Derivatives - viewed by some as a deadly virus capable of destroying financial institutions and careers - will disappear from many community banks' balance sheets next year, according to a recent nationwide survey.
Though 84% of the more than 800 community banks surveyed invest in the financial instruments that were the focus of so many negative headlines in 1994, only 58% of those banks expect to invest in them in the future, according to the poll, which was conducted by Grant Thornton LP, a financial consulting firm.
"We have a new rule in our bank," said Joseph D. Hudgins, president and chief executive of $75 million-asset West Coast Bank of Sarasota, Fla. "If it takes longer than five seconds to explain, we don't buy it."
Mr. Hudgins' comment reflects a sentiment shared by many community bankers who watched the value of their investment portfolios plunge as interest rates were jacked up in the past year.
Mortage derivatives made up 29%, or $5.6 billion, of all unrecognized losses in held-to-maturity accounts of banks nationwide last year, according to Veribanc Inc., a bank research firm in Wakefield, Mass. That figure represents half again as many losses resulting from other types of securities, said Veribanc.
Banks currently have on-balance-sheet holdings of $154 billion in mortgage derivatives, an amount that has stayed roughly the same for several quarters, according to Veribanc.
In the future the use of structured notes, considered the most complex of the three categories of derivatives, will see the largest reduction, about 30%, according to the survey. The structured note has also been the derivative that has had the most growth in the past year.
"The structured note growth has been the most recent phenomenon," said Diane M. Casey, national director of regulatory issues at Grant Thornton. "They looked great when they were purchased, but not so great at the end of the year after the uptick in interest rates."
The $84 million-asset Grafton State Bank in Grafton, Wis., is one of those that has had enough of structured notes, after dabbling in them briefly.
"We've found that they can get pretty complicated and pretty scary," said Thomas J. Sheehan, president and chief executive of Grafton State, which has a $20 million investment portfolio. "We don't need to take any undue risk. There are enough investments out there that are far easier to understand."
The community bank survey showed that the most common derivatives used by community banks are mortgage-backed securities, at 69%, followed by collateralized mortgage obligations, 65%, and then structured notes, 47%.
The most common problem with these investments, according to those interviewed, was that bankers did not understand what they had until their value began to plummet.
"You'd ask a lot of banks a year ago if they have derivatives, and they'd say no," said Ms. Casey. "They didn't really know what they had until the examiners came in and pointed them out."
J. Hal Roberts, president of $112 million-asset Port St. Lucie National Bank of Florida, said some bankers may not realize they own a derivative because the term covers such a broad spectrum of investments.
"If you look at the true definition of derivative, you're in it before you even know what it is," he said.
The market value of Mr. Roberts' bank portfolio fell about 2.5% last year because of its derivative holdings, but it has rebounded recently to about a 1.2% devaluation, he said.
While community banks generally have been investing in derivatives for seven or eight years now, 1994 was a dreadful year due not only to rising interest rates but also to the new accounting rule, FAS 115, bankers said. That rule requires banks to disclose the market value of securities that are not being held to maturity.
"The upsurge (in interest rates) occurred at exactly the worst time for the banking industry," Mr. Hudgins said. "If it had occurred in 1993, it would have been a nonevent. But 1994 was the first time we had to value our bonds at market."
Those planning to continue investing in derivatives will undergo intensive training and exercise more prudence, they said. They are not looking for any help from government agencies, as only 28% said regulation of derivatives is needed, the survey showed. But 51% believe regulatory oversight of the instruments will increase.
While most community banks invest in some sort of derivative, such investments represent a much smaller percentage of the portfolios than at larger banks, according to Veribanc. For banks with under $1 billion of assets, mortgage derivatives make up an average of 5.4% of total securities, compared with 13.9% at the big banks, Veribanc said.