1 NASCUS Washington Examiners May 2, 2017Interest Rate Hedging NASCUS Washington Examiners May 2, 2017
2 Agenda The problem Interest rate risk mitigation strategiesRate history Asset competition / member service Funding Interest rate risk mitigation strategies Sell assets Borrow Interest rate derivatives Market history and scope Swaps Caps Futures
3 Effective Fed Funds Recent History
4 How To Fund Longer Duration Mortgage PortfoliosMortgage portfolios require funding along the yield curve Financial institution’s tend to lack a natural funding source for longer duration assets Interest rate derivatives can synthetically extend the duration and complement natural hedges for shorter-term funding sources Hedges must be rebalanced dynamically
5 Originate and Sell vs. Originate and HedgeInstitutions that can hedge select assets along the entire curve Institutions that can’t hedge compete for assets in the crowded short duration space
6 Size and Use Notional amount of OTC contracts ~ $493 trillion per BISInterest rate contracts make up the lion’s share of OTC derivatives at ~78% of the market 12/31/16 SIFMA market size Treasuries $14 trillion MBS $9 trillion Corporate debt $9 trillion Municipal $4 trillion Agency debt $2 trillion
7 Exchange Traded vs. OTC Many institutions use over-the-counter derivatives to hedge and manage their duration and convexity risks Over-the-counter derivative contracts are considered “tailor made” when compared to futures contracts that trade as “standardized contracts” The over-the-counter derivatives market has its origins in the exchange traded futures market Futures markets were established in the 19th century to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include FX, rates, energy, metals, etc. Exchanges are in infancy stages now for interest rate derivatives
8 Hedging ConsiderationsSwap rates anticipate the Fed’s actions Last rate cycle ( ), 5-year swap rates increased by 2.06% from the low of the cycle until the Fed raised rates Hedging = decreasing or transferring risk As with any risk/ reward tradeoff, hedging results in lower returns than if you "bet the farm" on a volatile position, but it also lowers the risk of “losing your shirt”
9 Interest Rate Risk Mitigation OptionsSell assets Eliminates all risk, not just interest rate risk Relatively expensive Risk avoidance, not risk management Issue wholesale CDs Leverages balance sheet Can be more expensive than derivatives Economic value may not be there given early withdrawal option Borrow More expensive than derivatives Ties up liquidity Interest rate derivatives (consider product as net)
10 Derivative Types Interest Rate Swap – a stream of interest payments is exchanged for another based on a pre-specified notional amount. Interest Rate Cap/Floor – an instrument protecting from increasing/decreasing short-term rates by making a payment when the interest rate is above/below a specified strike rate.
11 Using Swaps vs. BorrowingCost savings of ~8 to 111 basis points on FHLB and repo, which equates to $80K to $1.11M per year on $100M. As of 3/31/17, tenor in years, FHLB Des Moines Advance Rates Tenor Swap FHLB Dif. 3 1.81 1.89 0.08 4 1.95 2.12 0.18 5 2.05 2.32 0.27 6 2.14 2.55 0.41 7 2.22 2.70 0.48 10 2.38 3.15 0.77 15 2.54 3.54 1.00 20 2.62 3.73 1.11
12 Margin Maintenance Example$50M of new 3.625% mortgage loans 0.25% for servicing and 0.25% for losses 0.40% funding cost = $1.36M margin assuming flat rates (no swap) = $163K margin assuming +300 rates (no swap) = $1.08M margin assuming +300 rates (with swap) Margin maintenance assumes 1:1 hedge ratio with entire notional in 5-year swap. Funding cost has 80% beta.
13 Systematic Approach To Derivatives UseIdentify a hedging need or “risk” Are my identified risks hedgeable, diversifiable or unhedgeable? Are derivatives available to hedge this identified risk? Can we measure the “basis” risk? Is it reasonable? Are hedged returns sufficient? Do we have analytically robust models and tools?
14 Projected Derivative Operating CostsCost Type Year 1 Year 2 ALM First Derivative Cost $29,000 $0 ALM First Maintenance $34,000 Hedge Accounting $17,000 Dodd-Frank $1,000 $100 Legal Fees $10,000 Total Operating Cost $90,000 $51,100 1Costs presented in table assume $50,000,000 in notional balance.
15 Interest Rate Swap DefinitionA financial instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another. 3 month LIBOR 2.25% B Party A Party B Party A pays a fixed rate for 10 years Party B pays a floating rate for 10 years
16 Interest Rate Swap Characteristics12/20/2017 Interest Rate Swap Characteristics Notional amount (principal never paid) Maturity / tenor Start date Rate and underlying index Payment frequency Accrual method Business day adjustment 055_PowerPoint Interior Slides and Graphs_ pptx
17 Interest Rate Swap Cash Flow MechanicsWhen executed, the swap value is zero with no upfront premium As interest rates increase, the swap becomes more valuable and vice versa
18 Interest Rate Swap Example – (Assumes $50 Million Swap)12/20/2017 Interest Rate Swap Example – (Assumes $50 Million Swap) Current Position Swap Rates Increase 1% Rates Decrease .50% Loan Yield 4.50% Cost of Funds (1.00%) (2.00%) (0.50%) Swap Rate Paid (2.30%) Swap Rate Received --- 0.50% 1.50% 0.00% Net Interest Margin (NIM) 3.50% 1.70% Assumes same gap between cost of funds and 6-month LIBOR in all scenarios 055_PowerPoint Interior Slides and Graphs_ pptx
19 Interest Rate Cap Cap term - Length of time between initial agreement and termination of contract Cap index - Rate on which the contract will be based Cap premium - Cost to purchase cap; amortized over the life Cap strike - Maximum the underlying index can increase to Cap barrier – Activation/termination trigger (if applicable)
20 Interest Rate Cap – Flow3LIBOR Above 4.00% 3LIBOR Below 4.00% Premium 0.00% B Party A Party B Party A Party B
21 Interest Rate Cap – Price Sensitivity
22 Treasury Futures A Treasury futures contract is a standardized contract between you and a futures exchange to buy or sell a term Treasury for a price agreed upon today (the futures price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are negotiated at a futures exchange, which acts as an intermediary between the two parties. Contracts expire on a quarterly basis (March, June, September, and December) therefore must be continually rolled forward to maintain the hedge basis. T-note and T-bond contracts are based nominally on a 6% coupon. The contract permits the delivery of any coupon and the deliverer will choose the “cheapest-to-deliver” on the expiration date. Treasury rolls generally occur 2-4 days before Intention Day (two business days prior to the first day of the expiration month) 2-, 3- (no liquidity), 5-, 10- (most liquid), 30- year Treasury
23 Futures Contract DistinctionsThe main distinctions of futures contracts are: Trade on an organized exchange Have standardized contract terms A clearinghouse governs the fulfillment of contract terms Positions are marked to market Requires margin Liquidity is high Regulated by an identifiable agency Initial margin requirements are set at 110% of the maintenance rate. Maintenance margin is indicated at contract purchase. If outside margin, must deposit funds to bring account back to initial margin. CME clearing is ultimate clearing house. Can use other clearing parties. CFTC is regulator.
24 Treasury Trading Treasury futures are valued based on the movement of underlying Treasury securities. 5-year notes, 10-year notes, and 30-year bonds trade in units of $100,000 face value. 2- and 3-year notes trade in units of $200,000 face value. Futures contracts are traded in blocks of $1,000 and $2,000. Futures contracts permit for the delivery of a wide range of securities at the discretion of the short party. Short party will have right of “Cheapest-to-Deliver”. The invoice value must be adjusted to reflect the pricing characteristics of the security tendered. Invoice Price = Future Settlement x Conversion Factor x $1,000 Conversion factor – adjustment to account for price of delivered security compared to generic notional security Can deliver any security as long as it matures within 15 to 25 years of the delivery date. In upward sloping curve, short may be biased to deliver higher yielding securities with longer maturities. If yields are less than 6%, bias toward short duration securities (high coupon, short maturity)
25 Treasury Futures ExampleAn institution is worried rates will increase in the future. Institution shorts (sells) 10 December 2016 contracts on 10-year Treasury Note futures at Committed to deliver $1,000,000 worth (10 contracts at $100,000 each) of 10-year Treasuries at a price of Rates increase causing bond prices to decline. Contracts are worth On December 2016 deliver Treasuries or buy back contracts for a gain. Gain = 10*(125 – 115)*$1,000 = $100,000 When short Treasury futures, an institution hedges rising rates. When long Treasury futures, an institution hedges falling rates.
26 Hedging With Futures Notional allocation is similar to swap notional allocation. Key rate durations are analyzed to guide tenors. Hedge ratio is informed by comparing durations of futures contracts and rate-sensitive asset. There are fewer tenors of Treasury futures available compared to swap rates. Due to lack of differing tenors among issued Treasury securities. Slight imprecision in hedging compared to swaps. Must buy a specific number of Treasury Futures contracts. The notional is informed by balance of rate-sensitive asset (projected mortgage growth) and the hedge ratio. Potential for basis risk. Treasury prices are not perfectly correlated with mortgage prices or other market rates. Hedge Ratio = Dollar Value of BP for portfolio / (DV of BP ctd/CF for ctd) Can adjust portfolio duration by including HR = (Dtarget – Dcurrent)/(Dcurrent)
27 10-Year Swap Rates to 10-Year Treasury Rate
28 Hedge Ratios Decrease up the coupon stack from ~0.95 – 0.20DV01 / DV01 expanded through key rate durations Basis Point Value Ratio of price change in dollars to a basis point of yield Key rate durations gauge slope risk based on elasticity interval Duration risk is asymmetric along the curve based on asset Front-end of the curve, generally, is cheaper to hedge Basket of swaps preferred to targeted amortization Rebalancing versus offsetting versus unwinding notional 3 6 12 24 36 60 84 120 180 360 -0.15 0.40 0.28 0.11 0.94 0.49 0.81 0.46 0.63 0.17
29 Trade Execution Best execution – impartial / unbiased approachClearing Cost of capital for counterparties post-Basel III Ongoing counterparty credit analysis Margining and collateral monitoring Tri-party custody Overcollateralization and minimum transfer amount
30 Documentation / Legal Legal opinion Hedge accountingDodd-Frank compliance International Swaps and Derivative Association (ISDA) negotiation and execution Master Schedule Credit support annex
31 Conclusion Many financial institutions need stable and long duration funding in rising interest environments Upward pressure on rates have expedited the need for an effective hedging program Duration risk ultimately flows through net interest margins as interest rates rise Deposits and borrowings alone are, at best, average sources for hedging benefits Interest rate swaps and caps are great tools for interest rate risk management and can enhance profitability