SAN FRANCISCO -- Chalk up another casualty to derivatives: Independent Bancorp of Arizona, the largest start-up in U.S. banking history.
Although some commercial banks have taken serious hits in their derivatives portfolios, banks by and large have not been among the disaster stories.
Phoenix-based Independent Bancorp is an exception, a rare example of a banking concern brought to its knees by derivatives, a story as dramatic as such notorious cases as Piper Jaffray Cos. and Askin Capital Management.
Independent, sponsored by California businessman Peter V. Ueberroth, was launched with great fanfare in April 1992 to buy a package of Arizona branches put up for sale by BankAmerica Corp.
A year later, Mr. Ueberroth's group completed the deal, operating under the name Caliber Bank and setting a strategy of building a Community-based business bank. With $1.7 billion in assets, Caliber was touted by the group as "the largest new bank in U.S. banking history."
It took just another year for the whole thing to crash. As interest rates climbed in 1994, the market value of the bank's derivatives and other securities tumbled, generating about $50 million in losses, slashing shareholders' equity by 35% and prompting federal regulators to step in, according to company disclosure documents.
"They got their heads handed to them when rates started going up," said Robert Feinstein, an investment banker with Friedman, Billings, Ramsey & Co., a firm which helped put together Independent's investor group.
Only an agreement to sell out to Minneapolis-based Norwest Corp. kept shareholders from losing their shirts. The $158.6 million deal, announced last month, will let Independent's investors get out with a small profit.
If a buyer had not stepped in, Caliber probably would have survived but Independent's shareholders undoubtedly would have seen the value of their investments fall sharply.
Analysts say the deal shows Independent might have succeeded had it not been derailed by derivatives.
"The fact that management totaly blew the bank up but could still get someone to buy the thing. and make investors out whole shows-there was something good there," said Stephen Berman, an analyst with NatWest Securities Corp.. the Ueberroth group'S investment bank in the BankAmerica acquisition.
Independent Bancorp officials declined to be interviewed for this article.
In response to written questions, chairman Richard D.C. Whilden provided a brief statement stressing that Independent's experience was not unique: "Many financial institutions manage investment portfolios with embedded or unrealized potential losses," Mr. Whilden's statement said. "Many others have experienced significant real losses in their portfolios."
Derivatives are highly-sophisticated financial instruments whose returns fluctuate with changes in interest rates, currencies or stocks. They are manufactured by slicing up garden variety equities and bonds.
The derivatives that caused Independent trouble were collateralized mortgage obligations, or CMOs, synthesized by separating into parts interest and principal payment streams from pools of home loans.
Because of their hybrid nature, CMOs can be extremely volatile, magnifying the movement of conventional mortgage-backed securities.
Under new accounting rules, banks are required to mark part of their CMO holdings to market value. Paper losses on CMOs held for short-term trading or eventual sale must be charged to earnings or capital.
And regulators at their discretion also can force a bank to write down the value of CMOs even if the bank intends to hold them to maturity.
At the beginning of the year, U.S. banks reportedly held more than $200 billion in CMOs. When mortgage security prices plummeted earlier this year, perhaps hundreds of banks across the country had to take hits.
What made Independent unique was the size of its CMO holdings in relation to its total balance sheet. As a startup with relatively few loans on its books, the bank was forced to put much of its cash into CMOs and conventional securities.
By yearend 1993, CMOs represented 22.5% of Independent's assets. Securities including CMOs represented 43% of assets, creating a balance sheet that looked more like that of a high-risk hedge fund than a commercial bank.
During the first six months of 1994, CMOs generated $30.9 million in paper losses at Independent. The company lost about another $10 million in its portfolio of conventional mortgage-backed securities.
"Securities were such a large part of their total assets," said Mr. Feinstein. "If it had been much less, the losses would have been just a hiccup."
With their eyes focused on building a banking franchise, Independent's managers apparently were caught unaware by their securities losses.
"They still can't explain what happened," said Jon D. Bosse, a manager at ARCO investment Management, one of Independent's shareholders.
As late as last December, the company declared in disclosure documents that "management believes the bank is interest-rate neutral."
Independent didn't begin a program to hedge its derivatives exposure until July 1994, months after most of the damage was done. The inattention stemmed partly from management turnover.
Former Postmaster General Anthony M. Frank, Independent's original chairman and chief executive, was a figurehead who served part time until his departure last December.
Illinois thrift owner Homer Holland, his designated successor, was vetoed for unknown reasons in late 1993 by Federal Reserve regulators, according to people close to the company.
Independent declined to comment and Mr. Holland did not return telephone calls.
As a result, Mr. Whilden, a data systems engineer and Ueberroth associate with no banking experience, became chairman and chief executive last December.
Last month, as it announced the Norwest deal, Independent hired long-time banker Robert P. Keller as its new chief executive.
People close to Independent said the company's investment portfolio strategy was designed in the spring and. summer of 1993 with help from Illinois-based Hawthorne Financial Group.
Steven Bangert, the Hawthorne principal hired by Independent as a consultant on asset/liability management, was formerly chief executive of River Valley Savings Bank, a Peoria-based thrift partly owned by Mr. Holland. In a telephone interview, Mr. Bangert played down his role in devising Independent's investment strategy, describing his involvement as simply "analyzing the interest rate profile" of Independent.
Banks monitor interest-rate risk through asset/liability management which uses a process called gap analysis to compare the time periods at which assets and liabilities change prices in response to interest rate movements.
Mortgage-backed securities are tough to analyze because they don't have fixed maturities since borrowers can prepay their loans, returning principal faster than expected.
When rates rise, prepayments slow and the average maturity of mortgage-backed securities can extend and play havoc with repricing projections.
That is exactly what happened to Independent. As fewer borrowers prepaid their mortgages, the average life of the company's CMOs increased from 4.9 years at Dec. 31 to 6.18 years at June 30, according to disclosure documents.
That threw off badly Independent's risk calculations. The firm originally reported it had a one-year gap of 17.01% at the end of December, meaning that the company had $146 million more assets than liabilities repricing in one. y. ear, .a moderate vulnerability to rising interest rates.
But in August, Independent recalculated its Dec. 31 one-year gap at 26.0%, which it admitted "implies extreme sensitivity to rising interest rates."
Although rates shot up between January and March, Independent was not forced to recognize its paper losses in the first quarter because most of its CMOs were classified as "held to maturity."
But people close to the company say Federal Reserve examiners became concerned that the losses, if realized, would reduce a key ratio of capital to assets below the special 6.5% level imposed on Independent as a startup institution.
The regulators demanded the company write off much of its losses and raise additional capital. Faced with that prospect, Independent chose instead to cut a deal with Norwest.
As part of the transaction, Independent last month sold $529 million in securities, taking a $39 million loss. The company said its remaining securities had $11 million in unrealized losses.
People who have watched Independent from the beginning say Mr. Whilden and his lieutenants are honest, conscientious managers who mostly made the right decisions.
Working with BankAmerica's castoff branches, they had steadily built a name in the community and a book of loan business. But their major mistake was a near-fatal one.
"It's not fraud; it's not criminal," said Mr. Feinstein. "It's just a damn shame because they wasted a great opportunity."
[TABULAR DATA OMITTED]
