Presentation on theme: "Interest Rate Risk Management Scott Hildenbrand March 26, 2013 Managing Director (212) 466-7865 FMS East Coast Regional."— Presentation transcript:
Interest Rate Risk Management Scott Hildenbrand March 26, 2013 Managing Director (212) FMS East Coast Regional Conference
1 Changes in rates from 2009 to now Which scenario is worse? Interest Rate Environment Index TODAY Fed Funds Target 0.25% 2 Year Treasury 0.76%1.14%0.61%0.25%0.26% 10 Year Treasury 2.25%3.30%1.89%1.78%1.93% Bank Margins ↑↑↑ Source: Bloomberg Slow increase over time? Rates stay here for 2 years then…?
2 Fed Funds Target Rate: The past four Fed tightening cycles have seen rates rise on average 300+ basis points over 1.2 years
3 Most banks have little or no loan demand and strong deposit growth Do I believe my interest rate risk results with regards to deposit behavior? Available for Sale securities portfolio as a percentage of assets continues to increase Average length of the bond portfolio continues to increase as well Are Tangible Common Equity ratios in trouble? Do I understand the potential impact? Thoughts and Questions
Interest Rate Risk Modeling
5 Persistent low rate environment for the past 4 years – how much longer will we be here? Every interest rate risk model run shows strong deposit base and ability to fund loan growth Banks have gotten comfortable with current and projected liquidity levels But… are we prepared for rising rates and potential deposit outflow? How will you fund loan growth if the economy improves and deposit base shrinks? Are you using your interest rate risk model as an effective “what-if” tool? Current Interest Rate Risk Model
6 By changing the current beta assumption from 45% to 80%, NII would decline an additional 4.48% up 300bps and 5.97% up 400bps (assumes an immediate rate shock) Prudent exercise to stress potential deposit competition in a rising rate/improving economy This bank’s MMDA accounts represent only 16% of deposit base Stressing Deposit Pricing -4.48% change $1.6mm change -5.97% change $2.2mm change ESTIMATED IMPACT ON NII VOLATILITY
7 ISSUE: Can we add 30 year fixed rate loans without significantly impacting the bank’s current interest rate risk position? OPTIONS: Overheard at ALCO… OPTIONPROSCONS Use excess cash Flush with deposits already Increase yield on assets Improve margin Adding duration to the asset side, which will hurt IRR in rising rate scenario Hedge specific loans Can immediately add floating rate assets Lowers initial spread Resource-intensive Use liability side combined with off- balance sheet Can use wholesale funding instead of deposits that may not be there if rates rise Accounting “path of least resistance” Cash flow hedge helps protect TCE against negative AFS mark if rates rise May require growing the balance sheet More expensive than using cash
8 Can We Add Fixed Rate Loans to the Balance Sheet? OPTIONDESCRIPTIONINITIAL SPREAD PROTECTS TCE IF RATES RISE? Use excess cash Use excess cash at 0.25% to put on $50mm of 3.625% fixed rate loans 3.375% (3.625% %) Hedge specific loans Swap fixed rate loans to 10 year floating rate at 1mL % 1.750% (2.00% %) Use liability side combined with off-balance sheet 1.New 7 year floating rate borrowing (currently 3mL %) 2.Hedge with forward-starting pay fixed swap (pay 2.36% starting in 2 years until final maturity) 2.875% (3.625% %)
9 Approach: After looking at current IRR profile, the bank wanted to ensure from an interest rate risk and liquidity perspective that their deposit base would remain in an improving economy Bank reviewed MM account balances at the end of 2007 and today. The growth they saw over this time period was concerning. They ran two “what-if” scenarios in the interest rate risk model: –25% of growth in MM accounts leaves the bank if rates rise 300bps –50% of growth in MM accounts leaves the bank if rates rise 300bps In both scenarios, the results showed significant margin contraction and stress on liquidity Action: Instead of only using excess cash to fund new fixed rate loans, they decided to use only a portion of cash and fund the other portion with long-term fixed rate wholesale funding (a combination of Options 1 and 3) Results: Using 50% cash and 50% wholesale funding gives an initial spread of 3.125% Locks in long-term liquidity near all-time lows in rates Protects TCE in a rising rate environment by combining economics and accounting (applying a cash flow hedge to long-term floating rate funding) Plan of Action
10 Enter into a forward-starting pay-fixed interest rate swap to “fix the rate” on new and/or newly- restructured floating rate advances The future rate is “locked in”, but there is no upfront cost or impact on current earnings The market value changes of the swap designated as “cash flow hedges” also flow through OCI, a component of Tangible Equity As rates rise, the swap increases in value and gains flow into OCI*, partially offsetting losses from the AFS portfolio The Bank is required to post collateral against the market value of the swap throughout its life, with potential for an independent amount to be posted at inception Forward Starting Swaps *Sandler O’Neill is NOT a licensed accounting advisor and this does not represent accounting advice. The Bank should consult their external auditors and/or accounting professionals for guidance on accounting treatment and impact of any proposed transactions. FHLB SWAP DEALER BANK LIBOR + spread Fixed Rate LIBOR + spread Floating Rate Borrowing Swap Starting X Years Forward
Evaluating the Bond Portfolio: Impact on IRR and Capital
12 Current Investment Portfolio – Sector Analysis (1) Market valuation as February 28, 2013, as provided by the Bank
13 Current Investment Portfolio – Price Volatility Analysis Market valuation as February 28, 2013, as provided by the Bank
14 Current Investment Portfolio – Cash Flow Analysis
15 Current Market: Efficient Frontier This graph shows the MOST yield that can be earned for increasing levels of duration risk. The different curves are for investment allocations with and without credit risk.
16 Quantifying Impact to the Bank’s Tangible Capital Ratio Estimated ratio reflects market value of investment portfolio as of February 28, 2013, as provided by the Bank Volatility reflects an instantaneous up 300bps shock Estimated Tangible Common Equity Ratio
17 AFS securities are one of the only instruments on bank balance sheets that are marked-to-market through equity (not through earnings) One of the other instruments that are treated this way are interest rate derivatives that are designated as “cash flow hedges” under ASC/815 (codification of guidance originally issued under FAS 133) In this interest rate environment, the preservation of tangible equity is one of the most-frequently stated goals that community banks cite for increasing their use of these derivatives Common qualifying cash flow hedge strategies are entering into pay-fixed interest rate swaps or purchasing interest rate caps, which are designated as hedges against wholesale funding, such as: –Floating rate FHLB advances / repo –Short term FHLB advances, repo, and / or brokered CDs –Brokered MMDA and other index linked deposit products If designated as effective cash flow hedges, the derivative is marked-to-market through OCI, a component of tangible equity, and as rates rise these instruments increase in value and gains flow through OCI, which can partially offset losses from the AFS portfolio Immunizing Tangible Equity Under Basel III as written, unrealized gains/losses on Cash Flow Hedges are backed out of Common Equity Tier 1 Capital unless the hedged item is fair- valued; under this rule, the benefit of these strategies still applies to GAAP Equity and therefore Tangible Book Value, but not to regulatory capital.
18 Bank wanted to hedge a portion of potential negative impact of AFS securities portfolio on TCE An immediate 300bps shock results in an approximate 2.00% change in the bank’s TCE ratio –Although this is an extreme scenario, an immediate rate shock illustrates the worst case impact to TCE In order to get a cash flow hedge on the books, the bank needed to find floating rate funding to apply the cash flow hedge Can restructure existing FHLB advances into floating rate funding, which can be done under debt modification accounting guidelines The newly-restructured funding was then swapped back to fixed, creating synthetic fixed rate funding In order to improve margin for the next two years, the bank chose to use a fixed rate swap with an effective date two years forward Improves +300bps TCE from sub-6% to over 6.25% Protecting TCE in a Rising Rate Environment
19 Estimated +300bps Impact of $50mm Pay Fixed Swaps Estimated TCE Ratio Estimated +300bps impact is based on price volatility analysis performed by Sandler O’Neill Assumes an immediate parallel rate shock and a 35% tax rate
20 Applying a Forward Starting Swap *New Effective Rate assumes prepayment amortized over the duration of the new borrowing. Results may vary if prepayment is straight lined amortized to maturity or accreted as a level yield calculation. The Bank should consult their external auditors for guidance. Step 1: Restructure to a LIBOR-based 7 year floating rate advances Step 2: Pay fixed on 5 year swap starting 2 years forward
21 Accounting for Swaps and Caps Under ASC 815 Not a hedging instrument –Gains/losses due to change in Fair Value of the instrument flows through earnings –This creates significant income volatility Cash flow hedge –Applies to pay fixed swap or purchased cap/floor to “fix” the cash flows of a floating rate liability –If no ineffectiveness is recorded, the entire change in Fair Value of the hedge is recorded on balance sheet in Other Comprehensive Income (OCI) –Any ineffectiveness, caused by a not perfectly matched hedge, goes through income Fair value hedge –Applies to pay fixed swaps to convert a fixed rate asset or liability to floating –Both the hedge and hedged item are marked to market through earnings, not OCI –Ineffectiveness is expected and will go through income There are three basic designations for a swap or cap on the balance sheet:
22 Hedge Accounting vs No Hedge Accounting If no hedge accounting is applied the gains/losses due to change in Fair Value of the cap will flow through earnings Example assumes a 1.30% 5 year cap purchased in the first quarter of 2010 Swings in price range from over 3% loss to 1.39% gain without any payout on the cap Changes in market value will not flow through OCI if no cash flow hedge accounting is applied Additionally, if there is a gain in the cap, it will be recognized far before actual LIBOR increases thereby creating a timing mismatch for the interest rate protection Why not just purchase a cap outright with no hedge accounting?
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