Balance Sheet Strategies For Changing Rate Environments Asset/Liability Management Seminar

Transcription

1 Balance Sheet Strategies For Changing Rate Environments Asset/Liability Management Seminar Pasadena & Concord, CA April 25-26, 2017 Ryan W. Hayhurst - Managing Director ryan@gobaker.com

2 Market Overview & A Brief History of Interest Rates Ryan Hayhurst Managing Director The Baker Group LP Financial Strategies Group Phone: ryan@gobaker.com

3 3 Economic Conditions & Fed Policy: 2nd Quarter 2017 What the FOMC says: o o o o Progress is being made toward the Committee s goals. Econ data will drive any changes to monetary policy Two more rate hikes may be appropriate. (A move in June appears more likely) Changes to fiscal policy expected, but still unclear 2016 Avg = 1.6% 4QYOY = 2.0% U.S. Fundamentals: o o o o o Modest (2%-ish) growth Inflation 2%-ish Reduced labor market slack Slow(but improving) wage growth Markets perceive economic positives from new administration Global Conditions: o o o o Global growth improving ECB continues QE Brexit consequences? Deflation risk becoming less

4 2-Year Treasury Yield Apr Today 4

5 10-Year Treasury Yield Jan Today 5 Taper Tantrum Trump Jump Reality Rally

6 Yield Curve Has Flattened Steepened Sharply Since Dec Pivot Point = 5yrs

7 Fed Funds Target Rate June Today Recession Goldilocks Economy, Globalization, Internet 9/11, 2001 Recession Financial Crisis 1994 Greenspan Bear Market Fed Tightens, Tech Stock Bubble Slow, Steady Tightening ZIRP, QE1, QE2, QE3

8 Be Careful At Peaks and Troughs in Rates The worst bonds are almost always bought at peaks and troughs 8 Orange County CA Bankruptcy Long Maturity Callable Advances, Corporates CDOs, Private Label MBS/CMO, Trust Preferreds, FN/FH Preferred Stock Structured Notes: Dual Index Range Notes Inverse Floaters Structured Notes, Long Callables / Step-Ups, Extend-O-Matic CMOs?

9 Bull & Bear Markets Do Not Happen In A Straight Line 2003 Today bp +120bp +150bp +100bp +195bp +135bp -90bp -100bp +160bp -200bp +125bp -160bp -220bp -235bp -150bp

10 Developing Written Investment Strategies For The Interest Rate Cycles Ryan Hayhurst Managing Director The Baker Group LP Financial Strategies Group Phone:

11 A Written Investment Strategy Is An Essential Key To Success Successful high performance portfolio management begins with a defined plan of action 11 Why Do I Need a Written Investment Strategy? Keeps the Board & Management on the same page Provides regulators with a documented plan of what we are doing and why Helps you to build a portfolio rather than be sold one Provides a barrier to keep those bonds of the day from seeping into the portfolio Allows you to be proactive rather than reactive Develop Your Strategy in the Context of the Entire Balance Sheet The portfolio is not a hedge fund and should be managed taking into account overall ALM needs for IRR, liquidity, pledging, etc. Stable cash flows are critical to providing liquidity and reinvestment opportunities Your Strategy Should Be Updated At Least Quarterly A good strategy is not rigid, but rather fluid, changing with the market Relative value changes regularly, so should your strategy Monitor progress towards duration/allocation/performance targets and make adjustments Essential Components of a Written Investment Strategy Summary of the institution s objectives and risk tolerances Portfolio level duration and cash flow strategy Current sector allocations and short/long term allocation targets Sector level strategies

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18 Seminar Attendees: Credit Unions 18

19 Seminar Attendees: Banks 19

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21 March 2017 Portfolio Summary All Bank Portfolios on Baker Bond Accounting (BBA) Avg. Book Yield = 2.74% Avg. Life = 4.51 years +300bps Avg. Life = 5.98 years +300bps Price Risk = 10.65% 21

22 Fed Funds Target Rate June Today 22

23 The Interest Rate Cycle and Asset Strategies 23 Trough Rising Peak Falling Reduce duration Transition duration to neutral Extend duration Transition duration to neutral Premiums and/or higher coupons Roll up in coupon Buy negative convexity High cashflow bonds Transition from higher to lower coupons Discounts and/or lower coupons Roll down in coupon Reduce negative convexity Lockouts Transition from higher to lower coupons Buy ARMs & floaters Buy ARMs & floaters Sell ARMs & floaters Sell ARMs & floaters Current pay CMBS Current pay CMBS Lockout CMBS Lockout CMBS Prepay protection important Prepay protection less important Prepay protection more important 1X Callable Agencies Continuous calls outperform Bullet agencies or callables with call protection Cushion callables Discount callables Prepay protection critical Bullet agencies or callables with call protection

24 Once Again, Higher Coupon MBS Have Limited Price Depreciation 15yr MBS Price Volatility By Coupon 24 Taper Tantrum When Treasury yields rise and bond prices fall, lower coupon MBS normally fall much farther than higher coupons. To remain defensive in the face of a determined Fed, favor higher coupon MBS with good loan attributes. Trump Jump Px drop Nov 7 Dec 15 15yr 2.0 = 4.2% 15yr 2.5 = 3.6% 15yr 3.0 = 2.9% 15yr 3.5 = 1.9%

25 MBS Collateral Stories: Prepayment & Extension Protection 25

26 Loan Balance is Biggest Influence on Prepayment Volatility 26 When rates fall and homeowners refinance their mortgages, the size of the loan is the single biggest determinant of how quickly and how often refinancings occur. The chart above shows the historical 1mo CPR of FNMA 30yr 4% MBS issued in The blue line is the average of all those type of MBS, the grey line is only the jumbo loans and the red line is only those loans < $85,000. Clearly LLB MBS have the least prepayment volatility.

27 Stable Prepayments = Stable Yield Performance 27 Stable prepayments means stable yield/income. The chart above shows the historical yield of those same FNMA 30yr 4% MBS issued in This analysis assumes the Cohort (blue line) was purchased at 106, the LLB (red) at 107 and the Jumbos at 105. Even though you are paying an even larger premium for the LLB and a lower premium for the Jumbos, your yield/income on the LLBs is significantly more stable and nearly always higher.

28 Refinance Activity Near 15 Year Low Following Trump Jump 28 30yr mortgage rates jumped 80bp late last year, causing refinance activity to plummet. Refis are now down about 50% from the 2016 high and nearly 80% from the recent peak in Small drops in mortgage rates no longer cause spikes in refis as a significant portion of the market remains out-of-the-money. 30Yr Mortgage Rates Refinance Index

29 Extension Risk a Growing Concern With 80% of Mortgages OTM 29

30 Extension Protection Menu: MBS/CMO 30 Low Loan Balance Collateral o LLB pools have slowed the LEAST over the last 6mos of falling prepayments. Relocation Pools o Relos tend to be less rate sensitive and often prepay faster than their cohort when out of the money as the homeowners are relocated by their employees. Roll Down in MBS Terms and Up in Coupon o o Aggregate 10yr terms are now paying faster than 15yrs, 20yrs, and 30yrs! The lowest coupons in the stack are showing significant extension risks at current prepay speeds Agency CMBS: K-Fred Lockout (A2) and/or FNMA DUS o Steady Predictable Cash Flows are crucial in a rising rate environment. PAC/VADM CMOs o o o Planned Amortization Class CMOs are often structured to limit extension risk by creating support tranches that give-up their principal when prepays slow Very Accurately Defined Maturity CMOs can be structured to have virtually no change in cash flows across a range of prepay speeds Short stated final CMOs or those with short pay windows roll down the curve better than longer WAM MBS

31 Extension Protection: LLB Collateral 31 Low loan balance collateral tends to have faster speeds relative to larger loans as rates rise. Borrowers in smaller loans have less disincentive to move when mortgage rates are higher than borrowers with larger loans Smaller loans also tend to represent more first time home buyers and young families looking to move up, generating higher turnover speeds The top chart shows that during the period period of higher mortgage rates, seasoned FN 30yr pools with 100K loan sizes paid 4-6 CPR faster than loan sizes of 600K+ The bottom chart shows smaller loans in FH 30yrs of paid faster than higher loan balance pools during the higher rate environment of

32 Extension Protection: Relocation Pools 32 Relos are mortgages offered by employers to higher level professionals at discounted rates with low or no closing costs. Relo loans tend to have higher turnover speeds, regardless of the rate environment, as employees are relocated to various regions across the country. Relos also exhibit faster seasonal speeds, even during out of the money environments like

33 Yield/Cashfow Volatility Comparison: FNMA DUS vs 20yr MBS 33 Seasoned FNMA DUS FNMA 20Yr 3.5% MBS The call protection provided by CMBS means very little volatility of average life and therefore very stable yields. Traditional premium MBS will see more volatile average life and yields. The 20yr 3.5% MBS below sees more than 100bp of yield volatility and nearly 3.5yrs of average life volatility +/-300bp.

34 Cash Flow Comparison: FNMA DUS vs 20yr MBS 34 Seasoned FNMA DUS DUS bonds are on 25/30yr amortization schedules so there is very little cash flow until 6 months prior to maturity. The short final maturity produces a bullet type cash flow structure. FNMA 20Yr 3.5% MBS Tail cash flow becomes odd lot over time. This is what leads to MBS not rolling down the curve.

35 Price Shock Comparison: FNMA DUS vs 20yr MBS 35 Seasoned FNMA DUS FNMA 20Yr 3.5% MBS Because of the shorter stated final, the average life of the CMBS shortens nearly year for year while the 20yr shortens less than ½ year after 2 years. This means that despite the CMBS having more price volatility today (15.8% vs. 15.0%), the bullet style cash flow rolls down the curve better than a traditional MBS. Within a year or two, price volatility will be lower (12.1% vs. 14.2% in 2yrs).

36 Sector Spread Comparison 2011 Today: 10yr Municipals (yellow), 5yr Agencies (white), 15yr MBS (orange) 36 Municipal spreads widened dramatically following the election as the market priced in a significant tax cut, but has since unwound some of that expectation in TEY spreads remain 50bp above last summer, suggesting the market is still priced for some form of tax cut.

37 US vs. CA Bank Comparison 37 US < 5B CA < 5B US < 5B Top Yield Quartile Total Assets 385mm 810mm 348mm L/D Ratio ROA NIM COF/AEA Yield on Loans Yield on Sec TSY/AGY 24% 23% 15% Muni 25% 12% 47% MBS/CMO 40% 48% 29% Other 11% 17% 9%

38 Municipal Defaults Are Still Exceedingly Rare 38

39 Ensure Your Muni Process Can Filter Pension & Credit Data 39 Recommendation: Filter your municipal portfolio and consider selling bonds with a high levels of pension liabilities (UAAL/TA > 20% or NPL/TA > 50%)

40 Comparing BQ and NBQ Yields 40 BQ General Obligation LTD NBQ General Obligation LTD These two bonds are nearly identical in maturity, call date and credit, the only difference being the tax status of BQ vs NBQ. The NBQ however, picks up 45bps of nominal yield.

41 General Market Munis (NBQ) vs. BQs 41 Bank Qualified municipals are those sold by small issuers those that issue less than $10mm in a year. Only 5-10% of the municipal market is BQ limiting purchases to BQs significantly limits investment strategy, e.g. high coupon munis (4%+) Historically, spreads of NBQs over BQs has been about 15-30bps in the 10-15yr part of the yield curve. After the election, NBQ spreads widened to as much as 100bp over BQs. The Yield pickup can be significant when interest rates are low, however the relative value of NBQs tends to deteriorate as the bank s cost of funds rises As Cost of Funds rises, the TEFRA disallowance of interest (or TEFRA penalty ) rises as well In the prior example, cost of funds needs to average 2.00% or higher for a C Corp bank for the BQ TEY to exceed the NBQ TEY

42 Historical Cost of Funds 42 Current COF: 0.41% 10yr Avg COF: 1.16% 20yr Avg COF: 1.68% Breakeven Cost of Funds 2.0% 2.5% 4.0%

43 Interest Rate Risk & Liquidity Risk Management in a Rising Rate Environment Ryan Hayhurst Managing Director The Baker Group LP Financial Strategies Group Phone: ryan@gobaker.com

44 Regulatory Focus: Interest Rate Risk IRR is still on the regulator s radar, however, it was such a hot button area for several years, it has seemed to come down on the priority list. OCC: Semiannual Risk Perspectives Fall 2016 Do you have surge deposits? Note: Liquidity Coverage Ratio affects > $10 Billion in Assets What are the qualitative factors that will affect retaining deposits and attracting new deposits? 44

45 Interest Rate Risk Summary 582 Institutions on Baker IRRM Model as of 4Q2016: Earnings at Risk & Capital at Risk 45 Earnings at Risk o The average community bank on IRRM is well prepared for rising rates, with only a few outliers o If rates rise 300bp, the average bank would see margin income expand 2.6% o Two years ago the average margin income expansion was 2.1% Capital at Risk (EVE) o If rates rise 300bp, the average bank would see their Economic Value of Equity drop by 4.6% o Two years ago the average drop in EVE was 7.5%

46 NMD as a % of Total Funding Is Still Rising Despite Tightening 46 The previous peak in NMD funding (purple line) was Q By that point, the Fed had raised rates 5 times for a total of 125bp. So far during this cycle, the Fed has only raised rates twice for a total of 50bp and NMD funding is still rising. But Fed is expected to raise rates 2-3 times this year.

47 47 NMD Surge Balance Analysis Can be easily generated for any bank or credit union - call to request This institution got 68% of total funding from NMD in 4Q2014 vs. a 25yr average of just 53%. If rates rise and NMD funding reverts to the long-term average, this institution will have to replace funding for 15% of assets from CDs, Fed Funds or Borrowings. Simulating the impact of this deposit migration is critical to managing IRR in the next rate cycle.

48 NMD Migration Case Study 48 This institution decided to simulate the impact of NMD funding returning to the 25 year average They ran two simulations showing 15% of total assets migrating out of NMD and into higher cost, more rate sensitive liabilities For Earnings at Risk simulation, migration occurred over 12 months. For EVE simulation, migration occurred immediately. Simulation # 1 All funds into overnight borrowings at 1.00% Simulation # 2 45% into FHLB 1yr 1.25% 33% into FHLB 2yr 1.45% 22% into FHLB 3yr 1.65%

49 NMD Migration Case Study: Earnings at Risk Impact 49 Simulation # 1 (Overnight Borrowings) Simulation # 2 (FHLB Laddered Funding)

50 Regulatory Focus: Liquidity Risk Management 50 IRR & Liquidity Risk Are Closely Related Less Liquidity in the Banking System Due to Higher Loan Demand Focus on Measuring, Monitoring and Reporting Systems Forward Looking & Dynamic Sources & Uses Dynamic Cash Flow Analysis Stress Testing Contingency Funding Planning Diversified Funding Cushion of liquid assets (marketable investments) The Liquidity Regulatory Guidance is not new, however, there seems to be more focus on Liquidity Risk Management during recent examinations.

51 Possible Liquidity Risks from Rising Interest Rates 51 Reduced Mortgage/Loan Payments Refinance incentive goes away Reduced Deposit Levels Migration / Disintermediation Increased Loan Demand Local economic activity improves Options Risk (Callable Bonds and MBS/CMOs) Reduced Asset Valuations Reduced Borrowing Capacity (Can be related to #5) Call Options no longer in-the-money Can no longer painlessly liquidate securities / monetize loans Increased haircuts / requirements for REPO lines, etc.

52 Projected Cash Flow Volatility During 2013 Taper Tantrum Callable Agencies vs MBS/CMO 52 Callable Agency Focus May 2013 MBS/CMO Focus May 2013 Investment portfolio cashflow is one of the most important sources of liquidity that can also provide the necessary earnings to increase shareholder value. But we must ensure that our cashflow is stable and predictable as rates rise. Callable Agency Focus June 2013 MBS/CMO Focus June 2013

53 The average community bank has seen their investment portfolio swing from a gain to a loss in just a few months. Most community banks consider their investment portfolio to be their biggest source of liquidity. Since few banks want to take losses in the bond portfolio, many banks will look elsewhere to raise liquidity. 53

54 Just 2 quarters ago, 96% of community banks had a gain in their bond portfolio. Today, 79% have a loss. 54

55 Liquidity Projections Base Case 55

56 Liquidity Stress Testing - Scenario #1 56 Contingency Funding Plan Example Liquidity Crisis Stage #1 Stage # 1 Liquidity Crisis Indicators o Rates +100bp o 5% new loan growth o Runoff of at least 5% of NMD o 15% reduction in CD renewals Do we need to access our sources of funding? Do we have adequate contingent sources of liquidity? What are the roles and responsibilities of senior management?

57 Liquidity Stress Testing - Scenario #1 Stress Events: Increased Loan Demand, No New Deposits, 5% NMD Run Off & 15% Reduction of Time Deposit Renewals & +100bp Rate Increase Security selection is critical as we can lose cash flow as interest rates rise. Early warning signs 57

58 Liquidity Stress Testing - Scenario #2 58 Liquidity Crisis Stage #2 Contingency Funding Plan Example Stage # 2 Liquidity Crisis Indicators o Rates +200bp o 8% new loan growth o Runoff of at least 10% of NMD o 25% reduction in CD renewals Where do we go for funding? Do we have adequate contingent sources of liquidity? How does our cash flow & liquidity change with an increase in market rates? What are the roles and responsibilities of senior management?

59 Liquidity Stress Testing - Scenario #2 Stress Events: Increased Loan Demand, No New Deposits, 10% NMD Run Off & 25% Reduction of Time Deposit Renewals & +200bp Rate Increase Security selection is critical as we can lose cash flow as interest rates rise. Early warning signs Where do we go for funding? 59

60 Liquidity Stress Testing - Scenario #3 60 Contingency Funding Plan Example Liquidity Crisis Stage #3 Stage # 3 Liquidity Crisis Indicators o Rates +300bp o 15% new loan growth o Runoff of at least 15% of NMD o 30% reduction in CD renewals Where do we go for funding? Do we sell assets? Do we have adequate contingent sources of liquidity? How does our cash flow & liquidity change with an increase in market rates? What are the roles and responsibilities of senior management?

61 Liquidity Stress Testing - Scenario #3 Stress Events: High Loan Demand, No New Deposits, 15% NMD Run Off & 30% Reduction of Time Deposit Renewals & +300bp Rate Increase Security selection is critical as we can lose cash flow as interest rates rise. Immediate Liquidity Concerns Do we have enough funding? Do we need to expand our available lines? What alternative sources can we tap? 61

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