Redwood Empire Bancorp in theory had a foolproof way to negotiate interest rate swings. But management has found out that it's all in the execution.

In September 1990, Redwood Empire brought together a traditional commercial bank with a traditional savings and loan. The idea was that together they would cancel out each other's cyclical vulnerabilities to business conditions or interest rate swings.

In a rising rate environment, the bank would do well. In a falling rate environment, the thrift would do well.

It worked for three years, but only in one direction.

The $620 million-asset, Santa Rosa, Calif.-based company, owner of Allied Bank FSB and National Bank of the Redwoods, posted a third-quarter loss of $965,000 after taking an $815,000 pretax charge to restructure Allied's bloated mortgage banking operation.

The results, posted in October, caused a drop in share price from a high of $14 to a recent price of around $8.25, a decline that can't all be accounted for by the broader drop in bank stocks.

The decline in share price led to Redwood's calling off a planned purchase, for cash, of neighboring La Cumbre Savings Bank last week. The company would have had to sell $10 million of new common stock to finance the purchase, and management deemed the deal too dilutive at current share prices.

Just a few years ago, Redwood Empire was posting decent earnings in the face of California's recession. Its strategy of having a mortgage banking thrift and a business banking bank drew the attention of bank stock investors looking for new ways to cash in on the state's recovery.

"Their hybrid strategy looked like it would work," said Steve Didion, an analyst at Hoefer & Arnett in San Francisco. "But the recent performance of the company shows that they didn't spend enough resources on the bank and too much on the thrift."

Redwood chief financial officer Dennis Kelley admitted the company had become far too dependent on mortgage banking. When rates began to rise, cutting into mortgage originations, the commercial bank's performance wasn't up to the task of compensating.

"We're trying not to create the balance between commercial banking and mortgage banking that was originally foreseen when we bought Allied in 1990," Mr. Kelley said. "The mortgage side grew too much. And now we're in a transition period."

Redwood Empire shows that, when it comes to community banks, broad generalizations of how interest rates affect operations and spreads are hard to come by. Although the impact of this year's increase in short-term rates on regional banks has been reasonably calculable, analysts say, for community banks it is more elusive.

Frank Barkocy, managing director of the financial institutions group at Advest Inc., said community banks generally will benefit from rising rates because of their reliance on demand deposit accounts and commercial loans tied to interest rate indexes. But he cautioned against generalizing because the rate scenario can play out differently for each community bank, depending on its business niche and location.

Redwood Empire is a prime example.

While the company's bank subsidiary is indeed reporting growing spreads and bottom-line income, its fee-based products such as merchant credit card processing probably should have been cultivated while Allied was posting huge profits during the refinancing boom of 1991-92.

Instead, management began paying closer attention to National Bank of the Redwoods' fee-based products only this year. That category is growing but not fast enough to counteract the drop in mortgage originations.

Meanwhile, Allied's spreads have been thinning dramatically. The thrift's mortgage banking operation laid off 85 people in the third quarter. At the same time,-it is trying to build a bigger book of nonconforming mortgages and is opening origination offices in Portland, Ore., and Seattle. It also closed less profitable wholesale mortgage offices in Fresno, San Ramon, and San Diego, Calif.

Meanwhile, Mr. Kelley's concern about rising interest rates applies to the commercial bank, not just the thrift.

"Sure, its improving the performance of the bank, but it's also a damper on the economy," he said. "You can have your spreads now but pay for them later."

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