Indexed certificate of deposit

Indexed CDs: Critical mass needed to make them work

Bankers Financial Services Corp, Johnston, Iowa, has developed an indexed certificate of deposit program that links a fixed-term CD's performance to the Dow Jones Industrial Average. These instruments, known as ICDs, are an alluring hybrid combining the best features of a savings product with the glamour of an investment product.

An ICD has the potential to perform better than a traditional CD, although there is no guarantee the Dow will perform favorably. Either way, the customer will not lose a nickel of his or her FDIC-guaranteed principle. ICDs are more adventurous than CDs and less risky than gambling on the Dow Jones outright - a nice middle of the road instrument. For banks, the product represents a new way to attract deposits.

Behind the scenes, ICDs works like this: a bank sells, for example, one $10,000, five-year ICD. The bank pays an upfront premium to a hedge provider - such as Morgan Stanley -- who assumes the risk and agrees to pay the bank, at the ICD's maturity, the ICD's interest performance based on the Dow Jones.

In this example, the hedge premium is 15 percent of the ICD's principal. The bank now has $8,500 left of the original $10,000 deposit and remains responsible for repaying the entire deposit amount at the ICD's maturity. The hedge provider is responsible for the ICD's interest at maturity, which may be nothing or it may be extraordinary. Regardless, the banker sleeps without worrying about it since the hedge agreement shields the bank from the mood of the Dow Jones. For the deal to work for the bank, it needs to feel confident that it can leverage that $8,500 sufficiently over the term of the ICD to return $10,000 to the depositor upon maturity, in this example a rate of about 3 percent per year. Anything more than that, is profit to the bank. BFS sets the term of all its ICDs at five years.

The cost of funding is known at the time the ICD is sold. The bank pays the hedge premium, plus a fee to BFS.

Participating banks pool their premiums and BFS forges a new deal with a hedge provider once a month. The premium price, therefore, fluctuates a little. As more banks participate, BFS can make increasingly favorable deals with hedge providers.

"Morgan Stanley is not going to do business with a $100 million bank," said Kevin Murray, vice president of institutional products at BFS. "The volume isn't there. Banks need to partner with others to help them do things they are just not set up to do."

Murray said the bank's partner in ICDs - the hedge provider - Really doesn't assume much risk and that's why the deals work. He said a company like Morgan Stanley is so extremely diversified that its hedge portfolio represents a small part of a much larger portfolio. "You have to remember, an enormous investment company has huge teams of people working on investing. That's why they are what they are. Making a myriad of different deals is what they do. It's not what community banks do. Community banks typically don't have a widely diversified investment department, much less hundreds and hundreds of experts on staff. The hedge premium is what bankers pay to utilize that structure. The premium might be thought of as more like a fee."

Murray said the ICD program has had modest success. In the first several months that BFS has offered the product, four banks have signed up and have gained less than $1 million in new deposits.

Denver-based Risk Analytics has been offering a similar program since early 2001 through six Federal Home Loan Banks. Unlike the BFS service, Home Loan Bank membership is required to work with Risk Analytics, which bases its instrument's return on the S&P 500.

Risk Analytic's product is marketed through 100 banks in 16 states; these banks have gained roughly $100 million in new deposits from the sale of indexed CDs.

First National Bank of Otis, Colo., has been offering Risk Analytic's indexed CDs for four months with mixed results. "We have 12 banks in our holding company that are offering it. They were doing well at first, but sales have dropped off a bit," said Julie Strand, cashier. "We're in a rural, ag-based community. The drought hit us hard, so they've slowed up. People just haven't had the income. But we've pushed them really hard and there was a lot of interest in them at the beginning."

Right now the bank is viewing the product as more of a service than as a source of funding. "Maybe as the economy picks up, it will become a greater source of funding. With the bad economy, they haven't been reliable enough," Strand said.

Murray is confident that mixed results are just the growing pains of a new product. BFS is betting the market for indexed CDs will grow.

"This is just the beginning. The key with a program like this is getting the critical mass together. The banks we've gotten on board see the potential of this," said Murray. "As the pool of banks grows, the product's potential grows as well."