WASHINGTON - Many midsize banks and thrifts have become risky "arbitrage funds" that gamble with federally insured deposits and will fail if interest rates rise sharply, a risk management expert said in a speech here.
These institutions supplement their deposits with big-money repurchase agreements and Federal Home Loan Bank advances, said Mary Gottschalk, director of treasury risk management at Arthur Andersen in New York. They then invest most of this money in complex mortgage-backed securities.
Ms. Gottschalk said she didn't know how many institutions have adopted this strategy, but that it appeared to be in vogue because "there isn't enough mortgage business around to support all these banks."
As long as interest rates are right, the arbitrage route can be a profitable one. But if short-term rates go up, its followers are much more likely to fail than conventionally run banks and thrifts, Ms. Gottschalk said.
Speaking at the American Institute of Public Accountants annual savings institutions conference last week, she warned accountants that Office of Thrift Supervision approval of a thrift's operations does not by any means signify that the institution is safe.
"When the search for deep pockets goes on, if there's a problem, the fact that the OTS said it was all right is not very firm ground to stand on," she said. Many thrifts are at risk, she said, and so are their auditors.
"My argument is not that the OTS is misguided," she added. "My argument here is that regulation is not a substitution for management."
Ms. Gottschalk returned to the United States a year ago after six years of treasury consulting in Australia and New Zealand with KPMG Peat Marwick. Since her return, she said, she has encountered a number of financial institutions - ranging in size from $4 billion in assets to $50 billion - that don't fit the traditional deposit-taking, loan-making role of banks and thrifts.
What's more, these banks and thrifts, which should hold extra capital in reserve to compensate for their extra risk, usually have below-average capital levels, she said.
Ms. Gottschalk described a client, a thrift with about $4 billion in assets, $170 million in capital - just over 4% of assets - and an extremely risky business strategy.
One-fourth of the institution's assets are in loans it originated, while 60% are in mortgage-backed securities issued by Fannie Mae and Freddie Mac, half of them with maturities of 15 years or more. Of the thrift's liabilities, half come from deposits, the rest from Federal Home Loan Bank advances and short-term repurchase agreements.
"The picture you get here is they are leveraging up deposits and they are arbitraging government money against itself," she said. "I have difficulty with that as the core business of something that calls itself a thrift."
The thrift makes money as long as the London interbank offered rate, which generally determines how cheaply it can borrow money, is lower than the cost of funds index of mortgage rates. "My client was basically running a book on the Libor-Cofi spread," she said.
If the London interbank offered rate were to rise 200 basis points, the market value of the thrift's equity would be cut in half. If the rate rose 400 points, 90% of equity would be wiped out.
This was not the case of an institution out of control, Ms. Gottschalk added. "When you talked to the CEO, he knew precisely what he was doing. He knew the market risks, he knew the liquidity risks. But he also knew he had a put option on federal deposit insurance."
A put option is a contract that gives the holder the right to sell a security at a fixed price in the future; Ms. Gottschalk reasons that an FDIC guarantee resembles such a contract.
What is an auditor to do when a client takes such risks?
"We can't run their business for them," Ms. Gottschalk said. "If they've got legislative authority from Congress that says they can do this, fine."
Accountants should, however, make sure their clients understand the risks they are taking, and warn them if they are engaging in dangerous practices. Still, Ms. Gottschalk said, "I don't think it's an auditor's place to go out and tell the world, This is a high-risk institution."
