Each depositor insured to at least $250,000 per insured bank



Home > News & Events > Conferences & Events > Risk Management Webinar: Risk Management in a Flat-to-Inverted Yield Curve Scenario




Risk Management Webinar: Risk Management in a Flat-to-Inverted Yield Curve Scenario

FTS-FDIC

Moderator: Mike Dando
May 1, 2006
1:00 pm CT

Coordinator: Good afternoon and thank you for standing by. All participants will be able to listen only until the question and answer portion of today's conference. To ask a question, you may press star-1.

This conference is being recorded. If you any objections, you may disconnect at this time.

I would now like to turn the call over to Mr. Saurabh Narain.

Sir, you may begin.

   
Saurabh Narain: Thank you, Julie. And thank you everybody for joining in to this inaugural CDBI Exchange Network Risk Management Webinar, which is co-hosted by NCIF and the Federal Deposit Insurance Corporation.

I want to first thank FDIC for co-hosting, as well as the co-presenters, Paul Hudson from Broadway Federal Bank and David Oser from ShoreBank, for joining in and making this presentation possible.

Just a little bit of background on the NCIF, and what we do and how it fits into the overall strategy of NCIF. NCIF is a non-profit trust fund, which is federally chartered as a CDFI and a CDE Intermediary. Its mission is primarily to focus on increasing the numbers and capacity of CDBIs, as we call them, which are both effective agents of local community development as well as sound financial institutions.

It's important to make a distinction here between CDBI and CDFI. CDFIs are institutions which are certified as Community Development Financial Institutions by the Department of Treasury, whereas CDBIs are much more oriented towards development, but they don't necessarily want to get certified.

Two activities we focus on: one is investing and one is providing best practices. We've invested about $22 million in the CDBIs. We are the third largest private sector investor. Most of our investments are in minority focus and minority-owned institutions, and 91 percent are certified CDFIs.

You would note that we've got $38 million of new markets tax credits allocated to us which we are investing in the market.

How does this Webinar fit into our activities?

The CDBI exchange network has been set up as a mechanism for providing best practices to the sector. Best practices would come in the form of risk management evaluation, corporate governance, and so on. One of the other things that we focus on is providing development impact information to the sector and helping find ways of monetizing this impact.

This Webinar is the first in a series that we expect to do in the near future.

Let me talk a little bit about logistics here. We've got two presenters, Norm Williams, who is the Chief of the Economic Analysis Section at the FDIC, and Ross Waldrop, also from the FDIC, is a Senior Financial Analyst, who will talk about the background in interest rates, yield curve dynamics, give historical perspective, and highlight some of the risks we 'll see over this market scenario.

This [discussion] is based on some very significant research that they [the FDIC] have done recently in this context. And it's an important context to keep in mind, given that all of us bankers are faced with this issue today.

Paul will share with us some of his experiences in pricing of loans and deposits, and how he has sort of positioned the bank for a flat or inverted yield curve scenario.

David is then going to talk about bond portfolio management and how we can think about asset liability management from the investment side of the balance sheet perspective.

And then I will close with some policy implications and talk about future and next steps, et cetera. I would be very keen on getting Q&A at the end. We'll have roughly ten minutes or so for Q&A. But please do feel free to send us an e-mail or questions all along the presentation. But even after that, we will have the contact information at the end of this session, and we'll be able to respond as soon as possible.

I want to thank the FDIC for hosting this presentation and also to Paul and David for participating. I will now turn it over to the FDIC.

Norm?

   
Norm Williams: Great. Thanks, Saurabh.

This is Norm Williams. To kick this off, I just wanted to start with some very high level thoughts on interest rates in general. Just as a reminder, the nominal rates that we see embody several unobservable components, basically, the real interest rate and premiums for expected inflation, credit risk, liquidity, and uncertainty.

With respect to the yield curve, we have typically seen short-term rates tied more closely to monetary policy and long-term rates more influenced by market factors. Then we have arbitrage and the term structure acting as traffic cop, if you will, to keep abnormally-shaped yield curves, such as inverted curves, from persisting for very long.

So what is it that causes the yield curve to invert?

First off, normally the yield curve is upward sloping and that's basically because of two things: economic growth and inflation, which are the most common states in the U.S. economy. We usually only see inversions ahead of slowdowns, recessions, and disinflationary episodes.

So, typically, we have a positively-sloped yield curve. But when we do get an inversion, what it's usually signaling to us is that the market thinks that short-term rates are too high to be sustainable; typically, because monetary policy is seen as too restrictive.

Historically, the most severe recessions we saw, like in the 1970s and 1980s, were also preceded by the most steeply inverted yield curves we've seen. [With respect to the yield curve] we look mostly at the ten-year/Fed funds spread because it's used in the index of leading economic indicators. And on that basis, we've had ten inversions since 1960.

The first chart that we're going to take a look at is the yield curve as of Friday versus some recent annual averages. And you can see that although we've seen a modest re-steeping in the curve in recent weeks, it is still very flat; it is very similar in appearance, just at a lower interest rate level, as [the curve] in 2000. And, of course, 2000 was the year before the 2001 recession.

So the current flat yield curve has raised concerns on the part of a number of analysts worrying that we might be looking at a recession in the next few years.

In terms of where the yield curve was last Friday, here are a couple of different yield curve spreads versus their historical average. The first bar is the ten-year/Fed funds rate spread for Friday's close versus the historical average since 1959. You can see we're down basically about 60 basis points from the average slope.

If we look at the next one, which is the ten-year less the three-month T-bill, you can see the history only goes back to 1981, which is part of the reason why it looks so much flatter than we would expect.

And then you can see the 10/2 spread on the far right for Friday versus the average since 1976. You can see we were about 60 basis points below average.

If we get to a 5 percent Fed funds rate in May and if we had a historically average slope in the yield curve, we would expect to see the ten-year note yielding somewhere around 5.9 percent. So about a 90 basis points spread between the ten-year note and the Fed funds rate historically.

Again on this question of recessions and flat yield curves, you can see in this chart that usually to get a recession, we need to have some sort of an inversion in the yield curve, but that isn't always the case. Sometimes we've seen inversions or near inversions, and the economy has steered clear of recessions, such as in the late 1960s, and again in the mid to late ‘80s, and of course, the soft landing in the mid 1990s, and the inversion in 1998 after the LTCM debacle, we see that the economy continued to grow.

The current yield curve environment, basically, a positive slope from 0 to 100 basis points, historically has been followed by a recession one out of five times within a year.

Now that's not much different than the average historical random chance of having a recession in the next year of 16 percent. So the yield curve isn't signaling too much to us right now with respect to recession.

What it may be signaling though is that we're in a mid ‘90s situation; the yield curve may be suggesting we'll see some sort of a mid-cycle growth slowdown in 2007. And if you look at the consensus economic forecast from Blue Chip, or Macroeconomic Advisers, or other economic forecasters, they're looking for GDP growth to decelerate over the next few years. Although current forecasts are not calling for anything much south of 3 percent GDP growth.

If we look at the past ten inversions, we can see a distinct trend that prior to the 1980s most inversions were caused by significant upward spikes in short-term interest rates. And then recently it's been more due to modest declines in long-term rates.

Basically before [Federal Reserve Chairman] Volcker won the war on inflation in the late ‘70s/early ‘80s and then Greenspan successfully kept the peace for 20 years, we saw much wider cyclical swings in inflation. And that's why you also see the corresponding sharp policy response.

But since that time, since the early ‘80s, we've generally had a downward trend in inflation, and a moderation in volatility in inflation, and that's allowed for a less dramatic policy response over the business cycle and less of a role for short-term rates in inversions.

Now I want to turn briefly to the FYI we released earlier this year, and some of the key findings in that. We looked at a lot of different things. But in terms of the banking impact, one of the things that stood out to us is that if you look at large banks with assets over $10 billion, they saw their net interest margins decline with the flattening yield curve, whereas most of the rest of the industry, the smaller institutions, actually saw some continued improvement.

In fact, in 2005, 55 percent of FDIC insured lenders saw their NIMs improve despite the flattening yield curve.

Well, why did the large bank NIMs decline?

Looking at these two charts, we can see that it wasn't so much the yield on earning assets but rather the fact that their cost of funding assets rose much more dramatically than it did for the smaller banks. And, of course, we all know that community banks tend to fund themselves more from core deposits, and a lot of community bankers have been able to lag the Federal Reserve rate increases in terms of the funding costs on their liabilities. The larger banks are funded more through market-based sources, which have responded more readily to the increase in the Federal funds rate.

The longer the flat yield curse persists, of course, the more pressure community banks will be under to raise their deposit rates.

Lastly, this wasn't in the FYI, but we had one of our analysts look at the median NIM for residential mortgage lenders – the FDIC defines these as any bank with 50 percent or more of assets in real estate loans (mortgages and HELOCs, basically), plus MBS.

You can see here how the median [residential mortgage lender] NIM has fluctuated over the last few years with changes in the Fed funds rate on the short end of the yield curve and then shifts in long-term rates through 2003; and then the recent cycle up and down again.

So with that, I want to go ahead and turn things over to Ross Waldrop to give us a little more detail on some of the bank issues.

   
Ross Waldrop: Okay. Thank you, Norm.

To amplify a little bit on some points Norm was making about the dynamics of large bank versus small bank margins.

Basically, because long-term rates have been fairly stable over the past few years, I'll focus just on the funds rate because I think the movement in the short range has been a more defining element for the impacts on bank margins.

The chart you see here, which is kind of a reprise of an earlier one, shows the average funding costs for large banks dipping below the average cost for smaller banks starting in the middle of 2001.

It was interesting at that time because this was a declining rate environment on the short end. Long-term rates were fairly stable. So we were seeing a steepening yield curve and our expectation at that time was to see better margins, particularly in smaller institutions since they generally tend to borrow short and lend long.

What we didn't reckon with right away, although it became clear pretty quickly, was the fact that short-term rates were going down to a 40-year low. While small banks were able to re-price their core deposits downward, more or less in step with the decline in short-term rates for a while, once they got below a certain level, say below 2 percent or thereabouts, it was very difficult for community banks to pass these subsequent rate cuts on to their customers for fear of seeing an outflow of deposits.

So, basically, once the short-term rates got below a certain level and continued declining, the average funding cost on core deposits did not continue to move down, in contrast to the funding costs for the large institutions, which are more closely related to overnight rates, that did continue to go down.

So, we had this very unusual phenomenon that you don't ordinarily see where larger institutions, for a period of a couple of years when short-term rates were at their historic lows, had an actual funding cost advantage over smaller institutions.

I think the strategic hope that small banks had when they were enduring these narrower margins during this period was that they would make it back when rates started to go back up again, and that in fact is what we've seen since the Fed has reversed and started tightening money. We have seen the larger bank costs continue on up. Smaller banks have been able to limit the increase in their funding costs more successfully in a rising rate environment, and this in turn has translated into an improvement in their net interest margin.

You can see in the next chart that the average asset yields for small versus large banks don't have nearly the separation in terms of trend or response to changes in the short-term rate that the funding costs do. There 's never been an intersection there.

So that's one thing we've seen that is fairly interesting. And I think our sense is, from the banks' standpoint, that as long as short-term rates are in a fairly predictable steady motion upward, small institutions can continue to re-price their retail funding upward more slowly than wholesale fund costs, and they should have more success in protecting their margins.

But you can see in the next chart that they have not been able to raise their margins consistently. While they've registered some improvement in their margin from the trough that they hit at the bottom of the short-term rate cycle, there hasn't been any real dramatic improvement. It has been more of a maintaining type of exercise for smaller institutions, but at the same time, we have seen a much more pronounced decline at large institutions.

To reinforce or bring home the point about the function of core deposits in the funding of small versus large institutions, you can see that the relative level is substantially higher for smaller institutions. Although in the case of both size groups of institutions, there has been a downward trend in the relative share of core deposit funding recently, it still remains the predominant source of funding for community banks.

With a flat yield curve, however, there are very limited opportunities to try and go out the maturity spectrum in your assets in order to improve your yield.

An alternative for trying to raise average yields is to go into higher risk assets. We do see a rising trend in the focus on lending to commercial borrowers on the part of smaller institutions; at the same time, we see a trend away from that at larger institutions.

One big factor behind this, I think, has been the successful commodification of major lines of consumer lending, particularly residential mortgage loans, credit card loans, and to a lesser extent HELOCs and other types of credit where large volume, wholesale data-mining operations can achieve significant economies of scale. These have become high volume but relatively lower-spread types of lending activities that are dominated by larger institutions.

Smaller institutions in response are focusing more on the higher spread areas that tend to be the more labor intensive, more heterogeneous types of lending that are less susceptible to commodification and price pressures, which would be your commercial lending.

At the same time, these loans, unlike the commodified loans, do tend to have higher average dollar amounts, and they do represent greater concentrations of credit on a per loan basis. So there is some higher credit risk that institutions are taking on here.

One other way that you see this in a very, very crude fashion, we do assign risk weights to institutions' asset portfolios for purposes of computing their regulatory capital ratios. These risk weights typically don't tell us a lot about interest rate risks, however. They are more couched towards very crude but discreet measures of credit risks, and you can see a decidedly upward trend in the average credit risk weighting for smaller institutions.

There's been an upward trend at larger institutions as well at this time, but I think it is particularly significant for the smaller institutions. I think that's probably one way that in a flat yield curve environment they are trying to improve their yields while holding their funding costs relatively stable.

I think that sums it up for this segment. I want to help move things along since we're a little late starting, but we can certainly handle any questions at the end that might come up today.

Paul?

   
Paul Hudson: Yes. My name is Paul Hudson; I'm with Broadway Federal Bank. And we are a small community bank of about $292 million. We have about $209 million in deposits and about $227 million in loans as of December 2005.

What my presentation is designed to do is show you how small community banks make decisions throughout the year, to manage the interest rate risks and to adapt to a flattening yield curve. It will also show that we've made some mistakes in 2005 and how we are adjusting.

In the first quarter of 2005, in January, we raised three-month and one-year CD rates. We did that because we felt that we wanted to, early in the year, try and attract deposits in a very rate-sensitive environment marketplace like Los Angeles.

We made this move in January, and then the reason we did it is to be competitive to track new deposits and to retain the accounts that we have. We also thought we would go short with our CD rates, with the theory that maybe rates would come down; so we didn't want to lock-in long-term rates.

The result was that—and this is what we found out toward the middle of the year—was that all of our existing three-month to one-year CD customers that maybe were not rate sensitive, automatically rolled to these higher rates that we set on January 22nd.

And we got very few new deposits. Although our deposits were up $13 million, most of that was primarily wholesale deposits, broker deposits that were attracted by our great rates.

What it caused to happen was our cost of deposits went up by about 21 basis points in the quarter. Moving to the next quarter—the FDIC said it right—as a small community bank, we're trying to move to more commercial real estate loans that have higher yields that aren 't as much a commodity product.

So in February, because we saw that our loan portfolio was not growing at the rate we wanted, we purchased about $8 million of commercial real estate loans that were tied to prime with the idea that they would adjust as their interest rates moved up, and we also bought mortgage back [securities]. The reason was we thought prime would move up and that our internal loan production was not meeting targets.

In the first quarter, we didn't really have any growth in loans and our yield on loans only went up 3.8 basis points. If you look at the impact on our primary spread, we actually went down about 17.5 basis points for the first quarter.

So, we still haven't gotten it right. In April of last year, we reduced the passbook rates and that was primarily because we determined our passbook rates were high for our marketplace, and we also reduced the CD rate.

And we had the immediate benefit on our cost of funds and our core deposits of reducing those rates. But, again, we are still in this mindset that we are in this competitive environment and that we had to continue to increase our CD rates to be competitive, or else we will lose deposits and fail to meet our deposit targets for the year.

It was really not until June of the second quarter that we really figured out that increasing CD rates was not bringing in deposits; it was actually just increasing our cost of deposits.

What you can see is that our cost of deposits were up, year-to-date, 226 basis points. But for the quarter, they were up 5 basis points from the first quarter to the second quarter.

And then if we move to the next chart, we continue, in May, to increase our loan rates and that was to increase the yield on the loans. So, you see the effect on our net loans, we were still shrinking our loan portfolio, not intentionally, it was just the marketplace.

The yields on our loans year-to-date were up almost 10 basis points, and our quarter-to-quarter yields on our loans were up 6 basis points.

In the third quarter we'll start seeing the benefit of our decision that we made over the course of the first [quarter]. You see our primary spread is down less than it was the first quarter. The second quarter was down 16 basis points.

If we move to the third quarter, now we're actually starting to say, “Okay, let's reduce our CD rates further.” We created a four-month promotional CD rate so that we can have an attractive rate without increasing the rates across the board on our CDs. So, that was the reason for the four-month CD rate.

And, as you can see, year-to-date, our deposits were up 15 million, our cost of deposits year-to-date were up 31 basis points. And for the quarter, they were up 5 basis points.

And then, if you move to our loans, again, we increased loan rates at September 1, and the yield on our loans year-to-date was up 20 basis points, and for the quarter it was up 10 basis points.

The fourth quarter is where you see the most dramatic impact because it takes awhile for all these decisions to weigh into our overall portfolio. For the third quarter, our primary spread was only down 115 [11.5 basis points]. So you see, we started the year, at first quarter we were down almost 17 basis points. Now the third quarter we were down 11.5 basis points.

We move to the fourth quarter, you can see that we reduced CD rates further on October 25th, and the result was that our quarter-to-quarter cost of deposits was up less than 1 basis point. For the fourth quarter—now we knew this was going to happen, we just weren't sure when it was going to happen—we knew that our fixed hybrids that we originated in 2002 and 2003 would start rolling to adjustable rates. The bulk of them started rolling in the fourth quarter of 2005. And yield year-to-date on our loans at this point was up almost 41 basis points. And quarter to quarter, we were up 20 basis points.

So, the good news for our primary spread was that by the fourth quarter we had actually increased our primary spread from the first quarter, where we were down 17.5 basis points, to the fourth quarter, where we were up eight basis points.

And the management team meets on a weekly basis to look at interest rates, to look at the flattening yield curve, and to make asset and liability decisions. And as you can see, through the course of the year, we made some mistakes. We adjusted to those mistakes, and it benefited our primary spread over the course of the year.

That's it.

   
Saurabh Narain: Thank you Paul.

David?

   
David Oser: Okay, thank you very much.

May name is David Oser. I'm Senior Vice President at ShoreBank, which is a $1.7 billion community development financial institution. Our headquarters are in Chicago. We have offices in Cleveland and Detroit, as well. And I'm going to talk about my specialty, which is the bond portfolio, and what one can do in the current flat yield curve environment.

I want to start out with this cartoon. I think it's a cartoon that involves a series of misconceptions that we can take into account as we do our investing. The first is the chap with the sign clearly is out of step with the modern world and has been carrying this sign around and making this prediction for quite some time.

The two fellows in the garbage cans who take him very seriously and say, “Well, I think this calls for a little celebration,” have also clearly made a series of bad life decisions.

As we go forward, we want to have some caution in our thinking. But, with that as an initial caveat, there really are some opportunities now that haven't been available to us in the investment world for quite some time.

The first is that the Fed is nearing the end of its current tightening cycle. This was made clear, not only in Chairman Bernanke's testimony to Congress last week but in a number of speeches made by Fed governors. In fact, Jack Winn, who is the President of the Atlanta Fed, just concluded a speech an hour ago in which he had said that policy may be close to being properly calibrated.

So they are all coming out with the same message.

In addition, interest rates are at a four-year high. And particularly at long end, where the ten-year Treasury rates have finally broken above 5 percent after having been in the range of about 3.9 to 4.65 percent for more than three years.

We think the best opportunities for investment are in mortgages, even though 90 percent of existing 30-year mortgages are out of the money for refinancing. That is to say, they have coupons that are lower than current mortgage rates—30-year mortgages are around 6.5 percent.

One would think that as a result, the cash flows coming out of mortgage bank securities would be significantly reduced. And while they are lower than they were the last couple of years, it is the case that the Mortgage Bankers Association Refinance Index, which is the best gauge that we have of the refinancing of mortgages that leads to prepayments, remains above 1,500. That compares to the range of 300 to 400 that it was in for most of 2000, the last time we had a rate spike. And it most dramatically compares to between 100 and 200 where it was in 1994.

So mortgage products are a good place to go that combine high yields and good cash flows.

What you want to watch for, clearly, is in any type of mortgage product that you're looking at, whether it be mortgage-backed securities and sales pools or different types of CMOs, is the underlying mortgage.

We always recommend mortgages where there is a greater likelihood that there will be prepayment. But we look for a high weighted average coupon and a large average mortgage size underneath the product.

In agency CMOs, we suggest buying coupons in a 5.5 to 6 percent range. You can buy these coupons now at a discount, so you're paying 99 cents on the dollar and you're getting back 100 cents on a the dollar fairly quickly.

Whole loan CMOs, which tend to yield higher, contain a higher percentage of IO mortgages, a higher percentage often of investments mortgages. There are some opportunities in whole loan CMOs, but you want to be cautious and avoid any paper that has a large percentage of interest-only mortgages because these can really slow down. And when it comes time to make that full payment, you could have some big surprises in the amount of delinquencies of these securities.

Mortgage-backed pools, you can buy 30-year/6 percent Fannie and Freddie deals. And when I wrote this, at par, it's now even lower, you can buy them in the 99s, you can buy 5.5s below 97 [well below par]. I think there 's really value there.

Callable agencies: This is an unusual opportunity. When interest rates rise, what you really should be doing is taking a part of your portfolio and lengthening it because that's what you've been short for all these years is to get to that point where you can lock in higher yield.

Because of the break of the ten-year above 5 percent, they are now coming on through the secondary market—high coupon discount callables that have coupons over 5.5 percent that you can buy with discounts three, four, and in some cases, even more points. These will give you a high yield, plus the potential for appreciation down the line as interest rates turn around.

In Munis, we really like the Muni [municipal bond] market after not having liked it for much of 2005, where it was very rich. Right now, however, you can tie up ten to 15-year tax-free yields of 4 percent and greater, with call protection; most of these deals are not callable for the first ten years.

The curve in Muni land remains steep versus taxables because there are no international buyers as there are in the Treasury and agency markets and even the corporate markets. And there is always the added benefit in Munis that you can use in-state Munis to collateralize a lot of your public funds deposits. That's a real added attraction in that market.

At the short end for a yield play, you can now get 6 percent. We would say buy the shortest 6 percent yield you can get, and don't worry about the call feature. Even if it goes underwater, you're going to be staying ahead of Fed funds.

If the Fed really is coming to the end of their cycle, which we think they are, you will, at 6 percent, be ahead of the game. They are printing now five-year
non-call, three-month deals at 6 percent, and you can buy three-year deals at 5.75 or 5 5/8.

For more conservative investors, there's some nice opportunities in discount seven-year balloons and discount ten-year mortgage-backed securities. These can rise in price as interest rates at the short end begin to fall. We do not like hybrid ARMs and new production balloons. We don't think they are a good opportunity for the conservative, short-end investor.

In the funding area, I'm not going to go into this at all in detail, but the point I want to make here is that even for smaller institutions in the $200 million and $300 million range, there are more and more opportunities now to get into reverse repos and swaps of callable wholesale CDs where you can get funding at or below LIBOR.

I'll give you my contact information. You can talk to me more in detail offline or if you want to talk to your own brokers or correspondents. We think there's the ability here to get cheap, market rate funding.

And the last point that we want to make, and I think is really crucial in any type of asset liability management, that it's not just about the balance sheet anymore. No matter how you look at it, no matter how you think about it, no matter what good work you do to improve your margin, a flat curve is bad for banks; hurts our earnings.

So, the focus has to continue to be on increasing fee income and making the control of operating expenses a continuous process, not something you do now and then, not something you focus on at budget time, but something that gets done all the time.

And that concludes my presentation. Thank you.

   
Saurabh Narain: Thank you, David.

So, what is this presentation about? Where are we in the current market? The reason we put together this presentation was to understand not only the market, but also to understand what it is that we can do in a specific sense and what kind of strategies have been used to manage the current market risks.

I like to use the framework that I have presented here on slide 43 as to what is enterprise risk management. Business risks are risks that we are paid to take, and market risks are risks that we are paid to manage, which include interest rate risks.

We talked about credit risks and operational risks, which we are not only paid to manage but are paid to mitigate. What really comes out of these presentations is, there are four major things that we, as an industry, need to think about. There's margin compression, as Paul mentioned in his presentation. Changing the frequency of resetting of interest rates often can result in surprises.

The changes in interest rates in the deposits actually cost the funds sometimes because there's stickiness. But the loan pricing catches up eventually, and if you manage the resetting frequency, then one can lead to desirable results and with higher primary stress.

In this difficult scenario, we've come across institutions, which have actually ended up prepaying expensive broker fees, particularly when the loan growth is limited or when the loan growth is limited in the higher stress scenario.

Management of the bond portfolio, as David has pointed out, is critical because a lot of people in our industry have substantial investment portfolios. I've seen institutions that have 30, 40, 50 percent of their total assets in investments. And if you are not managing the mark-to-market on that, or if these assets are not held to maturity, then there can be substantial surprises arising out of a steepening yield curve eventually.

In the short end, one would be stuck with lower margins because there are bonds which are collateralizing some of the municipal deposits or if there are bonds which are being held pending disbursement.

As David rightly pointed out, one of the key things that we need to think about for ourselves is a way in which we can increase non-interest income. That has got be the key in a tough interest rate environment, which we believe would be there in the next several years. Whether it's through fees, whether it's through remittances, or other non-credit related activities—so there's credit card business, mortgage servicing rights—it is imperative to increase non-interest income and actually reduce operating costs.

The second level of risk that we need to think about is liquidity risk itself. As we look at maturing liabilities, one has to be very aware of what's happening in the market with brokers fees. We already talked about that, but several institutions in our industry have got up-and-coming maturities for trust preferred securities, and they've been very lured in by declining interest rates spreads in the trust preferred securities market.

One has to monitor this thing. There's a significant bunching of trust preferred securities coming up in the next month or so, which could lead to an increase in rates there as well.

A number of institutions have started securitizing and selling some of their assets in the market to create liquidity because liquidity can be a huge issue. Sometimes people would say that, in the market, liquidity is always available at a low price. Often times, that price may not be that favorable.

The third key risk is the risk of credit losses in the portfolio. As Paul, David, and Norm talked about, the situation here in the market, one would realize that interest rate risk very quickly converts into credit risks.

Very often, we are confident that we have our assets and liabilities matched in terms of maturities and re-pricing. What one has done effectively is we've passed on that risk to the consumers. Now, if for whatever reason, rates increase quite dramatically, some of these guys would not be able to give out the loans. Therefore, one can expect substantial delinquencies in the future, which is one reason why we believe at this point one has to be cautious with respect to hybrid ARMs, option ARMs, a number of ARM structures that have been floating around in the market just now, or even high LTV loans in an environment where the housing market has actually inflated quite a bit.

It is incredibly important for us to stress test the loan portfolio for some of these delinquencies and to analyze the ability of borrowers to absorb higher interest rates and higher commodity prices. The price of oil is going up, which can lead to decline in disposable incomes and therefore the ability to pay back debt.

And the last risk is business risk, which we are supposed to take. But, one has to be cognizant about the fact that we've got systemic risk in the market. And, as FDIC has also come out with guidelines on maintaining and/or managing the commercial real estate concentrations—one has to continue to monitor this thing because nobody really wants to see the S &L crisis coming back.

Nobody expects that crisis just now, but one has to be actively monitoring the portfolio on a regular basis.

I wanted to make one last comment before we open it up for questions and say that risk management to us is a function for the chief executive of the bank to increase shareholder value. If you don't have losses, it means that we may not be taking enough risks. On the other hand, if you take too much risk, we can have substantial losses, which are unanticipated. We are in the business of taking risks, managing it within well-defined limits and not betting the bank, and constantly transforming ourselves, as Paul has rightly pointed out, in line with changes in market conditions.

There are several tools available to identify, measure, and manage risks. Depending on the level of complexity of the balance sheet, one can go in from static gap analysis, simulation analysis, and then go on to talk about present values and market economic value, equity analysis.

What is more important for us as managers of the portfolio is to actually use the numbers that comes out of these analysis.

I want to stop our formal presentations here and open it up for questions. Like I said earlier, these presentations will be on the Website, but you can ask some questions now, and you can email us your questions in the future as well.

If there are any questions, we'd be happy to take those questions now.

   
Coordinator: Thank you.

Okay, we are ready for the question and answer portion of the conference. If you would like to ask a question, please press star-1. You will be prompted to record your first and last name. To withdraw your request, press star-2.

Our first question comes from Dana Kohl.

Your line is open.

   
Dana Kohl: I'm sorry, that request was done at the beginning to ask Mr. Saurabh to speak up. Sorry.
   
Coordinator: Our next question comes from Lloyd Weeks.

Your line is open.

   
Lloyd Weeks: Given that we have the flattening of the yield curve and all the news is saying that everything's going to be tightening, history has shown over the last 25 years that approximately seven to nine months after the flattening, rates start to drop.

The question I have is what is the panel's opinion of that in terms of when can we expect the rates to start to move downward in the next nine months or so?

   
Saurabh Narain: That's right. Let me take the question first, and I'll open it up for the rest of the panelists.
   
Lloyd Weeks: Okay.
   
Saurabh Narain: The way I think about our business is that we should be taking positions out of an investment portfolio. As far as the loans are concerned, one should be making sure that net interest margin is protected in a rising or declining interest rate environment.

So, one, I would make sure that the balance sheet is matched. I really wouldn't know whether rates would go up or down. At this point in time, it seems that rates are likely to continue to go up, particularly with the twin deficits. But, who knows in the future?

My thought is that we should manage the core balance sheet on a matched basis and then take some risks in the investment portfolio.

I'll open it up for the other panelists to answer.

   
David Oser: This is David Oser.

We take a fairly, I would say, radical position in that we do everything we can to avoid predicting interest rates. I don't believe that anybody can predict interest rates consistently and accurately over time.

So what we look for, particularly in the bond markets, is, where is there value at the present time? We do not know what rates will do in the future. We can't manage based on what or might not happen because if we try to do that, most of the time, we 're going to be wrong.

We might get the direction wrong; we might get the timing wrong. It's not going to be to our benefit to try to do that. What we want to do is look for value and take value when and where we find it.

   
Norm Williams: This is Norm. I would just state that the policy position for the FDIC is that we don't typically comment on our sister regulator's monetary policy. But I would back up David's assessment; it's a very hard call.
   
Saurabh Narain: Other questions?
   
Coordinator: Once again, to ask a question, please press star-1.

One moment.

Our next question comes from Andrew Lobert.

Your line is open.

   
Andrew Lobert: Thank you.

How do you balance where you've got mortgages lent out with the fact that you might have some shorter-term investments capitalizing the pool that you used to make those loans? Are there some strategies that you might recommend where you can balance the two so you don't have a long-term capital crisis or a shortfall?

   
Saurabh Narain: David, do you want to take the question?
   
David Oser: Yes.

The essence of risk management is to try to look at your entire balance sheet and not to say “We've got some mortgages that in our view that are funded by, let's say, three-month CDs. ”

Money is fungible. So you really want to take both sides of the balance sheet and look at where you are with long-term assets versus your overall liability posture.

So if you're in a position where you've got a lot of, overall, 30-year mortgages and your deposits are really short overall, you may say, “Well, we want to sell some of those mortgages.” You may say, “We want to have a deposit campaign where we pay a premium rate in order to get longer term CDs and balance our position in that way. ” But you really want to take a holistic view of it.

It's such a big question that it's very difficult to give anybody a pinpoint answer.

   
Saurabh Narain: I would agree with that. I think managing the assets and liabilities both from a duration perspective, as well as from an interest rate perspective, one has to take a holistic picture of the portfolio both on the loan side and on the investment side.

And then one could take appropriate action, lend to maturity of the deposits, short maturity of loans, whatever. So whatever may be appropriate, rather than trying to match specific assets and liabilities.

Paul, would you agree with that?

   
Paul Hudson: Yes.
   
Andrew Lobert: Thank you.
   
Saurabh Narain: Okay. Are there any other questions?
   
Coordinator: Yes.

We have our next question coming from Sean Doherty.

Your line is open.

   
Sean Doherty: I just wanted to ask, how can we download this? It doesn't look like it's available from the Website. Is there a way we can do that?
   
Saurabh Narain: Sean, it will be available soon after this presentation on our Websites, the NCIF Website, as well as the other Websites. FDIC might also post it, and we can email it to you too.
   
Sean Doherty: That's tremendous. Thank you.
   
Norm Williams: It will also be on the FDIC Website.
   
Sean Doherty: Very good.
   
Saurabh Narain: And Paul and David may also have it on their Websites.
   
Sean Doherty: Thank you very much.
   
Saurabh Narain: Okay.

And we can email it out to you specifically if you want. We have your email addresses.

   
David Oser: And I would urge anybody to call or email me personally if you have questions or want to go into any of this stuff in greater detail.
   
Saurabh Narain: Okay.

And the purpose again, I want to highlight. What we are trying to do is to stay away as much as possible from just pure discussion on theory and look at a practitioner perspective here, which is why Paul has been very kind to talk about some of the issues that he faced over the last 12 months or so and how he responded to those issues. And certainly David is talking about how one would strategically manage in this current scenario.

So it's much more a practitioner perspective that we're adopting here.

Other questions?

   
Coordinator: At this time, we have no further questions.

Sorry, we do.

Jim Clark, your line is open.

   
Jim Clark: Good afternoon.

Is there any way of knowing—and this is a mortgage-specific question and I'm not so sure anybody knows the exact answer, although it would be helpful— exactly what percentage of mortgages that originated in, say, the last X number of years, say, five years, that are interest-only, and how does that show up in the risk reporting of the loan originator?

   
Saurabh Narain: Norm, would you want to take that on?
   
Norm Williams: Yes. We look at data from Loan Performance and our estimates indicate that in the last few years, maybe 40 to 50 percent of the combined alt-A and B&C [subprime] was IO plus pay-option ARMs.

There's another good study out there by First American Real Estate Solutions who recently acquired Loan Performance by a gentleman named Cagan who directs their research service and he's also looked at the vulnerability of rate shock or rate reset. His calculations focused in on the 2004 and 2005 ARM book as being the most vulnerable.

In particular, he cited that low teaser rate mortgages and above market rate ARMs—which would suggest they're either loans to investors or
sub-prime borrowers—are a fairly significant chunk of mortgage originations, close to a fifth based on data from the Federal Reserve as of the end of last year.

But by the time you whittle down and actually look at your expected net losses, you're talking a much lower 1 percent or so in terms of net losses on mortgages outstanding.

So we have that study; we're happy to pass that along. That is a public study. If you want to send me an email for that First American Real Estate Solutions study, I can send that along.

   
Saurabh Narain: Thank you, Norm.

I think that'll be a very useful study to actually share among the participants, so maybe we'll share it around with everybody here, particularly if it gives that description of different asset classes.

Are there any questions?

   
Coordinator: We have no further questions.
   
Saurabh Narain: Well, we started a little late, but we caught up a little bit. I do want to thank everybody here for taking the time out for this presentation, and I do hope that you found it useful.

If there are no further questions, and you can also send questions specifically to the presenters, and we will respond to you as soon as possible.

Like I said, we will have the presentations posted on the Websites. We will also be looking for some feedback as to what future topics you would like to see.

There's a discussion on commercial real estate concentrations and we are contemplating putting on a similar Webinar on commercial real estate concentrations. We'd be interested in the feedback on the format, as well as the content that you'd like to see from NCIF and FDIC and other people in the industry.

I want to thank the presenters and our co-host, FDIC, Norm Williams, Ross Waldrop, Paul Hudson, David Oser. And I look forward to being in touch.

Thank you.

   
Man: Thank you.
   
Saurabh Narain: Julie?
   
Coordinator: Thank you.

One moment.

This does conclude today's presentation. Please disconnect.



Last Updated 05/15/2006 communications@fdic.gov