As if losses in their real estate and construction loan portfolios were not worrisome enough, small banks are starting to see problems crop up in another less expected area: their investment portfolios.
Several community banks recently said their second-quarter earnings would include hefty charges on their holdings in a group of mutual funds backed by mortgage bonds. Industry watchers said dozens more small financial institutions have incurred losses from their investments in the Asset Management Fund family of mutual funds but have yet to disclose them.
Large banks, of course, have been taking massive writedowns on their investments in mortgage-backed securities in recent quarters. But while community banks' loan portfolios have been weakened by the mortgage crisis, their bond portfolios have held up well because they typically have steered clear of investing in securities backed by risky mortgages.
These charges are "coming from banks where you wouldn't expect to see these type of problems," said Ed Krei, a managing director with Baker Group, a securities dealer in Oklahoma City. "This is a surprise."
The AMF funds, managed by Shay Assets Management Inc. in Chicago, were designed to be investment vehicles for banks, credit unions, and thrifts.
The impaired investments are related mostly to the $1.9 billion-asset AMF Ultra Short Mortgage Fund, which has lost about 5.5% of its value this year. Several bonds in the fund that had double- or triple-A ratings were recently downgraded by both Fitch Inc. and Moody's Investors Service Inc.
Some banks and thrifts are hanging on to their shares in Ultra Short fund in hopes that they will recover, while others are trying to minimize their losses by exchanging full shares in the fund for the underlying securities.
Cashing out is not an option. Shay has temporarily banned redemptions out of concern that too many investors would cash out at once, forcing a liquidation.
Jeff Davis, a senior analyst with First Horizon National Corp.'s FTN Midwest Securities Corp., said banks that opt to hold on could face more impairment charges at a time when loan delinquencies are already taking a balance-sheet toll.
"Once impairment occurs, it comes out of regulatory capital, and it comes at a time when the industry needs more capital, not less," Mr. Davis said.
Bond portfolios, he said, "aren't done providing surprises to investors." He warned that banks investing in pooled trust-preferred securities and corporate bonds may also report charges in the coming quarters.
The charges could wipe out some banking companies' second-quarter profits.
The $765 million-asset Pacific Premier Bancorp Inc. in Costa Mesa, Calif., announced June 20 that it would take a second-quarter charge of $2.1 million on its investments in the AMF funds — nearly twice what it earned in last year's second quarter.
That same day Prudential Bancorp Inc. of Pennsylvania in Philadelphia said it would take a charge of $2.3 million. It earned $977,000 in last year's second quarter.
Both banking companies said they have redeemed their shares in the AMF funds for the underlying securities.
Kearny Financial Corp. in Fairfield, N.J., and Osage Bancshares Inc. in Pawhuska, Okla., are keeping their shares and writing down the value. The $2.1 billion-asset Kearny said it would take a $659,000 second-quarter charge on its AMF investments; the $138 million-asset Osage said it is taking a $782,000 charge.
Mark S. White, Osage's president and chief executive, said last week that Osage opted to hang on to its shares because its executives are confident the mortgage market will recover. "It is just a paper loss at the moment," he said.
Steven R. Gardner, the president and CEO of Pacific Premier, said his company invested in the AMF funds because he believed Shay had more expertise at deciding where to put Pacific Premier's cash than anyone at his company did. He no longer believes that, he said.
"We are exceedingly frustrated and disappointed with Shay," Mr. Gardner said. "One would question the level of expertise, given such a dramatic decline" in the value of the Ultra Short fund.
Calls to Shay were not returned.
Jim Reber, the president of ICBA Securities, a subsidiary of the Independent Community Bankers of America, said community bankers turn their investment portfolios over to managers because they lack the time or expertise to manage the portfolios themselves.
But, Mr. Reber said, "Clearly a third-party portfolio manager can make" the same mistakes "that a multi-hat-wearing community banker can make."
He said he suggests banks avoid mutual funds because they are considered an equity investment with capital gains and losses that banks must account for and because they do not get to control what they invest in. For example, bankers likely would not have invested as much in private-label-issued securities as Shay did, he said.
In May, Fitch downgraded eight of the underlying private-label issues in the fund, to BBB or B, according to AMF's Web site.
"BBB isn't something that a banker is happy to own," Mr. Reber said. "They want to stay safe in triple-A and double-A land. This just points out that if somebody else is making the decisions about what you own, you are taking a risk."
