July 2 (Bloomberg) -- Mountain 1st Bank & Trust Co. Chief Executive Officer Greg Gibson forecast 12 percent loan growth for his North Carolina bank this year. Instead, he's spending more time handing out freshly baked cookies than extending credit.

Gibson is ``standing on the brakes'' because Mountain 1st, owned by 1st Financial Services Corp. of Hendersonville, North Carolina, can no longer sell trust-preferred stock to raise capital for loans so customers can buy airplanes or build veterinary clinics, Gibson said in a June 20 telephone interview. The bank, with $650 million in assets, is among more than 8,000 across the U.S. caught for the past six months in the shutdown of the $117 billion market for the securities, a hybrid of debt and equity.

The fallout from the subprime-mortgage collapse is spreading from global lenders such as Citigroup Inc. and UBS AG to local ones, including Lansing, Michigan-based Capitol Bancorp, FirsTier Corp. of Northglenn, Colo. and Mountain 1st, which tempts customers at log cabin-style branches with cookies and coffee. Less capital for such hometown banks may stymie Federal Reserve Chairman Ben Bernanke's effort to prevent a credit crunch.

``There is no question there is a problem,'' said Chris Cole, senior regulatory counsel for the Independent Community Bankers of America, a Washington-based trade group for about 5,000 lenders. ``Banks need the capital to lend. So that problem of raising capital causes a further slowdown. This inability to raise capital points to a damping of the whole economy.''

10-Fold Growth

So-called community banks and larger lenders have sold trust-preferred securities, known as TruPS, for about a dozen years. Collateralized debt obligations became the biggest buyers, generating enough demand to expand the market 10-fold, according to Merrill Lynch & Co. index data. The CDOs packaged the shares and sliced them into pieces with varying credit ratings.

Community banks such as FirsTier were too small to attract insurance companies or mutual funds and sold the securities to CDOs instead, in issues of $10 million or $20 million at a time, according to Fitch Ratings analyst Nathan Flanders.

The market was upended after mortgage foreclosures reached a record high of 2.47 percent for all loans in the U.S., starting a credit-market meltdown that sent investors fleeing to safer government securities.

As the preferred market seized up, the Standard & Poor's Small Cap Regional Banks Index has fallen 34 percent this year, leaving banks unable to sell common stock without diluting existing shareholders. Cut off from fresh capital, some lenders may file for bankruptcy, according to ICBA's Cole.

Too Small

Trust-preferred shares were attractive to banks because dividends are paid out of pre-tax income and may be suspended without penalty. The stock is considered Tier 1 capital, a lender's most basic layer.

U.S. banks can lend $12 for every dollar raised through the securities, so $100 million of the preferred shares may become as much as $1.2 billion in credit, based on Basel I banking rules.

Only 10 banks out of about 2,000 issuers halted dividends in the seven years ending in September, and all but two resumed distribution, according to Flanders.

Since September, 23 banks, including Pasadena, California- based IndyMac Bancorp Inc. and Omni Financial Services Inc. of Atlanta, stopped making preferred-stock dividend payments. IndyMac has fallen 89 percent and Omni 81 percent this year.

`Extremely Skittish'

Omni's chief financial officer, Shaun Williams, who said in a regulatory filing that he would resign on July 18, didn't return a telephone message. Katie McFadzean of the MWW Group, a public-relations firm representing IndyMac, declined to comment.

``The investment community is now extremely skittish about the magnitude of future mortgage losses and that is damping demand for raising capital through this particular channel,'' said Richard DeKaser, chief economist for Cleveland-based National City Corp.

Billionaire investor Wilbur Ross is looking to buy regional banks that fail during the coming crisis. Ross said he plans to wait until after the government cleans up the banks' balance sheets.

``The regional banks will have a harder time than the large ones getting capital,'' Ross said in an interview yesterday. During the 1990s savings and loan crisis, ``we lost 2,600 banks, but we still have 8,000 left. We'll lose another 1,000 or so this time.''

No Golf

Mountain 1st was founded in 2004 in western North Carolina's Smoky Mountains. The bank had planned three months ago to sell its first issue of trust-preferred shares, said Gibson, a 51- year-old certified public accountant who served as an executive at 12 other lenders prior to his current job.

The sale of $8 million to $12 million of shares to finance expansion has been shelved for now, said Gibson. A $10 million issue can support $120 million in loans, he said. That's equivalent to about 20 percent of the bank's assets.

``The market went from wide open to the spigot getting turned off,'' Gibson said. ``I can't recall a market as deep and as wide as this one go to nothing as this one has.''

Without access to the trust-preferred market, the bank has quit lending for building lots, golf courses and second-home developments, Gibson said.

If the market doesn't open up soon, the bank's parent may sell a different form of security in August, convertible trust- preferred shares paying a dividend of 8.5 percent to 9 percent and carrying an option to buy common stock at 1.7 to 1.9 times book value, Gibson said. Investors would gain if the price rises to its historical multiple of 2.5, he said.

The shares would be marketed to current holders, he said.

Fueling Growth

``Banks were using trust-preferred to fuel balance-sheet growth,'' said Mark Evans, executive vice president of ICBA Securities, a unit of the community lenders' trade group. ``If you cut off the supply, you curtail the growth.''

FirsTier, started by Joel Wiens in Nebraska in 1963, sold three trust-preferred issues since its founding in 2003. All were placed in CDO transactions by Bear Stearns Cos., said Len McIlvennan, the company's chief financial officer. Bear Stearns was bought by JPMorgan Chase & Co. last month in a bailout arranged by the Federal Reserve.

``It was so easy to create a trust-preferred security before,'' he said. ``Now you can't get in the market, so now you're out of luck''

About $46 billion of trust-preferred CDOs were sold since 2000, Flanders said. None has been created since November. Flanders said May 21 that he may downgrade parts of 59 CDOs because so many banks had defaulted or deferred dividends.

Moody's Investors Service said today that it will review all CDOs backed by bank trust-preferred securities, according to a report by analysts John Park and James Brennan.

Market Dead

``Clearly, the market is moribund, or, if that's not the right word, dead,'' said John Duffy, chief executive of KBW Inc., a New York-based investment bank that sold a CDO of trust- preferred securities about once a quarter last year.

Investors bought trust-preferred CDOs under the assumption that multiple lenders wouldn't suspend dividends simultaneously, said Joshua Rosner, a managing director at investment-research firm Graham Fisher & Co. in New York, who's working on a paper about the bank securities.

If the economy worsens, lenders' inability to obtain more capital means they'll face ``selling themselves, merging, raising dilutive equity or blowing up,'' he said.

Along with a possible sale of convertible shares, Mountain 1st's Gibson says he's trying to boost deposits to fund loans.

``We're still growing,'' said Gibson, ``We want to. Business is too hard to come by. You can't totally kill it, not just shutter the windows and bolt the doors.''

To contact the reporter on this story: Mark Pittman in New York at mpittman@bloomberg.net

Last Updated: July 2, 2008 17:21 EDT