Banks in a Quandary About Bond Holdings

Rising interest rates are forcing many community banks to choose between the lesser of two evils: Either live with eroded margins or lose a significant chunk of equity with the stroke of an accountant's pencil.

With rates expected to rise again this month, bankers and analysts expect more banks to move to protect future earnings by recognizing losses in their long-term holdings of securities. The step, however, could take some big bites out of capital.

The problem is most acute for banks with large "held to maturity" securities portfolios. While many banks would like to sell off some of these securities and plow the funds into higher-yielding loans, the maneuver would require marking the entire portfolio to market - and taking a hit to capital.

"If rates go higher, then some will take the hit and reinvest," said David Stumph, who follows banks for Wheat First Butcher Singer in Richmond, Va. "But for others the hit would be too large. It would have a real effect on capital ratios. There are a few in that situation, however."

Warren Heller, research director at Veribanc Inc., has identified 13 institutions, all community banks, whose unrealized losses in held-to- maturity portfolios equaled more than 50% of equity. Embedded losses are losses in held-to-maturity securities.

"It's hard to imagine the situation getting any better anytime soon," Mr. Heller said.

Industrywide, banks with less than $5 billion in assets have proportionately bigger securities portfolios. These fixed-income securities are particularly interest rate sensitive, and have lost value in the rising-rate environment. Veribanc puts the industrywide loss on held-to- maturity securities at $12 billion through the third quarter.

Analysts say that most of the banks they follow plan to ride out the cycle without realizing securities losses. While Financial Accounting Standard 115 allows banks to keep embedded losses off the balance sheet, if the securities are moved to available-for-sale, the market devaluation comes across as a reduction in equity.

"They can't sell (held-to-maturity securities)," Mr. Stumph said. "If they do, they run the risk of accountants stepping in. Now banks are tied in their ability to do what is prudent in their bond portfolios. They can't clean these securities out because of the accounting rule."

A few examples of what would happen if a bank did clean out its lower- rate bonds illustrate the conundrum.

BOK Financial Corp., the $3.5 billion-asset holding company for Bank of Oklahoma in Tulsa, has a $40 million embedded loss in the $923 million of securities in its held-to-maturity portfolio, according to Bill Baldwin, research director at Rauscher, Pierce, Refsnes Inc. in Dallas. That $40 million embedded loss equals roughly 1.28% of BOK's assets, which Mr. Baldwin said is high for its peer group.

"If they mark the portfolio to market, BOK would have a September equity-to-assets ratio of less than 5%," Mr. Baldwin said. "And that's before what happened in November (when interest rates were ratcheted up again.)"

Mr. Baldwin said, however, that it is not constructive to look at the embedded losses problem in a vacuum. A bank's loan demand, liquidity position, and capital position all have to be considered. The overall result among the Southwest banks he follows is about a 25- to 50-basis- point decline in the net interest margin as banks ride out the cycle.

Indeed, James White, chief financial officer at BOK, said that the held- to-maturity portfolio would be marked to market only if the bank had a liquidity crisis - a situation he deems "highly unlikely," given that the company has a $500 million available-for-sale portfolio.

"For us and for most banks, I suspect, it's an interesting but largely theoretical exercise," Mr. White said.

Donald Crowley, principal at San Francisco's Smith & Crowley, said that while some business-oriented independent banks will benefit from the rise in rates, the current environment is taxing chief financial officers.

"Matching (assets and liabilities) has become more of an art than we'd like to believe," he said. "People who are involved in mortgage-backed securities are chasing moving targets.

"From a bottom-line standpoint, it's more of an opportunity cost than anything else. Most banks can weather interest rate pressures unless they're in some kind of capital or liquidity bind."

The issue could also affect stock prices, as it already has at the large regional institutions that are thoroughly covered by both analysts and the media. But, said Elizabeth A. Summers at Ryan Beck & Co., community banks have been unaffected so far.

"I don't think the stock price has reacted yet" for community banks, she said. "What I don't know is whether it ever will."

According to Ms. Summers, third-quarter figures show that the so-called embedded losses in community banks she follows could cause changes in book value ranging from a rare rise in one bank of 0.9% to a loss of 58% to 59%.

But she also noted that the banks with the highest losses also held the highest amount of free checking accounts. That means those banks are seeing higher interest income from their loans, with little or no change in interest payments on deposits.

"I don't know how this is going to play out," Ms. Summers said, admitting that it might be a total "nonevent." "You've got these huge embedded losses there. I don't think there's been much focus on this yet, in terms of investors in community banks."

Still, community banks across the country are taking defensive measures short of reclassifying their held-to-maturity portfolio.

Santa Barbara Bancorp, a $980 million-asset holding company in Southern California, recently enacted a policy of dumping securities on a stop-loss basis when the current market yield on a security is 25 basis points higher than the rate at the time it was bought. The result was a $242,000 after- tax loss on securities sales in the third quarter.

But Steve Didion, an analyst at Hoefer & Arnett, said the action is positive because now Santa Barbara mitigates securities devaluations and can redeploy the funds in higher-yielding loans or securities.

"They had a proactive strategy," Mr. Didion said, adding that Santa Barbara is fairly unique in that it has a written policy on the topic. "Most community banks aren't as proactive."

Perhaps most community banks are facing the type of situation at Seguin State Bank, a $150 million-asset bank outside San Antonio, Tex., with 70% of its assets invested in securities. Joe Bruns, chief executive, said he is just suffering through with lower margins and taking pains to keep his maturity below three years.

"We're waiting for interest rates to top out before we lengthen our maturity dates," Mr. Bruns said. "But we have relatively little loan demand right now and we have $28 million in capital, so we can sustain the course with relative ease."

Steven T. Schuler, chief financial officer at $1.5 billion-asset Brenton Banks Inc., Des Moines, which operates 14 banks in Iowa, said his company's strategy for dealing with its liability sensitivity is a work in progress.

"We're focusing primarily on the loan side at this point in time because we have had too many longer-term fixed-rate loans," Mr. Schuler said. "You go through periods like this, and it emphasizes the importance of good systems from a technology standpoint."

Still, bankers aren't sure how much of a problem the embedded losses might pose.

"It all depends. We don't have that here, and it's not really an issue here," said Dennis Dinger, chief financial officer at $5 billion-asset Dauphin Deposit Corp., Harrisburg, Pa. He said if Dauphin did have embedded losses, "I think I would be concerned about it, but it depends under what constraints that security was put into the held-for-maturity category.

"I can see how that could be a potential problem" for community banks, he added.

- Staff writers Barbara Bronstien, Christopher Rhoads, and Jonathan D. Epstein contributed to this report.

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