Mellon Bank Corp. stunned analysts Monday by announcing it will take a one-time pretax charge of more than $200 million against fourth-quarter earnings.
The charge, which after taxes comes to $130 million, reflects the cost of repairing a securities-lending business wracked by recent interest-rate spikes.
The Pittsburgh-based bank said the charge would reduce fourth-quarter earnings by about 88 cents per share. That translates into a reduction to about $35 million in after-tax net income from an expected $165 million. Mellon earned $114 million in the fourth quarter of last year.
"The magnitude of the loss was a surprise," said Keefe Bruyette & Woods' Joseph Duwan.
The charge makes up about 20% of the bank's earnings even though securities lending makes up a minimal amount of Mellon's revenues, analysts said.
The securities-lending portfolio was primarily managed by an investment unit of The Boston Co., an institutional trust and money management firm that Mellon acquired in May 1993.
Mellon took an $89 million charge in the third quarter, to help pay for its August acquisition of Dreyfus Corp. That charge, which was expected by analysts, was unrelated to the one announced Monday.
Securities lending is a complex, arcane way banks try to boost the returns of portfolios of trust accounts they hold in custody for clients. Banks literally lend securities inside a trust client's portfolio to a broker-dealer who is seeking those specific securities.
As with any loan, the bank takes collateral, or cash from the broker-dealer.
Banks then invest that cash in fixed-income instruments with varying maturities. Even though the banks are making the loan to the broker-dealer, the banks are required to pay a rebate to the broker-dealer, usually at an overnight interest rate.
Banks bet that the yield of the fixed-income investments will exceed the interest paid to the broker-dealer.
In this case, Mellon lost its bet.
"The problem that we have here is that the maturities of some of those fixed-income investments are too long," said Steven Elliott, Mellon's chief financial officer.
When the Federal Reserve Board raised short-term interest rates in a recent 75 basis-point move, the yield on fixed-income investments with longer maturities declined. Thus, the yield the bank received on those investments was less than what Mellon must pay out to broker-dealers.
Mellon isn't the only bank to get hit hard by securities-lending losses. Chicago-based Harris Bank Corp. took a $33 million charge in the second quarter for the same reason, said Keefe's Mr. Duwan.
Mellon is responding to the damage by adding derivatives to its portfolio. The bank said in a release it "expects to arrange for a third party to enter into interest rate-swap contracts that will convert the income generated by certain securities lending collateral investments to a short-term floating rate."
Mr. Elliot refused to disclose the third party.
"The charge reflects the cost of the swap, but it sounds very expensive," said Merrill Lynch's Livia Asher. "The notional amount must be very large," she said.
In securities lending, banks can either take duration risk or credit-quality risk, but they rarely do the latter.
"We have managed client portfolios so they have a high degree of credit quality," said Frank Cahouet, Mellon's chairman, president, and chief executive officer. "In light of the sharp rise in interest rates, however, we believe our decision to change the income characteristics of these securities-lending portfolios is in the best interests of our clients and shareholders."
Ms. Asher said she was lowering her fourth-quarter earnings expectations to 15 cents from $1.03.
In a telephone interview, Mr. Elliot said Mellon executives intended to improve internal controls. He declined to say if anyone would be fired as a result of the charge, but he said "obviously, we're in a process of making some changes in investment responsibilities ."