Balance Sheet Strategies Beating the Curve

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Balance Sheet Strategies Beating the Curve
Don Ullmann Senior Vice President Financial
Strategies Group Keefe, Bruyette Woods, Inc.
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Key Topics

• The yield curveexperts cant predict it
  mathematics cant predict it.
• Do you want to base your ALCO decisions on your
  predictions?
• The investment portfolio is a considerable part
  of your balance sheet.
• Consider your security selections carefully.
• During a Fed tightening, funding decisions become
  increasingly important.
• In a difficult market environment, have the
  courage to stay the course.
• You will ultimately be rewarded for it.

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The Yield Curve Bear Flattening From the Front
End
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Market Expectation for Short Term Rates in March
02
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What Do Forward Rates Really Tell Us?

• Necessary for proper valuation of embedded
  options.
• NOTE forwards affect all models, including
  prepayments.
• Steepness also reflects many other
  factorsrisk/reward and demand for funds.
• Historically, forwards have rarely been good
  predictor of rates.
• Therefore, be aware of bets you are taking vs.
  forward curve.

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Fed Funds History Future???
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Is the Worst Behind Us?
Note NIM is based on the top 50 banks ranked by
market capitalization. NIM is calculated as FTE
net interest income divided by average earning
assets. Excludes C, JPM, and BAC. Source SNL
DataSource and KBW Research.

• Competitive pressures and a flattening yield
  curve have hurt margins
• Rising rates may be helping offset pressure at
  core deposit-funded banks
• Significant earning asset growth should be hard
  to fund this year without margin pressure

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Positioning the Balance SheetWhat Does Your
Balance Sheet Give You?

• Is your institution capital constrained? Do you
  hold unencumbered collateral?
• How deep is your deposit base? Do you have
  pricing flexibility?
• Are you asset sensitive or liability sensitive?
• What is the current composition of your net
  interest margin?

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Lets Look at the Portfolio

• What percent of earnings assets does it dominate?
  20
• How reliance on investment income as a source of
  core earnings? 15
• What risks are being taken?
• How is it funded?
• What are the capital constraints?
• What is the asset allocation Liquidity vs. Core
  holdings?
• What is the investment philosophy? Active vs.
  Passive?

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• The role of the investment portfolio will depend
  on
• The percentage of earning assets that it
  dominates
• 23 of earning assets as of 2Q05, down from 25.5
  in 2Q04
• Its impact on the interest rate risk profile
• NIIHow is it funded?
• MVPEWhat mismatch is being taken?
• CashflowAre there reinvestment opportunities?
• The reliance on investment income as a source of
  core earnings
• 17 of interest income for 2Q05, down from 19 in
  2Q04

• SOURCE SNL Data for Public Institutions
  between 500mm - 10b in total assets

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Representative Bank Portfolio

• Performance
• Yield (non FTE) 4.15
• Avg. Life 3.7 years
• Duration 3.1 years
• Price Vol. 200bps 3.6 years
• Composition
• U.S. Govt/Agency 29.0
• Mortgages 57.0
• Municipals 8.8
• Corporates 5.1
• Cash Flow (two years)
• Flat 33.5
• 300bps 27.3
• -100bps 49.6

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Portfolio Summary
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Market Volatility
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Cashflow
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Driving Factors behind Portfolio
Sec. Holdings lt AVG
Sec. Holdings gt AVG

• Intermediate/Short Duration
• Not as reliant on portfolio
• Can layer in more cashflow with yield

• Longer Duration
• Need for earnings
• Risk profile lets you reach for earnings

Asset Sensitive

• Intermediate/Short Duration
• Limit Extension Risk
• Delicate balance between cashflow/earnings/risk

• Short Duration
• Strong cashflow

Liability Sensitive
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Spread Product has Outperformed, Positive
Contribution to AFS
Valuations have benefited by spread tightening
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MBS IssuanceARM Share
Total ARMs Issuance for the FY-05 estimate
represents a 47 of total MBS Issuance and is an
8 increase over FY-04.
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ARM IssuanceNot Primarily a Curve Phenomenon
Hybrids Maintain 50 Origination Volume of Total
Mortgage Market
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Leverage Goes From the Sublime to the Ridiculous
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Conditions for Delevering

• High cost liabilities pressuring net interest
  margin
• Offsetting asset gains available
• Net interest margin improvement opportunity
  greater than alternatives
• Can achieve risk reduction in borrowings
• Ability to take losses vs. give-up in earnings

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Where has the activity been?

• Portfolio Cash flow has decreased significantly.
  
• Loan demand has been good
• Investments have been concentrated on the short
  end of the curve.
• - 4.75-5.25 with limited extension
• Portfolio management has been balance sheet and
  interest rate risk driven
• Improve cash flow
• Enhance earnings profile of portfolio
• Reduce market volatility and extension risk
• 4) Seeing a flurry of year end balance
  sheet restructurings
• - FNB, BANR, FCF, CBH, FCTR

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Recent Examples

• First Midwest Bancorp, FMBI
• Announced 200mm delevering on 12/22/05 (approx.
  9 of securities a/o 9/30)
• 6.4million loss, or 9 cents/share.
• Stock day prior at 36.51 stock day after at
  36.21
• Comment These securities sales represent
  important steps to better position ourselves for
  current and expected market conditions, said
  John OMeara, President and CEO. While this
  action should reduce 2005 performance by 0.09
  per diluted share, it should help maintain
  margins prospectively. (FMBI press release)
• Banner Corp., BANR
• Announced 200mm delevering on 12/05/05
  (approximately 41 of securities a/o 9/30)
• 8.9million loss, or .74 per share
• Stock day prior at 32.33 stock day after at
  32.40
• Comment By strengthening our earnings from
  core business areas, we have been able to place
  less emphasis on the use of wholesale assets and
  liabilities and now can accelerate this trend
  through these restructuring(s). we anticipate
  future benefits will include an expanded net
  interest margin, an improved interest rate risk
  position, stronger performance metrics, increased
  profitability, and enhanced shareholder value,
  said D.Michael Jones, President and CEO. (BANR
  press release)

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Funding

• Wholesale Funding comprised 21 of Interest
  Bearing Liabilities in 2Q05
• But this accounted for over 30 of Interest
  Expense
• Competition for deposits has been fierce
• There continue to be prepayment of FHLB Advances
  at losses, reducing short term funding
• With flat swap curve, little benefit to swapping
  fixed gt floating
• Seeing more creative funding structures

SOURCE SNL Data for Public Institutions
between 500mm - 10b in total assets
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Structured Repo - Overview

• Term and Structured Repo provide an alternative
  source of funding
• With Structured Repo, borrowers can create a
  funding structure that fits their overall balance
  sheet, economic outlook, and funding needs
• By selling optionality, borrowers can reduce
  their funding cost while quantifying the risk
• With the advent of FAS 133, structured repo lets
  borrowers achieve similar results without
  directly accessing the derivatives market.
• Structured Repo
• Floating to Fixed Alternatives
• Embedded Floors (Caps)
• Fixed Rate Callable
• For the sake of this discussion, we will use the
  term callable to denote the counterparty having
  the option to call the funding from the borrower.
  

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Structured Repo - Fixed Rate

• Structure
• Fixed rate during entire period with counterparty
  having the option to call the structure at
  various points in time. Rate is determined by
• Maturity
• Call date and frequency
• Benefit
• Locks in fixed rate funding to call, and possibly
  maturity depending on market conditions. Whether
  to the call, or maturity, rate is typically less
  than bullet structures to comparable maturities.
  
• Example
• 5 year non-call 2 year
• 25mm minimum
• Year 1-2 Rate fixed at 4.25.
• Years 3-5 Counterparty can call the funding
  after initial 2 years. If not called, the
  borrowing is callable quarterly until maturity
  (one-time calls are also available)
• As a reference
• 2 yr fixed bullet repo 4.84
• 5 yr fixed bullet repo 4.94

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Structured Repo - Floating gt Fixed

• Structure
• Initial period resets quarterly off floating rate
  index, typically 3 month Libor, LESS a spread.
  Spread is determined by a combination of factors
• Maturity of borrowing
• First call date, and subsequent call frequency
• Fixed rate the borrowing converts to at first
  call, OR, sub-libor spread during the initial
  floating period
• Benefit
• By adjusting the above terms, borrower can create
  a funding structure that fits their balance
  sheet, interest rate risk profile, and economic
  outlook
• Example
• 5 year non-call 1 year
• 25mm minimum
• Year 1 Borrower pays 3mL 124bps. Quarterly
  resets.
• Years 2-5 At beginning of year 2, rate converts
  to 4.50 fixed rate. Counterparty can call the
  funding at this point, or quarterly until
  maturity. (one-time calls are also available)
• If called, the borrower has benefited having
  sub-libor funding for 1 yr
• If not called, the average funding cost over the
  5 yr period would be 3.90
• To highlight how adjusting the fixed rate coupon
  can impact the spread to 3mL, see below table

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Structured Repo - Floating gt Fixed
1 yr repo rate adjusted for forward rates in year
2
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Key Take-Aways

• Todays flat yield curve is unprecedented, and it
  may or may not continue.
• Portfolio considerations become even more
  important in an environment offering little
  incremental yield on the curve or from spread.
• Creativity on the funding side may provide more
  value to the bottom line that reaching on the
  investment portfolio side.
• Integrity of the ALCO process is critical to
  performance.

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Financial Strategies Methodology
(2) FUNDING REVIEW
(1) PORTFOLIO REVIEW

• Product composition and characteristics
• Sector analysis
• Gain / Loss
• Yield analysis
• Volatility Analysis
• Price - Average life Duration
• Cashflow forecasting

• Term Structure Analysis
• Bullet
• Callable
• Floating
• Implicit value
• Market Value

(4) STRATEGIES

• Portfolio Restructurings
• Reposition risk / duration
• Enhance Earnings
• Improve Efficiency
• Wholesale Earnings
• Alternative use of capital
• Excess capital
• Cost of capital
• Risk/Reward strategies

(3) BALANCE SHEET IMPACT

• General risk profile
• Balance Sheet
• Income Statement
• Review of combined profile
• Assessing restructuring impact

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• Disclaimer
• This communication is not an offer to sell or a
  solicitation to buy the securities mentioned. The
  information relating to any company herein is
  derived from publicly available sources and
  Keefe, Bruyette Woods, Inc. makes no
  representation as to the accuracy or completeness
  of such information. KBW, its officers,
  directors, and employees may from time to time
  own the securities mentioned.