Strategic Moves for Todays Challenges

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Strategic Moves for Todays Challenges

• Thomas A. Farin
• Chairman , President and Chief Executive Officer
• Farin and Associates, Inc.

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Strategic Thinking for Todays Challenges

• Tom Farin
• President
• tfarin_at_farin.com
• www.fpwrestle.com

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Beginning Question

• What is Asset-Liability Management?
• Working definition management of the
  relationship between a financial institutions
  risk and its return.
• Lets begin by identifying the issues that drive
  return.
• Were willing to bet that some of the the risk
  management issues come out as we go through the
  return issues.
• Then lets look at the tools and techniques that
  allow us to measure and manage risk
• Along the way, well develop a series of 10
  financial management rules for managing your shop
  in the interesting times ahead of us.

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Effective Financial Management Keys

• 1. Understand the importance of financial
  leverage in managing your return.

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Measuring Return

• Traditional Measures
• Net income
• ROA
• ROE
• Earnings per share
• Total stockholder return
• All incorporate net income

Our focus

• Financial institutions of all kind need to focus
  on ROE as the primary measure of effectiveness of
  performance.
• Stock institutions measures how effectively
  stockholders capital is being used to produce
  income.
• Mutuals and credit unions measures the grown
  rate of the capital account which becomes a
  constraint on the institutions ability to grow
  assets.

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ROE, ROA Leverage
Management of financial leverage (capital) is a
key to delivering an effective return.
Capital Risk
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C/A Management Tools

• Increase C/A by
• Slowing growth
• Increasing ROA
• Reducing dividends
• Issuing stock

• Reduce C/A by
• Increasing growth
• Reducing ROA
• Increasing dividends
• Buying back stock

Not available to mutuals Or credit unions.
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Effective Financial Management Keys

• 2. Focus in managing your reoccurring sources of
  return.

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ROA Tree
Net interest margins Are declining and Will
continue to decline Forever.
Declines will need to be made up by increasing
non-interest income or reducing non-interest
expense.
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Importance of Asset Growth

• Institutions wishing to deliver ROEs must grow
  over the long term.
• How much? assets must grow at least as quickly
  as capital over the long term if financial
  leverage is to be maintained.Capital growth rate
  ROE x (1 D)
• Non-interest expense/AA will continue to decline
  over long-term. Two ways to do this
• Cut dollar operating expenses
• Grow assets
• Loans will outgrow deposits over long term
• Why? Gen X, Y, and Boomers dont look to CDs
  when investing long-term
• This means some of your funding growth will need
  to come from borrowed funds.

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Effective Financial Management Keys

• 3. Make sure your IRR measurement system
  considers both interest rate risk and option
  risk.

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Interest Rate Risk
Interest Rate Risk is the Risk that a Change in
Market Rates Will Affect An Institutions Income
... And The Market Value of Its Assets and
Liabilities.
Regulatory Viewpoint

• IRR Definitions
• IAR Income at Risk
• VAR Value at Risk
• EVE, NPV, MVPE, NEV

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Duration A way of looking at interest rate risk

• Measures An Instruments Price Sensitivity
• Weighted average of PV of an instruments cash
  flows
• Can be used in simple valuation formula(chg MV
  - D x chg MR)
• Can Be Used To Measure Price Sensitivity Of
• An instrument
• A portfolio of similar instruments
• A portfolio of dissimilar instruments

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Duration - Teeter Totter Approach
Considers amortization, prepayment repricing,
time value of money.
Duration is weighted average Of time of receipt
of cash flows -- 3 years
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Duration To Price
Chg MV - D x Chg MR -6 -3 x 2
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Option Risk You need to look at this too

• Definition
• The risk that the party to a financial instrument
  will exercise options imbedded in the instrument
  that affect its cash flow
• The IRR Issue
• Imbedded options in many financial instruments
  will cause their cash flows to vary with rate
  environments, complicating the analysis of their
  IRR.
• Convexity
• As a result of imbedded options, values track
  along a curve rather than a straight line.

• Examples of Imbedded Options
• Prepayment Options in Consumer Loans
• Annual and Lifetime Caps in ARMs
• Early Withdrawal Options In CDs
• Bump Rate CDs
• Options To Convert From ARMs to Fixed-rate
  Mortgages
• Step-up Bonds
• Derivative Mortgage-Backed Securities
• Callable Bonds and FHLB Advances

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Comparative Price Changes
5 Year Treasury
7 Year Bond 1 Year Call
15 Year FR MBS
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Convexity
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Convexity
MBS prepayments increase in falling rate
environment shortening duration
Treas D MBS D
MBS prepayments decrease in rising rate
environment lengthening duration
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Value at Risk (VAR) Regulatory View of IRRNPV,
MVPE, EVE, NEV

• Advantages
• Supported By Most AL Models
• Meets Most Regulatory Requirements For
• OTS - Manditory
• Banking Credit Union Agencies recommended for
  shops with complex balance sheets
• Disadvantages
• Assumption Intensive
• Control Post-Shock economic value and
  sensitivity

• Calculation Technique
• Calculate market value of all assets and
  liabilities on balance sheet.
• Economic value MVA - MVL
• Repeat calculations for variety of immediate and
  permanent changes in market rates. Cash flows
  are recalculated for each rate environment.
• Value at risk equal to changes in economic value
  caused by rate shocks.
• Application In IRR Management
• Used to evaluate effect of changes on rates on
  value of instruments over remaining life.
• Sums to changes in economic value.

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Value at Risk
OTS guideline for S in CAMELS
From TB 13-a http//www.ots.treas.gov/bltn_thrift.
html
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Effective Financial Management Keys

• 4. Use dynamic rather than static tools to
  manage interest rate risk Income at Risk and
  Value at Risk

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Static vs. Dynamic IRR Measurement

• Static Systems
• Measure IRR in Existing Balance Sheet
• Fail To Consider Institution Strategy
• Cant Be Used to Evaluate Risk/Return Tradeoffs
• Regulatory Systems Are Static
• Examples - Gap, Duration, Current VAR

• Dynamic Systems
• Measure IRR in Future Balance Sheet
• Consider Institution Strategy
• Evaluate Risk/Return Tradeoffs
• Example - Computer Simulation, Dynamic VAR

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Income at Risk (IAR) Simulation

• Definition
• A computer model is used to project an
  institutions financial statements based on a set
  of assumptions. The effect of changes in rates
  on income can be measured by running multiple
  rate environments. Fluctuations in income under
  the different rate environments are income at
  risk as measured by the model.

• Advantages
• Model used for income at risk analysis can be
  used for multiple purposes.
• Budgeting
• Strategic Planning
• Interest Rate Risk Analysis
• Measures what management is most concerned about
  over short and medium term the effect of
  changes in rate on bottom line and performance
  measures driven off the bottom line ROA, ROE,
  EPS, etc.
• Disadvantages
• Cost
• Data and Time Intensive
• Ideally your plan must be in place in model.

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Dynamic ModelingIncome At Risk Comparison of
Alternative Strategies
Income at Risk - ROE
Rate Env Pol Limit Stgy 1 Stgy 2 Stgy 3 Stgy
4 300 bp -25 7.2 7.2 9.6 9.2 Flat Maximum
12.0 7.2 11.4 11.8 -200 bp -25 15.6 7.2 13
.2 13.8
Unacceptable Strategy. ROE Drops 40 from Flat
to 300 bp.
Which of the Three Acceptable Strategies Would
You Choose?
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Setting Income At Risk Limits

• Recommended Approach
• Set a goal for primary ratio you use to measure
  income statement performance (ROA, ROE, EPS)
• Once goal is set, ask yourself how much of that
  goal are you willing to risk under adverse
  changes in rates.

• Example
• ROE Goal 16
• Maximum bet, 25 of goal
• Policy limit, either
• 25 of income
• ROE of 12

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Dynamic Value at Risk (VAR)NPV, MVPE, EVE, NEV
Today
3 Years

• Calculation Technique
• Run a computer simulation run of one or more
  management strategies in a single rate
  environment.
• Run a VAR Test on forecast balance sheet
• Application In IRR Management
• Used to evaluate effect of a strategy on future
  VAR.
• Only effective way to test the long-term effect
  of changes in rates on a strategy.
• Can be used as tool in comparing risk-return
  tradeoffs of alternative strategies.

Rates
Static VAR
Time
Rates
Dynamic IAR
Time
Rates
Dynamic VAR
Time
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Dynamic Value at Risk Example
OTS guideline for S in CAMELS
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Setting Value at Risk Limits

• Suggested Approach
• Use OTS TB 13-a Sensitivity guidelines as a
  starting point.
• Ask yourself, What is the lowest rating for S in
  sensitivity we are willing to accept?
• Set limits based on answer.

OTS guideline for S in CAMELS
A top 10 credit union decided that because of
their minimal liquidity and credit risk, they
could afford to go to a 2 rating for Sensitivity.
As a result any of the above post-shock/sensitivi
ty combinations would be acceptable.
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Effective Financial Management Keys

• 5. Use dynamic rather than static tools to
  manage liquidity risk

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Liquidity Risk Defined

• The risk that
• Sources of funds
• Investments
• Deposit inflows
• Cash flows off loans
• Will be unable to supply adequate funds to meet
  institution needs for funds.
• Deposit outflows
• Funding commitments for loans
• Funding new loans

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Static vs Dynamic Liquidity

• Static Measurement
• Measures liquidity in existing balance sheet
• Fail to consider institutions business plan
• Fail to consider role of deposit and loan pricing
  strategies
• Only way to measure liquidity using call report
  data
• Fails to consider borrowing power
• Uses outdated ratios loan/deposit ratio, other
  regulatory liquidity ratios

• Dynamic Measurement
• Measures liquidity in business plan
• Considers loan and deposit pricing strategies
• Requires business plan cant be generated from
  call reports
• Allows for evaluation of sources and uses of
  funds

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Liquidity Risk Ratio A Sources and Uses
Liquidity Ratio
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Liquidity Risk Ratio A Sources and Uses
Liquidity Ratio
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Liquidity Risk Ratio A Sources and Uses
Liquidity Ratio
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Liquidity Risk Ratio A Sources and Uses
Liquidity Ratio
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Effective Financial Management Keys

• 6. Understand the tradeoffs between deposits and
  borrowings

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Deposits vs. Borrowings

• Deposits
• Largest portion of non-capital funding
• Creates franchise value when well priced
• Customer relationship
• Pricing is used to increase or decrease volume
• Costs money to originate and service
• May have interest rate risk and option risk
• Cost is generally lower
• Greatest value is in non-maturity deposits
  because of rate and duration

• Borrowings
• Smaller portion of non-capital funding
• Neutral to franchise value
• No customer relationship
• Generally can have as much volume as you want at
  market rates subject to credit approval
• No origination and servicing cost
• May have interest rate risk and option risk
• Cost is generally higher
• Considered by some to be an undesirable source of
  funding
• Common sources
• FHLB
• Bond Market
• Fed funds
• Repos
• Brokered CDs

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Funding Strategy

• Use deposits whenever they can be raised at a
  marginal cost below borrowings. Deposits build
  franchise value while borrowings dont.
• Use borrowings when
• Marginal cost of deposits is too high raising
  deposits above borrowing rates erodes franchise
  value.
• You cant raise the kind of funding you need from
  customers to fund loans they are demanding.
• You need to match fund a lending or investment
  strategy in a very specific way.
• Short-range liquidity problems develop that cant
  be met by investment portfolio.

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Financially Sound Deposit Pricing Tools

• Benchmark rates
• Marginal cost
• Can be applied to individual account (savings
  account example)
• Can be applied to a sector (CD example)

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Benchmarks - Is Account Well Priced?
Account beats wholesale funding benchmark by 263
bp
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Marginal Cost Single Account Example
Marginal Cost of Additional Funds 12.75
Before Change After Change Difference
Assumes a 5 increase in volume.
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Effective Financial Management Keys

• 7. Have an effective process in place for making
  deposit pricing decisions.

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Deposit Pricing - Divide Accounts into Sectors

• You may want to start out with four funding
  sectors.
• Checking accounts
• Savings and MMDA
• Short-term CDs
• Long-term CDs

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Develop a Pricing Strategy for Each Sector

• What Is a Pricing Strategy?
• The account structure within the sector
• Example ST CD Sector
• 3 Month CD
• 6 Month CDs
• 12 Month CDs
• The rules for pricing the accounts within the
  sector

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What is a Pricing Rule?

• The rules for pricing the accounts.
• How the accounts are priced relative to each
  other and to competitive and wholesale rates.
• Example
• Price all CDs in this sector in the range of 40
  bp below the average rate in the market based on
  survey data.

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Applying Marginal Cost - Pay the Best Rates
Benchmark rate 2.60

• Pricing rules
• Current All accounts priced at midpoint of
  market
• Proposed All accounts priced at top of market

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Pay the Best Rate, Not the Best Rates Offensive
Special
Benchmark rate 2.60
Saves 136.3 pb at margin vs. 4.591
Saves 28,504 vs. 135,039 on 2.9 mm

• Pricing rules
• Current All accounts priced at midpoint of
  market
• Proposed CD special priced at top of market

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Pay the Best Rate, Not the Best Rates Defensive
Special
Benchmark rate 2.60
Saves 53 pbs at margin vs. 3.228

• Pricing rules
• Current All accounts priced at midpoint of
  market
• Proposed CD special priced at top rate offered
  under previous strategy

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Effective Financial Management Keys

• 8. Understand the tradeoffs between investments
  and loans

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Investments vs. Loans

• Loans
• Represents largest of earning assets
• Creates franchise value when well priced
• Cornerstone of many customer relationships
• Can have significant credit risk
• Generally less liquid
• Requires more capital to fund
• Pricing used to increase and decrease volume
• Costs money to originate and service
• May have interest rate risk and option risk
• Generally a higher yield given risks and costs

• Investments
• Smaller of earning assets
• Neutral to franchise value
• Does not lead to a customer relationship
• Generally less credit risk
• Generally more liquid
• Requires less capital to fund
• Generally you can have as much volume as you want
  at market rates.
• No origination and servicing cost
• May have interest rate risk and option risk
• Generally a lower yield given risks and costs.

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Securitization Process
Originates Mortgage Loans for Sale
Purchases Mortgages From Institution
Financial Institution
Fannie Mae
Issues Securities To Fund Loans Backed by Loans
as Collateral
Purchases Securities for Investment Portfolio
Note While the example illustrates mortgage
securitization, Virtually any type of loan being
made by financial institutions Is being
securitized and sold in the secondary markets.
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Effective Financial Management Keys

• 9. Have an effective process in place for making
  loan pricing decisions.

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Financially Sound Loan Pricing Tools

• Benchmark rates based on investment alternative
• Marginal yield
• Can be applied to individual accounts
• Can be applied to a sector (risk based pricing
  example)

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Developing a Wholesale Equivalent Rate15 Year
Fixed-Rate Mortgage

• Component of a Securitys Price
• Risk Free Return 1 Month Treasury Strip from
  market
• Duration Matched Return 5 Year Treasury from
  market
• Difference Interest Rate Risk Adjustment -
  subtraction
• Duration Matched Return Comparable Security
  from market
• Difference Option Risk Adjustment - subtraction

• At the 5.651 wholesale equivalent rate, the 15
  year
• fixed-rate MBS is providing enough yield to
• Provide a risk free return.
• Hedge the interest rate risk in the transaction
• Hedge the option risk in the transaction.

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Developing the Retail Equivalent Rate15 Year
Fixed-Rate Mortgage

• Adjusting for Credit Risk Servicing Cost
• Wholesale Equivalent Rate
• Credit Risk Adjustment From Loss Experience
• CR Adjusted Rate Calculated
• Servicing Cost Adjustment From Cost Model or
  Source Marginal Cost
• Retail Equivalent Rate - Calculated

• By adjusting the 5.651 wholesale equivalent
  rate,
• by 25 bp, the retail equivalent rate has also
  adjusted for
• Credit risk
• Servicing cost

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Using The Retail Equivalent Rate 15 Year
Fixed-Rate Mortgage

• Assumptions
• You dont set your markets rate, rather you
  react to competitor rate initiatives
• The funding is in place you are trying to
  determine how to invest.
• Capital is not a constraint.
• Decision Tool
• If comparing loans to investments, make the loan
  if origination rate is above retail equivalent
  rate.

Includes rate and amortized fees
Origination rate is 34.9 bp above the retail
equivalent. Conclusion Originate the loan.
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Considering Marginal Yield
Rates dropped 25 bp
Volume doubles

• Assumptions
• You are contemplating modifying the rate in an
  attempt to modify volume.
• When you are cutting loan rates to increase
  volume, you are giving up the rate change on loan
  volume at the old rate to gain additional volume
  at the higher rate.
• Decision Tool
• It makes sense to reduce rate to increase volume
  when the marginal yield on the additional volume
  is above the retail equivalent rate.

Income before and after
Marginal yield equals change in income divided by
change in volume 57.5 / 1,000 5.75
Marginal yield is below retail equivalent bad
pricing decision.
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Risk-Based Loans

• Situation Institution wishes to use pricing to
  increase auto loan originations.

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Marginal Yield Calculation
Strategy drop rates to increase volume.
Marginal Yield Chg Inc / Chg Balances 551.32
/ 8,500 6.486
Bad decision as marginal yield 94 bp below
breakeven
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Risk-Based Loans
Borrowers Segmented into credit class (A, B,
C) Credit adjustment is annual charge off
experience by credit class
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Risk-Based Loans
A Credit Consumer Loans Break Even Spread
A credits are extremely profitable As their loss
experience is well below the 0.75 average for
this Kind of loan.
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Risk-Based Loans
B Credit Consumer Loans Break Even Spread
B credits are profitable as their loss experience
is below the 0.75 average for this Kind of
loan.
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Risk-Based Loans
C Credit Consumer Loans Break Even Spread
C credits are unprofitable as their loss
experience is well above the 0.75 average for
this kind of loan.
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Risk-Based Loans
Risk Based Pricing Marginal Yield
6.846 Without segmentation
Marginal yield is higher as rate is dropped for
only rate sensitive customers (As)
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Effective Financial Management Keys

• 10. Develop the expertise to use SWAPs and CAPs
  as interest rate risk management tools

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What is a SWAP?

• Definition an off-balance sheet transaction
  that swaps the obligation to make payments on
  variable rate funding with the obligation to make
  payments on fixed-rate funding (or vice versa).
  Characteristics include
• Fixed-rate index
• Floating rate index
• Notional Principal
• Term
• Fee can be built into rate received.

• How it Works
• Three parties
• Party makes fixed-rate payment, receives
  variable-rate payment
• Counter-party makes variable-rate payment,
  receives fixed-rate payment
• Intermediary puts together and guarantees the
  transaction
• Institution can be either the party or the
  counter-party.

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Using a SWAP as a Hedge

• Situation Institution has used short-term CDs
  and MMDAs to fund fixed-rate mortgages. They are
  vulnerable to a rise in rates and want to hedge
  their risk.

• Interest rate SWAPs are executed with institution
  receiving short-term payments and paying
  long-term payments

Fixed-Rate Mortgage Yield
Fixed-Rate Mortgage Yield
Yield/Cost
Yield/Cost
Institution makes long-term Treasury interest
payments
CD MMDA Cost
CD MMDA Cost covered with short-term Treasury
interest payments
0
0
100
200
300
400
500
100
200
300
400
500
Rates -- gt
Rates -- gt
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Using a SWAP to Minimize Funding Costs

• Situation Customers prefer short-term CDs.
  They require a significant rate inducement to
  move CDs to 5-7 years. Institution needs 5-7
  year funding for fixed-rate mortgage lending.
  Here are two options
• Pay a the premium customers demand for 5-7 year
  CDs.
• Accept cheap short-term funding from customers
  and Swap to 5-7 years.

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What is a CAP?

• Definition - Synthetic instrument with following
  characteristics.
• Price
• Term
• Index
• Strike point
• Notional principal
• How it works
• You pay a price for the cap. The price is
  generally amortized over the life of the
  instrument.
• When the index rises past the strike point, you
  receive income equal to the difference between
  the index and the strike point times the notional
  principal.

Income
0
0
100
200
300
400
500
Rates -- gt
Amortized price
Income accelerates after strike point is reached.

• Speculative use Use an investment in an
  interest rate cap to bet on rising rates.

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CAP as a Micro-Hedge

• Situation - You originate 1 year ARMS to
  customers and fund with 1 year CDs. You wish to
  offer the ARMs with 3 lifetime caps.

• Solution Buy a CAP that begins producing income
  when rates rise 300 bp to offset risk from ARM
  cap.

CAP Income
ARM Yield
ARM Yield
Yield/Cost
Yield/Cost
CD plus CAP Cost
CD Cost
CD Cost
0
0
100
200
300
400
500
100
200
300
400
500
Rates -- gt
Rates -- gt
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CAP as a Macro-Hedge

• Situation you are seeing moderate changes in
  income with moderate rises in rates and severe
  drops in income with rapid rises in rates.

• Solution You purchase series of interest rate
  caps that begin producing income when rates rise
  between 200 and 300 basis points.

Income with CAP
Income
Income
On-balance sheet income
On-balance sheet income
0
0
300
400
500
300
400
500
100
200
100
200