Local banks weigh hedging risks

As interest rates continue to rise, banks are looking at hedging their bets through derivatives. The instruments typically allow banks to buy a guarantee that a portion of their portfolio is linked to the interest-rate market. The strategy is gaining popularity with Southern Nevada banks but some say it is still too risky.

Banks that want to hedge their loan portfolio typically seek out a large institution such as a Wall Street financier or a multi-national bank that is willing to guarantee additional interest payments if rates rise. In return, the bank seeking the hedge will pay a fixed percentage of the interest on the loan.

The hedging of interest rates has traditionally been the domain of major banks but with the Federal Reserve pushing interest rates higher, and lower hedging minimums, have led smaller banks to use a similar strategy. Arvind Menon, the president and CEO of Nevada First Bank, is beginning to use derivative hedging to protect his $462 million bank from the rising rates. If a customer wants to borrow at a fixed rate for the long-term, Nevada First's loan officers will seek to hedge the interest on the loan. The move is designed to protect his institution from interest rate shocks as short-term deposit rates rise at a quicker pace than long-term rates.

"As a bank, you don't want to take that type of interest rate risk," he says. Hedging can safeguard against that margin squeezing because the lending bank is guaranteed to receive the equivalent of the London Inter Bank Offering Rate (LIBOR) on the loan. That rate is based on an international index that allows investors to match their cost of lending with the cost of funds.

For example, Menon says, if he makes a 15-year, fixed-rate loan for 6 3/4 percent, the bank can turn around and hedge the interest. Nevada First will be guaranteed the floating LIBOR rate, while it agrees to pay the other institution the current fixed LIBOR of around 4 percent and an extra 2 percent more. So, Nevada First starts out paying the other institution 2 percent of its loan interest for the hedge.

"If rates go up 200 basis points, (the) Wall Street (financial institution) reimburses me and I'm fine," explains Menon. "By doing (derivative) swaps, we are willing to take a lesser profit from rates going down to protect us from going bust if rates go up."

Some other community bankers were skittish, if not outright opposed to, derivative hedging. Silver State Bank CEO Tod Little warns that the practice is more difficult than a lot of bankers think. "I have seen very smart people get hammered doing derivatives," he says.

Dropping interest rates can turn the hedge into a bad investment for the lending bank, Little cautions. "You are not insuring with Safeco Insurance. Somebody will make money and somebody will lose money. You are still guessing which way rates will go."

Bank West of Nevada President Larry Woodrum was also leery. "It takes special people to do that and you really have to be up on it when the regulators come," he advises.

Red Rock Community Bank doesn't do derivative hedging either. It's president, Tom Mangione, says the bank's parent company -- Capitol Bancorp -- doesn't allow it. Beyond that, the small institution lacks the staff and programs needed to make informed hedges.

Mangione doesn't necessarily think it is a bad idea for some banks. "Most of (Capitol Bancorp's) banks are around $125 million (in assets)," he says, "but if you are around $500 million, you might want to start getting into that."

A recent study by the University of Michigan's Ross School of Business analyzed data from 8,000 commercial banks from 1997 to 2003 and found that about 400 of those banks used hedging at the end of 2003.

"Over the last 15 or 20 years, more and more banks are using it," says its author, assistant professor Amiyatosh Purnanadam.

"When rates change a lot, or go up a lot, banks that are using derivatives show less change in their business than banks that aren't using it."

The last three years has shown a $43.3 trillion increase in the notional amount of derivative, or the value of the assets underlying the hedges, according to Federal Deposit Insurance Corporation reports. As of September, $99.6 trillion in assets were being used for hedging, compared to $56.3 trillion in December of 2002.

At one time the minimum hedge amount was $20 million, it now can be as low as $1 million, allowing community banks such as his to utilize derivatives.

Other factors have propelled the market, too. Dealer banks, such as Bank of America, have traditionally acted as brokers between the smaller lenders and other financial institutions. In recent years, however, aggregate banks have popped up to serve the growing demand. The aggregates sell the community banks' smaller hedges in bulk to large financial entities.

In a March 2003 report, the FDIC warned of the risk of the spread widening unexpectedly in response to market forces. In some of these cases, the hedge may actually cause a loss on the contract that it was put in place to protect, regulators cautioned.

Nevada State Bank uses hedging, but its president, Bill Martin, calls them "swaps," saying there's a negative tone to "derivatives."

"The word 'derivative' is like a lighting rod," he explains. "The swap is not a high-risk item. The swaps are a balancing vehicle. They close your risk. They don't open your risk."

Large banks, including Well Fargo and Bank of America, commonly use derivative hedging. It is the entrance of community banks into the practice that is raising a few eyebrows.

"If a small community bank is getting into derivatives, I would say that they are getting too smart," says Silver State's Little, whose bank has about $800 million in assets.

University of Michigan professor Purnanadam admits the practice is not without hazards. "Unless they have a system in place and the technical expertise, they could end up increasing their risk instead of hedging it," he says.

What are people saying about mortgages today:

Rates on 30-year mortgages edged down last week to a seven-month low. Mortgage-giant Freddie Mac reported Thursday that 30-year, fixed-rate mortgages fell to 6.3 percent, down slightly from 6.31 percent two weeks ago. It put rates at the lowest level since they were at 6.24 percent the first week of March.

Bank of Hawaii, Central Pacific Bank, Territorial Savings Bank and Wells Fargo Home Mortgages all cut their 30-year mortgage rates to 5.75 percent this week.

Most people think of a mortgage as a means to an end. After all, you buy a house, not a home loan. But a mortgage is much more than the path to homeownership. It is a financial instrument that must be managed, just like any other financial investment.