BID® Daily Newsletter
Mar 5, 2007

BID® Daily Newsletter

Mar 5, 2007

HOCKEY AND BANKING CAN BE ROUGH


In ice hockey, it is estimated that 40% of pro players get at least one concussion each season. While bankers may not be lying on the ice wondering what hit them, many have been telling us it feels that way given the ongoing net interest margin compression. As margins get squeezed, loan demand softens and rates seem as though they will not move for quite a few years, investment leverage programs (whereby a bank borrows thru FHLB advances and purchases securities) are expected to ramp up again. As mentioned in this column before, we are not big fans of leverage (how many broker-dealers would say that), since you are adding risk for only an incremental return. On an accounting basis, most leverage programs look great. On a risk-adjusted return on capital basis however, they often fall short. That said, most management teams are evaluated on accounting returns, so if your bank is going to embark on a leverage trade, here are some high sticks to try and avoid. The argument to add leverage right now is because there is just no other easy way to get return. Rates are relatively low and low rates tend to limit optionality. As rates rise, cash flows become more and more predictable. This brings us to another point, which is the importance of analyzing cash flow. Since all bond performance is a function of cash flow, hedging anything else (like book yield, duration or average life) is asking for trouble. The 2nd biggest problem to avoid with these programs results from not shocking the cash flows to see the variability of both the borrowing and the investment. To really understand the problem, banks should dismiss static rate shocks and opt for a dynamic approach. In the real world, when rates go up, prepayments or calls occur less often, liquidity changes and spreads tighten. A static shock misses a large part of the risk. To really understand leverage and the impact on the bank, it must also be shocked over a period of time. This allows bankers to understand what will happen down to the monthly cashflow level. Before bankers embark on a leverage program, they should shock rates each month over the life of the investment and then change assumptions according to interest rate, prepayment and liquidity projections. In this manner, surprises are eliminated and performance is enhanced. Finally, a leverage tactic is also not just a one-time event. Programs should be reviewed often and adjusted any time the cash flow differences move more than 20% (like last Tuesday). A bank involved in a leverage program should always be asking if they need to increase borrowings or purchase more securities to better hedge cash flows. A properly structured program should be able to conservatively add $180k per year for each $10mm of leverage. If properly designed, this amount should be relatively constant across rate scenarios. If your bank is looking for extra earnings and plans to undertake a leverage program, do the proper analysis upfront and be prepared to manage the program on an ongoing basis. Doing simple things outlined above will help bankers avoid a concussion, or being sent to the penalty box.
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