Managing liquidity
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Managing Liquidity. 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: Selling assets New borrowings New stock issues. Meeting Liquidity Needs.

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Managing Liquidity

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Managing liquidity

Managing Liquidity


Meeting liquidity needs

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:

    • Selling assets

    • New borrowings

    • New stock issues


Meeting liquidity needs1

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


Meeting liquidity needs2

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


Meeting liquidity needs3

Meeting Liquidity Needs

  • Holding Liquid Assets

    • “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


Meeting liquidity needs4

Meeting Liquidity Needs

  • Holding Liquid Assets

    • Banks hold cash assets to satisfy four objectives:

      • To meet customers’ regular transaction needs

      • To meet legal reserve requirements

      • To assist in the check-payment system

      • To purchase correspondent banking services


Meeting liquidity needs5

Meeting Liquidity Needs

  • Holding Liquid Assets

    • Banks own five types of liquid assets

      • Cash and due from banks in excess of requirements

      • Federal funds sold and reverse repurchase agreements

      • Short-term Treasury and agency obligations

      • High-quality short-term corporate and municipal securities

      • Government-guaranteed loans that can be readily sold


Meeting liquidity needs6

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


Meeting liquidity needs7

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


Reserve balances at the federal reserve bank

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


Reserve balances at the federal reserve bank1

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


Reserve balances at the federal reserve bank2

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


Reserve balances at the federal reserve bank3

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


Reserve balances at the federal reserve bank4

Reserve Balances at the Federal Reserve Bank

  • Impact of Sweep Accounts on Required Reserve Balances

    • MMDAs are considered personal saving deposits and have a zero required reserve requirement ratio


Reserve balances at the federal reserve bank5

Reserve Balances at the Federal Reserve Bank

  • Impact of Sweep Accounts on 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


Reserve balances at the federal reserve bank6

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


Reserve balances at the federal reserve bank7

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


Meeting legal reserve requirements

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


Meeting legal reserve requirements1

Meeting Legal Reserve Requirements


Meeting legal reserve requirements2

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


Meeting legal reserve requirements3

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


Meeting legal reserve requirements4

Meeting Legal Reserve Requirements

  • Lagged Reserve Accounting

    • 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


Meeting legal reserve requirements5

Meeting Legal Reserve Requirements

  • Lagged Reserve Accounting

    • 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


Meeting legal reserve requirements6

Meeting Legal Reserve Requirements

  • An Application: Reserve Calculation Under LRA

    • Four steps:

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

      • Apply the reserve percentages.

      • Subtract vault cash.

      • Add or subtract the allowable reserve carried forward from the prior period


Meeting legal reserve requirements7

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)


Meeting legal reserve requirements8

Meeting Legal Reserve Requirements

  • Correspondent Banking Services

    • 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


Meeting legal reserve requirements9

Meeting Legal Reserve Requirements

  • Correspondent Banking Services

    • 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


Liquidity planning

Liquidity Planning

  • Short-Term Liquidity Planning

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


Liquidity planning1

Liquidity Planning


Liquidity planning2

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


Liquidity planning3

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


Liquidity planning4

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


Liquidity planning5

Liquidity Planning

  • The Relationship Between Liquidity, Credit Risk, and Interest Rate Risk


Traditional aggregate measures of liquidity risk

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


Traditional aggregate measures of liquidity risk1

Traditional Aggregate Measures of Liquidity Risk

  • Asset Liquidity Measures

    • 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


Traditional aggregate measures of liquidity risk2

Traditional Aggregate Measures of Liquidity Risk

  • Asset Liquidity Measures

    • 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


Traditional aggregate measures of liquidity risk3

Traditional Aggregate Measures of Liquidity Risk

  • Asset Liquidity Measures

    • 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


Traditional aggregate measures of liquidity risk4

Traditional Aggregate Measures of Liquidity Risk

  • Asset Liquidity Measures

    • 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


Traditional aggregate measures of liquidity risk5

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


Traditional aggregate measures of liquidity risk6

Traditional Aggregate Measures of Liquidity Risk

  • Liability Liquidity Measures

    • 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


Traditional aggregate measures of liquidity risk7

Traditional Aggregate Measures of Liquidity Risk

  • Liability Liquidity Measures

    • 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


Longer term liquidity planning

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


Longer term liquidity planning1

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


Longer term liquidity planning2

Longer-Term Liquidity Planning


Longer term liquidity planning3

Longer-Term Liquidity Planning


Longer term liquidity planning4

Longer-Term Liquidity Planning


Longer term liquidity planning5

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


Contingency funding

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


Contingency funding1

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


Contingency funding2

Contingency Funding

  • Contingency Planning

    • 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


Contingency funding3

Contingency Funding

  • Contingency Planning

    • 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


Contingency funding4

Contingency Funding

  • Contingency Planning

    • 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


Contingency funding5

Contingency Funding

  • Contingency Planning

    • 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

The Effective Use of Capital


Why worry about bank capital

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


Risk based capital standards

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%


Risk based capital standards1

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


Risk based capital standards2

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


Risk based capital standards3

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


Risk based capital standards4

Risk-Based Capital Standards

  • The 1986 Basel Agreement

    • 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


Risk based capital standards5

Risk-Based Capital Standards

  • The 1986 Basel Agreement

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

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


Risk based capital standards6

Risk-Based Capital Standards

  • Risk-Based Elements of Basel I

    • Classify assets into one of four risk categories

    • Classify off-balance sheet commitments into the appropriate risk categories

    • Multiply the dollar amount of assets in each risk category by the appropriate risk weight

      • This equals risk-weighted assets

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


Risk based capital standards7

Risk-Based Capital Standards


Risk based capital standards8

Risk-Based Capital Standards


What constitutes bank capital

What Constitutes Bank Capital?

  • Capital (Net Worth)

    • The cumulative value of assets minus the cumulative value of liabilities

    • Represents ownership interest in a firm


What constitutes bank capital1

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


What constitutes bank capital2

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


What constitutes bank capital3

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)


What constitutes bank capital4

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


What constitutes bank capital5

What Constitutes Bank Capital?


What constitutes bank capital6

What Constitutes Bank Capital?


What constitutes bank capital7

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


What constitutes bank capital8

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


What constitutes bank capital9

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


What constitutes bank capital10

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 disclosure


What constitutes bank capital11

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


What constitutes bank capital12

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


What is the function of bank capital

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 taking


What is the function of bank capital1

What is the Function of Bank Capital


How much capital is adequate

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


The effect of capital requirements on bank operating policies

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


The effect of capital requirements on bank operating policies1

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


Characteristics of external capital sources

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


Characteristics of external capital sources1

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


Characteristics of external capital sources2

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


Characteristics of external capital sources3

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


Characteristics of external capital sources4

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


Characteristics of external capital sources5

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


Characteristics of external capital sources6

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


Characteristics of external capital sources7

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


Capital planning

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


Capital planning1

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


Capital planning2

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


Depository institutions capital standards

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


Depository institutions capital standards1

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


Depository institutions capital standards2

Depository Institutions Capital Standards


Federal deposit insurance

Federal Deposit Insurance

  • Federal Deposit Insurance Corporation

    • Established in 1933

    • Coverage is currently $100,000 per depositor per institution

      • Original coverage was $2,500


Federal deposit insurance1

Federal Deposit Insurance

  • Federal Deposit Insurance Corporation

    • Initial Objective:

      • Prevent liquidity crises caused by large-scale deposit withdrawals

      • Protect depositors of modes means against a bank failure


Federal deposit insurance2

Federal Deposit Insurance

  • Federal Deposit Insurance Corporation

    • 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


Federal deposit insurance3

Federal Deposit Insurance

  • Federal Deposit Insurance Corporation

    • 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


Federal deposit insurance4

Federal Deposit Insurance


Federal deposit insurance5

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


Federal deposit insurance6

Federal Deposit Insurance

  • FDIC Insurance Assessment Rates

    • 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)


Federal deposit insurance7

Federal Deposit Insurance

  • FDIC Insurance Assessment Rates


Federal deposit insurance8

Federal Deposit Insurance

  • FDIC Insurance Assessment Rates

    • 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”


Federal deposit insurance9

Federal Deposit Insurance

  • FDIC Insurance Assessment Rates

    • 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”


Federal deposit insurance10

Federal Deposit Insurance

  • FDIC Insurance Assessment Rates

    • 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”


Federal deposit insurance11

Federal Deposit Insurance

  • FDIC Insurance Assessment Rates


Federal deposit insurance12

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


Federal deposit insurance13

Federal Deposit Insurance

  • Problems With Deposit Insurance

    • 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


Federal deposit insurance14

Federal Deposit Insurance

  • Problems With Deposit Insurance

    • 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 problem


Federal deposit insurance15

Federal Deposit Insurance

  • Problems With Deposit Insurance

    • 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


Federal deposit insurance16

Federal Deposit Insurance

  • Problems With Deposit Insurance

    • 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


Federal deposit insurance17

Federal Deposit Insurance

  • Problems With Deposit Insurance

    • 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


Federal deposit insurance18

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


Managing the investment portfolio

Managing the Investment Portfolio


Managing the investment portfolio1

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


Managing the investment portfolio2

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


Managing the investment portfolio3

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


Dealer operations and the securities trading account

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


Dealer operations and the securities trading account1

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


Dealer operations and the securities trading account2

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


Dealer operations and the securities trading account3

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


Dealer operations and the securities trading account4

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


Dealer operations and the securities trading account5

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


Objectives of the investment portfolio

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


Objectives of the investment portfolio1

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


Objectives of the investment portfolio2

Objectives of the Investment Portfolio

  • Accounting for Investment Securities

    • 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


Objectives of the investment portfolio3

Objectives of the Investment Portfolio

  • Accounting for Investment Securities

    • 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


Objectives of the investment portfolio4

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


Objectives of the investment portfolio5

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


Objectives of the investment portfolio6

Objectives of the Investment Portfolio


Objectives of the investment portfolio7

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


Objectives of the investment portfolio8

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


Objectives of the investment portfolio9

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


Objectives of the investment portfolio10

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


Composition of the investment portfolio

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


Composition of the investment portfolio1

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


Characteristics of taxable securities

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


Characteristics of taxable securities1

Characteristics of Taxable Securities

  • Money Market Investments

    • 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


Characteristics of taxable securities2

Characteristics of Taxable Securities

  • Money Market Investments

    • 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


Characteristics of taxable securities3

Characteristics of Taxable Securities

  • Money Market Investments

    • 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


Characteristics of taxable securities4

Characteristics of Taxable Securities

  • Money Market Investments

    • 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


Characteristics of taxable securities5

Characteristics of Taxable Securities

  • Money Market Investments

    • 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


Characteristics of taxable securities6

Characteristics of Taxable Securities

  • Money Market Investments

    • 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:


Characteristics of taxable securities7

Characteristics of Taxable Securities

  • Money Market Investments

    • 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


Characteristics of taxable securities8

Characteristics of Taxable Securities

  • Money Market Investments

    • 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


Characteristics of taxable securities9

Characteristics of Taxable Securities

  • Money Market Investments

    • 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 basis


Characteristics of taxable securities10

Characteristics of Taxable Securities

  • Money Market Investments

    • 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


Characteristics of taxable securities11

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


Characteristics of taxable securities12

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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


Characteristics of taxable securities13

Characteristics of Taxable Securities

  • Capital Market Investments

    • Treasury STRIPS

      • Many banks purchase zero-coupon Treasury securities as part of their interest rate risk management strategies


Characteristics of taxable securities14

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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


Characteristics of taxable securities15

Characteristics of Taxable Securities

  • Capital Market Investments

    • Treasury STRIPS

      • Each component interest or principal payment constitutes a separate zero coupon security and can be traded separately from the other payments


Characteristics of taxable securities16

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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)


Characteristics of taxable securities17

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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


Characteristics of taxable securities18

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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)


Characteristics of taxable securities19

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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)


Characteristics of taxable securities20

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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.


Characteristics of taxable securities21

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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


Characteristics of taxable securities22

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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


Characteristics of taxable securities23

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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


Characteristics of taxable securities24

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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 refinance


Characteristics of taxable securities25

Characteristics of Taxable Securities

  • Capital Market Investments

    • 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


Characteristics of taxable securities26

Characteristics of Taxable Securities

  • Capital Market Investments

    • FHLMC

      • Federal Home Loan Mortgage Corporation (Freddie Mac)

    • FNMA securities

      • Federal National Mortgage Association (Fannie Mae)


Characteristics of taxable securities27

Characteristics of Taxable Securities

  • Capital Market Investments

    • Both are:

      • Private corporations

      • Operate with an implicit federal guarantee

      • Buy mortgages financed largely by mortgage-backed securities


Characteristics of taxable securities28

Characteristics of Taxable Securities

  • Capital Market Investments

    • Privately Issued Pass-Through

      • Issued by banks and thrifts, with private insurance rather than government guarantee


Prepayment risk on mortgage backed securities

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


Prepayment risk on mortgage backed securities1

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


Prepayment risk on mortgage backed securities2

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


Prepayment risk on mortgage backed securities3

Prepayment Risk on Mortgage-Backed Securities

  • Alternative Mortgage-Backed Securities

    • Collateralized Mortgage Obligations (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


Prepayment risk on mortgage backed securities4

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


Prepayment risk on mortgage backed securities5

Prepayment Risk on Mortgage-Backed Securities

  • Alternative Mortgage-Backed Securities

    • 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


Prepayment risk on mortgage backed securities6

Prepayment Risk on Mortgage-Backed Securities

  • Alternative Mortgage-Backed Securities

    • 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


Alternative mortgage backed securities

Alternative Mortgage-Backed Securities

  • Alternative Mortgage-Backed Securities

    • Collateralized Mortgage Obligations (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


Prepayment risk on mortgage backed securities7

Prepayment Risk on Mortgage-Backed Securities

  • Alternative Mortgage-Backed Securities

    • 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


Prepayment risk on mortgage backed securities8

Prepayment Risk on Mortgage-Backed Securities

  • Alternative Mortgage-Backed Securities

    • Stripped Mortgage-Backed Securities

      • More complicated in terms of structure and pricing characteristics

      • Example:

        • Consider a 30 year, 12% fixed-rate mortgage


Prepayment risk on mortgage backed securities9

Prepayment Risk on Mortgage-Backed Securities

  • Alternative Mortgage-Backed Securities

    • Stripped Mortgage-Backed Securities

      • Example:

        • There will be 30 x 12 (360) payments (principal plus interest)


Prepayment risk on mortgage backed securities10

Prepayment Risk on Mortgage-Backed Securities

  • Alternative Mortgage-Backed Securities

    • Stripped Mortgage-Backed Securities

      • 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


Prepayment risk on mortgage backed securities11

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


Prepayment risk on mortgage backed securities12

Prepayment Risk on Mortgage-Backed Securities

  • Corporate, Foreign Bonds, and Taxable Municipal Bonds

    • By regulation, banks can invest no more than 10% of capital in the securities of any single firm


Prepayment risk on mortgage backed securities13

Prepayment Risk on Mortgage-Backed Securities

  • Corporate, Foreign Bonds, and Taxable Municipal Bonds

    • In most cases, banks purchase securities that mature within 10 years

    • Occasionally, banks also purchase municipal bonds that pay taxable interest


Prepayment risk on mortgage backed securities14

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


Prepayment risk on mortgage backed securities15

Prepayment Risk on Mortgage-Backed Securities

  • Asset-Backed Securities

    • Two popular asset-backed securities are:

      • Collateralized automobile receivables (CARS)

      • CARDS

        • Securities backed by credit card loans to individuals


Prepayment risk on mortgage backed securities16

Prepayment Risk on Mortgage-Backed Securities

  • Asset-Backed Securities

    • 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


Prepayment risk on mortgage backed securities17

Prepayment Risk on Mortgage-Backed Securities

  • Asset-Backed Securities

    • 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


Prepayment risk on mortgage backed securities18

Prepayment Risk on Mortgage-Backed Securities

  • Asset-Backed Securities

    • 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


Characteristics of municipal securities

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


Characteristics of municipal securities1

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


Characteristics of municipal securities2

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


Characteristics of municipal securities3

Characteristics of Municipal Securities

  • Money Market Municipals

    • 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


Characteristics of municipal securities4

Characteristics of Municipal Securities

  • Money Market Municipals

    • 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


Characteristics of municipal securities5

Characteristics of Municipal Securities

  • Money Market Municipals

    • Banks buy large amounts of short-term municipals

      • They often work closely with municipalities in placing these securities


Characteristics of municipal securities6

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


Characteristics of municipal securities7

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 equivalent


Characteristics of municipal securities8

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)


Characteristics of municipal securities9

Characteristics of Municipal Securities

  • Liquidity Risk

    • Municipals exhibit substantially lower liquidity than Treasury or agency securities


Characteristics of municipal securities10

Characteristics of Municipal Securities

  • Liquidity Risk

    • 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


Characteristics of municipal securities11

Characteristics of Municipal Securities

  • Liquidity Risk

    • 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


Characteristics of municipal securities12

Characteristics of Municipal Securities

  • Liquidity Risk

    • Municipals are less volatile in price than Treasury securities

      • This is generally attributed to the peculiar tax features of municipals


Characteristics of municipal securities13

Characteristics of Municipal Securities

  • Liquidity Risk

    • 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


Characteristics of municipal securities14

Characteristics of Municipal Securities

  • Liquidity Risk

    • 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


Establishing investment policy guidelines

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


Establishing investment policy guidelines1

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


Establishing investment policy guidelines2

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


Active investment strategies

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


Active investment strategies1

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


Active investment strategies2

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


Active investment strategies3

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 costs


Active investment strategies4

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


Active investment strategies5

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


Active investment strategies6

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 strategy


Active investment strategies7

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


Active investment strategies8

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


Active investment strategies9

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


Active investment strategies10

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


Active investment strategies11

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


Active investment strategies12

Active Investment Strategies

  • Passive Strategies Over the Business 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


Active investment strategies13

Active Investment Strategies

  • Passive Strategies Over the Business 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


Active investment strategies14

Active Investment Strategies

  • Passive Strategies Over the Business 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


Active investment strategies15

Active Investment Strategies

  • Passive Strategies Over the Business Cycle

    • With a buy and hold orientation, these banks lock themselves into securities that depreciate in value as interest rates move higher


Active investment strategies16

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


Active investment strategies17

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


Active investment strategies18

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


The impact of interest rates on the value of securities with embedded options

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


The impact of interest rates on the value of securities with embedded options1

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?


The roles of duration and convexity in analyzing bond price volatility

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


The roles of duration and convexity in analyzing bond price volatility1

The Roles of Duration and Convexity in Analyzing Bond Price Volatility

  • 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


The roles of duration and convexity in analyzing bond price volatility2

The Roles of Duration and Convexity in Analyzing Bond Price Volatility

  • 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


The roles of duration and convexity in analyzing bond price volatility3

The Roles of Duration and Convexity in Analyzing Bond Price Volatility

  • 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


The roles of duration and convexity in analyzing bond price volatility4

The Roles of Duration and Convexity in Analyzing Bond Price Volatility

  • 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


Impact of prepayments on duration and yield for bonds with options

Impact of Prepayments on Duration and Yield for Bonds with Options

  • Embedded options affect the estimated duration and convexity of securities


Impact of prepayments on duration and yield for bonds with options1

Impact of Prepayments on Duration and Yield for Bonds with Options

  • 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


Impact of prepayments on duration and yield for bonds with options2

Impact of Prepayments on Duration and Yield for Bonds with Options

  • 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


Impact of prepayments on duration and yield for bonds with options3

Impact of Prepayments on Duration and Yield for Bonds with Options

  • 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


Impact of prepayments on duration and yield for bonds with options4

Impact of Prepayments on Duration and Yield for Bonds with Options

  • Effective Duration and Effective Convexity

    • Both are used to estimate a security’s price sensitivity when the security contains embedded options

Where:

Pi- = price if rates fall

Pi+ = price if rates rise

P0 = initial (current) price

P* = initial price

i+ =initial market rate plus the increase in rate i- = initial market rate minus the decrease in rate


Impact of prepayments on duration and yield for bonds with options5

Impact of Prepayments on Duration and Yield for Bonds with Options

  • 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


Impact of prepayments on duration and yield for bonds with options6

Impact of Prepayments on Duration and Yield for Bonds with Options

  • Effective Duration and Effective Convexity

    • Example:

      • 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


Impact of prepayments on duration and yield for bonds with options7

Impact of Prepayments on Duration and Yield for Bonds with Options

  • Effective Duration and Effective Convexity

    • Example:

      • 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


Total return and option adjusted spread analysis of securities with options

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


Total return and option adjusted spread analysis of securities with options1

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

  • 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


Total return and option adjusted spread analysis of securities with options2

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

  • Total Return Analysis

    • When rates rise

      • Borrowers prepay slower

      • Coupon income increases

      • Reinvestment income increases

      • The price at sale may rise or fall


Total return and option adjusted spread analysis of securities with options3

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

  • 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


Total return and option adjusted spread analysis of securities with options4

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

  • 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


Total return and option adjusted spread analysis of securities with options5

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

  • 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


Total return and option adjusted spread analysis of securities with options6

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

  • 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


Comparative yields on taxable versus tax exempt securities

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


Comparative yields on taxable versus tax exempt securities1

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


Comparative yields on taxable versus tax exempt securities2

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


Comparative yields on taxable versus tax exempt securities3

Comparative Yields on Taxable versus Tax-Exempt Securities

  • After-Tax and Tax-Equivalent Yields

    • Tax-exempt and taxable securities can be compared as:

where:Rm = pretax yield on a municipal security

Rt = pretax yield on a taxable security

t = investor’s marginal federal income tax rate


Comparative yields on taxable versus tax exempt securities4

Comparative Yields on Taxable versus Tax-Exempt Securities

  • After-Tax and Tax-Equivalent Yields

    • Example

      • Let:Rm= 5.75%Rt= 7.50%

        Marginal Tax Rate= 34%


Comparative yields on taxable versus tax exempt securities5

Comparative Yields on Taxable versus Tax-Exempt Securities

  • After-Tax and Tax-Equivalent Yields

    • 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


Comparative yields on taxable versus tax exempt securities6

Comparative Yields on Taxable versus Tax-Exempt Securities

  • After-Tax and Tax-Equivalent Yields

    • 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 security


Comparative yields on taxable versus tax exempt securities7

Comparative Yields on Taxable versus Tax-Exempt Securities

  • After-Tax and Tax-Equivalent Yields

    • 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


Comparative yields on taxable versus tax exempt securities8

Comparative Yields on Taxable versus Tax-Exempt Securities

  • After-Tax and Tax-Equivalent Yields

    • 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%


Comparative yields on taxable versus tax exempt securities9

Comparative Yields on Taxable versus Tax-Exempt Securities

  • After-Tax and Tax-Equivalent Yields

    • Municipals and State & Local Taxes

      • The analysis is complicated somewhat when state and local taxes apply to municipal securities:


Comparative yields on taxable versus tax exempt securities10

Comparative Yields on Taxable versus Tax-Exempt Securities

  • After-Tax and Tax-Equivalent Yields

    • Municipals and State & Local Taxes

      • Many analysts compare securities on a pre-tax basis

      • To compare municipals on a tax equivalent basis (pre-tax):


Comparative yields on taxable versus tax exempt securities11

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


Comparative yields on taxable versus tax exempt securities12

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%


Comparative yields on taxable versus tax exempt securities13

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


Comparative yields on taxable versus tax exempt securities14

Comparative Yields on Taxable versus Tax-Exempt Securities

  • The Effective Tax on Incremental 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


Comparative yields on taxable versus tax exempt securities15

Comparative Yields on Taxable versus Tax-Exempt Securities

  • The Effective Tax on Incremental 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):


Comparative yields on taxable versus tax exempt securities16

Comparative Yields on Taxable versus Tax-Exempt Securities

  • Example:

    • Assume

      • t =34%,

      • 20% Not Deductible

      • 7.5% Pooled Interest Cost

      • Rmuni = 7%.


The impact of the tax reform act of 1986

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


The impact of the tax reform act of 19861

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 criteria


The impact of the tax reform act of 19862

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)


The impact of the tax reform act of 19863

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%


The impact of the tax reform act of 19864

The Impact of the Tax Reform Act of 1986

  • Example:


Strategies underlying security swaps

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


Strategies underlying security swaps1

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


Strategies underlying security swaps2

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:


Strategies underlying security swaps3

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


Strategies underlying security swaps4

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


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