THE VIRGINIAN-PILOT
Copyright (c) 1994, Landmark Communications, Inc.
DATE: Sunday, September 25, 1994 TAG: 9409260378
SECTION: BUSINESS PAGE: D1 EDITION: FINAL
SOURCE: BY TOM SHEAN, STAFF WRITER
LENGTH: Long : 250 lines
An alarm sounded last April when Procter & Gamble Co. disclosed a $157 million loss from using derivatives.
Investment professionals and financial accountants were quick to note the unexpected loss.
One by one, other companies reported losses on similar sorts of contracts. Most were using derivatives to protect themselves from swings in interest rates, currency rates and the prices of stocks and commodities.
Among them were Gibson Greetings Inc., Mead Corp., Air Products & Chemicals and Dell Computer Corp.
In Hampton Roads, the parent of Virginia Beach Federal Savings Bank eventually joined the growing roster of companies stung.
What had seemed like a safe, uncomplicated transaction for Virginia Beach Federal in August 1993 suddenly had backfired.
The thrift had purchased a type of derivative - called an interest-rate swap - to protect the spread between the cost of its deposits and the yield on its loans and investments.
The swap was working as planned, but a runup in interest rates early in the year had wiped out its market value. By the end of June, Virginia Beach Federal had to navigate its way through the murky world of accounting for derivative-related losses.
After adjusting for the swap's reduced value, the thrift chalked up a $1.26 million net loss for the first half of 1994.
``Nobody believed it was an issue a year ago, but the Procter & Gamble matter busted the question wide open,'' says Dennis R. Stewart Jr., Virginia Beach Federal's chief financial officer.
Rate swaps and other contracts that have generated so much concern among corporate treasurers, mutual fund managers and regulators are called ``derivatives'' because they derive their value from underlying securities, indexes or interest rates.
For many users, the contracts serve as insurance policies - or hedges - against unfavorable movements in interest rates, currency rates or stock prices.
Derivatives also enable speculators to place enormous bets on interest rates, currencies, stocks and commodities while committing only token amounts of cash. But in many instances, the distinctionbetween seeking protection from financial market gyrations and speculating becomes blurry.
The burgeoning use of derivatives in recent years is due partly to the volatility of interest rates and foreign exchange rates.
But aggressive marketing has played a part, too. Securities firms and banks discovered they could earn hefty fee income by tailoring exotic contracts to the needs of particular customers.
For many companies, derivatives ``are enormously useful,'' says Mark R. Eaker, a finance professor at the University of Virginia's Darden Graduate School of Business Administration. ``But like any tool, they can be misused or oversold by the people developing them.''
Indeed, derivative dealers found a lucrative market among corporate treasurers trying to reduce their companies' borrowing costs. A treasurer may decide that ``this is an opportunity for me to shine,'' says Eaker. But in the process of using certain derivatives to do that, ``he may have exposed the company to significant risk.''
The risks - and losses - now associated with derivatives spurred the Securities and Exchange Commission to act. Some accountants expect the SEC to define the accounting rules for valuing derivatives later this year.
Virginia Beach Federal decided that it couldn't wait for action by the SEC.
``The longer you wait, the more you are exposed to second-guessing,'' says Stewart. For Virginia Beach Federal, ``the safest thing was to go ahead and report the loss.''
Recognizing the swap's lost value immediately apparently has worked for the thrift.
Shareholders of the thrift's parent company shrugged off the bad news. The company's share price dipped when results for the second quarter and first half were disclosed in early August, but it quickly stabilized.
Although the loss reduced shareholders' equity in the company, Virginia Beach Federal continues to meet the capital standards imposed by federal regulators. Also, its deposits remain insured up to $100,000 by the Federal Deposit Insurance Corp. PROFITS AND PITFALLS
Virginia Beach Federal's experience with the dark side of derivatives began in mid-1993.
Faced with a mismatch between the high cost of its deposits and the low yields on its portfolio of adjustable-rate home loans, the thrift sought some way to protect its meager earnings until interest rates rose and yields on its home loans improved.
In use since the early 1980s, interest-rate swaps have become widely accepted by financial institutions and large corporations. While Wall Street securities firms devise increasingly exotic derivatives tied to such things as commodities indexes, options and futures, the bulk of derivatives activity still consists of interest-rate swaps.
Stewart compared the interest rate swaps being offered last year by a handful of large Wall Street securities firms before settling on one that met Virginia Beach Federal's needs.
He chose a four-year swap pegged to the London Interbank Offering Rate (LIBOR), a widely used benchmark for interest rates. The swap would provide Virginia Beach Federal with periodic payments fixed at 5 1/2 percent. In return, the thrift would make periodic interest payments to a Wall Street securities firm that moved up or down with the LIBOR.
While the benchmark rate remained below 5 1/2 percent, Virginia Beach Federal would receive more from the securities firm than it paid. If the benchmark rate climbed above 5 1/2 percent, the thrift would pay more than it received. But rising rates also would raise the yields of its adjustable-rate loans, offsetting the higher payments it had to make to the swap dealer.
``It is formula-driven. There is no uncertainty'' about the mechanics of the swap, says Stewart.
But in the complicated world of swaps, all is not always apparent.
What Stewart did not anticipate was the change in accountants' thinking about recognizing a swap's value. PROTECTION OR SPECULATION?
Unlike a conventional interest-rate swap, Virginia Beach Federal's could be called back by the Wall Street securities firm before it matured. The callable feature provided the thrift with additional yield but raised questions among accountants when Procter & Gamble reported its derivative-related losses last spring.
If an ordinary interest-rate swap had lost value, accounting rules would allow Virginia Beach Federal to defer that loss into the future because the swap was clearly an effort to reduce risk.
But because this swap could be called back, it appeared to be speculative. And that prompted Virginia Beach Federal to recognize the swap's negative value immediately and include the loss in its quarterly financial results.
``We never even imagined that the callable nature would be viewed as speculation,'' says Stewart.
Some securities analysts and accountants question whether financial institutions should have to immediately mark down the value of an interest-rate swap to its market value.
In most cases, banks and thrifts will hold onto a swap - even one that has lost value - until it expires, says Merrill H. Ross, a banking analyst with the securities firm Wheat First Butcher Singer in Richmond.
By requiring an institution to immediately mark a swap to its market value ``suggests that the management has no other option except to sell it, and that's not the case,'' she says.
The Wheat First analyst contends that more restrictive accounting rules, including the pressure on banks to revise the values of swaps immediately when their values decline, will prove detrimental. ``Too much measurement,'' says Ross, ``rules out certain strategies. It limits the options available to companies to manage their asset-liability risks.'' GOOD INTENTIONS, BAD BREAK
Wrestling with the nuances of accounting for swaps came at a time when Virginia Beach Federal was making progress on two more troublesome problems: the high level of nonperforming assets and the high cost of its deposits.
Both problems were rooted in the early 1980s, when Virginia Beach Federal paid above-market interest rates to attract deposits from outside Virginia and made large loans on time-share resorts, hotels and other projects in the western United States.
In recent years, the thrift has sharply reduced its once-swollen portfolio of foreclosed real estate. And several million dollars of long-term certificates of deposit paying interest rates of 12 percent and 13 percent began rolling off the thrift's books this summer.
The complications from its interest-rate swap surfaced amid management efforts to restructure Virginia Beach Federal's operations. As part of a three-year plan, the thrift has been expanding its network of local branches, adding services and building up its mortgage-banking subsidiary.
The swap-related loss ``is a headache, but it's not anything that gets in the way of our business plan,'' says President and Chief Executive Officer John A.B. (Andy) Davies. BOUNCING BACK
Virginia Beach Federal's share price has held steady after a $1.26 million loss for the first half largely because investors expect the institution to be sold, says Ross, the Wheat First Butcher Singer analyst.
Several thrifts in Virginia have been acquired in recent years by statewide banks seeking to expand their operations in growing markets. Last week, Richmond-based Crestar Financial Corp. announced an agreement to buy the thrift holding company TideMark Bancorp Inc. in Newport News for more than twice TideMark's book value.
Making the damage from its interest-rate swap readily apparent and reporting a loss could work to Virginia Beach Federal's favor if it is approached by a prospective acquirer, says Ross.
``This brings it right out front and makes it easier to conduct (merger) discussions.'' ILLUSTRATION: Graphic
TEXT BY TOM SHEAN, ILLUSTRATIONS BY ROBERT D. VOROS/Staff
WHAT HAPPENED AT VIRGINIA BEACH FEDERAL
GROWTH IN THE VOLUME OF DERIVATIVES
SOME MAJOR U.S. COMPANIES THAT HAVE REPORTED DERIVATIVE-RELATED
LOSSES SO FAR THIS YEAR:
SOURCE: General Accounting Office, ``Financial Derivatives: Actions
Needed to Protect the Financial System'' (May 1994)
[For complete graphic, please see microfilm]
Photo
MORT FRYMAN/Staff
Dennis R. Stewart Jr., Virginia Beach Federal Savings Bank's chief
financial officer, says reporting a $1.26 million loss was the
bank's safest option in accounting for its derivatives.
Graphics
DERIVATIVE DEFINITIONS
Derivatives are hybrid financial contracts whose prices are tied
to the prices of underlying financial assets or indexes.
Some companies and investors attempt to protect themselves from
swings in interest rates, currency rates or stock prices by using
derivatives. Others try to profit by betting which way interest
rates, currency rates or stock prices will move.
Some types of derivatives, including interest-rate swaps, have
become widely accepted, but the complexity of newer, tailor-made
derivatives has provoked concerns about a possible threat to the
nation's financial system.
These are some of the widely used derivatives:
Interest-rate swaps: Contracts to exchange cash flows. One
party's payments are set at a fixed interest rate, while the
interest rate on the other party's payments varies according to
market conditions.
Structured notes: Contracts with a return tied to an external
factor, such as a stock market index or the difference between
short-term and long-term interest rates.
Collaterized mortgage obligations: Securities tied to
million-dollar pools of home mortgages. The interest and principal
payments on these securities are packaged in a way that investors
can choose a CMO with a specific maturity.
REGULATORY RESPONSES
Some highly publicized losses, along with the release of a
General Accounting Office report on derivative use in May, have
spurred calls from regulators for more detailed disclosure by
corporations. In addition, some members of Congress have pushed for
broader regulation of derivatives dealers and reporting.
The Securities and Exchange Commission cautioned mutual fund
managers in June that some types of derivatives were not suited for
money market mutual funds.
The Federal Reserve and the Office of the Comptroller of the
Currency have proposed higher capital standards for banks that trade
in more speculative derivatives.
The Financial Accounting Standards Board, the independent body
that writes most of the accounting rules used by U.S. businesses,
has drafted more detailed rules for the way companies report their
use of derivatives. These rules would require disclosure of the
amounts, terms and nature of a company's derivatives.
STAFF
VIRGINIA BEACH FEDERAL SAVINGS BANK
SOURCE: Company reports
[For complete graphic, please see microfilm]
by CNB