WASHINGTON - The four federal bank regulators told Congress that structured notes do not pose a threat to the industry, but a key lawmaker said the agencies are just living in blissful ignorance.
"While the bank regulators claim that they properly regulate and supervise the derivatives activities of banks, as far as structured notes go, the regulators simply don't know what the risks are," said Rep. Henry B. Gonzalez, D-Tex.
Rep. Gonzalez, the former chairman of the House Banking Committee, had posed a series of questions to the four agencies: the Federal Deposit Insurance Corp., the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision.
In separate replies, the four told Rep. Gonzalez that banks are not in danger as a result of their investments in the volatile instruments. However, they acknowledged they could not say how much of the derivative products banks hold.
"The inability of the bank regulators to provide aggregate statistics on financial institutions' exposure to structured notes raises serious questions about the adequacy of their supervision," said Rep. Gonzalez, who is now the banking committee's ranking Democrat.
"I'm afraid they are taking an 'ignorance is bliss' approach," he said.
The regulators said that though they lack hard data, they are confident the instruments do not pose widespread problems because their examiners have not found many problem cases.
Regulators have warned banks about buying structured notes in the past. Because the securities are often issued by government-sponsored enterprises and carry triple-A ratings for credit risk, some buyers do not realize that they have high liquidity and market risk.
The four agencies told Rep. Gonzalez that they do not now collect enough data to show how much in structured notes the institutions they supervise now hold.
Yet they assured the legislator that the instruments do not pose serious problems for banks. Regulators also noted that at the end of March, banks' quarterly reports will begin showing more data on the instruments.
The OCC also said it does not now collect information on structured notes. Further, it said that many banks' valuation of their structured notes is inaccurate because the values reflect the price that institutions paid for them, rather than what they are now worth.
"From our examination work, the OCC has tentatively concluded that some national banks may have experienced substantial depreciation in their structured note holdings," Comptroller Eugene A. Ludwig wrote. "However, those banks are almost exclusively smaller banks, which generally have strong capital ratios."
Because larger banks do not usually invest heavily in structured notes, "the OCC does not currently believe that structured notes represent a systemic safety and soundness threat," Mr. Ludwig said.
The FDIC also said it does not now collect data on structured notes.
However, the agency estimates that more than 650 of the 7,220 banks it supervises hold about $2.9 billion in structured notes. Unrealized losses come to about 3.5% of book value, or roughly $100 million.
Thrift regulators said most thrifts concentrate their structured note holdings in step-up bonds, which they consider low- to moderate-risk instruments.
"Although specific data on individual thrift holdings is not yet available, recent losses on step-up bonds - both realized and unrealized - resulting from shifts in the yield curve, appear to be comparable to losses on Treasury bonds of similar maturities," the agency said.
The OTS said the findings of its western region were representative of the rest of the country. Of the 84 thrifts surveyed there, 44 held structured notes. All but five held only step-up bonds, some of the less risky structured notes, the OTS said.
The Federal Reserve Board staff said some institutions have experienced declines in the market value of their structured notes, but acknowledged that the central bank did not have a handle on how large the losses are.
"The banking agencies do not, as yet, collect information on such holdings in any report except through the annual examination process," the Fed explained.
The Fed also said it asked its regional Reserve Banks to investigate the source of unrealized securities losses for the 63 banks whose government agency securities portfolios lost more than 5%.
The Fed found that 25 of those institutions held structured notes. None of them held enough in structured notes to put them in danger of failing, and just two banks had realized losses as a result of liquidating their holdings.
"Our supervisory experience indicates that structured notes have not, to date, been a significant contributor to depreciation in the U.S. agency security portfolios of state member banks," The Fed concluded. "To date, realized losses stemming from the liquidation of such securities have been nominal."
However, the Fed also said that at several banks, "management was unaware or did not fully understand the risk profiles of the structured notes they held."