Asset/Liability Management FHLB System Sales and Marketing Meeting Scottsdale, AZ February 27 th, 2016 Ryan W. Hayhurst Managing Director Financial Strategies Group ryan@gobaker.com 800-962-9468
The Baker Group 2 Established in 1979 as a Broker Dealer specializing in Asset/Liability Management consulting for community financial institutions Formerly known as James Baker Associates Dr. James Baker was a pioneer in Asset/Liability Management Established formed with a consultative and strategic approach in mind Work with over 1000 banks and credit unions nationwide Process IRR reports for 600-700 banks & credit unions annually Dedicated to ALM and Investment Strategy education for community banks and credit unions with over 70 seminars & speaking events in 2016 The Baker Group is the only firm in our space with its own proprietary IRR, Bond Accounting, Bond Analytics and Budgeting software
Market Conditions Post-Election 1 st Quarter 2017 2017 Market Assumptions Shift from monetary to fiscal stimulus o Fiscal Stimulus Infrastructure o Tax Cuts o Regulatory Relief o Faster GDP Growth o Greater Borrowing Needs o Potential Trade Barriers o Rising Inflation o Higher Interest Rates 2017 Fed Policy Outlook o Continued gradual tightening o 2 or 3 more rate hikes priced for 2017 o Risk to the upside for rate hikes Future Inflation Expectations Have Soared 3
Fed Funds Futures: Probability of Rate Hike 4
10-Year Treasury Yield Feb 2011 - Today 5 Taper Tantrum Trump Jump
Yield Curve Has Steepened Sharply Since July 6 The 2-5yr part of the curve has more than doubled since July and the 10yr is up 103bp.
Regulatory Concerns Entering 2017 7 Credit Risk o Credit risk increasing because of strong loan growth combined with easing in underwriting standards o Examiner surveys showing an easing in underwriting standards Cybersecurity o Will this ever go away? (Hint: The Answer is No!) o FDIC has new IT Technology Risk Examination Program (June 2016) o FFIEC released Cybersecurity Assessment Tool (July 2015) Liquidity Risk Management o Do we have good risk management systems in place to measure and monitor our liquidity levels? o Dynamic Liquidity Modeling Interest Rate Risk o Moved down the priority list last year or so, but with the recent move in the yield curve and the likelihood of 2017 rate hikes, it will likely remain a high regulatory focus.
Net Interest Change / Net Interest Income: 582 Institutions on Baker IRRM Model as of 4Q2016: Unchanged Rates, +300bps, Non-Parallel 8 Earnings at Risk o A flat rate environment would cause continued margin compression over the next 12mos o Rising Rates and/or curve flattening would stimulate margin expansion o Rates + 300bps = +2.60% NIC o Curve flattening +400/100 = +2.63% NIC
Economic Value of Equity (EVE) +300bps & Funding Data 582 Institutions on Baker IRRM Model as of 4Q2016 Economic Value of Equity holds up well with upward rate shocks Non-Maturity Deposits are a significant (and valuable) source of funding for banks o NMD Analysis and Migration Simulations remain necessary for all banks o Most banks see a drop in NIM & materially worse EVE if a migration of NMD to CD s is simulated 9
Interest Rate Risk Trends Since 2014 582 Institutions on Baker IRRM Model as of 4Q2016 Margin will continue be under pressure if rates stay low Higher rates and a steeper yield curve would be helpful to bank margins and earnings Capital at risk has lessened notably in the past 11 quarters 10
NMD as a % of Total Funding Is Still Rising Despite Tightening 11 The previous peak in NMD funding (purple line) was Q4 2004. 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.
Sensitivity Testing: 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 (Sensitivity Tests) 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 12
13 Baker 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.
NMD Migration Case Study 14 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 0.75% Simulation # 2 45% into FHLB 1yr Advances @ 1.06% 33% into FHLB 2yr Advances @ 1.41% 22% into FHLB 3yr Advances @ 1.71%
NMD Migration Case Study: Earnings at Risk Impact 15 Simulation # 1 (Overnight Borrowings) Simulation # 2 (FHLB Laddered Funding)
Fed Funds Target Rate October 1986 - Today 16 90-91 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
Bull & Bear Markets Do Not Happen In A Straight Line 10-Year Treasury Yield 2003 Today 17 +135bp +120bp +150bp +100bp +195bp +135bp -90bp -100bp +160bp -200bp +125bp -160bp -220bp -235bp -150bp
The Interest Rate Cycle and Asset Strategies 18 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
The Interest Rate Cycle and FHLBank Products 19 Trough Rising Peak Falling Short-term Long-term Short-term Short-term Floating rate advances Fixed rate advances Floating rate advances Floating rate advances Floating rate advances with caps Floating rate returnable advances Floating rate advances with caps Fixed rate returnable advances Amortizing advances Floating rate returnable advances Amortizing advances Floating rate returnable advances Forward starting advances Letters of credit Loan sales via MPF
A Written Investment Strategy Is An Essential Key To Success Successful high performance portfolio management begins with a defined plan of action 20 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
Bank Holdings of Agencies Are At An All Time Low Need for LOCs could be rising as many Agencies were pledged 21
Liquidity Risk Management: Then and Now 22 2017 Source: FDIC
Complying with Regulatory Expectations for Liquidity Investment Price Risk Limits Sources & Uses Reporting Stress Testing Contingency Funding Plans Cushion of Highly Liquid, Unencumbered Assets o High grade credit quality o Easily converted into cash marketable US Government, Agency (including MBS), or high-grade municipals Stable and predictable cash flows o Security selection is critical o Beware of too much negative convexity (options risk) 23
Five Possible Liquidity Risks from Rising Rates 1. Reduced Mortgage Payments Refinance incentive goes away 2. Reduced Share/Deposit Levels Migration / Disintermediation 3. Increased Loan Demand Local economic activity improves 4. Options Risk (Callable Bonds and MBS/CMOs) Call Options no longer in-the-money 5. Reduced Asset Valuations Can no longer painlessly liquidate securities / monetize loans 6. Reduced Borrowing Capacity (Can be related to #5) Increased haircuts / requirements for REPO lines, etc. 24
10-Year Treasury Yield Feb 2011 - Today 25 Taper Tantrum Trump Jump
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. 26
Just 2 quarters ago, 96% of community banks had a gain in their bond portfolio. Today, 79% have a loss. 27
Projected Cashflow Volatility Comparison: Callables vs MBS 28 Callable Agency Focus May 2013 MBS/CMO Focus May 2013 Callable Agency Focus June 2013 MBS/CMO Focus June 2013
Stress Testing Your Sources and Uses Report 29 Where are your sources of potential liquidity strain? You have a Contingency Funding Plan, but are you running stress tests? Source: 2010 Interagency Policy Statement on Funding and Liquidity Risk Management
Liquidity Projections Base Case 30
Liquidity Stress Testing - Scenario #1 31 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?
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 32
Liquidity Stress Testing - Scenario #2 33 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?
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? 34
Liquidity Stress Testing - Scenario #3 35 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?
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? 36
Session Takeaways Most Community Banks & Credit Unions Are Prepared For Higher Rates IRR remains a regulatory priority, but less than in years past. Average of 580 banks on Baker s IRR model shows 2.6% better margin income and just 4.6% decline in EVE +300bp. Surge in NMD Funding Has Not Abated Yet, But It Will Eventually NMD funding is at an all-time high and 50% higher than 10 years ago. During the last rate cycle, NMD funding began to fall after 5 rate hikes totaling 125bp Is an institution still prepared for higher rates if 30% of NMD shifts to higher beta CD s? Every institution should analyze their NMD to determine level of surge balances please call/email me to request this report on any bank or credit union. FHLB advances are the perfect hedge against NMD migration Every Institution Should Have A Written Investment & Liability Strategy A quarterly written investment strategy is essential to maximizing performance and managing risk Strategies keep the institution focused with a disciplined plan and keep you involved in ALCO Strategies should be dynamic and change with the rate cycle Investment Portfolios Are Now At Losses and No Longer Major Source of Liquidity The percentage of banks with an unrealized loss in their bond portfolio has jumped from 4% to 79% in 2 quarters Since many institutions won t take losses, their primary source of liquidity is impaired FHLB advances are a natural replacement Dynamic Liquidity Risk Management is Critical in 2017 Regulators are laser focused on ensuring institutions have a robust & dynamic liquidity risk management system Banks/CUs should stress their liquidity regularly to ensure they have adequate lines open and available The Baker Group can provide any institution on our IRR model an interactive Dynamic Liquidity Model The Baker Group is Available To Partner On ALM Seminars With Any FHLBank We can present half or full day seminars on ALM strategies jointly with FHLB in any market We also have several seasoned speakers available to present at conferences, conventions & group meetings on topics related to ALM, Investments & Liquidity Risk Management We also would to invite FHLB representatives to speak at our various seminars please contact me if interested 37