When Bankers' Bets Go Bad

With a load of derivatives to unwind, banks may face serious trouble from rising rates

Has your conservative commercial bank suddenly become a day trader placing big bets on interest rates? These days, the odds are it has. At the end of last year banks had a gross $71 trillion worth of derivatives on their books, based mostly on interest rates, according to the Office of the Comptroller of the Currency (OCC). That's double the amount of five years ago. Much of the activity is designed to protect the value of the mortgages they hold. But increasingly, banks are trading simply to make some money on the side.

The tactic can be rewarding. National City Corp. (NCC ), a Cleveland bank, said it earned $295 million pretax from interest-rate swaps in the first quarter. Winston-Salem's BB&T Corp. (BBT ) began hedging its mortgage servicing business with derivatives last summer. It posted a $4 million loss in the first quarter, a tenth of what it would have been without the hedging. Meanwhile, the nation's largest thrift, Washington Mutual Inc. (WM ), also has been "opportunistic" in its buying and selling of mortgage securities, says bank analyst David A. Hendler of CreditSights Inc.: "It was trading Treasury and mortgage-backed securities and taking gains when it could."

The gusher of easy money could be drying up. Earlier this year many banks arranged their portfolios to benefit from low interest rates, betting that those rates would stay down most of the year. So they were caught off guard when rates spiked from their March lows. Many were left holding low-yielding securities and were hit by losses on complex derivative contracts that take time to unwind. "They played the trading game for quite a while, and it worked," says Ron Papanek, market strategist for New York's RiskMetrics Group. "Now they're looking down the barrel of a Fed move." Adds Peter Nerby, a senior bank analyst at Moody's Investors Service (MCO ): "It's going to be a lot tougher for people to make money."

Or worse. The runup in rates in 1994 wreaked havoc on banks' securities holdings. Banks were socked with losses totaling about $16 billion, according to the OCC. Big regional banks such as Chicago's Bank One Corp. (ONE ) and PNC Bank Corp. (PNC ) of Pittsburgh took sizable hits. Cleveland-based KeyCorp (KEY ) lost $865 million, mostly in interest-rate swaps, by the third quarter of that year.

DAMAGE REPORTS

Similar strains are starting to reappear. Shares of New York Community Bancorp Inc. (NYB ), the nation's third-largest thrift, have been in a tailspin because of higher rates. The bank had doubled profits in the past year via a string of successful mergers, but on Apr. 21 it reported that its securities portfolio had unrealized losses of nearly $131 million. The company's shares have fallen 11%, to $23, since then, and it has hired investment bankers to shop the bank around. "We're considering strategies that make the most sense if rates are going up much more aggressively and sooner than anticipated," says the company's chief executive, Joseph R. Ficalora. "The [securities] portfolio is very large, and there's a large amount of leverage. We're looking at ways to deal with it."

Banks are loath to talk about their use of derivatives before they have to do so. So until second-quarter results are released in July, even institutional investors will be in the dark about how badly April's runup in rates hurt bank profits. "It's hard for an outsider to analyze all these derivative positions," says James K. Schmidt, portfolio manager of the $2.4 billion John Hancock Regional Bank Fund (FRBAY ). "We have to take it on faith that these are sophisticated institutions, and presumably they are using derivatives in a rational manner."

Although Warren E. Buffett once complained that all derivatives were "toxic waste," they do fulfill a useful function. Federal Reserve Chairman Alan Greenspan argues that their widespread use spreads risk among different market players, including nonfinancial companies, making the financial system a lot safer. All the same, Greenspan reminds banks that they need to keep pace with changes in the market and "readjust accordingly." Bank executives who aren't nimble enough to sidestep rate shocks could find themselves facing big losses or, worse, a quick sale to a larger -- and savvier -- competitor.

By Mara Der Hovanesian in New York

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