Friends of community banks should be saddened rather than gladdened by the results of a new study showing that these institutions are likely to curb sharply their use of derivatives.
The survey, conducted by Grant Thornton, an accounting and management consulting firm, reports that nearly one-third of the 800 responding banks that have purchased derivative securities in the past think they will not make similar investments in the future. According to the study, 82% of responding community banks have invested in mortgage-backed securities, collateralized mortgage obligations, and structured notes in the past. But only 58% of these organizations feel they will invest in such securities in the future.
To many observers, including this columnist, that is not good news.
Sure, we have seen disaster stories about the use of derivatives. The impact of such obligations on Orange County, Calif., Procter & Gamble, Barings PLC, and others have made many bank boards extremely wary about using such securities themselves. And many portfolio managers have become hesitant to use them because of career risk. If the use of derivatives brings added profit, this is considered to be part of the normal performance expected. But if a loss results, after all the recent adverse publicity, there is good likelihood the officer's career will suffer a severe setback.
So to many independent institutions, derivatives have become a no-no, even though Alan Greenspan has stated that by the new century virtually all banks will be using them.
What has been forgotten in so much of the commentary on derivatives is that basically they are intended to be means of curbing risk rather than augmenting it.
A futures contact for securities or commodities has as its goal offsetting the risk of price fluctuation that is involved in buying or selling in day-to-day business.
Here is a simple example:
A parent of a child going away to college signs a contract for board for the coming year. If food prices go up, the school has no recourse for additional funds. And if food gets cheaper, certainly the parent will not get a refund. Thus the school is "short" food for the year.
To avoid risk, some colleges buy pork belly futures - a derivative representing the average price of food. If food gets cheaper, they make it on the student, but lose it on the pork bellies, and vice versa. The key is that the school is balanced, so no food price change in either direction can cause it financial loss.
Sure, the school gives up a chance for financial gain, but it wants to avoid risk in feeding the students, not make a profit on them.
A bank is similar. For example, it wants no unpleasant surprises if interest rates change. So it may buy an inverse floater, a derivative whose yield goes up if interest rates fall and the bank otherwise would be stuck with fixed-yield deposits and variable yield assets.
So where does the trouble develop?
It comes when the institution does not use derivatives to balance a position, but rather to be in on a price movement.
Buying a derivative whose value goes up as interest rates move is no different from betting on a bond or stock. Only because of the low margin requirements, many speculators found they could take much larger positions than in the past.
The very fact that some investors, like Mr. Citron in Orange County, did so much better than the market for a while shows that he was gambling. For there is no way to beat normal returns other than speculating on price movements.
To blame the derivative for the loss is like blaming the bat for hitting the man over the head.
Diane M. Casey of Grant Thornton puts this in perspective when she comments that two-thirds of the community banks surveyed still plan to use derivatives. This shows that derivatives have a valid purpose. It is just a matter of understanding what you are buying before you put up your money.
"If it takes more than five seconds to explain it, we don't touch it," is the way one banker responded. To which one can add the old saying, "If it looks too good to be true, it is."
The key lesson for community banks is that just because the big boys do something doesn't mean that it is right or wrong for the independents. Investment officers at a number of money-centers and superregionals lost money on derivatives, just as some community banks did. And many other community banks have done just fine in using derivatives as a hedge and using mortgage-backs and CMOs as a regular investment in which added yield, rather than any windfall profit, was the goal.
To give up an instrument just because some player misused it would be like announcing, "If the giants can possibly lose money in this instrument, then we are bound to do so."
And, as anyone who has studied the success of community banking in today's competitive environment well knows, this is patently just not true.
Mr. Nadler is a contributing editor of the American Banker and professor of finance at the Rutgers University Graduate School of Management.
