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                                                  reflect the fact that many securities
Bank                           ...
2

can do is to apply modeling techniques        GAP and Earnings Sensitivity
to estimate these sensitivities, but we     ...
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interval (e.g., one year), and assess the       Duration and Economic Value of
underlying principal cash flows and thei...
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amortizing loans being hedged, inclusive        If no prepayments were to occur – ever –
of their short option, and, as...
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in the value of the loan due to the risk        focusing on the liabilities forces a
being hedged. On the other hand, i...
6

having optionality, such as a swaption,       Conclusions
or a series of swaptions. Based on some
modeling, bankers mig...
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hedge accounting, thereby forcing at
least some portion of derivative’s results
to be recognized in current earnings
wi...
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Bank Asset/Liability Management

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Bank Asset/Liability Management

  1. 1. 1 reflect the fact that many securities Bank (typically the assets) are structured with embedded options. Virtually all Asset/Liability depository institutions face this problem, Management with the most ubiquitous embedded option being the borrower’s option to Vol. 22, No.3, March 2006 prepay. Such options are especially common in mortgages, mortgage-backed Incorporating Prepayment Risk securities, mortgage servicing rights, and Considerations when Making Hedging a substantial number of other Decisions commercial loans. by Ira Kawaller and Timothy Koch* From the lender’s perspective, the prepayment option is a short call with an Introduction American style exercise.1 Specifically, the lender holds the loan as an asset; and Efforts to manage interest rate risk at the borrower has the right to buy the financial institutions are complicated by loan (i.e., the asset) back from the lender the many different options that are often for an amount equal to the outstanding embedded in traditional fixed income balance – a balance that will typically instruments – most notably prepayment differ from the market value of the loan. options. Risk managers typically This option may be exercised at any time endeavor to manage these risks by during the life of the loan. In advance of assessing the potential volatility in the exercise, the value of the option is earnings (earnings at risk), and they difficult to measure because conduct some form of sensitivity prepayments are affected by different analysis to estimate value changes per factors. For example, the pace of incremental rate change. If they deem prepayments may be influenced by the exposure to be unacceptable, they’ll changes in the general level of economic often overlay a derivative instrument activity, social or demographic position to offset at least some portion of adjustments, and, of course, variability the prospective effects. of market interest rates. Clearly, it would be difficult to assign a high level In the following discussion, we describe of confidence to any prepayment the general features of basic interest rate schedule forecast, given the inherent modeling at financial institutions and uncertainty associated with each of the explain alternative risk management various underlying factors. The best we approaches. Because many banks hold longer-term assets and shorter-term 1 liabilities, we assume this structure as a It is not clear precisely how the lender is starting position. The analysis should compensated for selling this option. Is it via a higher rate, a portion of the origination fee, deferred revenues that will ultimately be * Ira Kawaller is a Principal of Kawaller & Co. generated through mortgage servicing activities, and Managing Partner of the Kawaller Fund; or is it explicit prepayment charges? Given Timothy Koch holds the South Carolina Bankers seemingly low mortgage rates, analysts Association Chair of Banking, Moore School of frequently argue that lenders are not adequately Business, University of South Carolina. compensated for selling the prepayment option.
  2. 2. 2 can do is to apply modeling techniques GAP and Earnings Sensitivity to estimate these sensitivities, but we Analysis should be clear that these techniques will yield imperfect information. As a Earnings sensitivity analysis has evolved consequence, the ex post performance of from static GAP analysis, in which derivative hedges will typically generate managers compare the dollar amount of some measure of unintended gains or rate-sensitive assets with the dollar losses. amount of rate-sensitive liabilities across different time intervals, where GAP This imprecision may be particularly equals the corresponding difference.2 A critical under the regime of FAS 133, the positive (negative) GAP indicates accounting standard that pertains to relatively more rate-sensitive assets derivative instruments and hedging (liabilities) such that the bank’s net activity, in that hedge accounting might interest income will generally rise (fall) be proscribed if these unintended effects when interest rates rise. Among its many are of a sufficient magnitude. In such a weaknesses, GAP measures generally situation, financial managers could be either ignore the impact of embedded forced to choose between (a) hedging options or assume a known prepayment their risks and accepting the fact that the schedule. In reality, however, the rate hedge results might impact earnings in sensitivity of an asset or liability with an periods other than those in which the embedded option will vary because the hedged items’ income effects will occur, frequency or pace of option exercise or (b) not hedging these risks and differs under different interest rate bearing the associated, otherwise conditions. In addition, static GAP avoidable, market exposures. analysis ignores the differential adjustments in rates paid on interest- So how should banks proceed? If bearing liabilities versus rates earned on management chooses to hedge, should it earning assets. view the loans as a portfolio of long- term fixed-rate assets and hedge the Earnings sensitivity analysis strives to value of these assets? Alternatively, overcome this problem because it because most intermediaries focus on net represents “What if” or scenario interest margin, should management analysis. It involves the following steps: instead hedge its exposure to the risk 1) identify a base case interest rate associated with the roll-over of shorter environment including a benchmark term liabilities? Before addressing these interest rate and spreads/correlations questions directly, we first provide some between the benchmark rate and other background on various approaches rates; 2) given the assumed rate relating to measuring interest rate environment, identify assets and sensitivity. liabilities that will re-price within a time 2 Formally, static GAP equals rate-sensitive assets (RSAs) minus rate-sensitive liabilities (RSLs) where the dollar amount of RSAs and RSLs is determined by estimating the amounts that management expects to reprice within specific time intervals.
  3. 3. 3 interval (e.g., one year), and assess the Duration and Economic Value of underlying principal cash flows and their Equity Sensitivity Analysis associated gains or losses; 3) estimate the growth in loans, securities, core Market value (price) sensitivity analysis deposits, and non-core liabilities during is an alternative approach to GAP the same time interval; 4) estimate net analysis. With this orientation, banks interest income and net income; and 5) endeavor to measure the institution’s select another interest rate environment economic value of equity (EVE) by and repeat 2) through 5). The output calculating the market value of assets appears as a matrix of different assumed minus the market value of liabilities. rate environments versus the base case The difference represents the residual and the associated changes in net interest market value of the bank, which is income versus the base case. labeled EVE. Given the interest rate sensitivities of the assets and liabilities, One limitation of a GAP presentation is respectively, analysts can then predict the fact that results presume a given the incremental change in this residual prepayment exercise schedule, such that market value due to rate perturbations the reliability of the estimates will and use the information to design depend on whether the modeling process appropriate hedge positions. has accurately anticipated the pace of repayments under the respective rate Generally, a bank with longer duration scenarios. To the extent that these assets versus liabilities will lose (gain) assumptions are violated, some when interest rates rise (fall) because the discrepancies between the realized market value of assets will fall (rise) results versus those that may have been more than the market value of liabilities. anticipated should be expected. An even However, measuring the effects of this more critical shortcoming, however, is exposure for a given portfolio of loans the fact that the process doesn’t with embedded options is tricky, because eliminate the exposure – it simply delays the values and properties (i.e., the deltas, its realization. For example, assume a gammas, vegas, thetas, and rhos) of starting position with more rate-sensitive these options are subject to considerable assets than liabilities and the decision to volatility and lack of consensus. minimize the GAP for, say, the coming Moreover, even if there were uniformity 12 months. If interest rates fall, it is true of opinion, all of the relevant that the bank’s margin will be protected considerations are subject to change with during this year, but unless rates post a time passing and/or changing market reversal, the effect of the lower interest conditions. rates (i.e., a squeezed margin) will have to be realized through all subsequent Additionally, it is worth noting that periods for which those assets remain on because the duration being hedged is a the balance sheet. moving target, hedging the economic value requires using a dynamic process. That is, the hedge requires ongoing adjustments. Ultimately, the object of the dynamic adjustments would be to replicate in reverse the performance the
  4. 4. 4 amortizing loans being hedged, inclusive If no prepayments were to occur – ever – of their short option, and, as with any a receive fixed / pay variable interest replication procedure, the ex post results rate swap with a term equal to the of the process may likely differ – maturity of the associated loan and an possibly significantly – from ex ante identical amortization schedule would expectations. Not surprisingly, many serve as the perfect hedge. However, institutions do not focus on hedging with the contingency of prepayment at EVE given its emphasis on long-term the discretion of the borrower, the cash flows. hedger would need to be able to liquidate the swap position without Alternative Hedge Strategies suffering a loss. Given the fact that the strike price would have to change to Independent of the prepayment issue, the reflect the remaining balance of the loan, classic interest rate risk of the institution the hedger might choose to buy a series arises from the typical structure of of swaptions to cover this risk -- each longer-term assets and shorter-term with a horizon to the next payment date, liabilities. In addressing this risk, and each having a strike price equal to managers have the choice of either the prevailing outstanding loan balance. focusing attention on the longer-termed Alternatively, the hedger could assess assets by synthetically converting fixed the interest rate sensitivity of the loan rate loans to floating rate loans or, (inclusive of the prepayment alternatively, focusing on liabilities by optionality), and simply identify a synthetically extending the maturity of derivative position with an offsetting deposits. While the presence of a interest rate effect. In fact, this latter prepayment option adds a complicating approach, anecdotally, seems to be the factor, in fact, the two approaches still more common. serve as prospective starting points. Given that the “hedged item” is a fixed- Hedging long-term fixed-rate assets rate loan, if hedge accounting were applied, the correct treatment would be As previously mentioned, from the fair value accounting. It is by no means perspective of the lender, the clear that the bank would be able to prepayment option is a short call with an qualify for this treatment, however, American style exercise feature. That is, despite its efficacy in an economic the mortgage or loan is a fixed-rate asset sense. The critical question is whether held by the financial institution, and any or not the hedger can demonstrate, time during the life of the loan the prospectively, that the hedge gains or borrower has the right to buy it back losses could be expected to offset from the lender at a price equal to the changes in the fair value of the loan due outstanding balance. Critically, with to changes in the benchmark rate. The non-constant interest rates, this balance hedger must also demonstrate that the will likely differ in value from the hedge was effective in that same sense, market value of the remaining cash retrospectively. Assuming both flows of the loan. prerequisites can be validated, total gains and losses of the derivatives would be recorded in income, as would the change
  5. 5. 5 in the value of the loan due to the risk focusing on the liabilities forces a being hedged. On the other hand, if change in the accounting treatment. hedge effectiveness prerequisites cannot Here, the hedged item is the uncertain be satisfied, the accounting treatment of cash flows associated with variable-rate the loan would be unchanged from funding, and thus the hedge would be current practice, which, for most designated as a cash flow hedge. institutions is the lower of cost or market Critically, to qualify for this treatment, (LOCOM). In this case, derivative gains the forecasted event (i.e., the anticipated and losses would be recognized in variable interest expense) must be earnings. Of course, hedgers might elect probable. The prepayment possibility not to apply special hedge accounting, might seem to compromise this but in doing so, they would virtually assertion, but FASB does not require assure having to report a level of income lenders to dedicate specific funding volatility that could otherwise be instruments to specific assets. As long avoided. as funding takes place for the designated amounts, hedge accounting is not in Assuming hedge accounting could be jeopardy. With this approach, the applied, yet another problem arises. In hedger may elect to hedge rollover practice, lenders tend to consider the risk funding for virtually any horizon, of loans in a portfolio, rather than constrained by the requirement that the individually; that funding must be expected to actually is, they tend to consolidate loans having take place with a very high degree of similar characteristics and hedge confidence over the designated horizon. portfolios. FAS 133 imposes some rather serious constraints relating to The difficulty of this approach is that portfolio hedges. Specifically, the prepayment risk is specific to specific standard requires that if one component loans or securities. That is, the amount of the portfolio changes by 10 percent, to be hedged in the prospective periods price changes of all other components is an amount that is subject to the pace must fall between 9 and 11 percent for of prepayment activity. Thus the hedger hedge accounting to apply. If, instead, may find that he or she successfully the other components change by 7 locks up the cost for funds for a given percent or 13 percent, hedge accounting notional amount, but prepayments force would not be permitted.3 a substitution of lower-yielding assets, thereby resulting in a lower net interest Hedging short-term variable rate margin. On the other hand, if rates rise liabilities and the pace of prepayments slows, funding costs would rise for those loans Instead of hedging the asset side of the that had been expected to be retired, balance sheet, a bank may choose to again to the detriment of net interest operate on the liability side. Assume margin. that the balance sheet is composed of longer-term assets and shorter-term (i.e., At least theoretically, this uncertainty variable rate) liabilities. In this case, with respect to the prospective outstanding balance of pre-payable loans 3 See Paragraph 444 of Financial Accounting might be handled with a derivative Standard No. 133.
  6. 6. 6 having optionality, such as a swaption, Conclusions or a series of swaptions. Based on some modeling, bankers might be able to This article describes the basic assess a minimum outstanding balance framework for measuring interest rate that they could expect to remain – i.e., risk at financial institutions and focuses an amount reflecting the most rapid attention on problems associated with prepayment assumption under the hedging prepayment risk. It offers a scenario of the largest possible rate critique of issues associated with decline. For this exposure, they could hedging long-term fixed-rate assets with use a standard, pay fixed / receive embedded prepayment options. floating swap. Then, they could buy an option to enter a pay fixed /receive One approach designates the loan, per floating swap with a notional amount se, as the hedged item, where fair value that would equal the difference between hedge accounting applies. In general, the outstanding loan balance under the when operating on the asset side of the fastest prepayment assumption versus balance sheet, fair value hedge the balance under the slowest accounting would be intended. prepayment assumption. These options Assuming a hedge is designed with the could be arranged with monthly ideal derivative positions, hedge gains or expirations rolling into a new swaption losses would be recorded in income position following each expiration. along with the changes in the value of the hedged item (i.e., the loans) due to Critically, the use of swaptions in this the risk being hedged. The primary way would not qualify for hedge shortcoming of this approach is that accounting treatment, as the hedged modeling capabilities being as they are, item’s quantity is uncertain. Thus, the the capacity to measure the interest rate swaptions’ result would have to be sensitivities of these assets with recognized in current earnings sufficient accuracy to preclude material throughout the process. The result with unintended income effects is swaps, on the other hand, would qualify questionable. Importantly, institutions for hedge accounting treatment. That is, that are better at this type of modeling the swaps settlements and accruals and should emphasize this approach. any other “ineffective” hedge results would be recorded in earnings, along An alternative approach is to designate with the realized interest expense on the the exposure as being associated with deposits. All other mark-to-market variable-rate funding. As such, cash flow effects from the swap would be recorded hedge accounting applies. In this case, a in other comprehensive income. potential problem may arise in Presuming the forecasted funding occurs connection with uncertain pace of as “on schedule,” these deferred mark- prepayment activity, which implicitly to-market effects will be reclassified into translates to uncertainty with respect to earnings over the remaining course of the volumes of required funding. This the swap. lack of certainty could force some portion of the hedging derivative’s results to fail the prerequisite conditions that allow for the application of special
  7. 7. 7 hedge accounting, thereby forcing at least some portion of derivative’s results to be recognized in current earnings without a countervailing offset. The resulting income volatility under cash flow hedge accounting is therefore less than ideal. This shortcoming notwithstanding, cash flow hedging may still be elected by significant numbers of institutions bearing this risk. The rationale for doing so is the following. Most institutions tend to hedge only a portion of their exposures. Realizing (a) that the perfect hedge for the entire exposure is a combination of a swap with a swaption and (b) that overall interest rate sensitivity of this combination is smaller than the interest rate sensitivity of the swap by itself, hedgers may choose to simply use a swap with smaller notional value, designed with an interest rate sensitivity no larger than that of the ideal hedge. In setting up this hedge, the documentation would simply ignore the prepayment issue, per se, and designate cash flow hedges for a specified portion of the funding, for some given horizon, which might easily turn out to be a serious omission. It appears, then, that both approaches may be less than perfect -- either because they fail to address some portion of the existing economic exposure or because they foster accounting results that show some unintended income volatility. When compared to the possible consequences of not applying these techniques, however, these imperfections will likely be deemed to be of relatively minor consequence.

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