1 West Virginia Bankers Association Annual Convention White Sulphur Springs, WV July 25th, 2016Ryan Hayhurst | Managing Director The Baker Group LP | Financial Strategies Group Phone: | |

2 Economic Conditions & Fed Policy 3rd Quarter 2016The US Economy: 2 Steps Forward, 1 Step Back 1Q16 = 1.1% 4Q15 = 1.4% 3Q15 = 2.0% 2Q15 = 3.9% Year over Year = 2.1% Job Growth Starting To Deteriorate Average Payrolls Growth: 12mo 204k, 6mo 172K, 3mo 147k, 1mo 287k 4.9% Unemployment Rate Anemic Wage Growth Brexit Adds To Global Weakness Brexit causing volatility and raises risk of yet another Euro recession Japan can’t seem to stay out of recession China struggling to transition to consumer based economy Emerging markets on the brink Federal Reserve Brexit has significantly reduced risk of another hike in 2016 Odds of a rate hike in 2016 now 30%

3 Sovereign Curve Comparison U. SSovereign Curve Comparison U.S. (purple), Japan (red), Germany (blue) and Switzerland (green) While many U.S. investors consider our yields to be exceptionally low, the reality is that U.S. yields are the highest in the industrialized world. US 10yr = 1.49% Japan 10yr = -.29% German 10yr = -0.10% Swiss 10yr = -0.46%

4 The World Is Drowning In Negative Yields

5 Yield Curve Has Flattened With a Twist Since 2013“Twist Point” = 3 Years

6 FOMC “Dot Plot” vs. Fed Funds FuturesThe FOMC and the market differing views on the future path of Fed Funds. The FOMC want 1 or 2 more hikes this year while the market believes we will get that many hikes over the next 2-1/2 years.

7 Earnings at Risk & EVE: Risk Distribution & Trends Banks Processed on The Baker Group’s Interest Rate Risk Monitor as of 2Q16 (528)

8 July 2016 OCC Semiannual Risk Perspective: Interest Rate RiskInvestment Security Selection “The ongoing low interest rate environment poses interest rate risk as some banks may reach for yield by extending asset duration. Also, the stability of deposit inflows since the recession is difficult for banks to assess and there is a potential for increased competition for retail deposits as interest rates rise.” “Evaluating the banks’ interest rate risk measurement processes to ensure that banks properly assess vulnerability to changes in interest rates and implements measurement tools to monitor and control this risk. This includes the ability to accurately identify and quantify interest rate risk, with an emphasis on funding pressure that may arise with deposits.” NMD Stress Tests / Migration Simulation Dynamic Liquidity Model: Sources and Uses

9 Regulatory Meetings: FDIC, OCC, FedRecourse when misinterpretation/misapplication of guidance is suspected. Each agency has a protocol usually involving: 1- Examiner in Charge 2- Regional Director’s office (District Cap. Markets Lead Examiner) 3- National “Ombudsman” Independent Review of Processes – Annually Model (Software) Validation – Periodically OCC recommends that policy verbiage include reference to “model validation process” “The Bank will ensure that their model provider, Baker Group Software Solutions, Inc.” secures an audit of the mathematics, code, and methodology of the IRRM anytime material changes have been made, and every 36mos if no change has been made” NMD Analysis – Institution-Specific They like what we’re doing… establish a base-case supported by institution-specific data, then stress test periodically (annually) Beta / Time Lags Average Lives Migration Simulation Muni Credit Analysis – They love this… provide data, reports, and tools, but bank management is responsible for actual assessment of credits / creditworthiness. We do not grade or offer specific opinions on credits. Liquidity Risk – Good timing on DSU… but examiners will also focus on the contingency funding plan / Stress events beyond just cash flow dynamics. Consider bank-specific event risk (unexpected loss of large depositor, bad press, risk of “run on the bank”) All Good… must be stress-tested but not every quarter

10 Estimating NMD Betas Using Call Report Data

11 Example Open-Close Study to Estimate NMD Average LivesTracks account open date and closed date to determine an actual average life for accounts (MMDA, NOW, Savings, etc.) Query core processor for open accounts and any recently closed accounts Results will often demonstrate very long average lives (8-12yrs)

12 NMD as a % of Total Funding Has Surged With Low RatesThe average community bank has seen total funding from Non-Maturity Deposits surge from 36% in 2008 to nearly 60% today. The long-term average is 42%. Would you still do better in a rising rate environment if 18% of Total Assets shifted from NMD to CD’s? Every institution should understand the impact of NMD funding reverting to the mean.

13 Sensitivity Testing: Non-Maturity Deposits Whatever Baseline Assumptions You Use, Stress Test Them“Institutions should incorporate “stressed” assumptions for non-maturity deposits in IRR models” …FDIC Three Ways to Stress NMD Assumptions (Sensitivity Tests) Ratchet up pricing betas (shift sensitivities) and reduce time lags in order to mimic an aggressively competitive environment for NMD Reduce Average Life (and Duration) Assumptions in order to assess the EVE impact of lower duration liabilities Simulate a “migration” of NMD balances into more rate sensitive funding (time deposits or wholesale funding)… considered to be the most realistic depiction of what may happen in the next rate cycle Demographics Access to information

14 Baker NMD Surge Balance Analysis Can be easily generated for any bank - call to requestThis institution got 68% of total funding from NMD in 4Q2014 vs. a 25yr average of just 53%. If rates rise and NMD funding reverts to the long-term average, this institution will have to replace funding for 15% of assets from CDs, Fed Funds or Borrowings. Simulating the impact of this deposit migration is critical to managing IRR in the next rate cycle.

15 NMD Migration Case StudyThis institution decided to simulate the impact of NMD funding returning to the 25 year average They ran two simulations showing 15% of total assets migrating out of NMD and into higher cost, more rate sensitive liabilities For Earnings at Risk simulation, migration occurred over 12 months. For EVE simulation, migration occurred immediately. Simulation # 1 All funds into overnight borrowings at 0.50% Simulation # 2 45% into FHLB 1yr 0.75% 33% into FHLB 2yr 1.00% 22% into FHLB 3yr 1.20%

16 NMD Migration Case Study: Earnings at Risk ImpactSimulation # 1 (Overnight Borrowings) Simulation # 2 (FHLB Laddered Funding)

17 Liquidity Risk Management: Then and Now2016 Source: FDIC

18 Complying with Regulatory Expectations for LiquidityInvestment Price Risk Limits Sources & Uses Reporting Stress Testing Contingency Funding Plans Cushion of Highly Liquid, Unencumbered Assets High grade credit quality Easily converted into cash – marketable US Government, Agency (including MBS), or high-grade municipals Stable and predictable cash flows Security selection is critical Beware of too much negative convexity (options risk)

19 Projected Cashflow Volatility Comparison: Callables vs MBSCallable Agency Focus May 2013 MBS/CMO Focus May 2013 Callable Agency Focus June 2013 MBS/CMO Focus June 2013

20

21 Stress: Rates +200bp, 5% new deposits, 10% NMD runoff, 10% new loans, 90% CD/Loan renewalSchool Deposits Large Deposit Outflow Investment cash flows drop, callables and MBS extend

22 Interest Rate Risk & ALCO Checklist A pre-exam checklist for management reviewDirector Education Ensure directors have a basic understanding of IRR and the bank’s ALCO processes Provide directors with access to educational resources on interest rate risk Board minutes should reflect director participation in IRR discussions Regular (Quarterly) ALCO Meetings to Review & Discuss Reports ALCO minutes should reflect a demonstration of sound processes that quantify risk to earnings & capital Regular (Quarterly) Standard & Non-Standard Stress Tests -100bp, +100bp, +200bp, +300bp, +400bp, Non-Parallel (e.g. +400bp/+100bp Bear Flattener) Ramped Rate Shifts & Immediate Rate Shocks 12 & 24 Month Horizons Earnings at Risk & Economic Value of Equity Annual Validation Obtain most recent Validation Letter for Model (validates the “math” of the model) Back-Test your reports over a 12 month period (validates the results) Independent Review of ALCO Process (validates the process) Annual Assumptions Review Use Back-Test to determine if assumptions are generally reasonable Periodically perform analysis to ensure assumptions reflect institution’s profile and activities (e.g. Loan Prepayments, NMD Sensitivities, Open-Close Study, Decay Analysis, Surge Balances, etc.) Annual Sensitivity Testing (aka, “assumptions stress test” – e.g. increase NMD betas, shorten NMD average lives by 50%, run a migration simulation from NMD to CD’s, etc.) Annual Review of Investment & ALCO Policies

23 June 2016 Portfolio SummaryAll Bank Portfolios on Baker Bond Accounting (BBA) Avg. Book Yield = 2.70% Avg. Life = 3.8 years +300bps AvgLife = 5.8 yrs +300bps Price Risk = 9.89%

24

25 The Interest Rate Cycle and Investment StrategiesTrough Rising Peak Falling Reduce duration Transition duration to neutral Extend duration Premiums and/or higher coupons Transition from higher to lower coupons Discounts and/or lower coupons Roll up in coupon Roll down in coupon Buy negative convexity Reduce negative convexity High cashflow bonds Lockouts Buy ARMs & floaters Sell ARMs & floaters Current pay CMBS Lockout CMBS Prepay protection important Prepay protection less important Prepay protection more important Prepay protection critical 1X Callable Agencies Continuous calls outperform Bullet agencies or callables with call protection Cushion callables Discount callables

26 Pension Problems Continue to Make HeadlinesTop 20 Most Underfunded State Pension Plans Source: Bloomberg.

27 Municipal Credit Analyis ChecklistImplement Credit Metric Benchmarks Develop credit criteria as part of you investment policy and/or strategy Justify metrics that are out of benchmark when appropriate Document areas of concern Understand Your Exposure Municipal Holdings as a % of Net Worth – There is no specific threshold Geographic concentration Tax Status, Issue Type, Revenue Source, etc. Proof of an Established Credit Analysis Process Pre-Purchase Documentation: Credit Profile Sheets, Financial Statements, OS Evidence of a meaningful Post Purchase Review Process Monthly Post-Purchase Monitoring Annual Review Using Credit Criterion Check Worksheet

28 Pre-Purchase AnalysisHistorical Financial Data Debt-To-Assessed Overlapping Debt Debt Coverage Tax Collection Rates Top 3 Tax Payer % Intergovernmental Aid Population Trends Pension and OPEB Data Personal Income Statistics Unemployment Graph Operating Profit Rainy Day Fund Analysis General Fund Trend Chart Buying municipals begins with thorough pre-purchase analysis. Establish benchmarks for key credit criteria and ensure purchases meet those requirements. Pre-purchase reports should always include Pension Data if available. Many municipal balance sheets will appear O.K. until pension data is analyzed.

29 Ensure Your Municipal Credit Process Looks At Pensions

30 Annual Credit Review vs. PolicyUser Defined Custom Credit Metric Filtering – Added in 2012 Annual Credit Review vs. Policy Pension Liability Filtering – Added in 2014 Oil Concentration Filtering – Added in 2016 Just as economic conditions and regulations continue to change, so should our Municipal Credit Analysis process. We established our original process in 2008 during the financial crisis and well before Dodd-Frank. We have since added the ability to filter based on credit metric benchmarks (2012), pension liability criteria (2014) and the ability to filter for oil concentrations (2016).

31 Seasoned 15yr MBS offer a good, stable cashflow optionSeasoned 15yr MBS offer a good, stable cashflow option. Higher coupons tend to depreciate less, but come with a higher premium so make sure you also buy good prepay protection attributes such LLB

32

33 During the 2013 market selloff, Municipals had the greatest amount of price depreciation while CMOs had the least. From peak to trough, Munis fell about 8%, Agencies fell 4.5%, MBS fell 3.75% and CMOs fell about 1.5%

34 High WAC, Low Coupon CMO CMOs offer many more options than “pass-through” MBS. In this case, a low coupon CMO was created from higher coupon MBS. The result is an investment with a lower premium (101-16) than the underlying collateral would have (107-24). This CMO also has a shorter average life (4.2yrs vs. 4.6yrs) than the underlying collateral and less extension risk (0.6yrs vs. 5.1yrs). The result is a low premium investment, with good yield spread, stable cashflows and limited price depreciation.

35

36 Flatter Yield Curve Makes ARMs More AttractiveA flatter yield curve makes ARMs a more attractive option today than in prior years. The 1-year part of the curve (where many ARMs are indexed) has risen 40bp since 2013 while the 5-10yr part of the curve (where many fixed MBS are priced) has fallen bp. This combined with tighter spreads has significantly reduced the “yield give-up” for buying ARMs over Fixed Rate MBS.

37 1Yr CMT & 1Yr LIBOR Have Both Jumped in Recent Years1-Year LIBOR has doubled since 2014 and 1-Year CMT is up 5 fold! LIBOR is consistently higher than CMT and has more “stickiness” during rate rallies. Rising short-term rates, a flatter yield curve and tight mortgage spreads make ARMs an attractive alternative to 10yr and Seasoned 15yr fixed rate MBS 1Yr LIBOR 1Yr CMT

38 FN/FH Annual ARMs based on 1Yr LIBOR or 1yr CMT offer better yields than several months ago and provide a decent option if an institution needs true rate sensitivity. Premium are higher than on lower coupon Hybrids and prepayment volatility creates the potential for yield volatility, but well seasoned pools provide reasonable stability and depreciation potential is limited.

39 Session Summary Review Your Entire IRR & ALCO ProcessPrepare for your next exam – board education, validation, stress testing, NMD analysis, sensitivity testing, surge balance analysis, etc. Make Your IRR Assumptions Institution Specific & Simulate Migration Analyze your NMD to determine sensitivities/betas Run an open/close study to determine average lives Run an NMD Surge Balance Analysis and simulate impact of NMD migration Ensure Your Liquidity Management System Is Forward Looking & Dynamic IRR and Liquidity Risk are closely related – how will your liquidity hold up when rates rise? Don’t Be Complacent Fed rate hikes expected to be slowest on record – FF futures don’t reach 1% before 2018 Stay fully invested and buy the curve while limiting extension to take advantage of steep curve Build a High Performance Bond Portfolio With The Best Relative Value Minimize highly efficient call options in Agencies and buy less efficient options in MBS/CMO/Munis Municipals offer the best relative value in today’s market - maximize tax-free income Build a stable, predictable ladder of MBS/CMO cash flow, reduce extension risk and price volatility Scrub Your Municipal Credits for Pensions & Oil Concentration Counties Review your pre-purchase and muni credit process to get out in front of oil issues Consider Adding CMOs & ARMs For Cash Flow and Rate Sensitivity The right CMO can limit extension, stabilize cash flows, lower premium risk and roll down the curve A flatter yield curve, lower yields and tight spreads make ARMs relatively more attractive today