NCUA IRR POLICY
August 14, 2012
Presented By
Cullen Coxe
Financial Advisor
Agenda
•
•
•
•
•
•
•
•
Interest rate risk policy
Assumptions
Net interest income
Net economic value
Non-maturing deposit analysis
Prepayment sensitivity analysis
Spread / basis risk
Twisted yield curve
2
New IRR Policy
• NCUA passed a final ruling requiring federal credit unions to
develop and adopt a written policy on interest rate risk
management
• Effective date - 09/30/2012
• Required for CUs that meet one of the below criteria
– More the $50mm in assets
– Assets between $10-50mm only if “Supervisory Interest Rate
Risk Threshold Ratio” (SIRRT) is above 100%
SIRRT Ratio
Total first mortgages held + total investments with maturities greater than 5 years
Total Net Worth
3
IRR Policy Elements
Board approved
IRR Policy
Decision making that
is informed and
guided by IRR limits
Internal controls
BOD oversight and
implementation by
management
Models to assess
IRR sensitivity
(earnings and value)
4
IRR Policy Highlights
•
•
•
•
•
Document responsible parties
Set content and frequency of reporting
Set IRR policy limits
Test IRR impact on new business activities
Document and regularly evaluate assumption and
methodologies
• Separation of controls
• Action plan
5
ALCO
• Examining the impact of changing interest rates and
economic conditions
– Net economic value
– Net interest income
– Net income
• Monitoring the liquidity position
• Monitoring key ratios and statistics
• Reviewing and monitoring the credit union’s competitive
position
6
Internal Guidelines
• The credit union is responsible for setting internal policy
guidelines that best secure the stated goals and objectives of
the institution
In policy
In policy but
approaching a
policy limit
Over policy
limit
Within
defined
limits
No action required
More frequent analyses and reviews may be
required to discuss actions to remain in
compliance
Immediate
action
required
Actions should not interfere with
other corrective actions already
in motion
7
NCUA Risk Measurement
NCUA Risk Measurement
Low
Moderate
High
+/- 10%
+/- 10% to -20%
+/- 20%
Percent change in NII
> -20%
-20% to -30%
< -30%
Percent change in NII
> -40%
-40% to -75%
< -75%
< 6%
4% to 6%
< 4%
< -25%
-25% to -50%
< -50%
Cumulative gap
1 Year
Earnings at risk
Net economic value
NEV ratio
Percent change in NEV
8
NEV
• NEV ratio: must be above 4.00% in all environments between the
shock down 300 scenario and the shock up 300 scenario
Interest Rate Shock
Status
-300
Base
300
In Policy
> 6%
> 6%
> 6%
4% to 6%
4% to 6%
4% to 6%
< 4%
< 4%
< 4%
In Policy, Approaching Limit
Over Limit
9
NEV
• NEV Percent Change: must be within negative 40.00% in all
environments between the shock down 300 scenario and the shock
up 300 scenario
Interest Rate Shock
Status
In Policy
In Policy, Approaching Limit
Over Limit
-300
Base
300
> -30%
0%
> -30%
-30% to -40%
0%
-30% to -40%
-40%
0%
-40%
10
NII
• NII Percent Change: must be within negative 20.00% in each of the
four tested scenarios
Interest Rate Change
Status
In Policy
In Policy, Approaching Limit
Over Limit
Declining
Base
Rising
Shock 300
> -15%
0%
> -15%
> -15%
-15% to -20%
0%
-20%
0%
-15% to -20% -15% to -20%
-20%
-20%
11
IRR Measuring and Monitoring
• Model Sufficiency
– The model used to assess the risks of the credit union must
employ sufficient techniques, analytical capabilities, and
fundamental functionalities that properly capture the complexities
of the balance sheet at hand
• Model Maintenance
– A sufficient chart of accounts
– An appropriate level of data aggregation
– Inclusion and use of account level data
12
Assumptions
• Play an important role in classifying the risk of the balance
sheet
• BOD must understand these assumptions and their impact on
the model
• The credit union is responsible for:
– Documenting all assumptions that have a substantial impact on
the credit union’s risk position and ensure that these
assumptions are appropriate
– Monitoring these assumptions regularly
– Ensuring any assumption changes are properly recorded and
fully disclosed in a transparent way
13
Different Types of Rates
• Weighted average book rate
– Aggregate note rate as of a specific period of time
• Reinvestment rate
– Used in earnings simulation to depict the current rate at which
cash flows will be reinvested
• Discount rate
– Used in value simulation to determine the present value of future
cash flows
14
NII Assumptions
• Reinvestment rates should be product and term specific
• Reinvestment rates
–
–
–
–
Loans: offering rates
Investments: market yields
Non-maturity deposits & certificates: offering rates
Borrowings: FHLB fixed-rate term advance rates
• Reinvestment rates will be adjusted depending on the interest
rate scenario
– Base, rising, declining and shock up 300
15
NEV Assumptions
• Determine appropriate discount rate
– Present value of projected future cash flows
• Primary versus secondary market rates
– Primary: current offering rate
– Secondary: observable market rate
16
NEV Assumptions
Sources for discount rates
• Offering rates for accounts without an actively traded
secondary market
– Unique loan types
– Signature loans
• Secondary market spread over an index for accounts with an
actively traded secondary market
– Auto loans
– Credit card loans
• Observable market rates
– Home equity loans: closed-end second liens and HELOCs
– Mortgage loans: fixed and adjustable
17
Spread Relationships
• Asset-backed securities (ABS)
– Auto loans
– Credit card loans
• LIBOR / swap curve plus additional spread
– Servicing
– New versus used auto loans
– Liquidity
• Final spread is based on the average spread of observable
ABS as published by multiple brokers
18
Spread Relationships
• Home equity
– Bankrate represents comprehensive and objective average rate
obtained in the primary market for home equity loans
• Rate specific based on fixed versus floating
• Example: 1/31/12 discount rates
– Fixed 6.00%
– Floating 4.71%
– Discounting over a curve
• 1st lien residential mortgage
– FHLMC servicing retained, 30-day mandatory delivery price
– Post-settlement delivery fees (loan-level pricing adjustments)
19
NEV Assumptions - Investments
• Obtain base prices from third-party pricing source
– IDC, Reuters
• Collect all security information
– Bloomberg
• Retrieve structured product cash flows
– Moody’s, Intex
20
Assumptions
Wtd. Avg.
Book Rate
Reinvestment
Rate
Source
Discount
Index
Rate
Source
Assets
Consumer Loans
Visa
7.20
7.20
Offer
MasterCard
Direct Auto Loans
7.09
7.09
Offer
5.15
4.58 - 5.27
Offer
Indirect Auto Loans
5.30
4.03 - 4.31
Offer
HELOCs
4.16
3.06 - 6.00
Offer
Wtd. Avg.
Book Rate
7.34
1M LIBOR + 7.12
Broker Avg.
7.34
1M LIBOR + 7.12
Broker Avg.
2.18 - 4.13
Swaps + 1.94 to 2.40
Broker Avg.
2.18 - 4.13
Swaps + 1.94 to 2.40
Broker Avg.
4.60
National Average
Bankrate
Reinvestment
Rate
Source
Rate
Discount
Index
Source
Business Loans
Business Loans Fixed
4.73
4.25 - 6.25
Offer
4.94 - 6.43
Swaps + 4.70
Broker Avg./Offer
Business Loans Adjustable
5.49
6.75 - 9.81
Offer
7.74 - 9.23
Swaps + 7.50
Broker Avg./Offer
21
Assumptions
Wtd. Avg.
Book Rate
Reinvestment
Rate
Source
Discount
Index
Rate
Source
Mortgage Loans
15-Year Fixed Rate Mortgages
4.22
2.88
Offer
30-Day Price Table
FHLMC
15-Year Fixed Rate Mortgages, Jumbo
4.06
2.88
Offer
30-Day Price + Spread
FHLMC
30-Year Fixed Rate Mortgages
5.00
3.63
Offer
30-Day Price Table
FHLMC
30-Year Fixed Rate Mortgages, Jumbo
5.26
3.63
Offer
30-Day Price + Spread
FHLMC
1-Year ARMs
2.87
1.38
Offer
30-Day Price Table
FHLMC
3-Year ARMs
2.78
1.63
Offer
30-Day Price Table
FHLMC
5-Year ARMs
3.50
2.38
Offer
30-Day Price Table
FHLMC
5 Year ARM Jumbo
5.13
2.38
Offer
30-Day Price + Spread
FHLMC
Wtd. Avg.
Book Rate
Total Investments
Agency Notes, Fixed
Agency Notes, Callable
MBSs, Fixed
MBSs, Variable
CMOs Fixed
1.80
1.40
2.87
2.72
2.31
Reinvestment
Rate
Source
0.55
0.59
0.87
2.03
1.48
Discount
Index
Rate
IDC
IDC
IDC
IDC
IDC
0.55
0.59
0.87
2.03
1.48
Source
NA
NA
NA
NA
NA
IDC
IDC
IDC
IDC
IDC
22
NEV Assumptions - Liabilities
• Share certificates
– Federal Home Loan Bank fixed-rate term advance curve
– Early redemption
• Borrowings
– Federal Home Loan Bank fixed-rate term advance curve
– Call / put features modeled in ZMdesk
• Non-maturity deposits
– Federal Home Loan Bank fixed-rate term advance curve
– X-coefficient, effective maturity, decay rate
– Net non-interest costs
23
Assumptions
Wtd. Avg.
Book Rate
Reinvestment
Rate
Source
Rate
Discount
Index
Source
Funding
Regular Shares
0.25
0.25
Offer
0.26 - 2.54
Term Advances
FHLB Atlanta
Share Drafts
0.25
0.25
Offer
0.26 - 2.54
Term Advances
FHLB Atlanta
IRA Shares
0.35
0.35
Offer
0.26 - 2.54
Term Advances
FHLB Atlanta
Money Market
0.37
0.37
Offer
0.26 - 2.54
Term Advances
FHLB Atlanta
Regular Certificates
1.09
0.40 - 1.44
Offer
0.26 - 2.54
Term Advances
FHLB Atlanta
Jumbo Certificates
1.52
0.40 - 1.44
Offer
0.26 - 2.54
Term Advances
FHLB Atlanta
IRA Certificates
2.39
0.60 - 1.44
Offer
0.26 - 2.54
Term Advances
FHLB Atlanta
FHLB Borrowing
3.61
0.26 - 2.54
FHLB Atlanta
0.26 - 2.54
Term Advances
FHLB Atlanta
24
Net Interest Income Analysis
• It is important to remember the purpose of any analysis
• In the case of NII, the purpose is not budgetary
– That is, the primary goal is not to determine the projected income
for the institution over a given time period
• To do so would require balance and rate projections
• The goal is to project the volatility of earnings in changing
(rising / declining) interest rate environments
– NII is then compared in alternative scenarios in order to evaluate
interest rate risk
25
NII Assumptions
Rate Environment
usually parallel
shocks or ramped
scenarios
Horizon Period
12 to 24 months
Reinvestment Rates
offering or market
rates
Balances
are held constant
Prepayment Speeds
historical vs.
projected
26
NII Scenarios
Declining
Base
Rising
Shock
Up 300
• Possible scenarios include:
– Base scenario - rates are held constant
– Declining scenario - rates decrease 25 basis points per month
for 12 months (resulting in a down 300 over 1 year)
– Rising scenario - rates increase 25 basis points per month for 12
months (resulting in an up 300 over 1 year)
– Shock up 300 scenario - rates shock immediately 300 basis
points and hold at that level indefinitely
– A non-parallel shift in rates (a “twisted yield curve”)
27
Reinvestment Rates
• Should be product and term specific
• Reinvestment rates
–
–
–
–
Loans: offering rates
Investments: market yields
Non-maturity deposits & certificates: offering rates
Borrowings: FHLB fixed-rate term advance rates
• Reinvestment rates will be adjusted depending on the
interest rate scenario
– Base, rising, declining and shock up 300
28
NII Projected Outputs
•
•
•
•
•
•
•
•
Projected interest income
Projected interest expense
Projected NII and net income
Percent change from base model
Asset yields and costs of funding
Net interest spread
Net interest margin
Return on assets
29
Reinvestment of Cashflows – Example
Current Offering Rate = 3.00%
Month 1
Month 2
Month 3
$600K
Principal
$400K
Principal
$375K
Principal
Base
3.00%
3.00%
3.00%
Declining
2.75%
2.50%
2.25%
Rising
3.25%
3.50%
3.75%
Shock Up
300
6.00%
6.00%
6.00%
30
Net Interest Income Output – Nominal Values
Declining
Base
Rising
Shock Up 300
Total Consumer Loans
11,688
12,129
12,790
13,878
Total Real Estate Loans
19,275
21,229
23,248
24,950
Total Business Loans
4,585
4,890
5,091
5,606
Total Investments
3,171
4,283
6,634
8,439
Total Interest Income
38,719
42,531
47,763
52,873
Total Interest Expense
7,026
8,242
13,844
19,895
Net Interest Income
31,693
34,289
33,919
32,978
31
NII Output – Interpreting Interest Rate Risk
Declining
Base
Rising
Shock
Up 300
Interest Income
% Change from Base
$ 39,719
-6.61%
$ 42,532
0.00%
$ 47,764
12.30%
$ 52,873
24.31%
Interest Expense
% Change from Base
$ 5,026
-39.02%
$ 8,242
0.00%
$ 13,844
67.97%
$ 19,895
141.38%
Net Interest Income
% Change from Base
$ 34,693
1.18%
$ 34,289
0.00%
$ 33,919
-1.08%
$ 32,978
-3.83%
Provision for loan losses
Other Income
Other Expense
$ 3,000
$ 13,000
$ 35,000
$ 3,000
$ 13,000
$ 35,000
$ 3,000
$ 13,000
$ 35,000
$ 3,000
$ 13,000
$ 35,000
Net Income
% Change from Base
$ 9,693
4.34%
$ 9,289
0.00%
$ 8,919
-3.98%
$ 7,978
-14.12%
Yield on Earning Assets
Cost of Paying Liabilities
3.28%
0.65%
3.60%
0.77%
4.04%
1.29%
4.48%
1.85%
Net Interest Spread
Net Interest Margin
2.62%
2.68%
2.83%
2.90%
2.75%
2.87%
2.62%
2.79%
Return on Assets
0.35%
0.32%
0.29%
0.25%
32
What do NII Results Provide?
• Breakdown of interest income and interest expense by
category type
• Projected earnings on a static balance sheet
• Earnings at risk due to constant, rising or declining interest
rates
• Potential balance sheet problems prior to interest rate shifts
33
What is NEV?
• Evaluate interest rate risk from a value perspective
• Economic value is calculated at a single point in time
• Net economic value
– The present value (PV) of the balance sheet
-
Economic Value of Assets
Economic Value of Liabilities
= NEV
34
Purposes of NEV
Measures IRR to
capital
Understand
trade-offs
between risk
and return
Conduct what-if
analyses to be
proactive
Measure
effective
duration of
assets and
liabilities
35
Why Calculate NEV?
•
•
•
•
•
•
Superior to cost accounting information
Captures interest and principal cash flows
Provides an analysis of options risk
Allows for comparisons between different scenarios
More complete than the income simulation
Properly managing NEV can reduce the volatility of earnings
and net worth
36
NEV Measurements
• NEV percent change
– The projected net gain or loss of net economic value assuming
changes in interest rates, relative to the starting value
– The sensitivity of capital to changes in interest rates
• NEV ratio
– A measurement of capital adequacy from an IRR perspective
– Calculated as the NEV of equity / NEV of total assets
37
Price Examples
• There is an asset and it has a fixed rate of 3%, with a maturity
of 5 years
Current Market
Rate
3%
Current Market
Rate
2%
Current Market
Rate
4%
Price
Par
100
Price
Premium
>100
Price
Discount
<100
38
Calculating Prices
• Example
30-year mortgage portfolio
–
–
–
–
–
–
Book value
$30,000,000
Book rate
4.55%
Market (discount) rate
3.96%
Market value
$31,102,800
Gain / (loss)
$1,102,800
Price
103.68
39
Net Economic Value (Micro)
Selected asset prices:
Assets
Visa Platinum
New Auto
Used Auto
Share Secured
Signature Loans
Home Equity LOC
First Mortgage Loans
Second Mortgage Loans
Agency Fixed
Agency Callables
Bank CDs
Corporate CDs
CMO Fixed
CMO Variable
ARMs
MBS Fixed
Book Value
$22,526
$65,000
$44,269
$11,229
$14,801
$32,405
$30,000
$26,457
$2,000
$9,994
$5,475
$1,000
$15,996
$3,870
$2,688
$36,588
(200)
97.63
103.17
102.70
104.16
100.00
99.90
104.91
100.99
100.03
100.31
101.24
100.01
100.05
100.32
105.85
102.83
(100)
97.59
103.12
102.65
101.97
100.00
99.88
104.67
100.03
100.03
100.31
101.05
100.01
100.34
100.21
106.09
102.89
Interest Rate Scenario
200
100
Base
300
400
93.77
99.78
99.10
95.87
97.68
99.81
94.90
91.98
97.32
96.76
97.04
99.98
97.04
97.65
102.58
93.31
92.46
98.63
97.81
93.98
96.67
99.78
90.16
89.50
95.78
94.93
95.64
99.96
94.83
95.84
100.38
88.92
91.17
97.51
96.59
92.16
95.68
99.76
85.51
87.14
94.26
93.14
94.27
99.95
92.47
93.63
97.87
84.68
96.48
102.64
101.64
99.86
99.74
99.85
103.68
97.32
100.02
100.03
99.93
100.01
100.08
99.81
105.64
101.07
95.11
101.05
100.32
97.83
98.70
99.83
99.85
94.58
98.84
98.56
98.47
100.00
98.88
98.99
104.36
97.57
40
Net Economic Value (Micro)
Selected asset gains / (losses):
Assets
Visa Platinum
New Auto
Used Auto
Share Secured
Signature Loans
Home Equity LOC
First Mortgage Loans
Second Mortgage Loans
Agency Fixed
Agency Callables
Bank CDs
Corporate CDs
CMO Fixed
CMO Variable
ARMs
MBS Fixed
Book Value
$22,526
$65,000
$44,269
$11,229
$14,801
$32,405
$30,000
$26,457
$2,000
$9,994
$5,475
$1,000
$15,996
$3,870
$2,688
$36,588
(200)
(100)
(534)
2,063
1,195
467
(0)
(31)
1,473
261
1
31
68
0
9
12
157
1,034
(542)
2,026
1,172
221
(0)
(39)
1,401
7
1
31
57
0
54
8
164
1,058
Interest Rate Scenario
Base
100
200
(793)
1,719
724
(16)
(38)
(47)
1,103
(709)
0
3
(4)
0
12
(7)
152
393
(1,102)
683
143
(244)
(192)
(55)
(45)
(1,434)
(23)
(144)
(84)
(0)
(180)
(39)
117
(887)
(1,403)
(145)
(398)
(464)
(344)
(63)
(1,530)
(2,123)
(54)
(324)
(162)
(0)
(474)
(91)
69
(2,446)
300
(1,699)
(893)
(969)
(676)
(493)
(71)
(2,951)
(2,778)
(84)
(507)
(239)
(0)
(827)
(161)
10
(4,055)
400
(1,989)
(1,621)
(1,509)
(880)
(639)
(79)
(4,347)
(3,402)
(115)
(686)
(314)
(1)
(1,204)
(247)
(57)
(5,604)
41
Net Economic Value (Micro)
Selected liability prices:
Liabilities
Regular Shares
Share Draft
Money Market
IRA Shares
Share Certificates
IRA Certificates
Total Other Liabilities
Book Value
$93,296
$71,794
$82,567
$12,376
$52,666
$24,083
$11,206
(200)
107.56
107.85
104.71
108.21
102.53
103.22
100.00
(100)
103.90
103.44
102.42
104.78
102.36
103.05
100.00
Interest Rate Scenario
Base
100
200
100.93
99.46
100.33
101.77
101.34
101.96
100.00
98.21
95.81
98.44
99.01
100.09
100.61
100.00
95.71
92.53
96.84
96.48
98.87
99.28
100.00
300
400
93.41
89.60
95.67
94.16
97.69
97.99
100.00
91.51
86.96
94.74
92.21
96.53
96.74
100.00
We can see that the regular shares are priced above par in the base
case (which is a detriment to the credit union as it reduces capital),
whereas the share drafts are priced below par in the base case
(which benefits the credit union by increasing capital)
42
Net Economic Value (Micro)
Selected liability gains / (losses):
Liabilities
Regular Shares
Share Draft
Money Market
IRA Shares
Share Certificates
IRA Certificates
Total Other Liabilities
Book Value
$93,296
$71,794
$82,567
$12,376
$52,666
$24,083
$11,206
(200)
7,055
5,635
3,887
1,016
1,334
776
-
(100)
3,639
2,472
2,001
592
1,243
734
-
Interest Rate Scenario
Base
100
200
867
(389)
276
219
704
473
-
(1,674)
(3,010)
(1,289)
(122)
46
146
-
(4,005)
(5,360)
(2,611)
(435)
(595)
(173)
-
300
(6,144)
(7,469)
(3,577)
(723)
(1,218)
(483)
-
400
(7,921)
(9,363)
(4,341)
(964)
(1,825)
(786)
-
The gains and losses, based on the prices, are shown
43
NEV- Macro
($,000 omitted)
Interest Rate Scenario
Base
100
3,002
-3,686
Change in Economic Value of Assets
(200)
7,560
(100)
7,479
200
-10,553
300
-17,251
400
-23,853
Minus Change in Economic Value of Liabilities
7,235
3,932
-271
-4,785
-9,208
-13,542
-17,789
Equals Cumulative Change in Economic Value
325
3,547
3,273
1,099
-1,345
-3,710
-6,064
Plus Book Capital
31,267
31,267
31,267
31,267
31,267
31,267
31,267
Equals Economic Values of Book Capital
31,592
34,814
34,540
32,366
29,922
27,557
25,203
NEV Dollar Change
(2,948)
274
-
(2,174)
(4,618)
(6,983)
(9,337)
NEV Percent Change
-8.54%
0.79%
0.00%
-6.30%
-13.37%
-20.22%
-27.03%
NEV Ratio
7.79%
8.59%
8.62%
8.21%
7.72%
7.24%
6.74%
44
Purpose of an NEV Analysis
• Measure interest rate risk
• Understand trade-offs between long term risk and short term
return
• Conduct “what-ifs”
45
Break
46
Non-Maturity Deposit Analysis
Consists of two regression analyses
• Financial institution’s dividend rate sensitivity
– How does the financial institution’s dividend rate change with a
given change in market rates
– X-coefficient
• Membership sensitivity
– Calculate an effective final maturity for each deposit account
– 10-year maximum maturity
47
Non-Maturity Deposit Analysis
•
•
•
•
•
•
•
Should be updated every year
Regression analysis for final maturities
Regression analysis for dividend payments
Non-interest costs
Run sensitivity analysis
Discussion with ALCO on reasonableness of rate movements
These scenarios test maturity and sensitivity assumptions
48
Non-Maturity Deposit Analysis
Regular Shares
– Dividend rate
– Coefficient
– Non-interest cost
Non-interest cost
Dividend rate
Total cost
0.50%
0.27%
1.39%
Down 100
1.39%
0.23%
1.62%
Base
1.39%
0.50%
1.89%
Up 100
1.39%
0.77%
2.16%
49
Coefficient Materiality
Regular Shares
Share Drafts
Money Market
NEV Ratio - Base
NEV Ratio - Up 300
NEV % Change Up 300
Asset Duration - Up 300
Liability Duration - Up 300
Coefficient
0.27%
0.15%
0.45%
Model A
0.41%
0.23%
0.68%
Model B
0.54%
0.30%
0.90%
Initial
11.26%
9.03%
-23.04%
2.77%
1.16%
Model A
10.92%
8.20%
-29.78%
2.77%
1.04%
Model B
10.58%
7.37%
-34.82%
2.77%
0.91%
50
Maturity Materiality
Regular Shares
Share Drafts
Money Market
Maturity
8
10
6
Model A
4
5
3
NEV Ratio - Base
NEV Ratio - Up 300
NEV % Change Up 300
Asset Duration - Up 300
Liability Duration - Up 300
Initial
11.26%
9.03%
-23.04%
2.77%
1.16%
Model A
9.84%
7.14%
-32.13%
2.77%
1.14%
51
NMD Price Materiality
NEV Ratio - Base
NEV Ratio - Up 300
NEV % Change Up 300
Asset Duration - Up 300
Liability Duration - Up 300
Initial
11.26%
9.03%
-25.04%
2.77%
1.16%
NMD @ par
9.67%
4.71%
-54.45%
2.77%
0.44%
52
Prepayment Speeds
• Prepayments are early repayments of a loan
• Prepayment risk results when cash flows contract or extend
more than expected
– Leads to reinvestment risk
– Increased / decreased volatility in net economic value
• Generally, if rates rise, all else equal, prepayments will slow
• Generally, if rates fall, all else equal, prepayments will rise
53
Prepayment Speeds
• Auto loans - based on historical prepayment speeds of
asset-backed securities
• Residential mortgages - derived from prepayment model
which accounts for the following among many other factors:
–
–
–
–
–
Refinancing incentive
Seasoning
Burnout
Seasonality
Media effect
54
Prepayment Sensitivity
•
•
•
•
Impact of slower prepayment speeds
Extend mortgage loans and mortgage investments
Run annually or more frequently depending on rates
Most important when projected prepay speeds are fast
55
Prepayment Curve
High
Prepayments
CPR
Agency MBS prepayment “S” curve
Low
Prepayments
Rates are ‘low’
relative to mortgage
coupon
Prepayment
Incentive
Rates are ‘high’ relative to
mortgage coupon
Rates
56
Two Sample Financial Institutions
Financial institution - Mortgage
• Total Assets = $740 million
– 37% Fixed-rate mortgages
– 18% Adjustable mortgages
– 5% Auto loans
• Total Liabilities = $673 million
– 50% Share certificates
– 10% Money market
• Total Capital = $67 million
Financial institution - Auto
• Total Assets = $500 million
– 55% Auto loans
– 10% Fixed-rate mortgages
– 5% Adjustable mortgages
• Total Liabilities = $455 million
– 50% Share certificates
– 10% Money market
• Total Capital = $45 million
57
Sample Economic Value Simulation
Financial Institution - Mortgage
Net Economic Value Analysis
NEV Ratio
NEV Percent Change
(200)
9.28%
-13.77%
Interest Rate Scenario
(100)
Base
100
10.45%
11.26%
11.29%
-6.49%
0.00%
200
10.32%
300
9.03%
400
7.39%
-11.98%
-23.04%
-35.80%
100
9.30%
200
9.36%
300
9.20%
400
8.87%
-1.00%
-5.21%
-7.84%
-10.66%
-1.26%
Financial Institution - Auto
Net Economic Value Analysis
NEV Ratio
NEV Percent Change
(200)
7.65%
-15.39%
Interest Rate Scenario
(100)
Base
8.98%
9.25%
-3.45%
0.00%
58
Prepayment Materiality
Initial
Model A
Model B
15 year fixed
30 year fixed
3/1 ARM
-200
48
52
44
-100
43
47
39
Base
23
21
39
100
11
9
39
200
7
6
37
300
6
6
34
400
6
5
31
15 year fixed
30 year fixed
3/1 ARM
-200
36
27
39
-100
32
25
35
Base
17
18
16
100
8
13
7
200
5
7
4
300
5
6
4
400
4
5
4
15 year fixed
30 year fixed
3/1 ARM
-200
24
18
26
-100
22
17
23
Base
11
12
11
100
5
8
5
200
3
4
3
300
3
4
3
400
3
3
3
59
Prepayment Materiality
Financial Institution - Mortgage
NEV Ratio - Up 300
NEV % Change Up 300
Asset Duration - Up 300
Liability Duration - Up 300
Initial
9.03%
-23.04%
2.77%
1.16%
Model A
8.21%
-32.76%
2.94%
1.16%
Model B
7.32%
-40.33%
3.11%
1.16%
Financial Institution - Auto
NEV Ratio - Up 300
NEV % Change Up 300
Asset Duration - Up 300
Liability Duration - Up 300
Initial
9.25%
-7.84%
1.55%
1.01%
Model A
9.01%
-10.53%
1.59%
1.01%
Model B
8.67%
-17.22%
1.63%
1.01%
60
Spread / Basis Risk
• Secondary market spreads widen due to economic or market
conditions
• Mortgage spreads
• Auto spreads
• November 2008 spreads
• Discount spreads are used to determine the value of a
holding. Higher spreads (i.e. a higher rate expected by the
market) result in lower prices
• Capital drops, and capital volatility increases
61
Spreads
62
Spreads
63
Rate Spreads
Primary vs. secondary rates comparison as of Dec 2008
• Primary - average offering rates
– New auto 5.75%
– Credit cards
10.00%
– Home equity
4.30%
• Secondary market rates
– New auto
– Credit cards
– Home equity
AA spread over LIBOR/Swap 10.40% - 12.10%
12.25%
AA spread over LIBOR/Swap 30.40% - 42.10%
64
Two More Sample Financial Institutions
Financial institution - Mortgage
• Total Assets = $900 million
– 48% Mortgages
– 19% Investments
– 4% Auto loans
Financial institution - Auto
• Total Assets = $900 million
– 52% Auto loans
– 18% Mortgages
– 26% Investments
• Total Liabilities = $784 million • Total Liabilities = $784 million
– 40% Share certificates
– 16% Money market
– 19% Savings
– 40% Share certificates
– 16% Money market
– 19% Savings
• Total Capital = $117 million
• Total Capital = $117 million
65
Spread / Basis Risk
Financial Institution - Mortgage
NEV Ratio - Up 300
NEV % Change Up 300
Asset Duration - Up 300
Liability Duration - Up 300
Initial
11.60%
-23.30%
2.57%
1.64%
Spreads + 200
7.59%
-35.07%
2.75%
1.64%
Financial Institution - Auto
NEV Ratio - Up 300
NEV % Change Up 300
Asset Duration - Up 300
Liability Duration - Up 300
Initial
14.22%
-2.89%
1.61%
1.64%
Spreads + 200
13.99%
-7.66%
1.66%
1.64%
66
Twisted Yield Curve
• Interest rate shift with a change in the spread between two
interest rates at different maturity points
• Non-parallel shifts and twists
• Change in shape and slope of yield curve
• Choose a curve that adequately stress your balance sheet
• These changes stress different parts of the balance sheet
• “Shocking” this new curve then measures the risk to the
balance sheet (in other words, if the curve moved like this,
what would the new ALM report look like at that time?)
67
Twisted Yield Curve-Steepener
Dec-11
TYC
Change
Fed Funds
Prime
0.25
3.25
0.25
3.25
0.00
0.00
Treasury Curve
1 month
3 month
6 month
12 month
24 month
36 month
60 month
120 month
360 month
0.02
0.02
0.06
0.11
0.24
0.36
0.83
1.88
2.90
1.00
1.00
1.50
1.50
2.00
3.00
4.00
5.20
6.20
0.98
0.98
1.44
1.39
1.76
2.64
3.17
3.32
3.30
Swap
1 month
3 month
6 month
12 month
24 month
36 month
48 month
60 month
120 month
360 month
Dec-11
TYC
Change
0.30
0.58
0.81
1.13
0.73
0.82
1.01
1.22
2.03
2.62
1.25
1.40
1.60
2.20
2.35
3.25
3.50
4.25
5.30
5.90
0.95
0.82
0.79
1.07
1.62
2.43
2.49
3.03
3.27
3.28
FHLB Dallas
1 month
3 month
6 month
12 month
18 month
24 month
36 month
48 month
60 month
120 month
Dec-11
TYC
Change
0.25
0.26
0.32
1.03
1.07
1.12
1.39
1.63
1.94
2.79
1.20
1.20
1.80
2.30
2.50
2.80
4.00
4.30
5.00
5.80
0.95
0.94
1.48
1.27
1.43
1.68
2.61
2.67
3.06
3.01
68
Twisted Yield Curve
7.00
6.00
5.00
4.00
3.00
Dec-11
TYC
Dec-12
2.00
1.00
0.00
69
Twisted Yield Curve- Flattener
Dec-11
TYC
Change
0.25
3.25
0.25
3.25
0.00
0.00
Treasury Curve
1 month
0.02
3 month
0.02
6 month
0.06
12 month
0.11
24 month
0.24
36 month
0.36
60 month
0.83
120 month
1.88
360 month
2.90
2.02
2.02
2.20
2.40
2.60
2.80
2.80
3.25
3.35
2.00
2.00
2.14
2.29
2.36
2.44
1.97
1.37
0.45
Fed Funds
Prime
Dec-11
Swap
1 month
3 month
6 month
12 month
24 month
36 month
48 month
60 month
120 month
360 month
0.30
0.58
0.81
1.13
0.73
0.82
1.01
1.22
2.03
2.62
TYC
2.24
2.32
2.55
2.81
2.58
2.75
3.00
3.00
3.40
4.00
Change
1.94
1.74
1.74
1.68
1.85
1.93
1.99
1.78
1.37
1.38
FHLB Dallas
1 month
3 month
6 month
12 month
18 month
24 month
36 month
48 month
60 month
120 month
Dec-11
TYC
Change
0.25
0.26
0.32
1.03
1.07
1.12
1.39
1.63
1.94
2.79
2.20
2.25
2.30
2.85
3.00
3.00
3.40
3.70
3.70
4.20
1.95
1.99
1.98
1.82
1.93
1.88
2.01
2.07
1.76
1.41
70
Twisted Yield Curve
3.50
3.00
2.50
2.00
1.50
Dec-11
TYC
1.00
0.50
0.00
71
Twisted Yield Curve Steepener
Financial Institution - Mortgage
NEV Ratio - Up 300
NEV % Change Up 300
Asset Duration - Up 300
Liability Duration - Up 300
Initial
11.60%
-23.30%
2.57%
1.64%
Twisted YC
4.51%
-47.65%
2.79%
1.54%
Financial Institution - Auto
NEV Ratio - Up 300
NEV % Change Up 300
Asset Duration - Up 300
Liability Duration - Up 300
Initial
14.22%
-2.89%
1.61%
1.64%
Twisted YC
13.22%
-8.33%
1.65%
1.54%
72
Conclusion
• IRR Policy update
• What-ifs stress different aspects of the balance sheet.
Understanding the impacts assumption changes have is
important in helping monitor and manage interest-rate risk
• Assumptions
• Supplemental IRR test
–
–
–
–
NMD assumption sensitivity
Prepayment sensitivity
Basis risk
Twisted YC
• Testing IRR impact of strategy
73
2911 Turtle Creek Blvd.
Suite 500
Dallas, Texas 75219
Phone: 800.752.4628
Fax: 214.987.1052
www.almfirst.com