Investment Strategies for 1 st Quarter 2015 Conference Call will begin at 11:00am CT, lines open at 10:50am CT Audio: 855-749-4750 Access Code: 929 460 526 You can also listen to the conference call audio using your computer speakers. To maximize the webinar viewing area, please select View Full Screen from the menu or press Alt-Enter on your keyboard. Presented by: Jeffrey F. Caughron, Managing Director & COO Ryan W. Hayhurst, Managing Director jcaughron@gobaker.com ryan@gobaker.com
How Would You Describe Your Local Economy? Polling Answers from 4 th Quarter 2014 Conference Call (10 9 14) A. Weak (Declining) 5% B. Flat 32% C. Moderate 40% D. Strong 23% 2
When Will The Fed Begin Raising Rates? Polling Answers from 4 th Quarter 2014 Conference Call (10 9 14) A. 2015 57% B. 2016 39% C. 2017+ 4% 3
Where Will the Fed Stop Tightening? Polling Answers from 4 th Quarter 2014 Conference Call (10 9 14) A. 1% 3% B. 2% 18% C. 3% 36% D. 4% 37% E. 5% 5% F. 6%+ 1% 4
Economic Conditions & Fed Policy: 1st Qtr 2015 The US Economy: Growing Faster, but All Alone Third Quarter = 5.0% Year over Year = 2.8% Labor Market Improvement 3mo Avg. Payrolls Growth 288K 5.6% Unemployment Rate Labor Participation still weak Anemic Wage Growth Incomes and Spending Still Modest Growth Housing Sector Growing, but much more slowly Global Economies on the Brink Japan in recession, Europe barely growth, and China rolling over Dollar strength and the oil price collapse: Double edged swords Deflation: Real and Feared Fed Policy: Preparing to Normalize Monetary Policy When to Tighten and How Fast? FOMC intent on raising rates, but markets not convinced Dollar Strength acts as tightening 5
10yr T-Note Yield: Jan 12 - Today Driven Primarily by 1. Less Treasury Issuance 2. Strong International Demand Relative Value Safe Haven 3. Low Inflation / Deflation Threat 6
2yr T-Note Yield: Jan 12 - Today Driven Primarily by Expectations of Fed Tightening 7
US vs German Yield Curve Comparison Even when adjusted for inflation, US yields are far better US 10yr T-Note Yield = 1.83% CPI Inflation = 1.3% Germany 10yr Bund yield =.47% CPI Inflation = 0.1% 8
Trade-Weighted Dollar: Jan 2011 - Today Dollar Strength produces tightening-like conditions: Hurts US exports Reduces real earnings of US corporate sector (via overseas operations) Decreases inflation pressures domestically 9
Fed Five Year Forward Inflation: Fed 5yr Forward Inflation Rate: 2012 Today Produced by the Fed Research Staff, this is the FOMC s measure of inflation expectations. 10
Fed Funds Futures: Dec 15 Contract FOMC Median Projection = 1.00% 11
Bank Performance Trends: ROA and Net Interest Margin Returns are as strong as they ve been in five years Asset Quality Improvement Non Performing Assets / Equity + LLR down to 19.7 from 31.5 Higher Yield on Investments Investment yield 30bps higher than 1yr ago Margin creeping up from historically low levels Cost of Funds as low as they can go More lending, but no higher loan yields Loans / Deposits over 75%, highest in over 4yrs Loan yield 20bps lower than 1yr ago 12
Save the date! Feb 10 Baker Group Interest Rate Risk Conference Call 13
14
FDIC Supervisory Insights: Winter 2014 15
Non-Maturity Deposit Trends: 2010 - Today Sep 14 69.45% Mar 10 54.48% 16
Continuing Hot Topic : Non-Maturity Deposits Whatever Baseline Assumptions You Use, Stress Test Them Institutions should incorporate stressed assumptions for non maturity deposits in IRR models FDIC Three Ways to Stress NMD Assumptions 1. Ratchet up pricing betas (shift sensitivities) and reduce time lags in order to mimic an aggressively competitive environment for NMD 2. Reduce Average Life (and Duration) Assumptions in order to assess the EVE impact of lower duration liabilities 3. Simulate a migration of NMD balances into more rate sensitive funding (time deposits or wholesale funding) considered to be the most realistic depiction of what may happen in the next rate cycle Demographics Access to information 17
NMD Migration Simulation Results: Eight Sample Banks from TX, KS, ND, CO, OK, KY Static Balance Sheet Bank Total Assets NMD/TD 12mo NIC NP 12mo ROA NP EVE NP 1 70mm 46.6% 4.95 0.05 0.98 2 850mm 76.3% 3.76 0.93 0.05 3 80mm 68.8% 0.67 1.26 15.99 4 120mm 64.0% 9.17 1.65 10.19 5 200mm 71.4% 6.08 0.96 7.19 6 325mm 55.3% 3.88 1.37 9.62 7 100mm 55.9% 1.93 1.41 9.85 8 550mm 53.1% 1.66 1.02 9.69 Average 287mm 61.4% 1.69 1.08 2.82 NP = Non=Parallel Rate Scenario (+400/+100bps) NMD Migration Stress Test: 20% Bank Total Assets NMD/TDM 12mo NIC NP 12mo ROA NP EVE NP 1 70mm 37.2% 7.72 0.06 7.62 2 850mm 61.0% 10.45 0.75 8.12 3 80mm 55.0% 4.47 1.02 20.48 4 120mm 51.2% 4.51 1.52 0.66 5 200mm 57.2% 1.18 0.71 6.57 6 325mm 44.3% 7.96 1.22 19.28 7 100mm 44.7% 4.16 1.29 19.85 8 550mm 42.5% 5.75 0.91 2.39 Average 287mm 49.1% 4.65 0.92 3.60 18
Alternative Funding Source: Brokered CDs Cost effective versus local markets or other wholesale funding alternatives. Flexible maturities: 1 month to 30 years. Can match funds according to your asset/liability needs. A single certificate per maturity. Unlike FHLB advances, no collateral is required. No early withdrawal feature. Only upon death or adjudication of incompetence declared by court of law. Excellent resource for Contingency Funding Plans Through Baker Group arrangement with Financial Northeastern Companies 19
20
Last 3 Fed Tightening Cycles 2/4/94-2/1/95 12 Months +300bp 6/30/99-5/16/00 11 Month +175bp 6/30/04-6/29/06 24 Months +425bp 21
Treasury Yield Curve Changes 22
Yield Curve Change: 1994-95 3Mo +307 2Yr +330 5Yr +289 10Yr +232 30Yr +174 23
Yield Curve Change: 1999-2000 3Mo +167 2Yr +233 5Yr +218 10Yr +178 30Yr +102 24
Yield Curve Change: 2004-06 3Mo +410 2Yr +336 5Yr +193 10Yr +94 30Yr +17 25
Spread Changes 26
Yield/Spread Changes in Basis Points 1994 95 1999 2000 2004 06 Fed Funds +300 +175 +425 3 Month +307 +167 +410 2 Year +330 +233 +336 5 Year +289 +218 +193 10 Year +232 +178 +94 30 Year +174 +102 +17 10yr 2yr Spread 98 55 242 30yr FF Spread 126 73 408 5Yr Agency Spread +18 +30 0 15yr MBS Spread 38 5 45 10Yr Muni Spread 60 29 112 * Tightening cycle dates are 2/4/94-2/1/95, 6/30/99-5/16/00, 6/30/04-6/29/06. Changes in yields/spreads are quoted in basis points and are calculated from 6 months prior to first rate hike until the day of the last rate hike. 27
Basel III Opt-Out March 2015 CR 28
Basel III Opt-Out March 2015 CR 29
GASB 67/68: Pension Reporting Changes Pension liabilities must now be shown on the municipality s balance sheet rather than as a note in their financials. This will decrease the net assets for municipality s with pension liabilities. Requires a more conservative discount rate be used if benefits owed exceed the net position of the plan. Plans must also report sensitivity to a 100bp change in discount rate. Increased transparency and comparability of pension liabilities GASB 67 effective for FY2014 and GASB 68 effective for FY2015 so investors won t notice full effects until 2016. 30
How Does This Affect Banks? The Baker Group has been collecting pension data for several years even though the liability was off balance sheet Pension information will be available more often You should begin to see these ratios more often No need to change benchmarks at this time, but once more data is available, we may recommend changes to your policy 31
Share of State GDP From Oil & Gas 32
% Share of State Employment 33
52% of US Oil From These Counties 34
Potential Oil Stress Filter Counties with more than 10% of incomes from Oil/Gas/Mining according to the BEA Counties listed in the top 20 oil producing areas accounting for more than 50% of US oil production Counties listed is the top 10 in oil production in certain states Results: 70 counties; 4,000 CUSIPs out of 65,000 We ran those 4,000 CUSIPs through our Municipal Credit Criterion Check spreadsheet and only 550 were outside of 2 or more of our standard benchmarks 35
Global APM Summary Avg. Book Yield = 2.82% Avg. Life = 4.1 years +300bps Avg. Life = 6.1yrs Eff. Duration = 2.43 +300bps Price Risk = 10.6% 36
10yr Treasury Yield 2003 Today +135bp +150bp +120bp +100bp +195bp +135bp -90bp -100bp +160bp -200bp Bull Markets & Bear Markets do not happen in a straight line, but are rather a series of large yield moves followed by retracements. Portfolio performance should be evaluated in the wake of last summer s jump in yields. Use the current retracement to make any necessary adjustments. -220bp -160bp -235bp -120bp 37
8.0 Yield, Duration and +300bp Average Life All Bank Portfolios on BBA 7.0 +300bp Average Life 6.0 5.0 4.0 3.0 Portfolio Yield 2.0 Effective Duration 1.0 0.0 38
Monthly Portfolio % Gain/Loss All Bank Portfolios on BBA 6.0 4.0 5.0 3.0 2.0 Fed Funds Rate (%) 4.0 3.0 1.0 Gain / Loss (%) 2.0 (1.0) 1.0 (2.0) (3.0) 39
6 Monthly % Gain/Loss by Sector All Bank Portfolios on BBA Muni 4 MBS 2 Gain/(Loss) % 0 CMO 2 Agency 4 6 40
Lessons Learned in a Volatile Market Bull/Bear markets do not happen in a straight line, but are rather a series of large yield moves in one direction, followed by a retracement in the other The worst bonds are nearly always bought at peaks/troughs in rates and/or when spreads are tight don t chase yield! We really do need a written investment strategy Low coupon bonds have significantly more volatility than high coupon bonds It pays to pay up for prepayment protection Callable agencies always get called until they don t! During the recent market volatility, CMO s owned by our clients had the least price volatility, least extension risk and shortest average, but yields are similar to MBS and above Agencies The opportunity cost of staying too short and/or buying too many floaters has been high, better to buy the curve & limit extension 41
Refis Finally Spiked Last Week Refinance Index 30Yr Mortgage Rates 42
Refi Index vs. Avg Refi Loan Size During 2011 13, mortgage rates were falling to record lows, HARP 2.0 allowed underwater mortgages to qualify and nearly everyone could refinance. As shown in the chart, the average loan size of refis fell from 2011 13 since even the smallest mortgages could save. Now the mortgage industry has cut capacity, so when rates fall today, they are focusing attention mainly on those loans that can benefit the most jumbos! 43
LLBs Cont. To Offer Good Call Protection * Prepay speeds are for January payments and do not take into account this weeks spike in refi index. 44
FHA MIP Reductions Effective Immediately, Annual MIPs for both purchase and refis reduced to 85bps (from 135bps) Lowest Since April 2011 45
FHA Now More Competitive With GSEs 46
Potential Prepayment Impact To minimize the potential impact of the cut in FHA MIPs, scrub your portfolios for MBS and CMO with GNMA 30yr 3.5 4.5% collateral. Some of these pools could see spikes of 20+ CPR with 1yr increases of 5 7CPR. 47
Investment Strategy Summary Yields Are Low and Spreads Are Tight, But This Is Not The Time to Chase Yield Stick To Your Strategy! The worst bonds are almost always bought during times like this, the modest yield pickup in alternative sectors is not worth the risk The Market Is Giving Your Portfolio a Do Over Use It Review your portfolio s performance in 2013 and use the current market rally to make adjustments. Consider selling bonds/sectors that did poorly and adding those that performed well the last time rates rose. Bull/Bear market do not happen in a straight line, eventually long yields will bounce. Consider Adding CMOs They Performed Best During Selloff in 13 The right CMO can help to reduce extension risk, lower price volatility, lower premium risk and still provide a better yield than other low duration alternatives Consider Scrubbing Your Municipal Credits for Potential Oil Stress Use Municipal Credit Criterion Check spreadsheet to isolate weak credits in oil counties/states Prepayment Risk Has Risen Sharply, Focus on Call Protection Attributes Combination of falling mortgages rates and FHA MIP cut mean refis should rise in coming months. Focus on MBS/CMO loan attributes that provide the best protection like LLB, shorter WAMs, investor, NY/TX, retail, high LTV, etc. 48
Thank You For Attending Investment Strategies for 1 st Quarter 2015 If you have any additional questions or if you would like to receive more information on any of the topics discussed today, please call your representative or: Jeff Caughron @ 800 937 2257 jcaughron@gobaker.com Ryan Hayhurst @ 800 962 9468 ryan@gobaker.com