Interest Rate Risk Management
FMS East Coast Regional Conference
March 26, 2013
Scott Hildenbrand
Managing Director
(212) 466-7865
shildenbrand@sandleroneill.com
Interest Rate Environment
• Changes in rates from 2009 to now
Index
2009
2010
2011
2012
TODAY
Fed Funds Target
0.25%
0.25%
0.25%
0.25%
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
↑
↑
↑


• Which scenario is worse?
Slow increase over time?
Source: Bloomberg
Rates stay here for 2 years then…?
300
300
250
250
200
200
150
150
100
100
50
50
0
0
1
Fed Funds Target Rate: 1986 - 2012
10
The past four Fed tightening cycles
have seen rates rise on average
300+ basis points over 1.2 years
9
8
7
Tightening Fed Fund
Cycle
Increase
'04 - '06
4.25%
'98 - '99
1.75%
'94 - '95
3.00%
'87 - '88
3.25%
Average
3.06%
Period
(Days)
735
329
371
336
443
6
5
4
3
2
1
0
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Year
2
Thoughts and Questions
• 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?
3
Interest Rate Risk Modeling
Current Interest Rate Risk Model
• 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?
5
Stressing Deposit Pricing
ESTIMATED IMPACT ON NII VOLATILITY
up 300 bps
up 400 bps
0.00%
-2.00%
-4.00%
-6.00%
-7.07%
-8.00%
-10.01%
-10.00%
-11.55%
-12.00%
-14.00%
-4.48% change
$1.6mm change
-5.97% change
$2.2mm change
-16.00%
-15.98%
-18.00%
CURRENT NII VOL
PROJECTED NII VOL
•
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
6
Overheard at ALCO…
ISSUE: Can we add 30 year fixed rate loans without significantly impacting the bank’s current interest
rate risk position?
OPTIONS:
OPTION
PROS
CONS
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 offbalance 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
7
Can We Add Fixed Rate Loans to the Balance Sheet?
OPTION
DESCRIPTION
INITIAL 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%

Hedge specific
loans
Swap fixed rate loans to 10 year
floating rate at 1mL + 1.80%
Use liability side
combined with
off-balance sheet
1. New 7 year floating rate borrowing
(currently 3mL + 0.47%)
2. Hedge with forward-starting pay
fixed swap (pay 2.36% starting in 2
years until final maturity)
(3.625% - 0.25%)
1.750%
(2.00% - 0.25%)
2.875%
(3.625% - 0.75%)


8
Plan of Action
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)
9
Forward Starting Swaps
Floating Rate Borrowing
Swap Starting X Years Forward
LIBOR + spread
FHLB
LIBOR + spread
BANK
SWAP DEALER
Fixed Rate
•
Enter into a forward-starting pay-fixed interest rate swap to “fix the rate” on new and/or newlyrestructured 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
*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.
10
Evaluating the Bond Portfolio: Impact on IRR and Capital
Current Investment Portfolio – Sector Analysis
PORTFOLIO SNAPSHOT
Par Value
Book Value
Market Value
SECTOR BREAKDOWN
$246,313,200
249,986,944
253,339,879
Unrealized Gain/(Loss)
Unrealized Gain/(Loss) - AFS Only
Aggregate Gains
$3,352,935
3,352,935
4,186,379
Aggregate Losses
(833,445)
Book Yield: Historical 3Mo. Speeds
Bank's Book Yield
2.97%
3.17%
Effective Duration - Flat
Effective Duration - +300bps
Average Life
3.8
5.6
8.0
Book
% of
Gain /
Value
Total
Agencies - Non-Callable (4)
4.0
1.6%
0.0
Agencies - Callable (14)
23.1
9.2%
Agencies - Step-Ups (6)
18.9
Fixed MBS (77)
Book Yield
Bank's
Flat
+300bps
2.74%
2.65%
0.2
0.2
(0.1)
2.66%
2.68%
5.8
10.2
7.6%
(0.1)
2.25%
2.26%
8.0
12.3
76.8
30.7%
1.7
2.13%
2.77%
3.5
5.0
MBS ARMs (0)
0.0
0.0%
0.0
0.00%
0.00%
0.0
0.0
CMO/SBA (29)
16.6
6.7%
0.4
1.24%
2.27%
2.1
4.5
Corporates (2)
1.0
0.4%
0.0
3.05%
3.21%
0.0
0.0
Municipals - Non Callable (81)
22.0
8.8%
0.4
2.75%
2.79%
0.8
1.0
Municipals - Callable (236)
86.8
34.7%
1.0
4.36%
4.10%
4.0
5.2
Other (2)
0.7
0.3%
0.0
0.00%
0.00%
0.0
0.0
250.0
100.0%
3.4
2.97%
3.17%
3.8
5.6
TOTAL (451)
(Loss) $ 3m Speed
Effective Duration
Agencies - Non-Callable
Agencies - Callable
Agencies - Step-Ups
Fixed MBS
MBS ARMs
PORTFOLIO STATISTICS
Projected Book Yield <1%
Lots smaller than 1MM
Premiums with 3mo CPR > 25
% of Total Portfolio
5.3
49.1
15.7
(1) Market valuation as February 28, 2013, as provided by the Bank
CMO/SBA
Corporates
Municipals - Non Callable
Municipals - Callable
Other
12
Current Investment Portfolio – Price Volatility Analysis
PRICE VOLATILITY ANALYSIS
Down 100
Flat
Up 100
Up 200
Up 300
15,000
10,000
$8,895
$3,353
Gain / Loss ($thousands)
5,000
0
(5,000)
(10,000)
($8,584)
(15,000)
(20,000)
($21,271)
(25,000)
(30,000)
(35,000)
($33,260)
(40,000)
Current Notional
Market Value
Change in MV
Gain/Loss
Avg Life
Eff Duration
246,313,200
$258,882,096
2.2%
$8,895,151
2.3
1.2
Market valuation as February 28, 2013, as provided by the Bank
246,313,200
$253,339,879
$3,352,935
8.0
3.8
246,313,200
$241,402,597
(4.7%)
($8,584,348)
9.1
5.2
246,313,200
$228,715,879
(9.7%)
($21,271,065)
9.6
5.6
246,313,200
$216,726,706
(14.5%)
($33,260,238)
9.7
5.6
13
Current Investment Portfolio – Cash Flow Analysis
PROJECTED ANNUAL PRINCIPAL CASH FLOWS
Year 1
Year 2
Year 3
Year 4
Year 5
120,000
Down 100
Principal Cashflows ($thousands)
100,000
Flat
Up 100
Up 200
Up 300
80,000
60,000
40,000
20,000
0
$
%
$
%
$
%
$
%
$
%
Down 100
100,255
41%
65,506
68%
28,116
79%
16,445
86%
11,021
90%
Flat
46,091
19%
38,477
34%
20,656
43%
8,144
46%
6,780
49%
Up 100
32,954
13%
27,393
25%
18,275
32%
10,024
36%
9,426
40%
Up 200
22,995
9%
24,224
19%
18,388
27%
12,121
32%
11,062
36%
Up 300
20,282
8%
21,177
17%
19,228
25%
12,765
30%
11,648
35%
*Dol l a r va l ues s hown on a n a nnua l ba s i s , percenta ges s hown a re cumul a ti ve.
14
Current Market: Efficient Frontier
3.50
Current Portfolio:
3.00
Market Yield : 1.79%
Book Yield : 2.97%
14.5% Price Decrease up 300bps
3.16
Book Yi eld: 2.97%
3.02
2.87
2.73
2.50
2.13
2.41
2.25
1.93
1.52
Yield
1.95
1.73
1.92
1.50
2.41
2.27
2.12
2.09
1.78
Ma rket Yi eld: 1.79%
1.61
1.32
1.27
1.00
0.50
0.00
6.0%
1.08
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.
8.0%
10.0%
17.3% Pri ce Decrease up 300bps
12.0%
2013 Budget Projected Yi eld: 2.43%
ALLOCATION LIMITS
"Without Credit"
Treasury
Agency Debenture
MBS - Fixed
MBS - Adjustable
Agency CMO
FN DUS, GN Multifam, SBA
1.44
1.10
2.51
2.33
2.57
2.00
2.68
14.0%
16.0%
40%
40%
40%
40%
40%
33%
"With Credit"
Same limits as above, plus:
CMBS
40%
Student Loan Bonds
40%
CMBS
40%
Corporates
40%
GO BQ Muni
40%
Private Label
40%
18.0%
20.0%
% Price Decrease up 300bps
With Credit
Without Credit
Investment Policy
Book Yield
Market Yield
Projected Yield
15
Quantifying Impact to the Bank’s Tangible Capital Ratio
Estimated Tangible Common Equity Ratio
9.00%
7.90%
8.00%
7.00%
5.89%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
2/28/13
Tangible Common Equity
Tangible Assets
TCE Ratio
Estimated OCI Mark (PreTax)
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 +300 bps
As of
2/28/2013
85,301
1,080,068
7.90%
3,353
Estimated
+300 bps
61,503
1,043,455
5.89%
(33,260)
16
Immunizing Tangible Equity
•
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
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 fairvalued; under this rule, the benefit of these strategies still applies to GAAP Equity and therefore Tangible Book Value, but not to regulatory capital.
17
Protecting TCE in a Rising Rate Environment
•
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%
18
Estimated +300bps Impact of $50mm Pay Fixed Swaps
Estimated TCE Ratio
7.00%
6.26%
6.00%
5.89%
5.00%
Estimated +300 bps
Tangible Equity
Tangible Assets
TCE Ratio
Estimated OCI Mark (PreTax)
Estimated +300bps impact is based on price volatility analysis performed by Sandler O’Neill
Assumes an immediate parallel rate shock and a 35% tax rate
With Swap
+300 bps
Estimated
+300 bps
61,503
1,043,455
5.89%
(33,260)
With Swap
+300 bps
65,779
1,050,034
6.26%
(26,681)
19
Applying a Forward Starting Swap
Step 1: Restructure to a LIBOR-based 7 year floating rate advances
CURRENT LIABILITIES
ESTIMATED PREPAYMENT
RESTRUCTURE RESULTS
Existing Structure
2YNP 2m
2Y Bullet
Current
Balance
25,000,000
25,000,000
Current
Rate
2.92
2.70
Maturity
Date
02/02/15
01/28/15
Market
Price (%)
103.40
103.80
Estimated
Unwind Fee
(850,750)
(950,000)
Effective
Duration
1.8
1.8
Total Restructured (2)
50,000,000
2.81
01/30/15
103.60
(1,800,750)
1.8
New Debt
Type
7Y Floater
7Y Floater
New
Effective
Rate*
1.05
1.10
New Effective
Floating Rate
3mL+0.77
3mL+0.82
New
Market
Rate
0.55
0.55
1.07
3mL+0.79
0.55
Potential
Rate
Effective
Change Duration
(1.88)
0.2
(1.60)
0.2
(1.74)
NPV
Change
7.09%
9.35%
0.2
Step 2: Pay fixed on 5 year swap starting 2 years forward
CURRENT LIABILITIES
INTEREST RATE SWAP HEDGE
Existing Structure
2YNP 2m
2Y Bullet
Current
Balance
25,000,000
25,000,000
Current
Rate
2.92
2.70
Maturity
Date
02/02/15
01/28/15
Total Restructured (2)
50,000,000
2.81
01/30/15
IMPACT YEARS 1 - 2
Pay Fixed
Swap Term
2y5y
2y5y
Fixed Swap
Rate
2.07
2.07
2.07
Effective Rate
Rate
Years
New Effective Change w
Unhedged
Rate w Swap
Swap
3mL+0.77
2.84
(0.09)
3mL+0.82
2.89
0.19
3mL+0.79
2.86
0.05
New
Duration
4.9
4.9
4.9
IMPACT YEARS 3 - 7
Total Strategy Size:
50,000,000
Total Strategy Size:
50,000,000
Old Borrowing Rate:
2.81%
Old Borrowing Rate:
2.81%
New Borrowing Rate:
1.07%
New Borrowing Rate:
2.86%
Ann. Cost of Funds Δ (%):
(1.74)
Ann. Cost of Funds Δ (%):
0.05
Ann. Cost of Funds Δ ($):
(868,649)
Ann. Cost of Funds Δ ($):
26,301
*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.
20
Accounting for Swaps and Caps Under ASC 815
There are three basic designations for a swap or cap on the balance sheet:
•
•
•
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
21
Hedge Accounting vs No Hedge Accounting
Why not just purchase a cap outright with 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
Quarter End
3/31/2010
6/30/2010
9/30/2010
12/31/2010
3/31/2011
6/30/2011
9/30/2011
12/30/2011
1.30% Cap
Market Value
8.07%
4.70%
2.60%
3.99%
4.24%
2.53%
0.90%
0.69%
LIBOR
0.29%
0.45%
0.29%
0.30%
0.27%
0.26%
0.43%
0.54%
5Y Swap
2.73%
2.05%
1.51%
2.17%
2.46%
2.03%
1.25%
1.22%
Gain / Loss
%
$/mm
-3.37%
-2.10%
1.39%
0.25%
-1.71%
-1.63%
-0.21%
(33,700)
(21,000)
13,900
2,500
(17,100)
(16,300)
(2,100)
•
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
22
GENERAL INFORMATION AND LIMITATIONS
This presentation, and any oral or video presentation that supplements it, have been developed by and are proprietary to Sandler O’Neill &
Partners, L.P. and were prepared exclusively for the benefit and internal use of the recipient. Neither the printed presentation nor the oral or
video presentation that may supplement it, nor any of their contents, may be reproduced, distributed or used for any other purpose without
the prior written consent of Sandler O’Neill & Partners, L.P.
The analyses contained herein rely upon information obtained from the recipient or from public sources, the accuracy of which has not been
verified, and cannot be assured, by Sandler O’Neill & Partners, L.P. Moreover, many of the projections and financial analyses herein are based
on estimated financial performance prepared by or in consultation with the recipient and are intended only to suggest reasonable ranges of
results. Finally, the printed presentation is incomplete without any oral or video presentation that supplements it.
Because Sandler O’Neill’s analyses and data contained herein are provided for information purposes only, they do not constitute an offer, or a
solicitation of an offer, to buy or sell any of the securities described herein at the levels noted. In addition, as Sandler O’Neill’s analyses are
prepared as of a particular date and time, they will not reflect subsequent changes in market values or prices or in any other factors relevant to
their determination.
Sandler O’Neill & Partners, L.P. prohibits employees from offering, directly or indirectly, favorable research, a specific rating or a specific price
target, or offering or threatening to change research, a rating or a price target to a company as consideration or inducement for the receipt of
business or compensation. Sandler O’Neill also prohibits research analysts from being compensated for their involvement in, or based upon,
specific investment banking transactions.
Sandler O’Neill & Partners, L.P. is a limited partnership, the sole general partner of which is Sandler O’Neill & Partners, Corp., a New York
corporation. Sandler O’Neill & Partners, L.P. is a registered broker-dealer and a member of the Financial Industry Regulatory Authority, Inc.
Sandler O’Neill Mortgage Finance Corp. is a wholly-owned indirect subsidiary of Sandler O’Neill & Partners, Corp.
We have provided this analysis at your request on the understanding that you will make an independent judgment regarding the reliability and
use of the analysis and its outputs. We also understand that you will not represent that Sandler O’Neill & Partners, L.P. is the source of, or has
vouched for the accuracy of, this analysis in any public statement or filing you might make, including reports or other filings submitted to your
regulators.
Sandler O’Neill & Partners, L.P. is not an accounting advisor, and this information and analysis does not represent accounting advice. You
should consult your auditors and/or accounting professional for accounting guidance.
This material is protected under applicable copyright laws and does not carry any rights of publication or disclosure.