Managing the Investment Portfolio: Size, Complexity and Evolving Choices

Transcription

1 Managing the Investment Portfolio: Size, Complexity and Evolving Choices Tuesday, June 18, :00 PM 3:15 PM Presented by: Ajay Ganju, CFA, Vice President Marc Gall, Vice President BOSC, Inc N. Mayfair Road, Suite 303 Milwaukee, WI P: E: (Ajay) (Marc)

2 AGENDA 1. Economic Overview and Outlook 2. Portfolio Management and Security Selection 3. Regulatory and Accounting Issues slide 2

3 AGENDA 1. Economic Overview and Outlook 2. Portfolio Management and Security Selection 3. Regulatory and Accounting Issues slide 3

4 Unemployment Picture U6 unemployment rate dropped to 13.9% compared to 14.5% in April 2012 Headline unemployment rate declined to 7.5% with 165,000 new jobs added Improvement came from a decline in participation rate, lowest since 1978 slide 4

5 Labor Force Participation Rate slide 5

6 Missing from Unemployment Stats Is disability being used as a stop gap between unemployment benefits and retirement/social security? No set expiration for disability, unlike unemployment benefits with run out slide 6

7 Wages vs. Profits Real wages relatively flat over past several years Illustrates slack in labor market Greater productivity = higher corporate profitability slide 7

8 Year over Year Treasury Yield Curve Yield curve anchored on short end shifting 3 years and beyond What issues would cause the 10 year to rise/fall from current levels? slide 8

9 Housing Starts Housing starts improving from 2009 lows, but still well below historical averages Multi-family starts increasing at faster pace, aiding overall housing start data slide 9

10 Fed Statement When Will Purchases End? Interest rates will stay low at least as long as the unemployment rate remains above 6.5 percent and if inflation between one and two years ahead is projected to be no more than 2.5 percent Bernanke mentioned unemployment targets won t be met until 2015 or 2016 Concerned about restrictive fiscal policy Company Bank of America Bank of Montreal Bank of Nova Scotia Barclays BNP Paribas Cantor Fitzgerald Citigroup Global Markets Credit Suisse Daiwa Capital Markets Deutsche Bank Goldman Sachs HSBC Securities Jefferies JPMorgan Chase Mizuho Securities Morgan Stanley Nomura Securities RBC Capital Markets RBS Securities Societe Generale UBS Tapering Starts Tapering Ends March 2014 Sept Q Early 2015 Q Mid 2015 Q Q Dec Q Q Sept./Oct Q Sept March 2014 Q3/Q Q4 2013/Q Q Dec Dec Q Q N/A Q Q Dec Q Q Q Q Mid 2014 Sept March 2014 Q Q Sept Early 2014 Sept Dec Q June 2014 slide 10

11 Best of a Bad Bunch? If the largest world economies are struggling, are we just the best of the worst? Central banks pumping liquidity into system, but issues remain slide 11

12 Historical Interest Rates slide 12

13 AGENDA 1. Economic Overview and Outlook 2. Portfolio Management and Security Selection 3. Regulatory and Accounting Issues slide 13

14 Investment Portfolio Growth Investment portfolios represent 20.71% of bank total assets as of Dec 2012 Increasing relative importance, both to manage liquidity and drive earnings Banks <$5 billion total assets Investment Portfolio + Cash and Due represented 23.04% of total assets in 2006 Increased to 31.54% of total assets in % in cash at end of 2012 Source: FDIC Quarterly Banking Profile, FDIC slide 14

15 Where to Start Top down approach to investment portfolio Interest rate risk will help determine investment portfolio duration Asset sensitive banks may take on more duration in portfolio, while liability sensitive banks could add floating rate exposure at lower yields to offset risk Key to looking at peer data banks may make investment decisions very differently based on other factors, i.e. loan portfolio structure, loanto-deposit ratio, etc Investment portfolio and wholesale funding are areas to help manage interest rate risk. We have 100% control over these decisions. Loan and deposit decisions will largely be dictated by customers slide 15

16 Questions to Ask What is the bank s current situation? Loan demand strong or weak? Liquidity position hot money parked in nonmaturing accounts? Are loan terms extending out, which will naturally lead the bank to become more liability sensitive? Regulatory action requiring certain level of liquidity? How much liquidity and does that mean Fed Funds or short term investments? Is the bank likely to see margin compress in the coming years? Fed has indicated it will be on hold until approximately 2015 slide 16

17 Questions to Ask What is the bank s current situation? Capital position Taxes Am I constrained from growing or purchasing certain securities due to capital ratios? What impact does this have on ability to take risk in portfolio? Loss carry forwards that need to be utilized? AMT Sub-S or C-Corp Other portfolio constraints What are the pledging requirements of the portfolio? Diversification of assets slide 17

18 Diversification In today s volatile interest rate environment with little clarity, diversification becomes even more important Involves adding many different combinations of securities to improve yield/market value risk Many different security types can generate bps spread over alternatives Agency MBS & CMOs, Agency Callables and Step Ups, Taxable and Tax-Exempt Municipals, Agency CMBS, Corporate Securities Spread comes from option (call or prepay), duration and/or credit risk Different securities types tend to perform better than others in certain interest rate environments If we concentrate the portfolio to these security types, the portfolio will tend to perform similarly Diversification of the portfolio for a given duration will result in a portfolio that performs better across all scenarios (rates up/down/flat) slide 18

19 A Closer Look at Diversification Sample Bank Municipal 11.2% Peer Group Taxable Municipal CDs 2.2% 3.8% Whole Loan 5.4% Other 1.8% CDs 2.7% Agency 4.7% MBS Pass-throughs 25.8% Taxable Municipal 2.5% Agency CMOs 25.5% Municipal 28.6% ABS 2.9% Agency 82.7% slide 19

20 Earnings & structure Cashflow & liquidity Product Types: Diversification Options slide 20

21 Liquidity Concerns Evaluate cash flow needs from the portfolio There is a difference between needing to stay short due to liquidity concerns vs. interest rate risk positioning Liquidity concerns may be managed by understanding and analyzing portfolio cash flow Portfolio A Chart Title Portfolio B 45,000 8,000 40,000 7,000 35,000 6,000 25,000 20,000 15,000 10,000 5,000 0 Cashflows (in 000's) 30,000 5,000 Base Case ,000 Base Case 300 3,000 2,000 1,000 0 Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year slide 21

22 Opportunity to Enhance Margin Monthly Cashflow Projections (in thousands) Mar-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Annual Total Rates Up 300 BPS ,705 Rates Up 100 BPS ,615 Rates Down 100 BPS ,217 Current Forecast ,862 Mar-14 Apr-13 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Rates Up 300 BPS 154 1, Feb-15 Annual Total 93 4,123 Rates Up 100 BPS 272 2, ,481 Rates Down 100 BPS 291 2, ,784 Current Forecast 282 2, ,549 Annual Cashflow Projections (in thousands) Bank has 3 customers million each in8 money market accounts Year 1 Year 2that Year deposited 3 Year 4 Year$1 5 Year 6 Year 7 Year Year 9 Year 10 Rates Up 300 BPS 1,863 1,529 2, ,612 2, Option 1:2,705 Keep4,123 $3 million in excess funds those funds could leave at any time Rates Up 100 BPS 3,615 4,481 1,408 1,110 2,779 1,697 1,708 1, :4,217 Use 4,784 $3 million to981pre-invest cashflows RatesDown Option 100 BPS 1,444 2,560 1,897 1,322 1, Current Forecast 3,862 4,549 1,497 1,100 2,690 2,006 1,414 1, Immediately increase earnings to bank from 0.25% (maybe) to 0.75% % (typical portfolio Year 11 Year investment) 12 Year 13 Year 14 Year 15 Year 16 Year 17 Year 18 Year 19 Year 20 Rates Up 300 BPS If deposits 531 begin102to leave bank, portfolio is paying off $315,000 each month. Worst Rates Up 100 BPS case, bank 22rolls 1 month borrowing from 0.17% until not needed Rates Down 100 BPS Current on $3 16 million is $30,000 Forecast Difference between 0.25% and 1.25% for16a year slide 22

23 Investment Alternatives Mortgage Pool 10 YR Pool Backed by residential mortgages Where does it fit? Provides shorter amortizing cashflow Better yield than other alternatives with relatively stable profile slide 23

24 Investment Alternatives Multi-Family Agency Multi-Family Backed Security 20% risk weighed and generally accepted by FHLB as collateral for advances Where does it fit? Longer portion of portfolio to drive yield slide 24

25 Agency CMBS Credit Profile Fannie Mae DUS Outstanding: $125,036,153,020 in 17,718 properties $74,557,804 (15 properties) 0.060% delinquent 30 days $37,929,000 (6 properties) 0.030% delinquent 60 days $35,155,505 (11 properties) 0.028% delinquent 90+ day Freddie Mac KFRED Outstanding: $52,237,024,221 in 2,598 properties. $11,190,978 (2 properties) 0.021% delinquent 30 days $0 (0 properties) 0.000% delinquent 60 days $0 (0 properties) 0.000% delinquent 90+ days slide 25

26 Agency CMO Analysis slide 26

27 Agency CMO Analysis Vector: 40 CPR for 6-months, then 6 CPR for Life Fast prepayments can erode the support classes creating the PAC structure Security is 3-years longer in average life (than +300 scenario) and lower yield than Treasuries Final expected payment extends from 2026 in base case to 2040 in vector scenario Weighted Avg FICO: 755 Weighted Avg LTV: 72% slide 27

28 ARMs: Diversification or Buyer Beware? 5/1 Hybrid Arm - Created March FICO: WALTV: 61% - Loan Size: $344,971 5/1 Hybrid Arm - Created March FICO: WALTV: 60% - Loan Size: $313,063 slide 28

29 Selling Securities The portfolio is designed to be a store of liquidity for many banks What good is the liquidity if the bank never accesses it? Don t be afraid to sell bonds from the portfolio if it is in the best interest of the bank It seemed like a good idea at the time Times to consider selling: Need liquidity to fund loans Can harvest capital gains to augment income Especially if funds can be reinvested at higher rate Credit event creates cause for concern Need to restructure balance sheet given changing interest rate risk position slide 29

30 Municipal Yield Curves Tax exempt municipals provide more value than taxable securities past 10 years Assumes bank can take full advantage of tax-exemption Strong demand for 10 year sector investment policies may only allow purchases to 10 years slide 30

31 Kicker Municipals Older municipal issues that were issued when rates were higher Ideal structures have years maturities and 5-8 year call dates Ideal coupon is 3.50%+ Premium prices range from slide 31

32 Why buy kicker municipals? Designed for investors seeking incremental yield Take on option risk; targeted risk exposure with excellent risk/reward profile Buying a 5-7yr duration asset with the expectation the bond is called but accepting the risk that rates rise and the bond extends to maturity For this risk, you generally earn a premium of ~0.30% (0.45% TEY) to the call date slide 32

33 What happens if rates rise? Income: Accounting yield on security goes from 2.27% TEY to 6.06% TEY for remaining 8 years Market Value: Breakeven market value at call date if 8 yr treasury rates rise 3.50% by call date Amortization of premium is complete by call date and you are left with the coupon 8 yr treasury rate five years from now would have to be at approximately 5.00% in order for this bond to extend. This is nearly 3.50% higher that today s rate. One would think that if 8 year rates rose 3.50%, our security would be underwater from a market value perspective but the amortization of our premium reduces our book price from to This amortization offsets almost a 3.50% upward movement in the 8 yr treasury rate Attractive risk/reward profile versus alternatives 5NC1 callable YR step up YR YR Bullet +100 Genoa, WI +145 slide 33

34 Non-Bank Qualified Municipals Purchased by Banks Advantages of Non BQ Municipals Disadvantages of Non BQ Municipals Can be purchased in larger block sizes Structure advantages Higher coupon results in higher YTM Higher coupon results in less rate sensitivity Actual return fluctuates more with changes to the bank s Cost of Funds than BQ Municipals For bank s who purchase bonds inside 10 years, the yield difference is minimal Because banks get no tax deduction for cost of funds, the return on the shortest securities can actually be negative slide 34

35 Expected Return Non-Bank Qualified & Bank Qualified 1.0% COF 5.0 cpn AAA YTM General Market TEY (1.0% COF 34 BP TEFRA) 34% Tax AA BQ TEY (1.0% COF 6.8 BP TEFRA) 34% Tax Rate 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% slide 35

36 Change in Cost of Funds Cost of Funds vs. Market Indices Rate COF YR CMT YR CMT 6.37 FF MO LIBOR slide 36

37 Change In Expected Return Non-BQ YTM 1.00% COF Versus 2.25% COF 5.0 cpn AAA YTM General Market TEY (1.0% COF 34 BP TEFRA) 34% Tax 5.0 cpn AAA YTM General Market TEY (2.25% COF 76.5 BP TEFRA} 34% Tax Rate 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% -2.00% slide 37

38 Expected Return Non-BQ & BQ % COF 5.0 cpn AAA YTM General Market TEY (2.25% COF 76.5 BP TEFRA} 34% Tax Rate AA BQ TEY (2.25% COF 15.3 BP TEFRA) 34% Tax Rate 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% -2.00% slide 38

39 Various Municipals TEY (1.0% COF 34 bp TEFRA) 34% Tax Rate AAA MMD TEY (1.0% COF 34 BP TEFRA) 34% Tax Rate AA BQ TEY (1.0% COF 34 BP TEFRA) 34% Tax Rate A BQ TEY (1.0% COF 34 BP TEFRA) 34% Tax Rate INSD MUD A Underlying TEY (1.0% COF 34 BP TEFRA) 34% Tax Rate TX PSF A Underlying TEY (1.0% COF 34 BP TEFRA) 34% Tax Rate INSD MUD BBB Underlying TEY (1.0% COF 34 BP TEFRA) 34% Tax Rate slide 39

40 Texas Special Districts Created to provide utilities and services to residents and businesses in the district May provide water, irrigation, drainage, solid waste collection, wastewater treatment and recreational services The most common type of Special District issuances are Municipal Utility Districts (MUDS) When new developments are created, Municipal Utility Districts are formed to provide water, waste, irrigation and other services Two primary sources of income Usage charges for water and sewer Property taxes levied for maintenance, operations, and debt service slide 40

41 Creation of Utility Districts Special Districts provide an opportunity for Private Developers rather than the municipalities to make the initial capital investments and planning in new developments. The property is improved by the developer through the addition of water, sewer, drainage and other services. Combined with new home and business construction, the assessed value of the district rises rapidly. With higher land values, the district can issue bonds and the developer will be reimbursed for its investment slide 41

42 City of Prairie Du Chien, WI & Northwest Harris County Municipal Utility District No. 5, TX Total Revenues Prairie Du Chien Equalized/ Assessed Value Northwest Harris CO MUD #5 Prairie Du Chien Equalized Value Northwest Harris CO MUD #5 Percent of Assessed Value $7,000,000 $1,000,000,000 $6,000,000 $900,000,000 $800,000,000 $5,000,000 $700,000,000 $4,000,000 $600,000,000 $500,000,000 $3,000,000 $400,000,000 $2,000,000 $300,000,000 $200,000,000 $1,000,000 $100,000,000 $0 $ slide 42

43 City of Prairie Du Chien, WI & Northwest Harris County Municipal Utility District No. 5, TX Prairie Du Chien Percentage of Assessed Value Top 10 Taxpayes Northwest Harris CO MUD #5 Percent age of Assessed Value Other Taxpayers Top 10 Taxpayes Other Taxpayers 2% 25% 75% 98% slide 43

44 City of Prairie Du Chien, WI & Northwest Harris County Municipal Utility District No. 5, TX Prairie Du Chien Debt to Assessed Value: 4.12% Equalized Value: $323,952,200 Northwest Harris County MUD No. 5 Debt to Assessed Value: 7.82% Taxable Assessed Value: $931,089,552 Total Acreage: 2,111 Acres slide 44

45 Texas Commission on Environmental Quality (TCEQ) In the 1980 s, there were several occasions where Municipal Utility Districts missed debt service payments Often on debt for developments which had not been started Recession in the Houston area In response, Texas legislature created the Texas Commission on Environmental Quality (TCEQ) TCEQ has supervisory authority over all districts and authorities The commission generally requires strict criteria be met before bond issuance No utility district has defaulted on the payment of bonds issued under these economic feasibility rules slide 45

46 TCEQ Standards Prior to Bond Issuance Economic feasibility study demonstrating improvements will be sufficient for a reasonable tax rate for debt service payments on existing and proposed bond indebtedness All underground water facilities to be financed with proceeds from the proposed bond issue shall be 95% complete The developer must contribute 30% of the construction costs of the project All road construction to be financed with proceeds from the bond issue must be 95% complete At least 25% of the projected value of houses, buildings, and other improvements must be completed slide 46

47 Active Municipal Insurers Build America Mutual (BAM) New insurer Not rated by Moody s AA stable outlook by S&P Currently only insures municipal securities $600 Million claims paying resources on day 1, continues to grow Assured Guaranty (AGM) A3 stable outlook by Moody s AA- stable outlook by S&P AGM & AGC are wholly owned by Assured Guaranty Corp AGM has limited non municipal exposure, and has not insured any non municipal credits since 12/2009 Most new policies are written by AGM $501 Billion par outstanding $12 Billion claims paying resources $2.2 Billion new par insured in 2013 $260 Million operating income slide 47

48 Summary: Investing In Special Districts Significantly higher return than many other municipals Based in robust growth areas of Texas TCEQ provides regulation which requires economic feasibility and development benchmarks be met prior to bond issuance General Obligation pledge often available Rapid growth can cause higher debt burdens relative to assessed value and population than other GO s More established districts have lower debt burdens and proven returns Some utility districts have assessed values larger than many municipalities Insurance can provide additional security slide 48

49 AGENDA 1. Economic Overview and Outlook 2. Portfolio Management and Security Selection 3. Regulatory and Accounting Issues slide 49

50 Accounting for Premium Standard yield table provided by Bloomberg More complex than pass-through (mortgage pool) How do you amortize the premium? slide 50

51 Accounting for Premium Example: CMO purchased at $ December 2012 (assume $1 million par) Regardless of accounting method, premium will be amortized on principal payments received: $29, returned January x 4 points = $1, in amortization expense, plus: To Average Life Amortizes the remaining premium to average life What average life is being used? Remaining premium $38,835 ($40,000 - $1,165)/37.8 months = $1, To Maturity Amortizes the remaining premium to final maturity date Remaining premium $38,835 /329 months (to 5/2040) = $ To Specified Date Remaining premium $38,835 /150 months = $ Interest income approximately $2,500, less: Max amortization expense of $2,192 or minimum of $1,283 Accounting will have significant impact on current yield earned slide 51

52 Regulatory Issues Dodd-Frank Wall Street Reform and Consumer Protection Act To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations. - OCC What to Do? Add language to investment policy including what is being evaluated and how frequently Municipal financial statements come out annually; therefore, a more frequent review may not provide value Ratings upgrades/downgrades may come out more frequently Bond accounting reports generally have this data Focus is on municipals and non-agency mortgages slide 52

53 Regulatory Issues slide 53

54 Regulatory Issues Basel III Implications for Unrealized Gain/Loss Rules not finalized, proposal for gain/loss to be included in regulatory capital Banks fear that purchasing longer securities will negatively impact capital ratios once rates rise Option would be to designate HTM today or at future point Longer securities with greater volatility may be candidates Assess the potential impact, identify potential solutions and be prepared IF that is included in final rules Difficult to make decisions today solely based on what regulators might do in the future slide 54

55 About Us BOSC, Inc. is the capital markets affiliate of BOK Financial BOK Financial is a $27 billion financial services holding company Headquartered in Tulsa, OK BOKF, NA is 23rd largest US based bank Handle nearly 422,000 transactions and trades $200 billion in fixed income annually slide 55

56 About Us Milwaukee office opened July 2010 Focus on working with financial institutions Over 150 institutions currently served from our office Products and Services Offered Asset/Liability Modeling and Consulting Third Party Asset/Liability Model Validations Institutional Fixed Income Municipal Underwriting and Credit Analysis Portfolio Accounting and Safekeeping Wholesale Funding Correspondent Services slide 56

57 0 0 ROSS SINCLAIRE STIFEL NICOLAUS & CO INC 50 SAMCO 200 ROOS. & CROSS 100 UMB BANK 400 PNC Capital Markets 600 PIPER JAFFRAY COMPANIES 300 FTN 1,000 RAYMOND JAMES MORGAN 350 JANNEY MONTGOMERY 1,200 BOSC INC National Competitive Bank Qualified Full Year 2012 ROBERT W. BAIRD & CO INC SAMCO PNC Capital Marke ROSS SINCLAIRE PIPER JAFFRAY STIFEL NICOLAUS JANNEY MONTGOMERY BOSC INC ROOS. & CROSS UMB BANK FTN ROBERT W. BAIRD RAYMOND JAMES MORGAN Bank Qualified National Competitive Rankings National Competitive Bank Qualified 1st Quarter slide 57