One of the primary markets for structured notes (the great market, some would argue) was regional banks-back when interest rates were declining, bank profits were thin, and enhanced note coupons could pump up a bank's reported earnings. There's been much water under the bridge since then. A lot of blood was spilled when interest rates rocketed up in 1994 and the FASB tightened reporting rules. Now, a year and change later, there are lingering symptoms of battle fatigue and fear couched in the mantra "p-l-a-i-n v-a-n-i-l-l-a". The good news for dealers is that some regionals will listen to a story on structures and a handful may actually do a deal that is priced right.

Wallace Millner
Senior executive vice president and CFO, Signet Banking Corporation

Our position is that short-term rates will decline rather than rise, so we're moving the balance sheet modestly into a liability-sensitive position. We only use plain vanilla fixed received swaps and floors.

It's our practice not to mess with structured notes because we don't understand them. High-octane structured notes are difficult to model; it's tough to measure their performance. We want to keep it simple.

I can't say we've never used index amortizing swaps, but there are none on the books today. Our natural balance sheet is asset sensitive; we're predominately a consumer bank. We're moving outside our natural markets in Virginia and Maryland to generate assets. The natural balance sheet is asset sensitive generally, so our principle use of swaps is to bring it into balance and tilt to a more liability sensitive posture.

Long-term, the swap book will have a fairly short average life of under two years on balance. We've been letting our swaps run off and haven't replaced them as they've run off. We've had good success in putting on fixed rate consumer loans. The consumer loans aren't much longer than two to two-and-a-half years, so they're replacing fixed receive swaps as a balance sheet management device. In fact we've been less active in derivatives in the last 15 months than we have in the last five years-because Signet is getting more lending business and doesn't need swaps.

Kelly Deponte
Vice president, risk management, Bancorp Treasury

There seems to be a lot of disagreement in the market. Prices are bouncing up and down 50 points a day, reflecting disagreement on the direction of the economy and interest rates. There will be more pressure on rates to go up and more uncertainty in the short term.

First Interstate hasn't been an active user of derivatives or structured notes to hedge its portfolio, though recently a hedge program was instituted. Wells Fargo Bank is taking over effective April 1 or May 1 of this year, pending regulatory approval.

We've looked at putting in floors to protect against asset sensitivity to the bank. We're also locking in historically low rates with interest rate swaps. The bank's overall portfolio is repriced in the three-year range generally. Sometimes we go out longer for asset/liability purposes, and then hedge the overall portfolio, but we wouldn't go out more than five years; only if we issued long-term debt that was more than five years. In that case we'd purchase a swap and pay floating rate.

We're leery of structured notes. We took a close look at them in 1993. Index amortizing swaps have a spread over Treasuries, with that spread providing compensation for the prepayment risk of the embedded options. Many people were looking at the spread over Treasuries and not at the prepayment risk. Index amortizing swaps are cleaner than the CMOs because the prepayment risk is straightforward, based solely on interest rate changes. But the volatility of interest rates can still hurt the swap holder when rates increase or decrease dramatically.

The models that track index amortizing swaps are more of an art than a science. You can't be sure you'll get the spread over Treasuries. When mortgage-backeds fell tremendously in 1994, returns on index amortizing swaps fell as well. Given the volatility, we're not tempted to look at index amortizing swaps or other highly structured transactions, like LIBOR cubed, that reflect a strong bet on the direction or volatility of interest rates.

Steven Bluhm
Vice president, funds management, Banc One Funds Management Co.

We continue to view the index amortizing swaps as any other structure, and compare the option-adjusted returns. We look at the cost of the options, the stress-tested return, and make a relative value decision. We are not summarily dismissing them. The internal amortizing schedule is based on volatility, forward curves, and there are times when it gets out of whack which represents value. We're certainly not just drawing a line in the sand and saying no to putting on index amortizing swaps. But that is not to say we have put any on recently. If the structure gives us value compared to plain generic derivatives or other transactions, or if we're given the opportunity, for example, to sell CMOs that have embedded characteristics that are similar to index amortizing swaps, but at a rate that is richer than their off-balance-sheet brethren, then there is a lot to argue for doing the transaction. Net net the structure of optionality can be improved and improve yields as well. We are not going to close the door on an opportunity.

Fundamentally, I do not see the economy picking up or going into a recession. I see a 1 1/2­2 percent real GDP. The wild card is how much "balanced budget" is built into the rate structure. If the euphoria over the balanced budget is wrung out of the market, expect a market correction. The question is: how much euphoria is built into rates? Talk of a balanced budget has lasted a solid three to four months, but I am not convinced a balanced budget will occur until after the November elections. The market has a propensity to swing too far to either side of the pendulum. You might see rates swing too far to the plus side.

I am not shorting volatility, and we not adding negative convexity onto the balance sheet. I am not convinced rates will stay tame. So at this stage of game we do not see value in shorting options.

Jeanne Krips
Executive vice president, head of balance sheet management, KeyCorp

On the balance sheet we are allowing our securities portfolio to reduce through maturities or prepayments and using that cash flow to fund loans. Alternatively, we may allow the run-off to trigger a deleveraging of the balance sheet and create an opportunity to buy back capital.

We have tightened our parameters for managing interest rate risk, and through a series of balance sheet restructurings, we are maintaining only a minimal amount of exposure to rate movements as measured by our simulation model. In addition, we have included duration analysis in our management of risk, providing a longer-term aspect to our controls.

We are anticipating two more Fed easings before the third quarter and believe the economy continues to show weakness. Over the long term our current expectation is for a turn in rates in mid-1997, with a steepening yield curve accompanying it. However, in light of our nearly neutral interest rate risk positioning, we are not overly concerned about guessing wrong on the timing.

We have limited our use of structured products and will continue to have only minimal exposure in that market.

Douglas Jacobs
Treasurer, Fleet Financial Group

Fleet has three primary needs for hedge-related derivatives. The first is to achieve a reasonably interest-rate-insensitive balance sheet. Fleet has been in an aggressive acquisition mode over the past year, merging with Shawmut National and announcing plans to purchase the US franchise of NatWest.

While Shawmut was a pooling-of-interests transaction, NatWest will be a purchase transaction. In order to buy NatWest without resorting to the need for additional dilutive equity issuance, Fleet plans an asset substitution strategy. Roughly $15­18 billion of assets, primarily securities and residential mortgages, will be sold off Fleet's books. Proceeds will be used to retire capital markets borrowings. NatWest's balance sheet will be downsized the same way. At closing Fleet will thus be purchasing only core assets and liabilities, primarily commercial and consumer loans and deposits. It is anticipated that the net change to the size of the Fleet balance sheet will be small.

Sale of long-duration assets and reduction of short-duration liabilities will tend to make the resulting Fleet balance sheet asset sensitive, i.e., exposed to a reduction in earnings in a lower-rate environment. In order to rebalance it is necessary to add duration to the asset side of the balance sheet. This can be accomplished through plain vanilla receive fixed-pay floating swaps. Unfortunately, the currently inverted yield curve means that there are carry costs to such positions, making it critical that we correctly estimate the required notional amount and duration of such swap hedges in order to provide adequate protection at a reasonable cost.

The second need for derivatives relates to hedging of purchased mortgage service rights (PMSRs) on the books of Fleet Mortgage Group (FMG). Due to prepayment behavior on the underlying mortgages service by FMG, lower interest rates tend to lower the value of PMSRs in similar fashion to their effects on interest only strips.

FMG and other major mortgage bankers hedge against this eventuality with a combination of OTC long-dated floor contracts, typically against Treasuries, and futures positions.

The third need is to hedge portfolio basis risk. Certain portfolio instruments, such as GNMA ARM securities, float based on a Treasury index. We have used basis swaps to convert this exposure to LIBOR-based indexes more closely approximating our funding costs.

Our economist, Nick Perna, is calling for one or two more 25-basis-point rate reductions followed by stabilization of the curve with some increase to the long end.

With the exception of an index amortizing swap position put on in 1993 for balance sheet hedging purposes, Fleet does no structured products. The index amortizing position largely matures during the summer of 1996 and we have no plans to replace it.

Fleet engages in an interest rate protection product business for its middle market corporate customer base. Total notional is about $4 billion, representing a balanced two-way book in swaps, caps and floors.