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Getting Past the "D" Word to Better Manage Balance Sheet Risk
By Jeff Reynolds, Managing Director, Darling Consulting Group, Inc.
When I first left the field of audit and started with Darling Consulting Group back in 1996, I was amazed at how little I really knew about managing balance sheet risk. As I grew into the job, I was fascinated by how some banks used off-balance-sheet contracts to manage risk and how some just couldn’t get past the “D” (derivative) word and take advantage of hedging instruments to complement their organic business model.
Roll the clock forward 10 years. A lot has changed, including the fear of the “D” word. Thanks to the good intentions of the folks at FASB to simplify derivatives accounting (boy did they miss it on that one), SFAS 133 and 138 are turning more and more community financial institutions away from using hedge instruments at a time when, quite frankly, many need to get some financial options working in their favor.
One such option is the power of an interest-rate floor, which is nothing more than an insurance policy against falling interest rates. This article provides a brief overview of how interest-rate floors work, why they make sense for asset-sensitive institutions, and how wholesale funding providers, such as the Federal Home Loan Bank of Seattle, have been working the economic power of interest-rate floors into floating-rate funding structures that enable their customers to avoid derivatives accounting issues and get past the “D” word.
Think of it as an insurance policy.
The economics behind an interest-rate floor are pretty simple. It really behaves much like an insurance policy. If your balance sheet structure exposes your earnings to falling rates (e.g., you are asset sensitive), you can insure against that risk with a floor. As such, you choose:
- The length of coverage, or term, in years
- The deductible you are willing to live with before the insurance kicks in. This is called the strike—a predetermined rate level, which LIBOR (or other rate index) must push through before the insurer starts paying you.
The pricing of the insurance is determined by the market’s perception of the risk. Back in June 2006, a five-year floor on LIBOR at 5.25% would have cost 185 basis points (i.e., the insurance premium). That cost is amortized over the life of the contract.
The benefit of a hedge with a floor is that it protects against a drop in rates, but does not disrupt the potential benefit if rates rise. The most one could ever lose on a floor is the premium paid. If I am hedging, I hope that I never collect on the insurance policy. I think of it this way: I send in a check every month on a life insurance policy that I hope I (well, my wife) will never collect on. The same should be true with a hedge. Buy only the insurance you need, and don’t speculate on the timing of the purchase because odds are you will not have the insurance when you need it and the cost will be outrageously high when you do.
Hedge costs have gone up, but don’t sit idle.
Today, given the clear pause by the Fed and evident economic slowdown, that same floor outlined above would cost 347 basis points. As the saying goes, the worst time to buy fire insurance is when the fire truck sits in the driveway! Conversely, if floors become cheap, happy times are here again for asset-sensitive institutions. While the cost of the floor is a drag, the additional earnings thrown off by the rest of the balance sheet will dwarf the money spent on the floor.
Is it too late to hedge falling rates? If an institution were to look at buying that floor today, it might find the insurance package to be cost prohibitive. That is not to say they shouldn’t still look at floors. Depending on the institution’s profile, it might lessen the cost by shortening the term and/or increasing the deductible by lowering the strike to 5.00%. Regardless of cost, the risk of living with a pronounced exposure of earnings to changes in rates (up or down) is not something a community financial institution that lives off margin should do.
Floors without the headaches
Most financial institution managers that I talk to don’t sweat what a regulator might say about a prudently used hedge contract such as a floor, cap, or swap. In fact, many think their regulator will love the fact that they take earnings risk seriously and are actually hedging. The problem comes down to the uncertainty of accounting for a hedge contract.
There are some very legitimate accounting concerns and some very real examples to justify those concerns. In days of yore, that insurance premium paid up front would simply be amortized over the life of the insurance contract. The contract value would be zero at maturity, regardless of whether it was collected on or not. Post SFAS#133, that straight-line amortization may not happen if the hedge is not clearly documented and properly accounted for.
Enter the Seattle Bank. Shorter-term funding is advisable for asset-sensitive institutions. By paying for the floor in the form of a spread over the floating advance rate, you can get the power of a floor embedded in funding and working in your favor.
Example
Let’s say that the financial institution I have referenced thoughout this article has a pronounced exposure to falling rates and has executed a floored funding strategy through the Seattle Bank. The institution used floating-rate funding to purchase fixed-rate MBS (20-year, yielding 5.90%). While this mismatched leverage position (long assets funded short) helped reduce asset sensitivity and produced a positive spread, the instition added the 5.25% LIBOR strike and five-year floor to the funding.
If rates fall, the advance reprices down. basis point for basis point. with the drop in LIBOR. If LIBOR crosses the 5.25% threshold, the cost of the funding drops two basis points for every basis drop in LIBOR.
The net effect of the transaction: The institution booked $25 million of assets at 5.90%, funded with floating-rate funding at LIBOR + 50 basis points (5.85%). I know what you are thinking: awful skinny (5 basis points) spread for $25 million of leverage. But remember, this was about reducing risk to future earnings. This equated to a $50 million reduction in the institution’s asset-sensitive profile (the power of the $25 mismatch leverage and a $25 million floor). Reference the impact on the position as shown in the charts below.
Conclusion
Hindsight is always 20/20. As I write this article, 20-year MBS yields have slipped from 5.90% to 5.40%, and the cost of the floor is through the roof. The strategy, in hindsight, looks like a home run.
If we were to do a similar transaction today (and we are), the floor might be shorter with a lower strike. We might consider aggressively priced loans in lieu of MBS. What we won’t do is sit idle. We will continue to look for ways to prudently reduce earnings exposure. One can never predict with certainty which way rates will move, when, and by how much. If you have risk, look for alternatives to reduce it and carefully weigh the risk/return trade-offs.
Are you exposed to falling rates? If so, funding with an embedded floor may be a good fit for your balance sheet.
Jeff Reynolds is Managing Director at Darling Consulting Group, Inc.
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