Managing Fixed Income Risk in an Uncertain WorldSilicon Valley Bank

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Silicon Valley BankFebruary 1, 2012

• Dave Bhagat, Senior Advisor, Interest Rate and Currency Risk Management, Silicon Valley Bank

• Joe Morgan, Chief Investment Officer, SVB Asset Management

Panelists

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Agenda

• Prospects for our economy

• Europe’s prospects – how will that impact us?

• The Fed and the yield curve

• LIBOR and the futures markets

• Investor perspective

• Borrower perspective

• Wrap up

Prospects for our EconomyJoe Morgan

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Joe Morgan

Prospects for 2012 – Tugs of War

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Tugs of War – Consumer Austerity Takes a Break

7.0

8.0

9.0

10.0PCE Consumption Expenditures

• Why the surge?

• No cultural shift toward savings

• Spending reserves built up over the last three years

• Wage income is not keeping up with recent expenditure growth

5.0

6.0

Source: Bloomberg

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Tugs of War – Too Many 99% ers?

105

110

115

120

125

U.S. Full Time Employment

• Regardless of “unemployment rate” measures, population increasing while number of workers has been decreasing

• Job “stimulus” programs can only smooth the bottom of the riverbed

• Solution to our economic woes cannot be found in the jobs market

100

12/1

/2005

3/1

/2006

6/1

/2006

9/1

/2006

12/1

/2006

3/1

/2007

6/1

/2007

9/1

/2007

12/1

/2007

3/1

/2008

6/1

/2008

9/1

/2008

12/1

/2008

3/1

/2009

6/1

/2009

9/1

/2009

12/1

/2009

3/1

/2010

6/1

/2010

9/1

/2010

12/1

/2010

3/1

/2011

6/1

/2011

9/1

/2011

12/1

/2011

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Tugs of War – Housing

-1.0%

-0.5%

0.0%

0.5%

1.0%

FHFA Home Price Change

• Downside wealth volatility at record high for majority of Americans

• Mortgage market drives housing

• No resolution in sight on mortgage market structure

-2.0%

-1.5%

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Tugs of War – Summary

• 2012 will NOT be a repeat of 2011

• Many “tugs of war” occurring today will continue through most of 2012

• Consumer spending surge in late 2011 will not continue

• Housing effects come in two parts• Housing effects come in two parts

• Construction -> showing signs of life

• Prices/turnover -> downside volatility remains

http://www.svb.com/blogs/jmorgan/Tugs_of_War/

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How Will Europe Impact our Economy?Dave Bhagat

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Dave Bhagat

Europe’s Prospects Look Dim

• A break up of the Euro Zone is unlikely in the near-term

• Impact could be catastrophic

• Not in anyone’s interest – today

• The Greek situation is not resolved. It will probably result in a restructuring of debt for some investors. Hedge funds and others may force a default on their portion, triggering insurance payouts

• Muddling through is the best possible outcome today• Muddling through is the best possible outcome today

• However, the long-term prospects for a stable EU and a strong Euro are poor. At some point, it is likely some countries will leave and the charter will be redefined

• Europe will probably be in a technical recession soon; negative growth is possible when Q4 2011 data is in, probably most of 2012 as well

• European banks remain under-capitalized and exposed to sovereign risk. An extended credit crunch remains a real possibility

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The Impact Will be Felt Here at Home

• Europe accounts for over 20% of our exports

• Europe will continue to undermine global confidence and risk appetite

• If European banks fail or the credit crunch worsens, the effect on the U.S. will be even more severe

• Our banks are in better shape than most European banks, but still have significant challenges and exposure to Europe. They will be impacted more significant challenges and exposure to Europe. They will be impacted more by a recession and by European bank failures than by a single default (Greece?)

• Countries with entrenched deficits (like us) will continue to be viewed and rated negatively

• The bottom line: My view is that Europe’s problems could shave half a percentage point of U.S. GDP growth in 2012, more if there is a catastrophe

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The Fed and the Yield CurveJoe Morgan

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Joe Morgan

What has the Fed Done with Rates?

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

Interest Rates

• Cost of funds extremely low, yet economic growth remains muted

• Inflation concerns will arise when economy catches hold

• Market rates will lead the Fed upward

0.00%

1.00%

Fed Funds 2-Yr Treasury 10-yr Treasury

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Today, the Fed is Divided into Two Camps

• Camp Fear:

• Inflation is prime concern

• Protect the Fed’s credibility

• Argue for higher interest rates

• Camp Greed:

• Employment and growth concerns drive viewpoint

• Velocity of money is low, leaving room for more stimulus

• A thriving economy heals all wounds

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Market Rates are Always Subject to Change

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

• Market resets every date/all day

• Longer exposures are subject to greater price changes

• Even “passive” strategies require an active stance

0.00%

1.00%

Fed Funds 2-yr Treasury 10-yr Treasury

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LIBOR, the Futures and Swaps MarketsDave Bhagat

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Dave Bhagat

What Fed Funds Futures are Predicting

0.40%

0.50%

0.60%

0.70%

0.80%

0.90%

0.00%

0.10%

0.20%

0.30%

Fed Funds Futures 1-23-12 Fed Funds Futures 1-27-12

Source: Bloomberg

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3 Month LIBOR vs. Fed Funds Effective

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

• 3 mo. LIBOR has normally maintained a steady relationship to Fed Funds

• During times of financial stress, however, the spread tends to widen

• October of 2008 is the most dramatic example, when it spiked to over 200 bps above Fed Funds

0.00%

1.00%

1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011 1/1/2012

3 month LIBOR Fed FundsSource: Bloomberg

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0.40%

0.50%

0.60%

0.70%

3 month LIBOR

Euro zone Concerns Elevate 3-month LIBOR…

Eurozone concerns = increased cost of credit- August 1, 2011 – 25 bps- Jan. 27, 2012 – 55.1 bps- 128% increase

0.00%

0.10%

0.20%

0.30%

3 month LIBOR Source: Bloomberg

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4.00%

5.00%

6.00%

7.00%

3 year swap rates

… but Swap Yields are Near All Time Lows

0.00%

1.00%

2.00%

3.00%

1/1/2002 1/1/2003 1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011 1/1/2012

3 year swap rates

Near all-time lows

Oct.10’ to Feb.‘11- 0.67% to 1.63%- 143% increase

Jun ‘03 to Jun ‘06- 1.64% to 5.64%- 250% increase

Source: Bloomberg

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What the Markets are Telling Us

• European concerns have driven LIBOR higher since August 2011

• However, the market is pricing in less than a 25 basis point rise in Fed Funds through mid-2014 and only 50 basis points tightening by the end of 2014

• As a result, 2 to 5-year swap rates are at historical lows

• However, the curve is steeper further out, commodity prices remain high and the fiscal deficit, national debt and inflation remain concernsthe fiscal deficit, national debt and inflation remain concerns

• If the economy picks up steam and Europe appears to be on the mend, market rates could rise appreciably even with the Fed on hold

• When the economy has recovered and the tightening cycle begins, it is possible that Fed Funds will rise fairly rapidly to a more “normal” level of 3 to 4%

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From the Perspective of an InvestorJoe Morgan

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Stay on Point

• Maintain a laser-focus on your objectives of:

• Capital preservation – keep it safe!

• Liquidity – keep it available!

• Return – keep it growing!

• Work with an advisor whose incentives and regulatory structure are aligned with youwith you

• Ensure appropriate communication and service from your advisor

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Credit Research Team

Research and analysis focused on appropriate

investment vehicles

Portfolio Management Team

Manage investments for capital preservation, liquidity, and

competitive return

An Independent Approach to Portfolio Decisions

SVB Asset Management

Investment Committee

• SVB Asset Management Chief Compliance Officer

• Representative of SVB Credit Group• President of SVB Asset Management & SVB

Securities• Head of Bank Treasury

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Suitable Investment Strategy Treasury Strategy Government Strategy Comprehensive Strategy

Treasury securities

TLGP debt

Government Sponsored Enterprises

(GSEs).

High quality investment grade

corporate bonds

Select Money Market Instruments

Client Risk Tolerance

No tolerance for credit exposure Comfortable with government-related credit risk

Minimal corporate credit risk

Investment Strategies Mindful of Each Client’s Risk Tolerance

Appropriate InvestmentsTLGP debt

Treasury only Rule 2a-7

Money Market Funds

Government strategy Rule 2a-7

Money Market Funds

Treasury securities

Government securities

Pre-qualified prime 2a-7 money

market funds

Portfolio CharacteristicsPredominately a buy and hold strategy with

emphasis on highest degree of liquidity

Treasury strategy with yield

enhancements from GSEs and

government funds.

Potential opportunity to swap credit

and duration to improve total return

objectives.

Greater yield pickup than government

focused strategies.

Requires in-depth knowledge of credit

and sector analysis. Should avoid

corporate issuers with a high reliance

on wholesale funding.

Select opportunities to capture gains

on credit improvements and duration

reallocation.

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Security Type Allocation and Maturity Distribution

1/9/12MMF

10%

Treasuries

25%

Agencies

5%

Money

Market

Instruments

30%

Corporates

30%

0%

5%

10%

15%

20%

25%

30%

35%

40%

12-month Comprehensive Benchmark Strategy

Matu

rity

Weig

htin

gStrategy

• Average Maturity: Neutral stance allows for participation in market rallies without

increasing undue credit risk.

• Maturity Targets: Regardless of maximum allowed in investment policy. Barbell

approach places 30 percent of the portfolio near the 1-year part of the yield curve.

• Liquidity: Twenty-five percent of portfolio maturing within 180 days to capitalize on

future interest rate increases.

• Overall Strategy: Based on our current view of the economy and fixed income markets

as they relate to future expectations.

• Our Goal: To outperform an investment in the 12-month Treasury - as proxied by the

Merrill Lynch 12-month Treasury Bill index - while providing required liquidity needs and

preserving capital.

Summary

• Average credit quality: AA+

• Average days to maturity:

365 Days

• Estimated Yield To Maturity:

.60%

30%

27Rates and yields shown are representative of the market’s recent activity and are subject to future market conditions and availability. The rates and yields have

been obtained from sources we believe to be reliable, but we cannot guarantee their accuracy or completeness. They are for informational purposes only and

are not a solicitation or recommendation that any particular investor should buy or sell a particular security or strategy..

From the Perspective of a BorrowerDave Bhagat

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Dave Bhagat

Managing Floating Rate Debt Risk

• Hedging rate risk is not speculative. Not hedging is a bet that rates will stay low, which is speculative, at least in the medium term

• The decision to hedge (or not) should be based on the degree of leverage and the impact of interest payments on cash flow and net income at your company

• Even though the Fed has indicated they expect to remain on hold for some • Even though the Fed has indicated they expect to remain on hold for some time, the situation could change

• Managing exogenous risks such as foreign exchange and interest rates is viewed as sound risk management policy, especially for public companies

• We will now discuss two commonly used hedging tools

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• A contract between 2 parties to exchange interest payments over a set period of time based on an agreed upon principal amount (“Notional”)

• One party pays fixed (the borrower in most cases), the other pays floating

• LIBOR is the foundation for the swaps market, but swaps can be indexed to

Prime and other indices

What is an Interest Rate Swap?

Prime and other indices

• The fixed swapped rate is the present value average of the LIBOR forward

curve

• No principal changes hands; the parties simply exchange (“swap”) interest payments for a set period of time

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Interest Rate Swap (continued)

• Net Effect• Synthetically fix debt service

• Pros• No upfront cost

• Known debt service

• Flexibility (hedge all or a portion of the debt, all or a portion of the

SVB Debt Borrower SVB Swap

LIBOR +

Spread

LIBOR +

Spread

Fixed Rate

of the debt, all or a portion of the term)

• Possible breakage payment if rates are higher than expected

• Cons• Negative carry (minimal today)

• Possible breakage costs if rates are lower than expected

Time

LIBOR

Fixed Rate

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• Gives the buyer (generally the borrower) the right but not the obligation to

pay a pre-determined fixed rate (the strike price)

• Guarantees the borrower a maximum fixed rate, yet allows the borrower to

retain the properties of a floating rate loan if rates remain below the strike

• Costs the borrower a premium to purchase because of the added flexibility

What is an Interest Rate Cap?

• Costs the borrower a premium to purchase because of the added flexibility

and lack of downside

• It is most cost-effective for shorter maturities and/or when providing “worst

case” disaster protection at a high (out of the money) cap strike rate

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Interest Rate Cap (continued)

• Net Effect• Set maximum level for funding

cost in a rising rate environment

• Pros• Known cost (premium) which is

also the maximum downside

• Cap is always an asset – can be sold back if needed

SVB Debt Borrower SVB CapLIBOR +

Spread

Cap

Premium

LIBOR -

Strike

(if > 0)

sold back if needed

• Cons• Upfront premium could be

significant depending on the strike and term

Time

LIBOR

Cap strike

Option

payout

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Conclusions on Managing Rate Risk

• Rates are low now and stay low for some time. How long and at what pace they ultimately rise is not clear today

• The longer the tenor of your borrowing needs, the more you need to pay attention

• Hedging a little early is better than being too late

• Even though the risk of official rates rising appear very low today, that could change. Market rates could rise ahead of Fed Funds if the economy gathers momentum

• Most importantly, entering into hedges is extremely cost effective today. Example: 3-month LIBOR is currently 0.55%, a 3-year swap is 0.63%, while a 5-year swap is 1.04% as of 1/30/12

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Questions?

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Biographies

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Biographies

Joe Morgan is the chief investment officer for SVB Asset Management and has been with the firm for 8 years. For more than 18 years he has successfully navigated the financial markets, managing institutional portfolios for the purposes of total return, current income, and liability diffusion. In his current role, Morgan works with a team of portfolio managers that set and execute investment strategy for all of SVB Asset Management’s client investments.

Frequently invited to speak at financial industry events, Morgan is widely sought out by business media and influencers for his perspective on issues affecting the fixed income market. He is most well recognized for his leadership in exiting and speaking out about the substantial risks associated

Joe Morgan

Chief Investment Officerleadership in exiting and speaking out about the substantial risks associated with auction rate securities since 2004. The Wall Street Journal called Morgan “The Auction Rate Cassandra” once the market started to fail in 2008.

Prior to joining SVB, Morgan was a senior portfolio manager with City National Asset Management in Beverly Hills, and was responsible for the bank's taxable fixed income total return oriented clients. He also spent seven years with Seneca Capital Management in San Francisco. At Seneca, he was responsible for managing institutional fixed income assets totaling over $5 billion with various return objectives and benchmarks.

Morgan received both his bachelor's and master's degrees in finance from Texas A&M University, and is a Chartered Financial Analyst.

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Chief Investment Officer

SVB Asset Management

jmorgan@svb.com

415.764.31498

Dave Bhagat is a senior product advisor for SVB Silicon Valley Bank’s global financial services group, based in Palo Alto, Calif. He advises clients on interest rate and currency hedging strategies and other aspects of global banking. In addition, he regularly writes articles on topics covering the global markets and conducts client seminars and webinars.

Bhagat has over 25 years of experience in the currency, fixed income and structured products markets and has lived and worked in Asia, Europe and North America. Prior to joining SVB Silicon Valley Bank in

Dave Bhagat

Senior Advisor - Global Treasury Europe and North America. Prior to joining SVB Silicon Valley Bank in 2005, he worked at several financial institutions including JP Morgan Chase, HSBC and Citigroup. He has been a fixed income and currency trader and has managed multi-product sales and trading desks.

Bhagat earned a bachelor’s degree in economics and a master’s in business administration from the Wharton School of Finance at the University of Pennsylvania.

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Senior Advisor - Global Treasury Management

Silicon Valley bank

dbhagat@svb.com

650.320.1158

This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction. Interest Rate Swaps are offered by

Disclosures

any investment or to engage in any other transaction. Interest Rate Swaps are offered by Silicon Valley Bank.

SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. Products offered by SVB Asset Management are not FDIC insured, are not deposits or other obligations of Silicon Valley Bank, and may lose value. 0112-0016

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