managing liquidity

1

Managing Liquidity

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Meeting Liquidity Needs Bank Liquidity

A bank’s capacity to acquire immediately available funds at a reasonable price

Firms can acquire liquidity in three distinct ways:1. Selling assets2. New borrowings3. New stock issues

3

Meeting Liquidity Needs How effective each liquidity source is

at meeting the institution’s liquidity needs, depends on: Market conditions The market’s perception of risk at the

institution as well as in the marketplace

The market’s perception of bank management and its strategic direction

The current economic environment

4

Meeting Liquidity Needs Holding Liquid Assets

“Cash Assets” Do not earn any interest Represents a substantial opportunity cost

for banks Banks attempt to minimize the amount of cash

assets held and hold only those required by law or for operational needs

Liquid Assets Can be easily and quickly converted into

cash with minimum loss

5


“Cash Assets” do not generally satisfy a bank’s liquidity needs

If the bank holds the minimum amount of cash assets required, an unforeseen drain on vault cash (perhaps from an unexpected withdrawal) will cause the level of cash to fall below the minimum for legal and operational requirements

6


Banks hold cash assets to satisfy four objectives:

1. To meet customers’ regular transaction needs

2. To meet legal reserve requirements3. To assist in the check-payment

system4. To purchase correspondent banking

services

7


Banks own five types of liquid assets1. Cash and due from banks in excess of

requirements2. Federal funds sold and reverse repurchase

agreements3. Short-term Treasury and agency obligations4. High-quality short-term corporate and

municipal securities5. Government-guaranteed loans that can be

readily sold

8

Meeting Liquidity Needs Borrowing Liquid Assets

Banks can provided for their liquidity by borrowing

Banks historically have had an advantage over non-depository institutions in that they could fund their operations with relatively low-cost deposit accounts

9

Meeting Liquidity Needs Objectives of Cash Management

Banks must balance the desire to hold a minimum amount of cash assets while meeting the cash needs of its customers

The fundamental goal is to accurately forecast cash needs and arrange for readily available sources of cash at minimal cost

10

Reserve Balances at the Federal Reserve Bank Banks hold deposits at the Federal

Reserve because: The Federal Reserve imposes legal

reserve requirements and deposit balances qualify as legal reserves

To help process deposit inflows and outflows caused by check clearings, maturing time deposits and securities, wire transfers, and other transactions

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Reserve Balances at the Federal Reserve Bank Required Reserves and Monetary

Policy The purpose of required reserves is to

enable the Federal Reserve to control the nation’s money supply

The Fed has three distinct monetary policy tools:

Open market operations Changes in the discount rate Changes in the required reserve ratio

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Reserve Balances at the Federal Reserve Bank Required Reserves and Monetary Policy

Example A required reserve ratio of 10% means that a

bank with $100 in demand deposits outstanding must hold $10 in legal required reserves in support of the DDAs

The bank can thus lend out only 90% of its DDAs If the bank has exactly $10 in legal reserves, the

reserves do not provide the bank with liquidity If the bank has $12 in legal reserves, $2 is excess

reserves, providing the bank with $2 in immediately available funds

13

Reserve Balances at the Federal Reserve Bank Impact of Sweep Accounts on

Required Reserve Balances Under Reg. D, banks have reserve

requirements of 10% on demand deposits, ATS, NOW, and other checkable deposit (OCD) accounts

not reservable

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Required Reserve Balances MMDAs are considered personal

saving deposits and have a zero required reserve requirement ratio

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Required Reserve Balances Sweep accounts are accounts that

enable depository institutions to shift funds from OCDs, which are reservable, to MMDAs or other accounts, which are not reservable

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Reserve Balances at the Federal Reserve Bank Impact of Sweep Accounts on Required

Reserve Balances Sweep Accounts

Two Types Weekend Program

Reclassifies transaction deposits as savings deposits at the close of business on Friday and back to transaction accounts at the open on Monday

On average, this means that for three days each week, the bank does not need to hold reserves against those balances

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Reserve Balances at the Federal Reserve Bank Impact of Sweep Accounts on Required

Reserve Balances Sweep Accounts

Two Types Threshold Account

The bank’s computer moves the customer’s DDA balance into an MMDA when the dollar amount reaches some minimum and returns funds as needed

The number of transfers is limited to 6 per month, so the full amount of funds must be moved back into the DDA on the sixth transfer of the month

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Meeting Legal Reserve Requirements Required reserves can be met over a

two-week period There are three elements of required

reserves: The dollar magnitude of base liabilities The required reserve fraction The dollar magnitude of qualifying

cash assets

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Meeting Legal Reserve Requirements

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Meeting Legal Reserve Requirements Historical Problems with Reserve

Requirements Reserve requirements varied by type of

bank charter and by state. Non-Fed member banks had lower

reserve requirements than Fed member banks

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Meeting Legal Reserve Requirements Lagged Reserve Accounting

Computation Period Consists of two one-week reporting

periods beginning on a Tuesday and ending on the second Monday thereafter

Maintenance Period Consists of 14 consecutive days

beginning on a Thursday and ending on the second Wednesday thereafter

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Reserve Balance Requirements The balance to be maintained in any

given maintenance period is measured by:

Reserve requirements on the reservable liabilities calculated as of the computation period that ended 17 days prior to the start of the maintenance period

Less vault cash as of the same computation period

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Reserve Balance Requirements Both vault cash and Federal Reserve

Deposits qualify as reserves The portion that is not met by vault

cash is called the reserve balance requirement

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Meeting Legal Reserve Requirements An Application: Reserve Calculation

Under LRA Four steps:

1. Calculate daily average balances outstanding during the lagged computation period.

2. Apply the reserve percentages.3. Subtract vault cash.4. Add or subtract the allowable reserve

carried forward from the prior period

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Meeting Legal Reserve Requirements Correspondent Banking Services

System of interbank relationships in which the correspondent bank (upstream correspondent) sells services to the respondent bank (downstream correspondent)

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Common Correspondent Banking Services Check collection, wire transfer, coin and currency

supply Loan participation assistance Data processing services Portfolio analysis and investment advice Federal funds trading Securities safekeeping Arrangement of purchase or sale of securities Investment banking services Loans to directors and officers International financial transactions

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Banker’s Bank A firm, often a cooperative owned by

independent commercial banks, that provides correspondent banking services to commercial banks and not to commercial or retail deposit and loan customers

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Liquidity Planning Short-Term Liquidity Planning

Objective is to manage a legal reserve position that meets the minimum requirement at the lowest cost

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Liquidity Planning

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Liquidity Planning Managing Float

During any single day, more than $100 million in checks drawn on U.S. commercial banks is waiting to be processed

Individuals, businesses, and governments deposit the checks but cannot use the proceeds until banks give their approval, typically in several days

Checks in process of collection, called float, are a source of both income and expense to banks

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Liquidity Planning Liquidity versus Profitability

There is a short-run trade-off between liquidity and profitability

The more liquid a bank is, the lower are its return on equity and return on assets, all other things equal

In a bank’s loan portfolio, the highest yielding loans are typically the least liquid

The most liquid loans are typically government-guaranteed loans

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Liquidity Planning The Relationship Between Liquidity, Credit

Risk, and Interest Rate Risk Liquidity risk for a poorly managed bank

closely follows credit and interest rate risk Banks that experience large deposit

outflows can often trace the source to either credit problems or earnings declines from interest rate gambles that backfired

Potential liquidity needs must reflect estimates of new loan demand and potential deposit losses

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Liquidity Planning The Relationship Between Liquidity,

Credit Risk, and Interest Rate Risk

38

Traditional Aggregate Measures of Liquidity Risk Asset Liquidity Measures

The most liquid assets mature near term and are highly marketable

Any security or loan with a price above par, in which the bank could report a gain at sale, is viewed as highly liquid

Liquidity measures are normally expressed in percentage terms as a fraction of total assets

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Highly Liquid Assets Cash and due from banks in excess of required

holdings Federal funds sold and reverse RPs. U.S. Treasury securities and agency obligations

maturing within one year Corporate obligations and municipal securities

maturing within one year and rated Baa and above

Loans that can be readily sold and/or securitized

40


Pledging Requirements Not all of a bank’s securities can be

easily sold Like their credit customers, banks are

required to pledge collateral against certain types of borrowings

U.S. Treasuries or municipals normally constitute the least-cost collateral and, if pledged against debt, cannot be sold until the bank removes the claim or substitutes other collateral

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Pledging Requirements Collateral is required against four

different liabilities: Repurchase agreements Discount window borrowings Public deposits owned by the U.S.

Treasury or any state or municipal government unit

FLHB advances

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Loans Many banks and bank analysts monitor

loan-to-deposit ratios as a general measure of liquidity

Loans are presumably the least liquid of assets, while deposits are the primary source of funds

A high ratio indicates illiquidity because a bank is fully loaned up relative to its stable funding

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Traditional Aggregate Measures of Liquidity Risk Liability Liquidity Measures

Liability Liquidity: The ease with which a bank can issue

new debt to acquire clearing balances at reasonable costs

Measures typically reflect a bank’s asset quality, capital base, and composition of outstanding deposits and other liabilities

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Commonly used measures: Total equity to total assets Risk assets to total assets Loan losses to net loans Reserve for loan losses to net loans The percentage composition of deposits Total deposits to total liabilities Core deposits to total assets Federal funds purchased and RPs to total liabilities Commercial paper and other short-term

borrowings to total liabilities

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Core Deposits A base level of deposits a bank expects

to remain on deposit, regardless of the economic environment

Volatile Deposits The difference between actual current

deposits and the base estimate of core deposits

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Longer-Term Liquidity Planning This stage of liquidity planning involves

projecting funds needs over the coming year and beyond if necessary Forecasts in deposit growth and loan demand

are required Projections are separated into three categories:

base trend, short-term seasonal, and cyclical values

The analysis assesses a bank’s liquidity gap, measured as the difference between potential uses of funds and anticipated sources of funds, over monthly intervals

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Longer-Term Liquidity Planning The bank’s monthly liquidity needs are

estimated as the forecasted change in loans plus required reserves minus the forecast change in deposits:

Liquidity needs = Forecasted Δloans + ΔRequired reserves - Forecasted Δdeposits

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Longer-Term Liquidity Planning

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Longer-Term Liquidity Planning Considerations in the Selection of

Liquidity Sources The costs should be evaluated in

present value terms because interest income and expense may arise over time

The choice of one source over another often involves an implicit interest rate forecast

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Contingency Funding Financial institutions must have

carefully designed contingency plans that address their strategies for handling unexpected liquidity crises and outline the appropriate procedures for dealing with liquidity shortfalls occurring under abnormal conditions

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Contingency Funding Contingency Planning

A contingency plan should include: A narrative section that addresses the

senior officers who are responsible for dealing with external constituencies, internal and external reporting requirements, and the types of events that trigger specific funding needs

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A contingency plan should include: A quantitative section that assesses the

impact of potential adverse events on the institution’s balance sheet (changes), incorporates the timing of such events by assigning deposit and wholesale funding run-off rates, identifies potential sources of new funds, and forecasts the associated cash flows across numerous short-term and long-term scenarios and time intervals

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A contingency plan should include: A section that summarizes the key

risks and potential sources of funding, identifies how the modeling will monitored and tested, and establishes relevant policy limits

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The institution’s liquidity contingency strategy should clearly outline the actions needed to provide the necessary liquidity

The institution’s plan must consider the cost of changing its asset or liability structure versus the cost of facing a liquidity deficit

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The contingency plan should prioritize which assets would have to be sold in the event that a crisis intensifies

The institution’s relationship with its liability holders should also be factored into the contingency strategy

The institution’s plan should also provide for back-up liquidity

The Effective Use of Capital

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Why Worry About Bank Capital? Capital requirements reduce the risk of

failure by acting as a cushion against losses, providing access to financial markets to meet liquidity needs, and limiting growth

Bank capital-to-asset ratios have fallen from about 20% a hundred years ago to around 8% today

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Risk-Based Capital Standards Historically, the minimum capital

requirements for banks were independent of the riskiness of the bank

Prior to 1990, banks were required to maintain: a primary capital-to-asset ratio of at

least 5% to 6%, and a minimum total capital-to-asset ratio

of 6%62

Risk-Based Capital Standards Primary Capital

Common stock Perpetual preferred stock Surplus Undivided profits Contingency and other capital reserves Mandatory convertible debt Allowance for loan and lease losses

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Risk-Based Capital Standards Secondary Capital

Long-term subordinated debt Limited-life preferred stock

Total Capital Primary Capital + Secondary Capital

Capital requirements were independent of a bank’s asset quality, liquidity risk, interest rate risk, operational risk, and other related risks

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Risk-Based Capital Standards The 1986 Basel Agreement

In 1986, U.S. bank regulators proposed that U.S. banks be required to maintain capital that reflects the riskiness of bank assets

The Basel Agreement grew to include risk-based capital standards for banks in 12 industrialized nations

Regulations apply to both banks and thrifts and have been in place since the end of 1992

Today, countries that are members of the Organization for Economic Cooperation and Development (OECD) enforce similar risk-based requirements on their own financial institutions

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A bank’s minimum capital requirement is linked to its credit risk

The greater the credit risk, the greater the required capital

Stockholders' equity is deemed to be the most valuable type of capital

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Minimum capital requirement increased to 8% total capital to risk-adjusted assets

Capital requirements were approximately standardized between countries to ‘level the playing field'

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Risk-Based Capital Standards Risk-Based Elements of Basel I

1. Classify assets into one of four risk categories

2. Classify off-balance sheet commitments into the appropriate risk categories

3. Multiply the dollar amount of assets in each risk category by the appropriate risk weight This equals risk-weighted assets

4. Multiply risk-weighted assets by the minimum capital percentages, currently 4% for Tier 1 capital and 8% for total capital

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Risk-Based Capital Standards

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Risk-Based Capital Standards

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What Constitutes Bank Capital? Capital (Net Worth)

The cumulative value of assets minus the cumulative value of liabilities

Represents ownership interest in a firm

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What Constitutes Bank Capital? Total Equity Capital

Equals the sum of: Common stock Surplus Undivided profits and capital reserves Net unrealized holding gains (losses)

on available-for-sale securities Preferred stock

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What Constitutes Bank Capital? Tier 1 (Core) Capital

Equals the sum of: Common equity Non-cumulative perpetual preferred

stock Minority interest in consolidated

subsidiaries, less intangible assets such as goodwill

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What Constitutes Bank Capital? Tier 2 (Supplementary) Capital

Equals the sum of: Cumulative perpetual preferred stock Long-term preferred stock Limited amounts of term-subordinated

debt Limited amount of the allowance for

loan loss reserves (up to 1.25 percent of risk-weighted assets)

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What Constitutes Bank Capital? Leverage Capital Ratio

Tier 1 capital divided by total assets net of goodwill and disallowed intangible assets and deferred tax assets

Regulators are concerned that a bank could acquire practically all low-risk assets such that risk-based capital requirements would be virtually zero

To prevent this, regulators have also imposed a 3 percent leverage capital ratio

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What Constitutes Bank Capital?

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What Constitutes Bank Capital?

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What Constitutes Bank Capital? Tier 3 Capital Requirements for Market

Risk Under Basel I Market Risk

The risk of loss to the bank from fluctuations in interest rates, equity prices, foreign exchange rates, commodity prices, and exposure to specific risk associated with debt and equity positions in the bank’s trading portfolio

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What Constitutes Bank Capital? Tier 3 Capital Requirements for Market

Risk Under Basel I Banks subject to the market risk

capital guidelines must maintain an overall minimum 8 percent ratio of total qualifying capital [the sum of Tier 1 capital, Tier 2 capital, and Tier 3 capital allocated for market risk, net of all deductions] to risk-weighted assets and market risk–equivalent assets

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What Constitutes Bank Capital? Basel II Capital Standards

Risk-based capital standards that encompass a three-pillar approach for determining the capital requirements for financial institutions

Basel II capital standards are designed to produce minimum capital requirements that incorporate more types of risk than the credit risk-based standards of Basel I

Basel II standards have not been finalized 86

What Constitutes Bank Capital? Basel II Capital Standards

Pillar I Credit risk Market risk Operational risk

Pillar II Supervisory review of capital adequacy

Pillar III Market discipline through enhanced public

disclosure87

What Constitutes Bank Capital? Weaknesses of the Risk-Based Capital

Standards Standards only consider credit risk

Ignores interest rate risk and liquidity risk

Core banks subject to the advanced approaches of Basel II use internal models to assess credit risk

Results of their own models are reported to the regulators

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What Constitutes Bank Capital? Weaknesses of the Risk-Based Capital Standards

The new risk-based capital rules of Basel II are heavily dependent on credit ratings, which have been extremely inaccurate in the recent past

Book value of capital is often not meaningful since It ignores:

changes in the market value of assets unrealized gains (losses) on held-to-maturity

securities 97% of banks are considered “well capitalized” in

2007 Not a binding constraint for most banks

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What is the Function of Bank Capital For regulators, bank capital serves to

protect the deposit insurance fund in case of bank failures

Bank capital reduces bank risk by: Providing a cushion for firms to absorb

losses and remain solvent Providing ready access to financial

markets, which provides the bank with liquidity

Constraining growth and limits risk taking90

What is the Function of Bank Capital

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How Much Capital Is Adequate? Regulators prefer more capital

Reduces the likelihood of bank failures and increases bank liquidity

Bankers prefer less capital Lower capital increases ROE, all other

things the same Riskier banks should hold more capital

while lower-risk banks should be allowed to increase financial leverage

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The Effect of Capital Requirements on Bank Operating Policies Limiting Asset Growth

The change in total bank assets is restricted by the amount of bank equity

where TA = Total Assets EQ = Equity Capital ROA = Return on Assets DR = Dividend Payout Ratio EC = New External Capital

93

11

21 /TAEQ

ΔEC/TADR)ROA(1ΔTA/TA

The Effect of Capital Requirements on Bank Operating Policies Changing the Capital Mix

Internal versus External capital Change Asset Composition

Hold fewer high-risk category assets Pricing Policies

Raise rates on higher-risk loans Shrinking the Bank

Fewer assets requires less capital

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Characteristics of External Capital Sources Subordinated Debt

Advantages Interest payments are tax-deductible No dilution of ownership interest Generates additional profits for

shareholders as long as earnings before interest and taxes exceed interest payments

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Characteristics of External Capital Sources Subordinated Debt

Disadvantages Does not qualify as Tier 1 capital Interest and principal payments are

mandatory Many issues require sinking funds

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Characteristics of External Capital Sources Common Stock

Advantages Qualifies as Tier 1 capital It has no fixed maturity and thus

represents a permanent source of funds

Dividend payments are discretionary Losses can be charged against equity,

not debt, so common stock better protects the FDIC

98

Characteristics of External Capital Sources Common Stock

Disadvantages Dividends are not tax-deductible, Transactions costs on new issues

exceed comparable costs on debt Shareholders are sensitive to earnings

dilution and possible loss of control in ownership

Often not a viable alternative for smaller banks

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Characteristics of External Capital Sources Preferred Stock

A form of equity in which investors' claims are senior to those of common stockholders

Dividends are not tax-deductible Corporate investors in preferred stock

pay taxes on only 20 percent of dividends

Most issues take the form of adjustable-rate perpetual stock

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Characteristics of External Capital Sources Trust Preferred Stock

A hybrid form of equity capital at banks It effectively pays dividends that are tax deductible

To issue the security, a bank establishes a trust company

The trust company sells preferred stock to investors and loans the proceeds of the issue to the bank

Interest on the loan equals dividends paid on preferred stock

The interest on the loan is tax deductible such that the bank deducts dividend payments

Counts as Tier 1 capital

101

Characteristics of External Capital Sources TARP Capital Purchase Program

The Troubled Asset Relief Program’s Capital Purchase Program (TARP-CPP), allows financial institutions to sell preferred stock that qualifies as Tier 1 capital to the Treasury

Qualified institutions may issue senior preferred stock equal to not less than 1% of risk-weighted assets and not more than the lesser of $25 billion, or 3%, of risk-weight assets 102

Characteristics of External Capital Sources Leasing Arrangements

Many banks enter into sale and leaseback arrangements

Example: The bank sells its headquarters and

simultaneously leases it back from the buyer The bank receives a large amount of cash

and still maintains control of the property The net effect is that the bank takes a fully

depreciated asset and turns it into a tax deduction

104

Capital Planning Process of Capital Planning

Generate pro formal balance sheet and income statements for the bank

Select a dividend payout Analyze the costs and benefits of

alternative sources of external capital

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Capital Planning Application

Consider a bank that has exhibited a deteriorating profit trend

Assume as well that federal regulators who recently examined the bank indicated that the bank should increase its primary capital-to-asset ratio to 8.5% within four years from its current 7%

The $80 million bank reported an ROA of just 0.45 percent

During each of the past five years, the bank paid $250,000 in common dividends

106

Capital Planning Application

Consider a bank that has exhibited a deteriorating profit trend

The following slide extrapolates historical asset growth of 10%

Under this scenario, the bank will actually see its capital ratio fall

The following slide also identifies three different strategies for meting the required 8.5% capital ratio

107

Depository Institutions Capital Standards The Federal Deposit Insurance

Improvement Act (FDICIA) focused on revising bank capital requirements to: Emphasize the importance of capital Authorize early regulatory intervention

in problem institutions Authorized regulators to measure

interest rate risk at banks and require additional capital when it is deemed excessive

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Depository Institutions Capital Standards The Act required a system for prompt

regulatory action It divides banks into categories

according to their capital positions and mandates action when capital minimums are not met

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Depository Institutions Capital Standards

111

Federal Deposit Insurance Federal Deposit Insurance Corporation

Established in 1933 Coverage is currently $100,000 per

depositor per institution Original coverage was $2,500

113


Initial Objective: Prevent liquidity crises caused by

large-scale deposit withdrawals Protect depositors of modes means

against a bank failure

114


The Financial Institution Reform, Recovery and Enforcement Act of 1989 authorized the issuance of bonds to finance the bailout of the FSLIC

The act also created two new insurance funds, the Savings Association Insurance Fund (SAIF) and the Bank Insurance Fund (BIF); both were controlled by the FDIC

115


The large number of failures in the late 1980s and early 1990s depleted the FDIC fund

During 1991 - 92, the FDIC ran a deficit and had to borrow from the Treasury

In 1991 FDIC began charging risk-based deposit insurance premiums ranging from $0.23 to $0.27 per $100, depending on a bank’s capital position.

By 1993, the reduction in bank failures and increased premiums allowed the FDIC to pay off the debt and put the fund back in the black

116

Federal Deposit Insurance

117

Federal Deposit Insurance FDIC Insurance Assessment Rates

FDIC insurance premiums are assessed using a risk-based deposit insurance system

Deposit insurance assessment rates are reviewed semiannually by the FDIC to ensure that premiums appropriately reflect the risks posed to the insurance funds and that fund reserve ratios are maintained at or above the target designated reserve ratio (DRR) of 1.25% of insured deposits

Deposit insurance premiums are assessed as basis points per $100 of insured deposits

118


FDIC Improvement Act Merged the BIF and SAIF into the Deposit

Insurance Fund (DIF) Increasing coverage for retirement

accounts to $250,000 and indexing the coverage to inflation

Established a range of 1.15% to 1.50% within which the FDIC Board of Directors may set the Designated Reserve Ratio (DRR)

119


120


Subgroup A Financially sound institutions with only

a few minor weaknesses This subgroup assignment generally

corresponds to the primary federal regulator’s composite rating of “1” or “2”

121


Subgroup B Institutions that demonstrate

weaknesses that, if not corrected, could result in significant deterioration of the institution and increased risk of loss to the BIF or SAIF

This subgroup assignment generally corresponds to the primary federal regulator’s composite rating of “3”

122


Subgroup C Institutions that pose a substantial

probability of loss to the BIF or the SAIF unless effective corrective action is taken

This subgroup assignment generally corresponds to the primary federal regulator’s composite rating of “4” or “5”

123


124

Federal Deposit Insurance Problems With Deposit Insurance

Deposit insurance acts similarly to bank capital In banking, a large portion of borrowed funds

come from insured depositors who do not look to the bank’s capital position in the event of default

A large number of depositors, therefore, do not require a risk premium to be paid by the bank since their funds are insured

Normal market discipline in which higher risk requires the bank to pay a risk premium does not apply to insured funds

125


Too-Big-To-Fail Many large banks are considered to be

“too-big-to-fail” As such, any creditor of a large bank

would receive de facto 100 percent insurance coverage regardless of the size or type of liability

126


Deposit insurance has historically ignored the riskiness of a bank’s operations, which represents the critical factor that leads to failure

Two banks with equal amounts of domestic deposits paid the same insurance premium, even though one invested heavily in risky loans and had no uninsured deposits while the other owned only U.S. government securities and just 50 percent of its deposits were fully insured

The creates a moral hazard problem127


Moral Hazard A lack of incentives that would

encourage individuals to protect or mitigate against risk

In some cases of moral hazard, incentives are created that would actually increase risk-taking behavior

128


Deposit insurance funds were always viewed as providing basic insurance coverage

Historically, there has been fundamental problem with the pricing of deposit insurance

Premium levels were not sufficient to cover potential payouts

129


Historically, premiums were not assessed against all of a bank’s insured liabilities

Insured deposits consisted only of domestic deposits while foreign deposits were exempt

Too-big-to-fail doctrine toward large banks means that large banks would have coverage on 100 percent of their deposits but pay for the same coverage as if they only had the same $250,000 coverage as smaller banks do

130

Federal Deposit Insurance Weakness of the Current Risk-Based Deposit

Insurance System Risk-based deposit system is based on capital

and risk Hence, banks that hold higher capital, everything

else being equal, pay lower premiums “Too Big to Fail”

The FDIC must follow the “least cost” alternative in the resolution of a failed bank. Consequently, the FDIC must consider all alternatives and choose the one that represents the lowest cost to the insurance fund

131

Managing the Investment Portfolio

132

Managing the Investment Portfolio Most banks concentrate their asset

management efforts on loans Managing investment securities is

typically a secondary role, especially at smaller banks

Historically, small banks have purchased securities and held them to maturity

133

Managing the Investment Portfolio Large banks, in contrast, not only buy

securities for their own portfolios, but they also: Manage a securities trading account Manage an underwriting subsidiary

that helps municipalities issue debt in the money and capital markets

134

Managing the Investment Portfolio Historically, bank regulators have limited

the risk associated with banks owning securities by generally: Prohibiting banks from purchasing

common stock (for income purposes) Limiting debt instruments to investment

grade securities Increasingly, banks are pursuing active

strategies in managing investments in the search for higher yields

135

Dealer Operations and the Securities Trading Account When banks purchase securities, they

must indicate the underlying objective for accounting purposes: Held-to-Maturity Trading Available-for-Sale

136

Dealer Operations and the Securities Trading Account Held to Maturity:

Securities purchased with the intent and ability to hold to final maturity

Carried at historical (amortized) cost on the balance sheet

Unrealized gains and losses have no impact on the income statement

137

Dealer Operations and the Securities Trading Account Trading:

Securities purchased with the intent to sell them in the near term

Carried at market value on the balance sheet with unrealized gains and losses included in income

138

Dealer Operations and the Securities Trading Account Available for Sale:

Securities that are not classified as either held-to-maturity securities or trading securities

Carried at market value on the balance sheet with unrealized gains and losses included as a component of stockholders’ equity

139

Dealer Operations and the Securities Trading Account Banks perform three basic functions within

their trading activities: Offer investment advice and assistance to

customers managing their own portfolios Maintain an inventory of securities for

possible sale to investors Their willingness to buy and sell securities is

called making a market Traders speculate on short-term interest

rate movements by taking positions in various securities

140

Dealer Operations and the Securities Trading Account Banks earn profits from their trading

activities in several ways: When making a market, they price

securities at an expected positive spread Bid

Price the dealer is willing to pay Ask

Price the dealer is willing to sell Traders can also earn profits if they

correctly anticipate interest rate movements

141

Objectives of the Investment Portfolio A bank’s investment portfolio differs

markedly from a trading account Objectives of the Investment Portfolio

Safety or preservation of capital Liquidity Yield Credit risk diversification Help in manage interest rate risk

exposure Assist in meeting pledging requirements

142

Objectives of the Investment Portfolio Accounting for Investment Securities

FASB 115 requires security holdings to be divided into three categories

Held-to-Maturity (HTM) Trading Available-for-Sale

The distinction between investment motives is important because of the accounting treatment of each

143


A change in interest rates can dramatically affect the market value of a security

The difference between market value and the purchase price equals the unrealized gain or loss on the security; assuming a purchase at par:

Unrealized Gain/Loss = Market Value – Par Value

144


Assume interest rates increase and bond prices fall:

Held-to-Maturity Securities There is no impact on either the balance sheet or

income statement Trading Securities

The decline in value is reported as a loss on the income statement

Available-for-Sale Securities The decline in value reduces the value of bank

capital 145

Objectives of the Investment Portfolio Safety or Preservation of Capital

A primary objective of the investment portfolio is to preserve capital by purchasing securities when there is only a small risk of principal loss

Regulators encourage this policy by requiring that banks concentrate their holdings in investment grade securities, those rated Baa (BBB) or higher

146

Objectives of the Investment Portfolio Liquidity

Commercial banks purchase debt securities to help meet liquidity requirements

Securities with maturities under one year can be readily sold for cash near par value and are classified as liquid investments

In reality, most securities selling at a premium can also be quickly converted to cash, regardless of maturity, because management is willing to sell them

147

Objectives of the Investment Portfolio

148

Objectives of the Investment Portfolio Yield

To be attractive, investment securities must pay a reasonable return for the risks assumed

The return may come in the form of price appreciation, periodic coupon interest, and interest-on-interest

The return may be fully taxable or exempt from taxes

149

Objectives of the Investment Portfolio Diversify Credit Risk

The diversification objective is closely linked to the safety objective and difficulties that banks have with diversifying their loan portfolios

Too often loans are concentrated in one industry that reflects the specific economic conditions of the region

Investment portfolios give banks the opportunity to spread credit risk outside their geographic region and across different industries

150

Objectives of the Investment Portfolio Help Manage Interest Rate Exposure

Investment securities are very flexible instruments for managing a bank’s overall interest rate risk exposure

Banks can select terms that meet their specific needs without fear of antagonizing the borrower

They can readily sell the security if their needs change

151

Objectives of the Investment Portfolio Pledging Requirements

By law, commercial banks must pledge collateral against certain types of liabilities.

Banks that borrow via repurchase agreements essentially pledge part of their government securities portfolio against this debt

Public deposits Borrowing from the Federal Reserve Borrowing from FHLBs

152

Composition of the Investment Portfolio Money market instruments with short

maturities and durations include: Treasury bills Large negotiable CDs Bankers acceptances Commercial paper Repurchase agreements Tax anticipation notes

153

Composition of the Investment Portfolio Capital market instruments with longer

maturities and duration include: Long-term U.S. Treasury securities Obligations of U.S. government agencies Obligations of state and local governments

and their political subdivisions labeled municipals

Mortgage-backed securities backed both by government and private guarantees

Corporate bonds Foreign bonds

154

Characteristics of Taxable Securities Money Market Investments

Highly liquid instruments which mature within one year that are issued by governments and large corporations

Very low risk as they are issued by well-known borrowers and a active secondary market exists

156


Repurchase Agreements (Repos) A loan between two parties, with one

typically either a securities dealer or commercial bank

The lender or investor buys securities from the borrower and simultaneously agrees to sell the securities back at a later date at an agreed-upon price plus interest

157


Repurchase Agreements (Repos) The minimum denomination is generally $1

million, with maturities ranging from one day to one year

The rate on one-day repos is referred to as the overnight repo rate and is quoted on an add-on basis assuming a 360-day year

$ Interest = Par Value x Repo Rate x Days/360 Longer-term transactions are referred to as term

repos and the associated rate the term repo rate

158


Treasury Bills Marketable obligations of the U.S. Treasury

that carry original maturities of one year or less

They exist only in book-entry form, with the investor simply holding a dated receipt

Investors can purchase bills in denominations as small as $1,000, but most transactions involve much larger amounts

159


Treasury Bills Each week the Treasury auctions bills

with 13-week and 26-week maturities Investors submit either competitive or

noncompetitive bids With a competitive bid, the purchaser

indicates the maturity amount of bills desired and the discount price offered

Non-competitive bidders indicate only how much they want to acquire

160


Treasury Bills Treasury bills are purchased on a discount basis, so

the investor’s income equals price appreciation The Treasury bill discount rate is quoted in terms of a

360-day year:

where DR = Discount Rate FV = Face Value P = Purchase Price N = Number of Days to Maturity

161

N360

FVPFVDR


Treasury Bills Example: A bank purchases $1 million in face value of

26-week (182-day) bills at $990,390. What is the discount rate and effective yield?

The discount rate is:

The true (effective) yield is:

1.90%182360

$1,000,000$990,390$1,000,000DR

1.956%1(365/182)

$990,390$990,390$1,000,0001 YieldEffective

162


Certificates of Deposit Dollar-denominated deposits issued by

U.S. banks in the United States Fixed maturities ranging from 7 days to

several years Pay yields above Treasury bills. Interest is quoted on an add-on basis,

assuming a 360-day year

163


Eurodollars Dollar-denominated deposits issued by

foreign branches of banks outside the United States

The Eurodollar market is less regulated than the domestic market, so the perceived riskiness is greater

164


Commercial Paper Unsecured promissory notes issued by

corporations Proceeds are use to finance short-term working

capital needs The issuers are typically the highest quality

firms Minimum denomination is $10,000 Maturities range from 3 to 270 days Interest rates are fixed and quoted on a

discount basis165


Bankers Acceptances A draft drawn on a bank by firms that

typically are importer or exporters of goods

Has a fixed maturity, typically up to nine months

Priced as a discount instrument like T-bills

166

Characteristics of Taxable Securities Capital Market Investments

Consists of instruments with original maturities greater than one year

Banks are restricted to “investment grade” securities

If banks purchase non-rated securities, they must perform a credit analysis to validate that they are of sufficient quality relative to the promised yield

167


Treasury Notes and Bonds Notes have a maturity of 1 - 10 years Bonds have a maturity greater than 10 years Most pay semi-annual coupons

Some are zeros or STRIPS Sold via closed auctions Rates are quoted on a coupon-bearing basis

with prices expressed in thirty-seconds of a point, $31.25 per $1,000 face value

168


Treasury STRIPS Many banks purchase zero-coupon

Treasury securities as part of their interest rate risk management strategies

169


Treasury STRIPS The U.S. Treasury allows any Treasury

with an original maturity of at least 10 years to be “stripped” into its component interest and principal pieces and traded

170


Treasury STRIPS Each component interest or principal

payment constitutes a separate zero coupon security and can be traded separately from the other payments

171


Treasury STRIPS Example Consider a 10-year, $1 million par value

Treasury bond that pays 9 percent coupon interest semiannually ($45,000 every six months)

172


Treasury STRIPS Example This security can be stripped into 20

separate interest payments of $45,000 each and a single $1 million principal payment, or 21 separate zero coupon securities

173


U.S. Government Agency Securities Composed of two groups

Members who are formally part of the federal government

Federal Housing Administration Export-Import Bank Government National Mortgage

Association (Ginnie Mae)

174


U.S. Government Agency Securities Composed of two groups

Members who are government-sponsored agencies

Federal Home Loan Mortgage Corporation (Freddie Mac)

Federal National Mortgage Association (Fannie Mae)

Student Loan Marketing Association (Sallie Mae)

175


U.S. Government Agency Securities Default risk is low even though these

securities are not direct obligations of the Treasury; most investors believe there is a moral obligation

These issues normally carry a risk premium of about 10 to 100 basis points.

176


Callable Agency Bonds Securities issued by government-

sponsored enterprises in which the issuer has the option to call the bonds prior to final maturity

Typically, there is a call deferment period during which the bonds cannot be called

The issuer offers a higher promised yield relative to comparable non-callable bonds

177


Callable Agency Bonds Banks find these securities attractive

because they initially pay a higher yield than otherwise similar non-callable bonds

The premium reflects call risk

178


Callable Agency Bonds If rates fall sufficiently, the issuer will

redeem the bonds early, refinancing at lower rates, and the investor gets the principal back early which must then be invested at lower yields for the same risk profile

179


Conventional Mortgage-Backed Securities (MBSs)

Any security that evidences an undivided interest in the ownership of mortgage loans

The most common form of MBS is the pass-through security

Even though many MBSs have very low default risk, they exhibit unique interest rate risk due to prepayment risk

As rates fall, individuals will refinance180


GNMA Pass-Through Securities Government National Mortgage

Association (Ginnie Mae) Government entity that buys mortgages for

low income housing and guarantees mortgage-backed securities issued by private lenders

181


FHLMC Federal Home Loan Mortgage

Corporation (Freddie Mac) FNMA securities

Federal National Mortgage Association (Fannie Mae)

183


Both are: Private corporations Operate with an implicit federal

guarantee Buy mortgages financed largely by

mortgage-backed securities

184


Privately Issued Pass-Through Issued by banks and thrifts, with

private insurance rather than government guarantee

185

Prepayment Risk on Mortgage-Backed Securities Borrowers may prepay the

outstanding mortgage principal at any point in time for any reason

Prepayments typically increase as interest rates fall and slow as rates increase

Forecasting prepayments is not an exact science

186

Prepayment Risk on Mortgage-Backed Securities Example:

Current mortgage rates are 8% and you buy a MBS paying 8.25%

Because rates have fallen, you paid a premium to earn the higher rate

With rates only .25% lower, it is unlikely individuals will refinance

If rates fall 3%, there will be a large increase in prepayments due to refinancing

If the prepayments are fast enough, you may never recover the premium you paid

187

Prepayment Risk on Mortgage-Backed Securities Alternative Mortgage-Backed

Securities Collateralized Mortgage Obligations

(CMOs) Security backed by a pool of mortgages

and structured to fall within an estimated maturity range (tranche) based on the timing of allocated interest and principal payments on the underlying mortgages

189



(CMOs) Tranche:

The principal amount related to a specific class of stated maturities on a collateralized mortgage obligation. The first class of bonds has the shortest maturities

190

Prepayment Risk on Mortgage-Backed Securities Alternative Mortgage-Backed Securities

Collateralized Mortgage Obligations (CMOs) CMOs were introduced to circumvent some

of the prepayment risk associated with the traditional pass-through security

CMOs are essentially bonds An originator combines various mortgage

pools to serve as collateral and creates classes of bonds with different maturities

191


Collateralized Mortgage Obligations (CMOs)

The first class, or tranche, has the shortest maturity

Interest payments are paid to all classes of bonds but principal payments are paid to the first tranche until they have been paid off

After the first tranche is paid, principal payments are made to the second tranche, etc

192


Collateralized Mortgage Obligations (CMOs) Planned Amortization Class CMO (PAC)

A security that is retired according to a planned amortization schedule, while payments to other classes of securities are slowed or accelerated

Least risky of the CMOs Objective is to ensure that PACs exhibit highly

predictable maturities and cash flows

193

Alternative Mortgage-Backed Securities Alternative Mortgage-Backed


(CMOs) Z-Tranche

Final class of securities in a CMO, exhibiting the longest maturity and greatest price volatility

These securities often accrue interest until all other classes are retired

194


Collateralized Mortgage Obligations (CMOs)

CMOs’ Advantages over MBS Pass-Throughs

Some classes (tranches) exhibit less prepayment risk; some exhibit greater prepayment risk

Appeal to investors with different maturity preferences by segmenting the securities into maturity classes

195


Securities Stripped Mortgage-Backed Securities

More complicated in terms of structure and pricing characteristics

Example: Consider a 30 year, 12% fixed-rate

mortgage

196



Example: There will be 30 x 12 (360) payments

(principal plus interest)

197



Example: Loan amortization means the principal only

payments are smaller in the beginning: P1 < P2 < … < P360

Interest only payments decrease over time:

I1 > I2 > … > I360

198

Prepayment Risk on Mortgage-Backed Securities Corporate, Foreign Bonds, and

Taxable Municipal Bonds In mid-2008, banks held $563 billion in

corporate and foreign bonds, which was almost more than triple their holdings of municipals

199


Taxable Municipal Bonds By regulation, banks can invest no

more than 10% of capital in the securities of any single firm

200


Taxable Municipal Bonds In most cases, banks purchase

securities that mature within 10 years Occasionally, banks also purchase

municipal bonds that pay taxable interest

201

Prepayment Risk on Mortgage-Backed Securities Asset-Backed Securities

Conceptually, an asset-backed security is comparable to a mortgage-backed security in structure

The securities are effectively “pass-throughs” since principal and interest are secured by the payments on the specific loans pledged as security

203


Two popular asset-backed securities are:

Collateralized automobile receivables (CARS)

CARDS Securities backed by credit card loans to

individuals

204


Collateralized Debt Obligations Securitized interests in pools of assets,

typically bank loans and/or bonds When the underlying collateral is loans or

bonds, these securities are labeled CLOs or CBOs, respectively

205


Collateralized Debt Obligations As with CMOs, the originator creates

tranches, typically labeled senior, mezzanine, or subordinated (or equity)

Promised payments go initially to service senior debt followed by mezzanine and subordinated debt, respectively

206


Mutual Funds Banks have increased their holdings in

mutual funds to over $75 billion in 2008 Mutual fund investments must be marked-

to-market and can cause volatility on the values reported on the bank’s balance sheet

207

Characteristics of Municipal Securities Municipals are exempt from federal

income taxes and generally exempt from state or local as well General obligation

Principal and interest payments are backed by the full faith, credit, and taxing authority of the issuer

208

Characteristics of Municipal Securities

Revenue Bonds Backed by revenues generated from

the project the bond proceeds are used to finance

Industrial Development Bonds Expenditures of private corporations

209

Characteristics of Municipal Securities Money Market Municipals

Municipal Notes Provide operating funds for

government units Tax and Revenue Anticipation Notes

Issued in anticipation of tax receipts or other revenue generation

211


Bond Anticipation Notes Provide interim financing for capital

projects that will ultimately financed with long-term bonds

Project Notes Used to finance urban renewal, local

neighborhood development , and low-income housing

212


Tax-Exempt Commercial Paper issued by the largest municipalities,

which regularly need blocks of funds in $1 million multiples for operating purposes

Because only large, well-known borrowers issue this paper, yields are below those quoted on comparably rated municipal notes

213


Banks buy large amounts of short-term municipals

They often work closely with municipalities in placing these securities

214

Characteristics of Municipal Securities Capital Market Municipals

General Obligation Bonds Interest and principal payments are

backed by the full faith, credit, and taxing power of the issuer

This backing represents the strongest commitment a government can make in support of its debt

215

Characteristics of Municipal Securities Capital Market Municipals

Revenue Bonds Issued to finance projects whose

revenues are the primary source of repayment

Banks buy both general obligation and revenue bonds The only restriction is that the bonds

be investment grade or equivalent216

Characteristics of Municipal Securities Credit Risk in the Municipal Portfolio

Until the 1970s, few municipal securities went into default

Deteriorating conditions in many large cities ultimately resulted in defaults by:

New York City (1975), Cleveland (1978), Washington Public Power & Supply System (WHOOPS) (1983), Jefferson County, AL (2008)

217

Characteristics of Municipal Securities Liquidity Risk

Municipals exhibit substantially lower liquidity than Treasury or agency securities

218


The secondary market for municipals is fundamentally an over-the-counter market

Small, non-rated issues trade infrequently and at relatively large bid-ask dealer spreads

Large issues of nationally known municipalities, state agencies, and states trade more actively at smaller spreads

219


Name recognition is critical, as investors are more comfortable when they can identify the issuer with a specific location

Insurance also helps by improving the rating and by association with a known property and casualty insurer

220


Municipals are less volatile in price than Treasury securities

This is generally attributed to the peculiar tax features of municipals

221


The municipal market is segmented On the supply side, municipalities cannot

shift between short- and long-term securities to take advantage of yield differences because of constitutional restrictions on balanced operating budgets

Thus long-term bonds cannot be substituted for short-term municipals to finance operating expenses, and

Capital expenditures are not financed by ST securities

222


The municipal market is segmented. On the demand side, banks once

dominated the market for short-term municipals

Today, individuals via tax-exempt money market mutual funds dominate the short maturity spectrum

Municipals are less volatile in price than Treasury securities

223

Establishing Investment Policy Guidelines Each bank’s asset and liability or risk

management committee is responsible for establishing investment policy guidelines These guidelines define the

parameters within which investment decisions help meet overall return and risk objectives

224

Establishing Investment Policy Guidelines Because securities are impersonal

loans that are easily bought and sold, they can be used at the margin to help achieve a bank’s liquidity, credit risk, and earnings sensitivity or duration gap targets

225

Establishing Investment Policy Guidelines Investment guidelines identify specific

goals and constraints regarding: Return Objective Composition of Investments Liquidity Considerations Credit Risk Considerations Interest Rate Risk Considerations Total Return Versus Current Income

226

Active Investment Strategies Portfolio managers can buy or sell

securities to achieve aggregate risk and return objectives

Investment strategies can subsequently play an integral role in meeting overall asset and liability management goals Unfortunately, not all banks view their

securities portfolio in light of these opportunities

227

Active Investment Strategies Many smaller banks passively manage

their portfolios using simple buy and hold strategies

The purported advantages are that such a policy requires limited investment expertise and virtually no management time; lowers transaction costs; and provides for predictable liquidity

228

Active Investment Strategies Other banks actively manage their

portfolios by: Adjusting maturities Changing the composition of taxable

versus tax-exempt securities Swapping securities to meet risk and

return objectives

229

Active Investment Strategies Advantage is that active portfolio

managers can earn above-average returns by capturing pricing discrepancies in the marketplace

Disadvantages: Managers must consistently out

predict the market for the strategies to be successful

High transactions costs230

Active Investment Strategies The Maturity or Duration Choice for

Long-Term Securities The optimal maturity or duration is

possibly the most difficult choice facing portfolio managers

It is very difficult to outperform the market when forecasting interest rates

231

Active Investment Strategies Passive Maturity Strategies

Laddered (or Staggered) maturity strategy

Management initially specifies a maximum acceptable maturity and securities are evenly spaced throughout maturity

Securities are held until maturity to earn the fixed returns

232

Active Investment Strategies Passive Maturity Strategies

Barbell Maturity Strategy Differentiates investments between

those purchased for liquidity and those for income

Short-term securities are held for liquidity

Long-term securities for income Also labeled the long and short

strategy233

Active Investment Strategies Active Maturity Strategies

Active portfolio management involves taking risks to improve total returns by:

Adjusting maturities Swapping securities Periodically liquidating discount

instruments To be successful, the bank must avoid

the trap of aggressively buying fixed-income securities at relatively low rates when loan demand is low and deposits are high 234

Active Investment Strategies Active Maturity Strategies

Riding the Yield Curve This strategy works best when the yield

curve is upward-sloping and rates are stable. Three basic steps:

Identify the appropriate investment horizon Buy a par value security with a maturity longer

than the investment horizon and where the coupon yield is higher in relationship to the overall yield curve

Sell the security at the end of the holding period when time remains before maturity

235

Active Investment Strategies Interest Rates and the Business Cycle

Expansion Increasing Consumer Spending Inventory Accumulation Rising Loan Demand Federal Reserve Begins to Slow Money Growth

Peak Monetary Restraint High Loan Demand Little Liquidity

237

Active Investment Strategies Interest Rates and the Business Cycle

Contraction Falling Consumer Spending Inventory Contraction Falling Loan Demand Federal Reserve Accelerates Money Growth

Trough Monetary Policy Eases Limited Loan Demand Excess Liquidity

238

Active Investment Strategies Passive Strategies Over the Business

Cycle One popular passive investment strategy

follows from the traditional belief that a bank’s securities portfolio should consist of primary reserves and secondary reserves

This view suggests that banks hold short-term, highly marketable securities primarily to meet unanticipated loan demand and deposit withdrawals

240


Cycle Once these primary liquidity reserves

are established, banks invest any residual funds in long-term securities that are less liquid but offer higher yields

241


Cycle A problem arises because banks

normally have excess liquidity during contractionary periods when loan demand is declining and the Fed starts to pump reserves into the banking system

Interest rates are thus relatively low

242


Cycle Banks employing this strategy add to

their secondary reserve by buying long-term securities near the low point in the interest rate cycle

Long-term rates are typically above short-term rates, but all rates are relatively low

243


Cycle With a buy and hold orientation, these

banks lock themselves into securities that depreciate in value as interest rates move higher

244

Active Investment Strategies Active Strategies Over the Business Cycle

Many portfolio managers attempt to time major movements in the level of interest rates relative to the business cycle and adjust security maturities accordingly

Some try to time interest rate peaks by following a counter-cyclical investment strategy defined by changes in loan demand and the yield curve’s shape

245

Active Investment Strategies Active Strategies Over the Business

Cycle The strategy entails both expanding the

investment portfolio and lengthening maturities at the top of they business cycle, when both interest rates and loan demand are high

Note that the yield curve generally inverts when rates are at their peak prior to a recession

246

Active Investment Strategies Active Strategies Over the Business

Cycle Alternatively, at the bottom of the business

cycle when both interest rates and loan demand are low, a bank contracts the portfolio and shorten maturities

247

The Impact of Interest Rates on the Value of Securities with Embedded Options

Issues for Securities with Embedded Options Callable agency securities or

mortgage-backed securities have embedded options

248

The Impact of Interest Rates on the Value of Securities with Embedded Options

Issues for Securities with Embedded Options To value a security with an embedded

option, three questions must be addressed Is the investor the buyer or seller of the

option? How and by what amount is the buyer being

compensated for selling the option, or how much must it pay to buy the option?

When will the option be exercised and what is the likelihood of exercise?

249

The Roles of Duration and Convexity in Analyzing Bond Price Volatility

Recall that the duration for an option-free security is a weighted average of the time until the expected cash flows from a security will be received

251

i)(1i

PP

- Duration

Pi)(1

iDuration - P


From the previous slide, we can see: The difference between the actual price-

yield curve and the straight line representing duration at the point of tangency equals the error in applying duration to estimate the change in bond price at each new yield

For both rate increases and rate decreases, the estimated price based on duration will be below the actual price

253


Actual price increases are greater and price declines less than that suggested by duration when interest rates fall or rise, respectively, for option-free bonds

For small changes in yield the error is small

For large changes in yield the error is large

254


Convexity The rate of change in duration when

yields change It attempts to improve upon duration

as an approximation of price

This is positive feature for buyers of bonds because as yields decline, price appreciation accelerates 255

Price)iConvexity( Convexity to Due ΔPrice 2


Convexity As yields increase, duration for option

free bonds decreases, reducing the rate at which price declines

This characteristic is called positive convexity

The underlying bond becomes more price sensitive when yields decline and less price sensitive when yields increase

256

Impact of Prepayments on Duration and Yield for Bonds with Options

Embedded options affect the estimated duration and convexity of securities

257


Prepayments will affect the duration of mortgage-backed securities Market participants price mortgage-backed

securities by following a 3-step procedure: Estimate the duration based on an assumed

interest rate environment and prepayment speed

Identify a zero-coupon Treasury security with the same (approximate) duration.

The MBS is priced at a mark-up over the Treasury

258


The MBS yield is set equal to the yield on the same duration Treasury plus a spread The spread can range from 50 to 300

basis points depending on market conditions

The MBS yields reflect the zero-coupon Treasury yield curve plus a premium

259


Positive and Negative Convexity Option-free securities exhibit positive

convexity because as rates increase, the percentage price decline is less than the percentage price increase associated with the same rate decline

Securities with embedded options may exhibit negative convexity

The percentage price increase is less than the percentage price decrease for equal negative and positive changes in rates

260


Effective Duration and Effective Convexity Both are used to estimate a security’s price

sensitivity when the security contains embedded options

261

)i (iPP-P Duration Effective -

0

i-i

Where: Pi- = price if rates fallPi+ = price if rates riseP0 = initial (current) priceP* = initial price

2-i-i

)]i [0.5(i*P*2PPP Convexity Effective

i+ =initial market rate plus the increase in rate

i- = initial market rate minus the decrease in rate


Effective Duration and Effective Convexity Example:

Consider a GNMA pass-through which has 28-years and 4-months weighted average maturity

The MBS is initially priced at 102 and 17/32nds to yield 6.912%, at 258 PSA

At this price and PSA, MBS has an estimated average life of 5.57 years and a modified duration of 4.01 years

262



Assume a 1% decline in rates will accelerate prepayments and lead to a price of 102 while a 1% increase will slow prepayments and produce a price of 103

263



The effective duration and convexity for this security are thus:

Effective GNMA duration = [102-103]/ 102.53125x(.05921

- .07921) = -0.4877 years

Effective GNMA convexity = [102+103-2 x

(102.53125)]÷102.53125[0.52(.02)2]= -6.096 years

264

Total Return and Option-Adjusted Spread Analysis of Securities with Options

Total Return Analysis An investor’s actual realized return

should reflect the coupon interest, reinvestment income, and value of the security at maturity or sale at the end of the holding period

When a security carries embedded options, these component cash flows will vary in different interest rate environments

265


Total Return Analysis If rates fall and borrowers prepay faster

than originally expected: Coupon interest will fall Reinvestment income will fall The price at sale (end of the holding

period) may rise or fall depending on the speed of prepayments

266


Total Return Analysis When rates rise

Borrowers prepay slower Coupon income increases Reinvestment income increases The price at sale may rise or fall

267


Option-Adjusted Spread The standard calculation of yield to maturity is

inappropriate with prepayment risk Option-adjusted spread (OAS) accounts for

factors that potentially affect the likelihood and frequency of call and prepayments

Static spread is the yield premium, in percent, that (when added to Treasury zero coupon spot rates along the yield curve) equates the present value of the estimated cash flows for the security with options equal to the prevailing price of the matched-maturity Treasury

269


Option-Adjusted Spread OAS represents the incremental yield earned by

investors from a security with options over the Treasury spot curve, after accounting for when and at what price the embedded options will be exercised

OAS analysis is one procedure to estimate how much an investor is being compensated for selling an option to the issuer of a security with options

OAS is often calculated as an incremental yield relative to the LIBOR swap curve

270


Option-Adjusted Spread The approach starts with estimating

Treasury spot rates (zero coupon Treasury rates) using a probability distribution and Monte Carlo simulation, identifying a large number of possible interest rate scenarios over the time period that the security’s cash flows will appear

271


Option-Adjusted Spread The analysis then assigns probabilities

to various cash flows based on the different interest rate scenarios

For mortgages, one needs a prepayment model and for callable bonds, one needs rules and prices indicating when the bonds will be called and at what values

272

Comparative Yields on Taxable versus Tax-Exempt Securities Interest on most municipal securities is

exempt from federal income taxes and, depending on state law, from state income taxes Some states exempt all municipal interest Most states selectively exempt interest

from municipals issued in-state but tax interest on out-of-state issues

Other states either tax all municipal interest or do not impose an income tax

275

Comparative Yields on Taxable versus Tax-Exempt Securities Capital gains on municipals are taxed as

ordinary income under the federal income tax code This makes discount municipals less

attractive than par municipals because a portion of the return, the price appreciation, is fully taxable

When making investment decisions, portfolio managers compare expected risk-adjusted after-tax returns from alternative investments

276

Comparative Yields on Taxable versus Tax-Exempt Securities After-Tax and Tax-Equivalent Yields

Once the investor has determined the appropriate maturity and risk security, the investment decision involves selecting the security with the highest after-tax yield

277


Tax-exempt and taxable securities can be compared as:

278

t)(1RR tm

where:Rm = pretax yield on a municipal securityRt = pretax yield on a taxable securityt = investor’s marginal federal income tax rate


Example Let:

Rm = 5.75%Rt = 7.50%

Marginal Tax Rate = 34%

279


Example The investor would choose the

municipal because it pays a higher after tax return:

Rm = 5.75% after taxesRt = 7.50% (1 - 0.34)

= 4.95% after taxes

280


Marginal Tax Rates Implied in the Taxable - Tax-Exempt Spread

If taxable securities and tax-exempt securities are the same for all other reasons then:

t* = 1 - (Rm / Rt) where

Rm = pretax yield on a municipal security

Rt = pretax yield on a taxable security281


Marginal Tax Rates Implied in the Taxable - Tax-Exempt Spread

t* represents the marginal tax rate at which an investor would be indifferent between a taxable and a tax-exempt security equal for all other reasons

Higher marginal tax rates or high tax individuals (companies) will prefer tax-exempt securities

282


Example Let:

Rm = 5.75%Rt = 7.50%

Marginal Tax Rate = 34%

An investor would be indifferent between these two investment alternatives if her marginal tax rate were 23.33%

283

23.33% 7.50%5.75% 1t*


Municipals and State & Local Taxes The analysis is complicated somewhat

when state and local taxes apply to municipal securities:

284

)]t(t[1R)t(tR mtmm


Municipals and State & Local Taxes Many analysts compare securities on a

pre-tax basis To compare municipals on a tax

equivalent basis (pre-tax):

285

t)(t1)t(tRYield EquivalentTax

m

mm

Comparative Yields on Taxable versus Tax-Exempt Securities The Yield Comparison for Commercial Banks

Assume a bank portfolio manager wants to compare potential returns between a taxable security and a municipal security that currently yield 10% and 8%, respectively

Both securities are new issues trading at $10,000 par with identical maturities, call treatment, and default risk

The primary difference is that the bank pays federal income taxes at a 34% marginal rate on the taxable security while municipal interest is entirely exempt

286

Comparative Yields on Taxable versus Tax-Exempt Securities The Yield Comparison for Commercial

Banks The portfolio manager would earn

more in after-tax interest from buying the municipal

8%(1 − 0) = 8% > 10%(1 − 0.34) = 6.6%

287

Comparative Yields on Taxable versus Tax-Exempt Securities The Effective Tax on Incremental

Municipal Interest Earned by Commercial Banks Prior to 1983, banks could deduct the

full amount of interest paid on liabilities used to finance the purchase of muni's

After 1983 15% was not deductible and after 1984 20% was not deductible

289


Municipal Interest Earned by Commercial Banks The 1986 tax reform act made 100% not

deductible except for qualified muni's, small issue (less than $10 million)

The loss of interest expense deductibility is like an implicit tax on the bank's holding of municipal securities

290


Municipal Interest Earned by Commercial Banks To calculate after tax yields on muni's,

if interest expense is not fully deductible, calculate the bank’s effective tax rate on municipals (tm):

291muni

r

R

rate tax income local and statecost

interestPooled

Deductable%not

t

munit

Comparative Yields on Taxable versus Tax-Exempt Securities Example:

Assume t =34%, 20% Not Deductible 7.5% Pooled Interest Cost Rmuni = 7%.

292

7.49%0.0638)(18.0Ratmuni

6.38%00.08

(0.075)(0.20)(0.34)tmuni

The Impact of the Tax Reform Act of 1986 The TRA of 1986 created two classes

of municipals Qualified Nonqualified Municipals

After 1986, banks could no longer deduct interest expenses associated with municipal investments, except for qualified municipal issues

293

The Impact of the Tax Reform Act of 1986 Qualified versus Non-Qualified

Municipals Qualified Municipals

Banks can still deduct 80 percent of the interest expense associated with the purchase of certain small issue public-purpose bonds (bank qualified)

Nonqualified Municipals All municipals that do not meet the

qualified criteria294

The Impact of the Tax Reform Act of 1986 Qualified versus Non-Qualified

Municipals Municipals issued before August 7,

1986, retain their tax exemption; i.e., can still deduct 80 percent of their associated financing costs (grandfathered in)

295

The Impact of the Tax Reform Act of 1986 Example:

Implied tax on a bank’s purchase of nonqualified municipal securities (100% lost deduction)

Assume t =34% 20% not deductible 7.5% pooled interest cost Rmuni = 7%

296

The Impact of the Tax Reform Act of 1986 Example:

297

5.45%0.3188)(18.0Ratmuni

31.88%00.08

(0.075)(1.00)(0.34)tmuni

Strategies Underlying Security Swaps Active portfolio strategies also enable

banks to sell securities prior to maturity whenever economic conditions dictate that returns can be earned without a significant increase in risk

298

Strategies Underlying Security Swaps When a bank sells a security at a loss

prior to maturity, because interest rates have increased, the loss is a deductible expense At least a portion of the capital loss is

reduced by the tax-deductibility of the loss

299

Strategies Underlying Security Swaps Security Swap Example

Tax Savings:= (2,000,000 - 1,926,240) * 0.35 = 25,816

After Tax Proceeds= 1,926,240 + 25,816 = 1,952,056

Present Value of the Difference:

301

$35,3801.061

14,07547,9441.06114,075PV 6

6

1tt

Strategies Underlying Security Swaps In general, banks can effectively

improve their portfolios by: Upgrading bond credit quality by

shifting into high-grade instruments when quality yield spreads are low

Lengthening maturities when yields are expected to level off or decline

Obtaining greater call protection when management expects rates to fall

302

Strategies Underlying Security Swaps In general, banks can effectively

improve their portfolios by: Improving diversification when

management expects economic conditions to deteriorate

Generally increasing current yields by taking advantage of the tax savings

Shifting into taxable securities from municipals when management expects losses

303

managing liquidity

Documents

liquidity source

cash needs

federal reserve bankbanks

institutions liquidity

vault cash

level of cash

legal reserve requirementsto

banks liquidity needsif