Asset/Liability%20Management%20Day%204

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Asset/Liability ManagementDay 4

• Equity Valuation, Duration, EVE, Deposit Betas,
  Hedging

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Equity Valuation Focus

• Basic fixed income security valuation rule
• Rates rise ? value falls
• Rates fall ? value rises
• Market value of equity
• MVEQ is the market value of assets (MVA) minus
  the market value of liabilities (MVL)
• Rate changes result in changes in MVA and MVL
• Changes in MVEQ caused by interest rate changes
  reflect interest rate risk

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Duration GAP

• Duration GAP Analysis
• Price sensitivity of banks assets and
  liabilities
• Impact of rate changes on stockholders equity
  value
• Duration measures effective maturity of a
  security
• Time-weighted average of present value of
  expected cash flows relative to its price
• Measures price sensitivity to rate changes
• The greater the duration, the greater the price
  sensitivity
• The smaller the duration, the smaller the price
  sensitivity
• Duration is NOT maturity.

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Duration GAP

• Duration GAP Model
• Focus on managing market value of equity
• Compares duration of assets with duration of
  liabilities
• The larger the duration GAP, the larger the
  change in the economic value of stockholders
  equity when interest rates change
• A duration GAP of zero implies that changes in
  rates would not affect the value of equity

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Positive and Negative Duration GAPs

• Positive DGAP assets are more price sensitive
  than liabilities
• Rates rise assets fall proportionately more in
  value than liabilities, so EVE falls fall
• Rates fall assets rise proportionately more in
  value than liabilities, so EVE rises
• Negative DGAP - liabilities are more price
  sensitive than assets
• Rates rise assets fall proportionately less in
  value than liabilities, so EVE rises
• Rates fall assets rise proportionately less in
  value than liabilities, so EVE falls

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EVE Sensitivity Analysis

• Similar steps as earnings sensitivity analysis
• However, in EVE analysis the focus is on
• The relative durations of assets and liabilities
• How much the durations change in different
  interest rate environments
• What happens to the economic value of equity
  across different rate environments

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EVE Sensitivity Analysis EVE Sensitivity Analysis EVE Sensitivity Analysis EVE Sensitivity Analysis EVE Sensitivity Analysis
Rate Shocks DOWN200 STATIC UP200 UP300 UP400
FFS and Other 10,984 10,852 10,720 10,655 10,589
Net Loans 151,608 147,286 142,412 139,863 137,458
Securities 135,789 124,577 114,611 109,628 104,645
Non-earning Assets 23,186 23,186 23,186 23,186 23,186
Assets (Market Value) 321,567 305,901 291,029 283,332 278,878

MMDA/NOW/Savings 104,523  96,409 92,206 90,104 88,003
CDs 93,015  91,544 90,073 89,338 88,603
Checking 51,526 47,526 44,635 43,189 41,744
FFP Other Borrowings 32,324 30,728 29,077 28,252 27,427
Other 3,279 3,279 3,279 3,279 3,279
Liabilities (Market Value) 284,667 269,486 259,270 254,162 249,055
Economic Value of Equity 36,900 36,415 31,759 29,170 26,823
Percentage Change 1.3  0 -12.8 -19.9 -26.3
Equity Ratio 11.48  11.90 10.91 10.30 9.72
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Assumptions

• Prepayments on loans
• Does the model account for loan floors and caps?
• Call options on investment securities
• Non-Maturity Deposits
• Betas
• Decay Rates

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Assumptions-Deposit Betas

• Core Deposit accounts typically have administered
  rates, meaning the rates change when management
  at the bank say they change.  We do know however
  that there is often some response to market rate
  changes.  To model this sensitivity we use a 
  Beta factor. This is the percentage of rate
  change each account will move with a 100 basis
  point movement in Fed Funds. 

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Assumptions-Decay Rates

• Decay rates essentially are an assumption about
  the average life of your non-maturity deposits. 
  They will have the most impact on your bank's EVE
  measurement.  The longer you model these deposits
  to be, the more base EVE for the bank.   
  Calculating the value of all assets and
  liabilities is a reasonably straightforward
  exercise except when it comes to core deposits. 
  They have a beginning balance and a rate, but
  they are missing the term structure (i.e. they're
  "non-maturity" deposits).  The decay assumptions
  you provide give them an assumed term structure.

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Assumptions-Decay Rates

• Decay Rates are the most powerful assumptions in
  the measurement of EVE.
• They are also the most difficult to determine.
• FDICIA Decay Rates
• Industry Studies
• Bank Deposit Study
• Stress Testing

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Assumptions-Decay Rates

• FDICIA Decay Rates Developed in 1990s. Many
  models use these as default assumptions. May not
  be an accurate picture of your banks decay
  rates.
• Industry Studies Several models have recently
  adopted these as they indicate significantly
  longer decay rates than FDICIA rates. May not
  relate to what is going to happen when rates rise.

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Assumptions-Decay Rates

• Bank Deposit Study Very expensive and likely
  will not show how your deposits will react when
  rates start to rise from these low levels.
• Stress Testing Whatever assumption is being
  used for decay rates, they should be stress
  tested to see what speed will cause excess risk
  to the bank.

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Assumptions-Decay Rates
Checking NOW MMDA/Savings
Quarter 1 72 Months 60 Months 48 Months
Quarter 2 100 Months 100 Months 100 Months

Change in EVE 200 Basis Points 300 Basis Points 400 Basis Points
Quarter 1 -12.8 -19.9 -26.3
Quarter 2 4.6 4.1 6.0
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Surge Deposits

• Bank on previous slide had experienced growth in
  NMDs from 56 to 63 of total deposits over past
  two years. ( Approximately 15 million)
• Most banks have experienced sharp growth in NMDs
  over the past two to five years.
• Customers are parking money until rates start up.
• How should this effect decay rates?

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Recap

• Longer/Greater Duration More price sensitivity.
• Inverse Relationship between interest rates and
  prices/market values.
• EVE is a theoretical liquidation value of the
  institution NOT a going concern valuation.
• Nonetheless, it must be monitored, measured, and
  understood.
• NMD assumptions decay rates- and the changes
  therein are the most critical variables in EVE.
• Rates are at historic lows. They will go up. (
  Reversion to the mean unless the mean has
  experienced a generational shift.) What happens
  then?
• Modeling and stress testing are prudent, and
  required.

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How Do We Protect Our Institutions From The
Perils Of Rate Changes?

• Hedging, or mitigating , interest rate risk.
• Caps and Floors
• Interest Rate Swaps

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Caps and Floors

• Essentially insurance policies that are triggered
  by interest rates moving past an index point, or
  strike price.
• A one time up-front premium is paid for the
  contract.
• The buyers cash exposure is quantified at the
  outset.
• The buyer of the contract receives no payment
  unless triggered- just like your homeowners or
  auto insurance.
• The only residual risk is counterparty
  performance.

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How does it work?

• Assume a Notational Amount of a cap contract of
  50M.
• Index is the Prime Rate, currently at 4.
• Buyer (Bank) is concerned about rates rising, as
  they are Liability Sensitive. Should rates rise
  their deposit costs will go up faster than yields
  on loans and bonds.
• Bank purchases a cap contract from securities
  firm that pays them should Prime rise above 5,
  to be calculated on a quarterly basis, and the
  term of the contract is two years.
• Sure enough! 6 quarters later Prime is now 5.5
  (Ask me about 1994).
• Investment firm pays Bank cash equal to 50 BP X
  50M NA/4, or 62,500.
• Floor contract would operate in a similar
  fashion, as rates decline.

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Notational Amount

• This is the predetermined amount upon which
  payments are based.
• This is NOT an amount of principal at risk.
• This is NOT a market value.
• The notational or theoretical- amount NEVER
  changes hands.
• So.when we see statements in the news that the
  Bank and thrifts hold a total notational amount
  of all outstanding derivative contracts of 178
  TRILLION , 15 times our GDP !!!Your reaction
  should be So what?
• Notional amounts outstanding represent
  ACTIVITYNOT RISK.
• Risk is gauged by the market valuation of the
  contracts, which is , after netting out bilateral
  positions, roughly 4 of the notional amount.
  After netting and collateralization, the figure
  is closer to 3/10 of 1.
• Still a big number..
• BUT

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Lets Talk Real Risk

• Global stock of debt and equity outstanding in
  2013 was 62 Trillion of UNSECURED lending..
• 50 Trillion of Equity
• 47 Trillion of Government bonds
• 42 Trillion of Corporate Bonds
• Talk about your default risk!

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SWAPS

• Specifically Interest Rate Swaps
• Interest Rate Swaps are simply contracts between
  two parties to exchange interest rate cash flows.
• In the simplest, plain vanilla swaps, one party
  pays a fixed rate, and the counterparty pays a
  variable rate.
• The payments are based on a notional amount. (
  Youre experts on that now. )
• There are other swaps- currency swaps, commodity
  swaps, subordinated risk swaps, credit default
  swaps, zero coupon swaps, variance swaps, total
  return swaps.and more!
• An option on a swap is called a swaption.
• There will be 6 questions on your final exam
  about swaps, so pay attention.
• Just kidding..

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Why would we do an interest rate swap?

• Why indeed..???
• Perhaps to HEDGE our balance sheet, and hence the
  income statement, against an ADVERSE movement in
  interest rates.
• Rates ALWAYS movesometimes slowly, but
  inexorably.
• So for example, if we are liability sensitive, (
  our deposits reprice faster than our loans and
  bonds), with a loan portfolio of longer term
  fixed rate loansWhat might we do to hedge
  against rising rates?
• How about receiving a variable rate stream of
  income, while paying a fixed rate stream of
  income to our counterparty?
• In swap parlance this would be putting on a
  variable swap.

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Examplia Gratis

• Lets assume that Bank A has a 100M base of fixed
  rate loans with 10 year terms.
• The average repricing of our liabilities
  (Deposit Beta!!) is 8 months.
• WHEN rates rise, our Net Interest Margin, or NIM,
  will be squeezed, and our income will decrease.
  Cant have that. What to do?
• Lets enter into an interest rate swap with Brand
  X firm. (Brand X may actually be acting as a
  broker or intermediary in the transaction, but it
  doesnt matter.)
• We are going to pay a fixed rate of interest,
  lets say 1 for the next 3 years.
• We are going to receive a variable rate of
  interest, lets say 90 day LIBOR, currently at
  .25, for the same period.
• The notional amount of the swap contract is
  100M.
• At day 1, we are paying out a net of 75 basis
  points to Brand X, settling quarterly.
• .0075 X 100M NA/4 187,500 quarterly.
• This payment reduces our yield on our fixed rate
  loan portfolio.
• Rates begin to rise.

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A simple exchange of cash flows.
Your Bank
1 Fixed
Brand X
90 Day LIBOR

• Notional Amount is 100M US

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Continued.

• A year passesSure enough rates are rising. Each
  quarter the check we send to Brand X gets
  smaller.
• Eureka! 90 day LIBOR has broken the 1 barrier.
• At the end of year 2, 90 day LIBOR stands at 2.
• Now we are getting a quarterly check for 250,000
  from Brand X.
• 100 BP (1) difference X 100M NA/4 250,000.
• While our liability funding costs may or may not
  have moved in tandem with the movement of LIBOR,
  whatever increase we experience in our cost of
  funds is mitigated, or hedged, by the swap income.

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Notes

• Swap agreements are largely standardized by the
  ISDA, the International Swaps and Derivatives
  Association.
• Swap markets are primarily regulated by the
  Commodities Futures Trading Commission and the
  SEC.
• The Dodd-Frank Act mandates that banks can longer
  speculate in swaps markets, they may only use
  swaps to hedge their own balance sheets or on
  behalf of customers. ( The Volcker Rule.)
• All swaps are now required to be cleared and
  netted through transparent exchanges.
• Regulatory agencies ( Fed, OCC, FDIC, State
  Banking Commissions) will want clear explanations
  of the reasons and rationale behind bank swap
  positions, as well as well documented stress
  testing and concomitant effects if interest rates
  move away from your swap strategy.