WASHINGTON -- Federal regulators warned banks Thursday about buying a seemingly safe type of derivative that can suddenly plunge in value.
Community banks in particular have had problems with the volatile "structured notes," which are issued mainly by government-sponsored enterprises, such as the Federal Home Loan Bank System.
Buyers are often attracted to structured notes by their triple-A ratings for credit risk, but many buyers fail to understand the product's high liquidity and market risk, the Office of the Comptroller of the Currency said in an advisory to banks.
"We have examined banks and found losses associated with these instruments at a number of banks," said the OCC's Douglas E. Harris, senior deputy comptroller for capital markets. The agency's advisory concludes: "Some types of structured securities are inappropriate investments for most national banks."
One bank recently lost 25% of its capital after buying structured notes, and another narrowly avoided failure after investing 10% of its assets in the instruments, according to specialists in the notes market.
In the second case, after the bank realized its safe-seeming investment had lost money, the broker who sold the notes refused to take the bank's frantic phone calls.
The broker dealer "had made a killing selling these toxic wastes to an unsuspecting dummy," said another broker.
Regulators are increasingly concerned about structured debt. Just last week, the Office of Federal Housing Enterprise Oversight cautioned banks, thrifts, and other investors about the instruments' risks. The chairman of the Securities and Exchange Commission recently told Congress that he was concerned about money market funds investing in structured notes.
The OCC advisory makes clear that it is the responsibility of individual banks to determine whether the product is appropriate for them.
The Federal Deposit Insurance Corp. and the Office of Thrift Supervision are expected to issue similar warnings soon.
Community Banks Singled Out
"We are concerned that banks - and in particular community banks - may be purchasing these securities without a full understanding of the market and liquidity risks involved in these instruments," Mr. Harris said. "We believe that there may be confusion over the fact that there may be little or no credit risk associated with these instruments."
Recent interest rate increases have driven down the value of many structured notes. They are customized debt securities issued by government-sponsored enterprises, multilateral development banks, private companies, and foreign banks whose cash-flow characteristics depend upon one or more indices or which have embedded options.
Banks hold 15% of the $55.9 billion in outstanding structured notes of one of the biggest issuers, the Federal Home Loan Bank system, according to system estimates.
Fivefold Jump Since '90
Last year, a total of $86 billion in structured debt was issued, Merrill Lynch said, a fivefold increase from the $18 billion issued in 1990, and a 73% increase from the $50 billion issued in 1992. Merrill estimates that $92 billion in structured notes will be issued this year.
The most common structured notes are step-up bonds, index amortizing notes, dual index notes, deleveraged bonds, range bonds, and inverse floaters. Each has very different features, and used properly, each can be a good investment, depending on what a buyer is looking for.
Roy Hingston, a vice president of Miami-based Shay Financial Services Co., an institutional broker dealer, said, "Some smaller institutions who were sold these things did not know what they had and are unhappy," now that interest rates have shot up since last year.
Shay is the investment arm of the Savings and Community Bankers of America.
To be sure, the government-sponsored enterprises have taken precautions to try to keep structured notes from falling in the hands of unsophisticated buyers. They require underwriters to sign agreements saying they will sell the notes only to suitable investors and impose minimum purchase requirements of up to $100,000 on some complex instruments.
Called Useful If Appropriate
And Shay Financial's Mr. Hingston pointed out that many structured notes offer banks attractive features. He's particularly enamored now of multiple step-up callable notes, whose features are similar to adjustable-rate mortgages in that they offer a decent short-term return and adjust upward if interest rates rise. If rates fall, they are likely to be called.
Trade groups praised the OCC's move, which they said would raise awareness about the suitability of these derivitives. James D. McLaughlin, director of agency relations for the American Bankers Association, remided bankers of the old examiner's rule: "If you can't explain what it is, maybe you shouldn't buy it."