Minnesota Warns That Portfolio Losses Will Trigger Scrutiny

ST. PAUL, Minn. - Worried by depreciation of the securities portfolios of Minnesota-chartered banks, the state Department of Commerce has warned banks to take a close look at their investments.

The portfolios shrank by $178.7 million last year, or about 3.5%, according to figures released by the state.

In letters to 411 state banks, Commerce Commissioner James Ulland warned that those with unusually high losses or suspected of speculating "will receive special attention in examinations or targeted visitations."

The 1994 drop followed years of steady appreciation and reflects a national trend, because rising interest rates hurt the values of some mortgage-backed securities and other derivative investments.

Regulators said Minnesota's state-chartered banks hold securities investments of $5 billion. In 1993, the value of the same portfolios rose by $116.9 million.

State officials stressed that no banks are in danger at this time. But the officials worry that some may have gotten in over their heads with derivative investments.

"Some banks got suckered into buying things like inverse floaters without fully understanding what it could do to them down the road," said Al Long, assistant commerce commissioner.

Commerce Department officials said that structured notes, such as dual index notes, de-leveraged bonds, and inverse floaters - bonds with coupons that move in the opposite direction of interest rates - are turning up more often in bank portfolios.

Notes sold by the Federal Home Loan Bank and Federal Home Loan Mortgage Corp. hurt many banks because they appeared safe, according to Lewis Coffey, president of BPS Associates, a Minneapolis bank consulting firm.

"Bankers look at risk in terms of credit risk, because they are lenders," Mr. Coffey said. "There is no credit risk with those investments, but if interest rates change, they can go right down the well."

Such investments are effective tools only if a bank is "extremely asset sensitive," the Commerce letter states. However, none of Minnesota's state- chartered banks are believed to be in that position.

"Our focus is to try to get banks to understand ... that they have to manage and pay as much attention to their securities portfolios as they do their loan portfolios," Mr. Long added.

Mr. Coffey said the Minnesota situation "is not a disaster." In fact, it happens with every interest rate cycle.

As interest rates drop, bankers feel pressured to improve their margins with riskier and riskier investments.

"They rationalize taking on more risk, and invariably, they get in trouble," Mr. Coffey said.

Allen I. Olson, president of the Independent Community Bankers of Minnesota, agreed that some banks may have made investments that they didn't fully understand. But he called the present situation "manageable and instructive."

"Wall Street creates these new investments out of thin air, and there are plenty of people to sell them," Mr. Olson said. "But bankers are much more sophisticated as investors than they used to be. They aren't as vulnerable to fast-talking salesmen."

Mr. Coffey, however, said that investments may be getting too complex for some small-town bankers. "The level of sophistication in some small rural banks is easy to overestimate - especially in investments," he said.

Bankers "can find themselves intellectually and psychologically stretched to cover all the bases," he added.

State Commerce Department officials declined to give yearend holdings for specific banks. But published reports as of June 30, 1994, showed three Minnesota banks with almost half of their assets in collateralized mortgage obligations: Premier Bank of Rochester, with total assets of $64 million; Premier Bank Metro South of Farmington, with $53 million in assets; and $68 million-asset Kanabec State Bank of Mora. Mr. Coffey and Mr. Long agreed that not all derivatives are bad, and that high levels of such investments are not necessarily an indication of poor decisions. For instance, both Premier Banks were formed with the assets of old Resolution Trust Corp. properties.

Kanabec president Doyle Van Dyne said that although his bank's investments depreciated in 1994, the decline would have been greater if Kanabec had invested in Treasury notes.

Mr. Van Dyne said that about half of Kanabec's mortgage-backed holdings are variable-rate securities whose yields have moved up with interest rates.

"We will look at all our options," he said. "But we probably won't unload them, because they are performing quite well."

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