Asset/Liability Management Day 4 Equity Valuation, Duration, EVE, Deposit Betas, & Hedging

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

Duration GAP Duration GAP Analysis Price sensitivity of bank’s 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.

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

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

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

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 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 CD’s 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 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%

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

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. 

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.

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

Assumptions-Decay Rates FDICIA Decay Rates – Developed in 1990’s. Many models use these as default assumptions. May not be an accurate picture of your bank’s 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.

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.

Assumptions-Decay Rates Checking NOW MMDA/Savings Quarter 1 72 Months 60 Months 48 Months Quarter 2 100 Months Change in EVE +200 Basis Points +300 Basis Points +400 Basis Points -12.8% -19.9% -26.3% +4.6% +4.1% +6.0%

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

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.

How Do We Protect Our Institutions From The Perils Of Rate Changes? Hedging, or mitigating , interest rate risk. Caps and Floors Interest Rate Swaps

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.

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.

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 ACTIVITY…NOT 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…

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!

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. ( You’re 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..

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 move…sometimes 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 loans…What 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”.

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. Can’t 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 doesn’t 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…….

A simple exchange of cash flows. Your Bank 1% Fixed Brand X 90 Day LIBOR Notional Amount is $100M US

Continued……. A year passes…Sure 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.

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.