustee sued First Horizon, KBW and Cohen & Co., a Philadelphia-based securities firm affiliated with a family involved in almost half of such CDOs, saying their bankers bribed a Sentinel employee with Super Bowl tickets, strip-club visits and dinners at restaurants such as Tao in New York to get him to buy risky low-ranking slices of the CDOs.

Banks in ‘Downward Spiral’ Buying Capital in CDOs [Bloomberg]