Just as fear seems to be displacing greed as the driving force on Wall Street, some small banks are beginning to sell certificates of deposit tied to the performance of stocks.

Spurred by a final nod from the Office of Thrift Supervision at the end of 2000, the move could attract the dollars of investors hit by the nasty downturn in many stocks last year. They, of course, have gained a new appreciation for the concept of "money in the bank." The new instrument also could attract those skittish savers who missed out on the big bull market and want a safe way of catching the next wave.

The idea of offering a CD with market-style returns without the risk of ending up under water--the principal is guaranteed through FDIC insurance--is something smaller institutions have wanted for years.

They watched uneasily in the 1990s as deposit growth stagnated, their typical depositor grew older and many customers defected to index mutual funds offered by Vanguard, Fidelity and a host of others, including some sponsored by the large banks.

Early returns for the new CDs are mixed, with bankers reassessing the special costs and risks that are involved. Those include hedging against the unknown future of the market, special training for sales personnel, rights fees for the use of well-known indexes, and the risk that customers will be unhappy if returns don't match expectations.

The fourth quarter of last year, of course, was hardly the most auspicious time to introduce a CD with big gains on Wall Street as the main attraction. The Standard & Poor's 500 Stock Index slumped nearly 10% in 2000. Worse, Nasdaq's composite index and 100 index, the heralds of the "new economy," plummeted from the stratosphere as the technology bubble burst.

Crown Bank of Hasselberry, FL, launched its Nasdaq 100-indexed CD on Nov. 15 as tech stocks suffered a particularly dramatic erosion in value. Market-linked CD sales through year-end went "poorly," acknowledges the bank's president, John A. Koegel.

"With the Nasdaq really going down, things were very negative, and people just didn't want to think about it," he says of the timing of the launch, which had been in the works for about a year and required four months of preparation by the bank's salesforce.

As of year-end, Crown had sold around $650,000 of the five-year CDs, with far to go before reaching its target of $2 million by February. Only new customers of the federal savings bank bought the CD, while existing customers, many of them retirees in the Orlando area, were either wary of the Nasdaq or uninterested.

The new customers were certainly good news, Koegal says, but they didn't come cheaply. "It requires a lot of advertising dollars to let people know we have the product."

Most of Crown Bank's CD buyers were people already familiar with the risks and rewards of the stock market, who were looking to diversify their financial portfolios for more safety, Koegel says.

The CD requires a $5,000 minimum investment and pays annual returns up to 20%--the upside is capped. The bank asserts this provides buyers with the chance to enjoy stock price gains in Nasdaq companies like Microsoft, Intel and Cisco Systems "without the worries." The CD program will be reassessed in February.

Crown Bank is hedged against its own risk through a derivative security bought from Deutsche Bank, "which provides positive arbitrage for us, as compared to the CD rates that we offer," Koegel says. The CD program was put together by Suncoast Capital Group, a Fort Lauderdale-based financial firm.

'Safer Way Into Market'
Entering the market just after Crown Bank, last Nov. 17, was New South Federal Savings Bank, based in Birmingham, AL, with an S&P 500 Index-linked CD. New South sold about 100 of the three-year $5,000 minimum CDs in a two-week initial offering period, and the bank plans to renew the program in February.

"We wanted to gauge interest and see if our expectations were correct about the kinds of customers who might be interested," says Tommy Little, New South's vice president for marketing. "Of course, that was also the week after the presidential election, when there was a whole lot of distraction and uncertainty."

Little says the bank's offer attracted two very different sorts of customers: "The investor who is not that fearful of the market, but wants to diversify, and the traditional saver who remains fearful, but wants to find a safer way into the market environment."

So what does a financial planner think about market-indexed CDs? "It's not a bad idea, but it would have been a better one five years ago," says Bruno Giordano, president of Dorset Financial Services Corp. in Devon, PA. "If the banks are backing it up with a limited guarantee then it can't be bad for investors."

But Giordano says that buyers need to understand that an index-linked CD will still amount to "a bet on the market," as opposed to a straight CD that offers much more predictability.

Rather than capping the rate of return as Crown Bank did, New South is using an average taken from the S&P 500 on a "valuation date" every six months over the three-year term. While that serves to limit volatility and preserve gains, it also could dampen the impact of a strong performance by the index.

New South covers its own risks by purchasing a hedge from Lehman Brothers, with the averaging formula determining what the actual swap costs will be. And the greater the volume of CDs sold, the lower the unit cost of hedging the product will be, notes Jim Park, New South's vice president for capital markets.

There were also licensing expenses. Standard & Poor's, a unit of McGraw Hill Inc., closely monitors the use of its famous index. S&P vetted all promotional and marketing materials to make certain that the index was represented only as a neutral market tracking mechanism.

And there was considerable staff training, including role-playing by bank employees, in an attempt to cover every possible question, problem or scenario that the potential buyer of the CD might have, Little says.

As for the market, "we tell people there are upswings and downturns, and there may be a chance to catch a bounce. We try to impress this while there is no guarantee of a return, there are opportunities," he says. "And the big selling point is that the principal will be protected."

In fact, the education effort for the new CDs may be nearly as big a factor as attracting new customers. Certificates of deposit have long enjoyed a reputation as a reliable and easily understood fixed-income investment with very little risk attached.

That has put CDs "near the bottom of the excitement scale, about as stodgy as you can get," according to Paul A. Merrriman, president of Merriman Capital Management Inc., a Seattle-based investment advisory firm. He notes that CDs are seen as far removed from the "dazzling returns and heart-stopping volatility of the stock market," while serving as a mainstay for millions of investors preferring quieter lives.

But the biggest effort by smaller bank and thrift institutions to sell CDs linked to stock-market gains may just be getting underway.

On Feb. 15, members of the Federal Home Loan Bank of Pittsburgh will launch their Index Powered CD, with the Home Loan Bank bundling them for hedging purposes. The CD has a five-year term featuring a return equal to 90% of the gain of the S&P 500, noted David E. Jones, vice-president and credit money desk manager at the Home Loan Bank.

The CD was devised by Risk Analytics, a Denver consulting firm, primarily for banks and thrift institutions with assets of up to $10 billion. Institutions of this size suffered the most serious drain of deposits as huge stock price gains mesmerized the public during the 1990s.

Home Loan Bank Helps Out
Besides handling rights fees, Risk Analytics is providing marketing support and staff training at smaller banks and thrifts in the Pittsburgh FHLB district. Buyers can even track the performance of the S&P 500 and their CDs on its Web site at www.indexpoweredcd.com.

Some institututions have already taken the initiative themselves, with an eye toward the selling season for Individual Retirement Accounts that runs from January to mid-April, when tax returns are due. Brentwood Bank in Bethel Park, PA, has run its own local television advertising campaign.

"Our job is basically to provide a vehicle for managing risk," says Jones. "It wouldn't be possible to offer this product without a hedge."

At issuance, which will occur on the 15th of each month, member banks will buy hedge positions from the Home Loan Bank in the form of equity option agreements. "We will pay them 90% of the return of the S&P 500, and they will in turn pay that to their retail customers," Jones says. "In exchange, they will pay us a spread to LIBOR, for example LIBOR minus 50 or 100 [basis points]. It's very attractive funding for them and provides an exact hedge."

As of year-end, Pittsburgh was the only district Home Loan Bank signed onto the project. Jones says that a number of institutions outside the district have asked about the CD program, and several other district Home Loan Banks, including New York, Atlanta and Topeka, are monitoring the progress of the plan.

The market-linked CD has gone through much change and review. Initially, the term was to be 10 years, but many institutions felt that was too long to be saleable. State banking departments in the district had to grant approval, as did other regulators. The final nod from the Office of Thrift Supervision came late last year.

The Index Powered CD provides for averaging the return of the S&P 500 over the past 12 quarters of the five-year term. "That prevents someone from losing all their earlier gains as a result of market disruption," Jones says. In addition, there are no mutual fund-like sales or management fees.

Sizeable gains are possible, of course. An example provided by Risk Analytics shows that a hypothetical $10,000 CD issued in January 1995 would have more than doubled in value by January 2000, paying the owner principal and interest of $22,495.65. That would have been an increase of 124.96%, which works out to a 17.572% annual yield. By contrast, a five-year CD at the end of last year was yielding around 6%--and savers could face lower yields this year if interest rates fall.

Moreover, because the Pittsburgh district Home Loan Bank will be bundling the CDs, and other significant costs are being shared, much lower minimum deposits, such as $1,000, are possible. That puts the product within reach of many more potential buyers.

If the program is successful, Risk Analytics hopes to expand the available terms for CDs as well as the indexes that can be used, perhaps broad market indexes such as the Wilshire 5000 and Russell 2000.

That would please Giordano of Dorset Financial, who feels the capitalization-weighted S&P 500 index leans too much toward the largest company stocks and does not diversify risk as much as commonly believed. "You're really betting on just a few big companies that have an overwhelming impact on the index, and there have been times when that was a bad idea," he says.

Of course, whatever index is used, buyers of the new CDs and the bankers who sell them will need to keep in mind the cautionary phrase that jumps out in bold type from mutual fund prospectuses: "Past performance is in no way indicative of future performance."

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