WEEKLY ADVISER: In Categorizing Securities as 'Held to Maturity,' Look

Bankers, and community bankers in particular, have a major decision to make on their portfolios under FAS 115, the new accounting regulations covering investments.

Should you place securities in the "available for sale" category and have them, as stated, available to be sold whenever it is beneficial to the bank? Or should you place them in the "held to maturity" category, which means you plan to keep them until they are paid off.

This would be an easy decision if accounting were not involved. Any banker worth his salt would want to have the freedom to sell securities anytime it is beneficial to do so. By holding them to maturity the bank loses the opportunity to liquidate them if loan demand increases.

Equally important, it cannot take advantage of opportunities to take losses and reinvest for higher annual income when rates rise.

Why, then, would a bank keep its bonds in the "held to maturity" category?

The answer: If the bank keeps its bonds in the "held to maturity" category, it does not have to write them down as interest rates rise. If it holds them as "available for sale," it must mark to market quarterly, thereby causing capital to be impaired under generally accepted accounting principles.

And while the regulators may decide not to consider a bank to be in a capital-impaired position if it does have to write down its bonds, the public, many analysts, and other outside observers feel the bank is worse off if capital writedowns take place, with adverse implications for marketing efforts, share price, and the bank's stature.

So the bank must make a choice. And if it puts bonds in the "held to maturity" category and then sells any of them, the regulators may force it to write down the entire portfolio of "held to maturity" bonds to market, since it will then consider the whole portfolio to be available to be sold.

But think of this choice! The bank that holds a large portion of its bonds to maturity is sacrificing real opportunities for profit that could stem from switches, tax swaps, and moves to higher-yielding investments for the cosmetic benefit of not having to report paper losses on bonds when interest rates rise.

To this observer, the choice is really crazy.

Sure, you look better by holding the bonds to maturity in an environment of rising interest rates, but in actuality you are paying dearly for this posture. Your bonds are going down in value, no matter what your statement says. And if you do have to sell them, they will be worth only what the market says they are worth, not what they are nominally worth on your statement.

And one can assume that the people who really count - acute analysts, market makers, institutional buyers of bank stocks, and regulators - know what your bank's portfolio is really worth. So the cosmetically superior position is really of little value.

In fact, some analysts feel that by designating the portfolio as available for sale, not only do you have the flexibility to improve earnings and take advantage of tax savings, but you make the return on capital look better too. If you write down capital as bonds decline in value, it means your earnings are spread over a smaller capital base, so your ROE is improved by the operation.

Again, this is merely cosmetic, but it is a cosmetic development that is positive and thereby helps offset the negative impression involved in marking the portfolio to market.

FAS 115 has other flaws - notably that assets are written down to market while fixed-yield liabilities are not written up to market as interest rates rise.

But it is still superior to the old days when all bonds were held on the books at cost until sold. At that time, the stagnant bank that did nothing to take advantage of changes in money market conditions, but simply sat with its original portfolio, always looked better than the bank that realized losses, took the proceeds and tax savings, and then reinvested to gain the higher yields that had become available.

But FAS 115 is close enough to the old system to make bank statements still victims of the desire to avoid reporting bond losses that result from rising interest rates, and it still means that the improved reported position is bought at the expense of lessened opportunities for real income augmentation.

What should a community bank do?

Some analysts feel that it should move as rapidly as possible over to marking the portfolio to market.

This means placing all newly purchased bonds in this category and considering the bonds that come due in less than 90 days as available for sale, since this is allowed without forcing the entire "held to maturity" portfolio into the "available for sale" classification under the "safe harbor" provision of FAS 115.

But what about biting the bullet and making the entire portfolio available for sale?

This could do a lot for the bank. It would give it the flexibility to improve real profits, as mentioned above. Also, because the bonds are marked to market each quarter, it improves the reported yield that a fixed- coupon bond provides when rates rise.

But here the banker bumps into psychology and fear.

There is fear that the regulators may change their minds and hold that capital is impaired when the bonds are marked to market in a rising-yield environment.

There is fear of what outside accountants and analysts will say and do when they see the loss taken on the whole portfolio.

And there is a comfort of having the portfolio remain static to avoid having to undertake the writedowns. It sure makes life easier for the portfolio manager.

But some banks are still considering taking the plunge of marking all bonds to market, as they feel the real advantages are worth enough to overcome the fear and inertia.n Mr. Nadler is a contributing editor of the American Banker and professor of finance at the Rutgers University Graduate School of Management.

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