Vectra Banking Corp. is a community bank on the rise.
The Denver-based company recently raised $11 million in an initial public offering. Its core earnings just tripled. And it is actively looking to buy other banks.
Why, then, has 11% of Vectra's equity suddenly vanished?
Because of an interest rate glitch, Vectra had loaded up on mortgage securities with yields tied to a slow-moving index of interest rates. As market rates have risen this year, the yields on the securities haven't kept pace, causing a drop in value. That, in turn, required a deduction from capital.
Vectra is not alone.
A number of community banks holding securities like Vectra's could take hits in the coming months if interest rates continue to climb, 'analysts and executives suggest.
"I wouldn't be surprised if more banks, if they have the capital, choose to take hits on these securities," said Nathan C. Collins, president of BancTexas Group Inc., which recently took a big hit on some collateralized mortgage securities.
The securities at issue feature yields pegged to an index of western thrifts' costs of funds.
The measure, known as the 11th District-cost of funds index, or Cofi, is calculated monthly by the Federal Home Loan Bank of San FranCisco.
Many large thrifts use the index for setting rates on their adjustable mortgages. With the index rising slower than funding costs this year, thrifts have been reporting shrinking net interest margins.
But the problem has been even greater for some holders of Cofi-linked securities, partly because of new accounting rules.
Vectra, with $421 million in assets, disclosed in its third-quarter earnings release that the lag in the Cofi index had contributed to a $4.9 million pretax decline in the value of its investment portfolio.
Under mark-to-market accounting rules, this required $3 million deduction from shareholder equity.
BancTexas Group, meanwhile, saw the profit margin on its Cofi securities "squeezed to virtually nothing" earlier this year, chief executive Mr. Collins said.
The securities, he said, were "financed on a sh0rt-term basis, and the rates on what we borrowed to buy them went up instantly. The Cofis didn't."
The $38,7 million-asset company decided to sell the securities and take a $7 million loss.
"We were able to redeploy that money in earning assets and can go forward earning .some money now," Mr. Collins said.
Why does Cofi moves slower than other market rates?
First, the San Francisco Home Loan bank takes a month to compile and report the monthly data.
In addition, the data reflect thrifts' total funding costs -- both short-term and long-term liabilities.
The lag, of course, can produce fat profits when market rates fall, as they did in 1992 and 1993.
But margins can contract swiftly when rates rise.
For securities holders, the problems are compounded by rule No. 115 of the Financial Accounting Standards Board.
If a bank designates the securities as "for trading," the fluctuations in market price would be reflected on the income statement.
If the securities are "held to maturity," shifts in market value would not be reflected on the financial statements at all. Finally, if they are designated as "available for sale," changes in market price are reflected in the equity section of the balance sheet.
Vectra had placed its Cofi securities in the "available for sale," category.
"Our decision to designate Vectra's entire portfolio as available for sale provides full disclosure to shareholders of our capital position and demonstrates our commitment to prudently manage all assets, including our securities investments," said Vectra CEO Gary S. Judd in a statement.
Vectra "substantially" increased its securities investment activities this year, in part with $175 million in Federal Home Loan Bank of Topeka borrowings. What Vectra bought was $60 million in Cofi-indexed variable-rate collateralized mortgage obligations, $10.75 million of Home Loan bank notes, and $14.3 million -of fixed-rate CMOs.
The earnings spread on those securities is still nicely positive. But because of the Cofi lag and the extension of estimated average lives on most CMOs, the bank has suffered an unrealized decline in the market value of the investments.
Despite the setback, Vectra officials remain upbeat.
"Cofi has increased for the last five months; if it continues to rise, the yield from our Cofi portfolio will increase, and over time we expect the market value to also rise," said Ray L. Nash, chief financial officer.
And, while it isn't ruling out selling its Cofis, Vectra said it will most likely hold them to maturity, thereby making up the market value loss.
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