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Asset and Liability Management Fin6102 Ferriter – Spring 2018 Overview This chapter discusses securities brokerage firms and investment banks Activities of securities firms and investment banks Size, structure, and composition Balance sheets and recent trends Regulation of securities firms and investment banks Global issues Ch 4-2 ©McGraw-Hill Education. 2 Securities Firms and Investment Banks Securities firms Specialize in the purchase, sale, and brokerage of existing securities Retail Investment banks Specialize in originating, underwriting and distributing issues of new securities Advising on M&As and restructuring Commercial Ch 4-3 ©McGraw-Hill Education. 3 Securities Firms and Investment Banks Continued Growth in domestic M&A: Less than $200 billion in 1990 $1.83 trillion in 2000 In US: bottomed out at $458 billion in 2002 ($1.2 trillion worldwide) Topped $1.7 trillion 2007 ($4.5 trillion worldwide) Effects of financial crisis: fell to $687 billion in 2010 ($1.8 trillion worldwide) Worst financial crisis since 1930s, but M&A activity still greater than early 2000s Ch 4-4 ©McGraw-Hill Education. 4 Ch 4-5 Mergers and Acquisitions, 1990-2015 ©McGraw-Hill Education. 5 5 Structural Changes in Recent Years Acquisition of Bear Stearns by J.P. Morgan Chase Bankruptcy of Lehman Brothers Acquisition of Merrill Lynch by Bank of America Only two remaining major firms: Goldman Sachs and Morgan Stanley Converted to commercial bank holding companies in 2008 Ch 4-6 ©McGraw-Hill Education. 6 Largest M&A Transactions ©McGraw-Hill Education. 7 7 Size, Structure and Composition Dramatic increase in number of firms from 1980 to 1987 Decline of 37% in the number of firms following the 1987 crash, to year 2006 Concentration of business among the largest firms Ch 4-8 ©McGraw-Hill Education. 8 Size, Structure and Composition Continued Many recent interindustry mergers (i.e., insurance companies and investment banks) Role of Financial Services Modernization Act, 1999 Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley gone by end of 2008 Ch 4-9 ©McGraw-Hill Education. 9 Types and Relative Sizes of Firms National full-line firms are largest Service retail and corporate clients Three categories: commercial bank holding companies, national full-line firms, and large investment banks BOA (via acquisition of Merrill Lynch); Morgan Stanley National full-line firms specializing in corporate finance are second in size Goldman Sachs, Salomon Brothers/Smith Barney (Citigroup) Ch 4-10 ©McGraw-Hill Education. 10 Remainder of industry: Regional securities firms (subdivided into large, medium, and small) Specialized discount brokers Electronic trading firms Venture capital firms Other firms E.g., research boutiques, floor specialists, etc. Ch 4-11 Types and Relative Sizes of Firms Continued ©McGraw-Hill Education. 11 Ch 4-12 Top BHCs, 2014 (by brokerage fee income) ©McGraw-Hill Education. 12 .

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Asset and Liability Management Fin6102 Ferriter – Spring 2018 Overview This chapter discusses securities brokerage firms and investment banks Activities of securities firms and investment banks Size, structure, and composition Balance sheets and recent trends Regulation of securities firms and investment banks Global issues Ch 4-2 ©McGraw-Hill Education. 2 Securities Firms and Investment Banks Securities firms Specialize in the purchase, sale, and brokerage of existing securities Retail Investment banks Specialize in originating, underwriting and distributing issues of new securities Advising on M&As and restructuring Commercial Ch 4-3 ©McGraw-Hill Education.
3 Securities Firms and Investment Banks Continued Growth in domestic M&A: Less than $200 billion in 1990 $1.83 trillion in 2000 In US: bottomed out at $458 billion in 2002 ($1.2 trillion worldwide) Topped $1.7 trillion 2007 ($4.5 trillion worldwide) Effects of financial crisis: fell to $687 billion in 2010 ($1.8 trillion worldwide) Worst financial crisis since 1930s, but M&A activity still greater than early 2000s Ch 4-4 ©McGraw-Hill Education. 4 Ch 4-5 Mergers and Acquisitions, 1990-2015 ©McGraw-Hill Education. 5 5 Structural Changes in Recent Years Acquisition of Bear Stearns by J.P. Morgan Chase
Bankruptcy of Lehman Brothers Acquisition of Merrill Lynch by Bank of America Only two remaining major firms: Goldman Sachs and Morgan Stanley Converted to commercial bank holding companies in 2008 Ch 4-6 ©McGraw-Hill Education. 6 Largest M&A Transactions ©McGraw-Hill Education. 7 7 Size, Structure and Composition Dramatic increase in number of firms from 1980 to 1987 Decline of 37% in the number of firms following the 1987 crash, to year 2006 Concentration of business among the largest firms Ch 4-8 ©McGraw-Hill Education. 8 Size, Structure and Composition Continued Many recent interindustry mergers (i.e., insurance companies
and investment banks) Role of Financial Services Modernization Act, 1999 Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley gone by end of 2008 Ch 4-9 ©McGraw-Hill Education. 9 Types and Relative Sizes of Firms National full-line firms are largest Service retail and corporate clients Three categories: commercial bank holding companies, national full-line firms, and large investment banks BOA (via acquisition of Merrill Lynch); Morgan Stanley National full-line firms specializing in corporate finance are second in size Goldman Sachs, Salomon Brothers/Smith Barney (Citigroup) Ch 4-10 ©McGraw-Hill Education. 10 Remainder of industry: Regional securities firms (subdivided into large, medium, and small) Specialized discount brokers Electronic trading firms Venture capital firms Other firms E.g., research boutiques, floor specialists, etc.
Ch 4-11 Types and Relative Sizes of Firms Continued ©McGraw-Hill Education. 11 Ch 4-12 Top BHCs, 2014 (by brokerage fee income) ©McGraw-Hill Education. 12 12 Key Activities Investment banking Activities related to underwriting and distributing new (IPOs) and secondary (seasoned) issues of debt and equity Public and private offerings Venture Capital Market making Involves creating a secondary market Increasing importance of online trading Technology risk Ch 4-13 ©McGraw-Hill Education. 13
Key Activities (Continued) Trading Position trading, pure arbitrage, risk arbitrage, program trading, etc. Investing Cash management Mergers and Acquisitions (M&As) Back-office and service functions Ch 4-14 ©McGraw-Hill Education. 14 Recent Trends Decline in trading volume and brokerage commissions Particularly since crash of 1987, although some recovery since 1992 Record volumes 1995-2000 Resurgence in market values and commissions during mid-2000s New market value lows in 2008-2009 Commission income also declined Ch 4-15 ©McGraw-Hill Education. 15 Recent Trends (Continued) Pretax net income over $9 billion per year between 1996 and 2000 Pretax profits soared to $31.6 billion in 2000
Curtailed by economic slowdown and September 11, 2001 terrorist attacks Worries over securities law violations and loss of investor confidence E.g., Enron, Merck, WorldCom, etc. Financial crisis, 2008 Profits recovered, 2009 Ch 4-16 ©McGraw-Hill Education. 16 Ch 4-17 Securities Industry Pretax Profits, 1990-2014 ©McGraw-Hill Education. 17 17 Balance Sheet Key assets: Reverse repurchase agreements Receivables from other broker-dealers Long positions in securities and commodities Subject to high levels of market and interest rate risk Ch 4-18 ©McGraw-Hill Education.
18 Balance Sheet Continued Key liabilities: Repurchase agreements are major source of funds Payables to customers Payables to other broker-dealers Securities and commodities sold short Capital levels much lower than in depository institutions Ch 4-19 ©McGraw-Hill Education. 19 Regulation Primary regulator is the Securities and Exchange Commission (SEC) Reaffirmed by National Securities Markets Improvement Act (NSMIA) of 1996 Prior to NSMIA, regulated by SEC and each state in which the firm operated Ch 4-20 ©McGraw-Hill Education. 20 Regulation Continued
Early 2000s saw erosion of SEC dominance Increased vigilance by state attorney generals Criminal cases brought mainly by states against securities law violators New York State vs. Merrill Lynch Spring 2003, $1.4 billion in penalties over investor abuses New rules brought by SEC for greater disclosure by analysts of potential conflicts of interest Ch 4-21 ©McGraw-Hill Education. 21 Regulation Concluded Financial Industry Regulatory Authority (FINRA) Handles day-to-day regulation Independent, not-for-profit Authorized by Congress Writes and enforces rules governing security firm activities Enhance transparency in the market Dark pools Ch 4-22 ©McGraw-Hill Education. 22 Extension of Oversight Additional oversight from US Congress Hearings focused on role of investment banks in the financial crisis Goldman Sachs bundling of toxic assets
Ch 4-23 ©McGraw-Hill Education. 23 Extension of Oversight Continued 2010 Wall Street Reform and Consumer Protection Act Financial Services Oversight Council New authority for Federal Reserve to supervise systemically important firms Registration limits for advisors changed Regulation of securitization markets; stronger regulation of credit agencies Authority for government to resolve nonbank FIs Ch 4-24 ©McGraw-Hill Education. 24 Extension of Oversight Concluded Kenneth Feinberg (“pay czar”) given voice as to executive compensation packages Ch 4-25 ©McGraw-Hill Education. 25
Investor Protection and Other Monitoring Securities Investor Protection Corporation (SIPC) Protection level of $500,000 October 2003 implementation of provisions of Patriot Act to combat money laundering Scrutiny of individual identities and affiliations with terrorists Ch 4-26 ©McGraw-Hill Education. 26 Global Issues Global nature of securities firms Competition between US and European firms Foreign investors’ transactions in US securities and US investors’ transactions in foreign securities exchanges increased Global concern about capital, liquidity, and leverage following the financial crisis Implications for global competitiveness Strategic alliances Exit from foreign markets Ch 4-27 ©McGraw-Hill Education. 27 Pertinent Websites Federal Reserve NYSE SEC Securities Industry Association
SIPC FINRA Ch 4-28 www.federalreserve.gov www.nyse.com www.sec.gov www.sifma.com www.sipc.org www.finra.org ©McGraw-Hill Education. 28 Asset and Liability Management Fin6102 Ferriter – Spring 2018 Agenda Review Questions from Last Week Depository Institutions Security Brokers and Investment Firms Insurance Finance Companies Overview of Depository Institutions This chapter recognizes three major FI groups: Commercial banks, savings institutions, and credit unions This chapter discusses depository FIs:
Size, structure, and composition Balance sheets and recent trends Regulation of depository institutions Depository institutions performance Ch 2-3 ©McGraw-Hill Education. 3 Products of U.S. FIs Comparing the products of FIs in 1950, to products of FIs in 2016: Much greater distinction between types of FIs in terms of products offered in 1950 than in 2016 Blurring of product lines and services over time and wider array of services (Refer to Tables 2-1A and 2-1B in the text) Ch 2-4 ©McGraw-Hill Education. 4 Specialness of Depository FIs Products offered on both sides of the balance sheet Offer loans Asset side Accept deposits Liabilities side Ch 2-5 ©McGraw-Hill Education.
5 Other Outputs of Depository FIs Other products and services in 1950: Payment services, savings products, fiduciary services By 2016, products and services further expanded to frequently include: Underwriting of debt and equity, insurance and risk management products Ch 2-6 ©McGraw-Hill Education. 6 Size of Depository FIs Consolidation has created some very large FIs Combined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs Ch 2-7 ©McGraw-Hill Education. 7 Largest US Depository Institutions Ch 2-8CompanyBanking AssetsHolding Company Assets ($ billions)J.P. Morgan Chase$2,134.1$2,448.0Bank of America1,629.52,152.0Wells Fargo1,629.51,720.6Citigroup1,337.51,829.4U.S. Bancorp414.0419.1PNC Financial Services Corp.343.6354.2Bank of New York Mellon343.6395.3State
Street Corp.289.4294.6Capital One254.4310.6TD Bank252.4253.2 ©McGraw-Hill Education. 8 8 Commercial Banks Largest group of depository institutions Differ from other FIs in composition of assets and liabilities, as well as regulatory oversight Large and small commercial banks differ with regards to structure and composition E.g., larger banks make more commercial/industrial loans and small banks make more real estate loans Mix of very large banks with very small banks Ch 2-9 ©McGraw-Hill Education. 9 Structure and Composition Shrinking number of banks: 14,416 commercial banks in 1985 12,744 in 1989 5,472 in 2015 Mostly the result of Mergers and Acquisitions M&A prevented prior to 1980s, 1990s Consolidation has reduced asset share of smallest banks (under $1 billion) Ch 2-10
©McGraw-Hill Education. 10 Regulation, Functions & Structure Functions of depository institutions Regulatory sources of differences across types of depository institutions Structural changes generally resulted from changes in regulatory policy Example: Changes permitting interstate branching Riegle-Neal Act, 1994 Ch 2-11 ©McGraw-Hill Education. 11 Ch 2-12 Breakdown of Loan Portfolios ©McGraw-Hill Education. 12 12 Commercial Banks: Asset ConcentrationSize2015 AssetsPercent
of Total1984 AssetsPercent of TotalAll FDIC Insured14,679.2100.02,508.9100.0$100M or Less93.56.0404.216.1$100M - $1B1,014.76.9513.920.5$1B - $10B1,336.89.1725.928.9$10B or more12,234.383.4864.834.5 Ch 2-13 ©McGraw-Hill Education. 13 13 Structure and Composition of Commercial Banks Limited powers to underwrite corporate securities have existed only since 1987 Financial Services Modernization Act 1999 Permitted commercial banks, investment banks, and insurance companies to merge Ch 2-14 ©McGraw-Hill Education. 14 Composition of Commercial Banking Sector Community Banks Regional or Superregional Access to federal funds market to finance their lending and investment activities Money Center Banks Bank of New York Mellon, Deutsche Bank (Bankers Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USA
Ch 2-15 ©McGraw-Hill Education. 15 Balance Sheet and Trends Key trends since 1987 Business loans have declined in importance while securities and mortgages have increased What influences these trends? Increased importance of alternative funding via commercial paper market Securitization of mortgage loans Temporary effects: credit crunch during recessions of 1989-92 and 2001-02 Ch 2-16 ©McGraw-Hill Education. 16 Commercial Banks, June 2015 Primary assets: Real Estate Loans: $3,801.9 B C&I loans: $1,737.6 B Loans to individuals: $1,301.2 B Investment security portfolio: $3,953.0 B Of which, Treasury securities: $2,015.3 B Credit/default risk is a major exposure Ch 2-17
©McGraw-Hill Education. 17 Commercial Banks, June 2015 Continued Primary liabilities: Deposits: $11,108.4 billion Borrowings: $1,578.2 billion Other liabilities: $339.1 billion Inference: Maturity mismatch/interest rate risk and liquidity risk are key areas of exposure Ch 2-18 ©McGraw-Hill Education. 18 Terminology Transaction accounts Negotiable Order of Withdrawal (NOW) accounts Money Market Mutual Funds Negotiable CDs Ch 2-19 ©McGraw-Hill Education. 19
Equity Commercial bank equity capital 11.26 percent of total liabilities and equity (2015) TARP program 2008-2009 intended to encourage increase in capital Citigroup $25 B BOA $20 B Through 2015: $245 B in capital injections through TARP Ch 2-20 ©McGraw-Hill Education. 20 Off-Balance-Sheet Activities Heightened importance of off-balance-sheet items OBS assets, OBS liabilities Earnings and regulatory incentives Risk control and risk producing Role of mortgage backed securities “Toxic” assets Expansion of oversight to unregulated OTC derivative securities Ch 2-21 ©McGraw-Hill Education. 21 Major OBS Activities Issuing guarantees E.g., letters of credit
Typically contain an insurance underwriting element Loan commitments Derivative transactions Futures Forwards Options Swaps Ch 2-22 ©McGraw-Hill Education. 22 Other Fee-Generating Activities Trust services Correspondent banking Services generally sold as a package Types of services offered: Check clearing and collection Foreign exchange trading Hedging Participation in large loan and security issuances Ch 2-23 ©McGraw-Hill Education. 23 Key Regulatory Agencies FDIC Deposit Insurance Fund (DIF) Role in preventing contagious “runs” or panics OCC: Primary function is to charter (and close) national banks
FRS: Monetary policy, lender of last resort National banks are automatically members of the FRS; state- chartered banks can elect to become members State bank regulators Dual Banking System: Coexistence of national and state- chartered banks Ch 2-24 ©McGraw-Hill Education. 24 Ch 2-25 Bank Regulators ©McGraw-Hill Education. 25 25 Legislation, 1927-1956 1927 McFadden Act: Controls branching of national banks 1933 Glass-Steagall: Separates securities and banking activities, established FDIC, prohibited interest on demand deposits 1956 Bank Holding Company Act and subsequent amendments specifies permissible activities and regulation by FRS of BHCs Ch 2-26 ©McGraw-Hill Education. 26
Legislation, 1970-1978 1970 Amendments to the Bank Holding Company Act: Extension to one-bank holding companies 1978 International Banking Act: Regulated foreign bank branches and agencies in US Ch 2-27 ©McGraw-Hill Education. 27 Legislation, 1980 - 1982 1980 DIDMCA and 1982 Garn-St. Germain Depository Institutions Act (DIA) Mainly deregulation acts Phased out Regulation Q Authorized NOW accounts nationwide Increased deposit insurance from $40,000 to $100,000 Reaffirmed limitations on bank powers to underwrite and distribute insurance products Ch 2-28 ©McGraw-Hill Education. 28 Legislation, 1987-1989 1987 Competitive Equality in Banking Act (CEBA) Redefined bank to limit growth of nonbank banks Focus on recapitalization of FSLIC 1989 FIRREA
Imposed restrictions on investment activities Replaced FSLIC with FDIC-SAIF Replaced FHLB with Office of Thrift Supervision (OTS) Created Resolution Trust Corporation (RTC) Ch 2-29 ©McGraw-Hill Education. 29 Legislation, 1991 1991 FDIC Improvement Act Introduced prompt corrective action (PCA) Risk-based deposit insurance premiums Limited “too big to fail” bailouts by federal regulators Extended federal regulation over foreign bank branches and agencies in FBSEA Ch 2-30 ©McGraw-Hill Education. 30 Legislation, 1994 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act Permits BHCs to acquire banks in other states Invalidates some restrictive state laws Permits BHCs to convert out-of-state subsidiary banks to branches of single interstate bank Newly chartered branches permitted interstate if allowed by state law Ch 2-31 ©McGraw-Hill Education.
31 Legislation, 1999 1999 Financial Services Modernization Act Allowed banks, insurance companies, and securities firms to enter each others’ business areas Provided for state regulation of insurance Streamlined regulation of BHCs Prohibited FDIC assistance to affiliates and subsidiaries of banks and savings institutions Provided for national treatment of foreign banks Ch 2-32 ©McGraw-Hill Education. 32 Legislation, 2010 2010 Wall Street Reform and Consumer Protection Act Financial Services Oversight Council created Government gained power to break up FIs that pose a systemic risk to the system Consumer Financial Protection Bureau created GAO to audit Federal Reserve activities Nonbinding proxy vote on executive pay Trading via clearinghouse for some derivatives Ch 2-33 ©McGraw-Hill Education. 33
Industry Performance Economic expansion and falling interest rates through 1990s Brief downturn in early 2000s followed by strong performance improvements Record earnings $106.3 billion 2003 Performance remained stable through mid 2000s as interest rates rose Late 2000s: Strongest recession since Great Depression Ch 2-34 ©McGraw-Hill Education. 34 Savings Institutions Comprised of: Savings Associations (SAs) Savings Banks (SBs) Effects of changes in Federal Reserve’s policy of interest rate targeting combined with Regulation Q and disintermediation Effects of moral hazard and regulator forbearance Qualified thrift lender (QTL) test Ch 2-35 ©McGraw-Hill Education. 35 Savings Institutions: Recent Trends Industry is smaller overall Intense competition from other FIs E.g., mortgages
Ch 2-36 ©McGraw-Hill Education. 36 Primary Regulators Office of the Comptroller of Currency (OCC) FDIC-DIF Fund FDIC oversaw and managed Savings Association Insurance Fund (SAIF) SAIF and Bank Insurance Fund (BIF) merged in January 2007 to form DIF Same regulatory structure applied to commercial banks Ch 2-37 ©McGraw-Hill Education. 37 Credit Unions Nonprofit DIs owned by member-depositors with a common bond Specialize in small consumer loans Exempt from taxes and Community Reinvestment Act (CRA) Expansion of services offered in order to compete with other FIs Claim of unfair advantage of CUs over small commercial banks Ch 2-38 ©McGraw-Hill Education. 38
Ch 2-39 Composition of Credit Union Deposits, 2015 ©McGraw-Hill Education. 39 39 Global Issues Spread of US financial crisis to other countries Many European banks saved from bankruptcy through support of governments and central banks Target interest rates at or below 1 percent Links to macroeconomic performance Ch 2-40 ©McGraw-Hill Education. 40 Financial Statement Analysis Return on equity (ROE): measures overall profitability per dollar of equity Return on assets (ROA): measures profit generated relative to assets Equity multiplier (EM): measures extent to which assets are funded with equity relative to debt Profit margin (PM): measures ability to pay expenses and generate net income Asset utilization (AU): measures amount of interest and
noninterest income generated per dollar of total assets Ch 2-41 ©McGraw-Hill Education. 41 CAMELS Ratings Composite 1: Institutions are generally sound in every respect Composite 2: Institutions are fundamentally sound, but may reflect modest weaknesses Composite 3: Institutions exhibit financial, operational, or compliance weaknesses Composite 4: Immoderate volume of serious financial weaknesses Composite 5: Extremely high immediate or near term probability of failure ©McGraw-Hill Education. DIs and Regulators Ch 2-43 ©McGraw-Hill Education. 43 Technology in Commercial Banking Wholesale banking services E.g., account reconciliation, electronic funds transfer, electronic billing, cloud computing, etc. Retail banking services
E.g., ATMs, smart cards, online/mobile banking, tablet banking, loyalty programs, etc. Advanced technology requirements Ch 2-44 ©McGraw-Hill Education. 44 Asset and Liability Manangement FIN6102 Ferriter Spring 2018 Overview This chapter discusses types and characteristics of loans made by U.S. FIs, models for measuring credit risk, and applicable technological advances. Important for purposes of: Pricing loans and bonds Setting limits on credit risk exposure Ch 10-2 ©McGraw-Hill Education. 2 Objectives for Individual Loans
There are two primary questions that need to be answered about individual loans. First, what is the potential return on the loan Second, what is the probability of default What options do we have to measure the probability of default? Why is credit risk important? Credit Risk is perhaps the most important consideration for a loan. Loans have a fixed and defined payment, this means that there is very limited upside and more downside compared to equity investments Because of the greater emphasis on downside risk, bond and loan markets are very focused and very responsive to changes. Credit Quality Problems Problems with junk bonds, LDC loans, and residential and farm mortgage loans Late 1990s, credit card and auto loans Crises in other countries such as Argentina, Brazil, Russia, and South Korea 2006-2007, mortgage delinquencies on subprime loans surged Emphasizes importance credit risk analysis Ch 10-5 ©McGraw-Hill Education. 5 5 Credit Quality Problems Over the early to mid 1990s, improvements in NPLs for large banks and overall credit quality
Late 1990s and early 2000, Telecommunication and tech companies DotCom bubble – get big fast WorldCom Alan Greenspan – raises interest rates Mid 2000s, economic growth accompanied by reduction in NPL rates Mortgage crisis Increased emphasis on credit risk evaluation Ch 10-6 ©McGraw-Hill Education. 6 What is a junk bond? Many investors incorporate bondsinto their portfolios to benefit from the interest payments they typically provide. But a bond's investment value is only as good as its issuer's ability to make those payments. When a bond's credit rating falls below what's considered investment-grade level, it's referred to as a junk bond. Though junk bonds carry more risk than investment-grade bonds with higher ratings, they tend to offer much higher yields, and as such, they're an attractive option for some buyers. Bonds that have a high enough credit rating are considered investment-grade, which means that they're suitable for most investors. On the other hand, bonds with a low enough rating are considered non-investment-grade, or junk. There are three major ratings agencies used to evaluate bonds' creditworthiness: Standard & Poor's (S&P), Moody’s and Fitch These agencies analyze a number of factors, such as assets, liabilities, and cash flow management, when assigning ratings to issuers. S&P and Fitch use a similar ratings system where issuers can receive as high a rating as AA, and as low a rating
as D. Moody's uses a slightly different system where issues can go as high as Aaa and as low as C. A bond that carries a credit rating of BB or lower by S&P and Fitch, or Ba or lower by Moody's, is considered non-investment-grade, or junk. Junk Bond Crisis From the 1970’s to the 1980’s the junk bond market grew exponentially at a a pace of around 34% per year. During this period of time junk bonds achieved a superior risk adjusted return. Essentially, junk bonds in this period were a superior investment compared to other investments with the same amount of risk. However, this period of growth came to a sudden stop in 1989. There is some disagreement as to what caused it, but most point to the collapse of the US$6.75bn buyout of UAL as the main trigger. A buyout group consists of pilots union and an investment bank sought to take United Airlines private for $6.79 billion couldn't secure the necessary loans. Others point to the Ohio Mattress fiasco, a deal that would become known as “burning bed” and remains widely considered to be among the worst deals in modern finance. The Cleveland- based company that Gibbons, Green bought for $1.1 billion in April amid criticism that it was wildly overpaying. In August, Gibbons, Green had to shelve its efforts to line up permanent financing for the acquisition when investors in the high-risk, high-yield ''junk bond'' market refused to buy the bonds The culmination of the crash is considered to be the collapse of Drexel Burnham Lambert, which was forced into bankruptcy in early 1990, largely due to its heavy involvement in junk bonds. At one point it had been the fifth-largest investment bank in the US. Credit Card and Auto Collapse
At the close of the 1990s, against the backdrop of the economic boom, many low- and moderate-income families were struggling financially and taking on credit card debt at rates unprecedented in American history. There is growing evidence that a combination of structural and economic trends coupled with abusive credit card industry practices left working families with few options other than to borrow heavily. Between 1989 and 2001, credit card debt in America almost tripled, from $238 billion to $692 billion. The savings rate steadily declined, and the number of people filing for bankruptcy jumped 125 percent. During the 1990s, the average American family experienced a 53 percent increase in credit card debt, from $2,697 to $4,126 (all figures measured in 2001 dollars). Low-income families saw the largest increase—a 184 percent rise in their debt—but even very high-income families had 28 percent more credit card debt in 2001 than they did in 1989. With an increase in bankruptcy filings, it led to the drafting of a bankruptcy reform bill, which was considered by the Congress, and passed as Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. It made filing chapter 7 (liquidating) bankruptcy, more difficult and introduced a means-test. Effects of Deregulation Since the late 1970s, America’s credit card industry has enjoyed a period of steady deregulation. Two Supreme Court rulings, the first in 1978 and the second in 1996, effectively hobbled state usury laws that protected consumers from excessively high interest rates and fees. Aggressive Marketing Relentless Credit Extension. Between 1993 and 2000, the industry more than tripled the amount of credit it offered to customers, from $777 billion to almost $3 trillion. Lowering of Minimum Payment Requirements
The amount of their balance customers can pay without incurring a penalty—dropped from 5 percent to only 2 or 3 percent, making it easier for consumers to carry more debt. Assuming an interest rate of 15 percent, it would now take more than 30 years to pay off a credit card balance of $5,000 by making the minimum payment. Or sometimes, never. Skyrocketing Late Fees and Penalties. Late fees have become the fastest growing source of revenue for the industry, jumping from $1.7 billion in 1996 to $7.3 billion in 2001. Late fees now average $29, and most cards have reduced the late payment grace period from 14 days to 0 days. In addition to charging late fees, the major card companies use the first late payment as an excuse to cancel low, introductory rates—often making a zero percent card jump to between 22 and 29 percent. Asian Financial Crisis The Asian Financial Crisis occurred in 1997 and affected Indonesia, South Korea, Thailand, Hong Kong, Laos, Malaysia and the Philippines. Indonesia, South Korea, Thailand being the most affected. The causes are disputed but most agree that current account deficits, foreign currency denominated debt and a fixed exchange rate contributed to the crisis. In the mid-1990s, the maintenance of fixed exchange rates encouraged external borrowing and led to excessive exposure to foreign exchange risk in both the financial and corporate sectors. Most recognize the devaluation of the Chinese Renminbi, the devaluation of the Japanese Yen as a result of the Plaza accord and a strengthen US dollar and a rise in US interest rates as triggers for the collapse. Asian Financial Crisis
This made the United States a more attractive investment destination relative to Southeast Asia, which had been attracting hot money flows through high short-term interest rates, and raised the value of the U.S. dollar. For the Southeast Asian nations which had currencies pegged to the U.S. dollar, the higher U.S. dollar caused their own exports to become more expensive and less competitive in the global markets. The resulting panic among lenders led to a large withdrawal of credit from the crisis countries, causing a credit crunch and further bankruptcies. In addition, as foreign investors attempted to withdraw their money, the exchange market was flooded with the currencies of the crisis countries, putting depreciative pressure on their exchange rates. To prevent currency values collapsing, these countries' governments raised domestic interest rates to exceedingly high levels (to help diminish flight of capital by making lending more attractive to investors), and to intervene in the exchange market - buying up any excess domestic currency at the fixed exchange rate with foreign reserves. Neither of these policy responses could be sustained for long. Thailand On 14 May and 15 May 1997, the Thai baht was hit by massive speculative attacks. However, Thailand lacked the foreign reserves to support the USD–Baht currency peg, and the Thai government was eventually forced to float the Baht, on 2 July 1997, allowing the value of the Baht to be set by the currency market. As a result of high interest rates, Thailand's booming economy came to a halt amid massive layoffs in finance, real estate, and construction that resulted in huge numbers of workers returning to their villages in the countryside and 600,000 foreign workers being sent back to their home countries. The baht devalued swiftly and lost more than half of its value. The baht reached its lowest point of 56 baht to the U.S. dollar in January 1998. The
Thai stock market dropped 75%. Indonesia In July 1997, when Thailand floated the baht, Indonesia's monetary authorities widened the rupiah currency trading band from 8% to 12%. The rupiah suddenly came under severe attack in August. On 14 August 1997, the managed floating exchange regime was replaced by a free-floating exchange rate arrangement. The rupiah dropped further. Although the rupiah crisis began in July and August 1997, it intensified in November when the effects of that summer devaluation showed up on corporate balance sheets. Companies that had borrowed in dollars had to face the higher costs imposed upon them by the rupiah's decline, and many reacted by buying dollars through selling rupiah, undermining the value of the latter further. Before the crisis, the exchange rate between the rupiah and the dollar was roughly 2,600 rupiah to 1 U.S. dollar. The rate plunged to over 11,000 rupiah to 1 U.S. dollar on 9 January 1998, with spot rates over 14,000 during 23–26 January and trading again over 14,000 for about six weeks during June–July 1998. On 31 December 1998, the rate was almost exactly 8,000 to 1 U.S. dollar. Indonesia lost 13.5% of its GDP that year. South Korea The banking sector was burdened with non-performing loans as its large corporations were funding aggressive expansions. During that time, there was a haste to build great conglomerates to compete on the world stage. Many businesses ultimately failed to ensure returns and profitability. The chaebol, South Korean conglomerates, simply absorbed more and more capital investment. Eventually, excess debt led to major failures and takeovers. In the wake of the Asian market downturn, Moody's lowered the
credit rating of South Korea on 28 November 1997, and downgraded again on 11 December. That contributed to a further decline in South Korean shares since stock markets were already bearish in November. The Seoul stock exchange fell by 4% on 7 November 1997. On 8 November, it plunged by 7%, its biggest one-day drop to that date. And on 24 November, stocks fell a further 7.2% on fears that the IMF would demand tough reforms. In 1998, Hyundai Motors took over Kia Motors. Samsung Motors' $5 billion venture was dissolved due to the crisis, and eventually Daewoo Motors was sold to the American company General Motors (GM). The IMF provided US$57 billion as a bailout package. In return, Korea was required to take restructuring measures. The ceiling on foreign investment in Korean companies was raised from 26 percent to 100 percent. In addition, the Korean government started financial sector reform program. Under the program, 787 insolvent financial institutions were closed or merged by June 2003. The South Korean won, meanwhile, weakened to more than 1,700 per U.S. dollar from around 800, but later managed to recover. South Korea’s national debt-to-GDP ratio more than doubled (approximately 13% to 30%) as a result of the crisis. What is the current account? The components of the current account: goods, services, income and current transfers. 1. Goods - These are movable and physical in nature, and for a transaction to be recorded under "goods," a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in), and an import is noted as a debit (money going out).
2. Services - These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service, it is recorded like an import (a debit), and if money is received, it is recorded like an export (credit). 3. Income - Income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services, and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production. 4. Current Transfers - Current transfers are unilateral transfers with nothing received in return. These include workers' remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production. Mortgage Crisis of 2008 The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume risky mortgages in the anticipation that they would be able to quickly refinance at easier terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., borrowers were unable to refinance. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices fell, and adjustable-rate mortgage (ARM) interest rates reset higher. Several other factors set the stage for the rise and fall of housing prices, and related securities widely held by financial
firms. In the years leading up to the crisis, the U.S. received large amounts of foreign money from fast-growing economies in Asia and oil-producing/exporting countries. This inflow of funds combined with low U.S. interest rates from 2002 to 2004 contributed to easy credit conditions, which fueled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. Ch 10-18 ARMs’ Share of Total Loans Closed, 1987-2014 ©McGraw-Hill Education. 18 18 Ch 10-19 Annual Net Charge-Off Rates on Loans ©McGraw-Hill Education. 19 19 Ch 10-20 Nonperforming Asset Ratio for U.S. Commercial Banks
©McGraw-Hill Education. 20 20 Types of Loans C&I loans: secured and unsecured Syndication Spot loans, loan commitments Decline in C&I loans originated by commercial banks and growth in commercial paper market Effect of financial crisis on commercial paper market RE loans: Primarily mortgages Fixed-rate, ARMs Mortgages can be subject to default risk when loan-to-value rises and house prices fall below amount of loan outstanding Ch 10-21 ©McGraw-Hill Education. 21 Individual (Consumer) Loans Consumer loans: personal, auto, credit card Nonrevolving loans Automobile, mobile home, personal loans Revolving loans Credit card debt (i.e., Visa, MasterCard) Proprietary cards, such as Sears and AT&T Risks affected by competitive conditions and usury ceilings Bankruptcy Reform Act of 2005 High default rates during finance crisis highlight the importance
of risk evaluation prior to making a credit decision Ch 10-22 ©McGraw-Hill Education. 22 22 Other Loans Other loans include: Farm loans Other banks Nonbank FIs, such as broker margin loans Foreign banks and sovereign governments State and local governments Municipal bankruptcies Detroit,MI Central Falls, RI, Harrisburg, PA Ch 10-23 ©McGraw-Hill Education. 23 23 Calculating Return on a Loan Factors: Interest rate, fees, credit risk premium, collateral, and other nonprice terms, such as compensating balances and reserve requirements Return = inflow/outflow 1+k = 1+(of + (BR + ø))/(1-[b(1-RR)]) Ch 10-24 ©McGraw-Hill Education.
24 24 k is the promised gross return of = direct fees (origination fees) BR + ø = loan interest rate b= Compensating balance RR = Reserve Rate Note that the text displays 1+ E(r) = p(1+k) + (1-p)0 but this simplifies to the form displayed above. Return on Loan Equation Return = inflow/outflow 1+k = 1+(of + (BR + ø))/(1-[b(1-RR)]) Of = origination fee, this is the fee paid by the customer to initiate and process the loan application BR = Base rate Ø = risk premium of the customer b = compensating balance requirement RR = reserve requirement k = the gross return on the loan Example 10-1 Suppose a Bank does the following Sets a loan rate of 10% (BR = 6% and Ø =4%) Charges a .125% origination fee Imposes an 8% compensating balance requirement to be held in non-interest accounts Sets aside reserves of 10% per Federal Reserve 1 + k = 1 + (.00125+ (.06+.04))/(1-(.08)(.9) 1 + k = 1 + (.10125)/(.928) 1 + k = 1.1091 k = .1091 or 10.91%
Expected Return on a Loan Expected return: 1 + E(r) = p(1+k) + (1- p) 0 where p equals probability of complete repayment 1- p is the probability of non-payment or default This can be considered and binomial option as there are only two possible outcomes It’s important to note that Ø and p are not completely independent Loan originators consider the probability of default when setting the risk premium. This is to compensate for default risk To an extent it can be self-reinforcing, high interest rates equal higher payments, all else equal Higher fixed payments increases the likelihood of default which leads to higher interest rates Note that realized and expected return may not be equal Example Calculate the promised return (k) on a loan if the base rate is 13%, the risk premium is 2%, the compensating balance requirement is 5%, origination fees are .5% and the reserve requirement is 10% 1+k = 1+(of + (BR + ø))/(1-[b(1-RR)]) 1+k = 1 +((.005+(.13+.02))/(1-[.05(.9)) 1+k = 1+.155/ .955 1 + k = 1.1623 What is the expected return on the loand is the probability of default is 5% Retail versus Wholesale Credit Decisions At retail Usually a simple accept/reject decision rather than adjustments to the rate Credit rationing
If accepted, customers sorted by loan quantity For mortgages, discrimination occurs via loan-to-value rather than adjusting rates At wholesale Use both quantity and pricing adjustments Ch 10-29 ©McGraw-Hill Education. 29 29 Managing Credit Quality How do banks and financial institutions manage individual loan quality? Most banks have guidelines for various loan types Some guidelines come from outside the organization, others are internally developed Many banks use benchmarks rating to ensure market competitiveness and market share All banks have some form of Risk Model to estimate exposure to default risk Risk Models Availability, quality, and cost of information are critical factors in credit risk assessment Facilitated by technology and information Qualitative models consider borrower specific factors as well as market, or systematic, factors Borrowed-specific factors include reputation, leverage, volatility of earnings, and collateral Market specific factors include business cycle and interest rate levels
Ch 10-31 ©McGraw-Hill Education. 31 Linear Probability Model Credit scoring models are quantitative models that use borrower characteristics to gauge an applicant’s probability of default Major weakness is that estimated probabilities of default can often lie outside of the [0,1] interval Since superior statistical techniques are readily available, there is rarely justification for employing linear probability models Ch 10-32 ©McGraw-Hill Education. 32 Altman’s Discriminant Function Z=1.2X1+ 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 Critical value of Z = 1.81 X1 = Working capital/total assets ratio X2 = Retained earnings/total assets ratio X3 = EBIT/total assets ratio X4 = Market value equity/ book value of total liabilities X5 = Sales/total assets ratio Ch 10-33
©McGraw-Hill Education. 33 History of Altman Z-Score The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company. There are many variants of the Altman model depending on the nature of the company and industry. None of the Altman models or other balance sheet-based models are recommended for use with financial companies. This is because of the opacity of financial companies' balance sheets and their frequent use of off-balance sheet items. Market based estimate are used instead. Example 10-23 MNO, Inc., a publicly traded manufacturing firm, has provided the following financial information in its application for a loan. Assets Liabilities and Equity Cash $ 20 Accounts payable $ 30 Accounts receivables 90 Notes payable 90 Inventory 90 Accruals 30 Long-term debt150 Plant and equipment 500 Equity (ret. earnings = $0) 400
Total assets $700 Total liabilities and equity $700 Also assume sales = $500,000 cost of goods sold = $360,000 taxes = $56,000 interest payments = $40,000 net income = $44,000 the dividend payout ratio is 50 percent, and the market value of equity is equal to the book value. Part a What is the Altman discriminant function value for MNO, Inc.? Recall that: Net working capital = Current assets - Current liabilities. Current assets = Cash + Accounts receivable + Inventories. Current liabilities = Accounts payable + Accruals + Notes payable. EBIT = Revenues ‑ Cost of goods sold ‑ Depreciation. Net income = EBIT ‑ interest ‑ taxes. Retained earnings = Net income (1 ‑ Dividend payout ratio Part A solution Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 X1 = (20+90+90‑30‑30-90)/ 700 = .0714 X1 = Working capital/total assets (TA) X2 = 44(1-.5) / 700 = .0314 X2 = Retained earnings/TA X3 = (500-360) / 700 = .20 X3 = EBIT/TA X4 = 400 / 150 = 2.67 X4 = Market value of equity/long
term debt X5 = 500 / 700 = .7143 X5 = Sales/TA Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71) = 3.104 = .0857 + .044 + .66 + 1.6 + .7143 = 3.104 Part b Based only on the Altman’s Z-score, should you approve MNO, Inc.'s application to your bank for a $500,000 capital expansion loan? Since the Z-score of 3.104 is greater than 2.99, ABC Inc.’s application for a capital expansion loan should be approved. Part c If sales for MNO were $300,000, the market value of equity were only half of book value, and all other values are unchanged, would your credit decision change? ABC’s EBIT would be $300,000 - $360,000 = -$60,000. X1 = (20 + 90 + 90 ‑ 30 ‑ 30 ‑ 90) / 700 = .0714 X2 = 22 / 700 = 0.0314 X3 = ‑60 / 700 = ‑0.0857 X4 = 200 / 150 = 1.3333 X5 = 300 / 700 = 0.4286 Z = 1.2(0.0714) + 1.4(0.0314) + 3.3(-0.0857) + 0.6(1.3333) + 1.0(0.4286) = 1.0754 Since ABC's Z‑score falls to 1.0754 < 1.81, credit should
be denied. Part d Would the discriminant function change for firms in different industries? Would the function be different for retail lending in different geographic sections of the country? What are the implications for the use of these types of models by FIs? Discriminant function models are very sensitive to the weights for the different variables. Since different industries have different operating characteristics, a reasonable answer would be yes with the condition that there is no reason that the functions could not be similar for different industries. In the retail market, the demographics of the market play a big role in the value of the weights. For example, credit card companies often evaluate different models for different areas of the country. Because of the sensitivity of the models, extreme care should be taken in the process of selecting the correct sample to validate the model for use. Logit Model Logit models Overcomes weakness of the linear probability model by restricting the estimated range of default probabilities from the linear regression model to lie between 0 and 1 Quality of credit scoring models have improved, providing positive impact on controlling write-offs and default Ch 10-41 ©McGraw-Hill Education.
41 Linear Discriminant Model Problems associated with discriminant analysis model: Only considers two extreme cases (default/no default) No reason to expect that the weights in a credit scoring model will be constant long-term; sensitivity to variable weights Ignores hard to quantify factors, including business cycle effects and reputation Database of defaulted loans is not available to benchmark the model Ch 10-42 ©McGraw-Hill Education. 42 Newer methods of modeling Default Risk Newer models of credit risk use a combination of financial theory and financial data to infer the possibility of default. Because of the use of financial data these are primarily used to model the credit risk of large corporate firms. Term Structure of credit risk Mortality Rate models RAROC – Risk Adjusted Return on Capital Models Option Models – Black-Scholes Term Structure Derivation of Credit Risk If the risk premium is known, we can infer the probability of default Risk premium can be computed using Treasury strips and zero- coupon corporate bonds
p (1+ k) = 1+ i Ch 10-44 ©McGraw-Hill Education. 44 Implied Probability of Default By looking at the spread between Treasury Strips and zero- coupon corporate bonds, we can ascertain the implied probability of default. By comparing a risk-free asset to a risky asset we’ll be able to impute the difference in perceived credit risk One of the major assumptions is that there is no potential for arbitrage. p (1+ k) = 1+ i p(1+k) = Expected return on the loan: p is the probability of repayment and 1-p is the probability of default 1 + i = the risk free rate if i = 2.05% and k = 7.80% then p = (1+i)/(1+k) and 1.0205/1.078 = .94967 and 1-p = .0575 or 5.75% 10-32 The bond equivalent yields for Government of Canada and A- rated corporate bonds with maturities of 93 and 175 days are given below: Bond Maturities 93 days 175 days Government 8.07% 8.11% A-rated corporate 8.42% 8.66% Spread 0.35% 0.55% What are the implied forward rates for both an 82-day
Government of Canada and an 82-day A-rated bond beginning in 93 days? Use daily compounding on a 365-day year basis. Part A The forward rate, f, for the period 93 days to 175 days, or 82 days, for the Government of Canada is: (1 + 0.0811)175/365 = (1 + 0.0807)93/365 (1 + f )82/365 The forward rate, f, for the corporate bond for the 82-day period is: (1 + 0.0866)175/365 = (1 + 0.0842)93/365 (1 + f )82/365 = 8.933% Part B What is the implied probability of … Asset and Liability Management for Financial Ins Ferriter FIN 6102 – Spring 2018 Interest Rates and Net Worth FIs exposed to interest rate risk due to maturity mismatches between assets and liabilities Interest rate changes can have severe impact on net worth Thrifts, during 1980s Ch 8-2 ©McGraw-Hill Education.
2 US Treasury Bill Rate, 1965 - 2015 ©McGraw-Hill Education. Ch 8-3 3 3 Level and Movement of Interest Rates Federal Reserve: U.S. central bank Open market operations influence money supply, inflation, and interest rates Actions of Fed (December, 2008) in response to economic crisis Target rate between 0.0 and ¼ percent Ch 8-4 ©McGraw-Hill Education. 4 Central Bank and Interest Rates Actions mostly target short term rates Focus on federal funds rate, in particular Interest rate changes and volatility increasingly transmitted from country to country due to increased globalization of financial markets Statements by Jerome Powell can have dramatic effects on world interest rates
Ch 8-5 ©McGraw-Hill Education. 5 Repricing Model Repricing, or funding gap, model based on book value Contrasts with market value-based maturity and duration models in appendix Ch 8-6 ©McGraw-Hill Education. 6 Repricing Model Continued Rate sensitivity means repricing at (or near) current market interest rates within a specified time horizon Repricing gap is the difference between rate-sensitive assets (RSAs) and rate-sensitive liabilities (RSLs) Refinancing risk Reinvestment risk Ch 8-7 ©McGraw-Hill Education. 7 Maturity Buckets Commercial banks must report quarterly repricing gaps for assets and liabilities with maturities of:
One day More than one day to three months More than three months to six months More than six months to twelve months More than one year to five years More than five years Ch 8-8 ©McGraw-Hill Education. 8 Repricing Gap Example Cum. Assets Liabilities Gap Gap 1-day $ 20 $ 30 $-10 $-10 >1day-3mos. 30 40 -10 -20 >3mos.-6mos. 70 85 -15 -35 >6mos.-12mos. 90 70 +20 -15 >1yr.-5yrs. 40 30 +10 -5 >5 years 10 5 +5 0 Ch 8-9 ©McGraw-Hill Education. 9 Applying the Repricing Model - Example 1: In the one day bucket, gap is -$10 million. If rates rise by 1%,
-$10 million) × .01 = -$100,000 Ch 8-10 ©McGraw-Hill Education. 10 Applying the Repricing Model Continued Example 2: If we consider the cumulative 1-year gap, -$15 million)(.01) = -$150,000 Ch 8-11 ©McGraw-Hill Education. 11 Rate-Sensitive Assets Examples from hypothetical balance sheet: Short-term consumer loans: Repriced at year-end, would just make one-year cutoff Three-month T-bills: Repriced on maturity every 3 months Six-month T-notes: Repriced on maturity every 6 months 30-year floating-rate mortgages: Repriced (rate reset) every 9 months Ch 8-12 ©McGraw-Hill Education. 12
Rate-Sensitive Liabilities RSLs bucketed in same manner as RSAs Demand deposits warrant special attention Generally considered rate-insensitive (act as core deposits), but there are arguments for their inclusion as rate-sensitive liabilities Ch 8-13 ©McGraw-Hill Education. 13 GAP Ratio May be useful to express interest rate sensitivity in ratio form as CGAP/Assets, referred to as “gap ratio” Provides direction and scale of exposure Example: Gap ratio = CGAP/A = $15 million / $270 million = 0.056, or 5.6 percent Ch 8-14 ©McGraw-Hill Education. 14 Equal Rate Changes on RSAs, RSLs Example 8-1: Suppose rates rise 1% for RSAs and RSLs. Expected annual change in NII, = $15 million × .01 = $150,000 CGAP is positive, change in NII is positively related to change in interest rates
CGAP is negative, change in NII is negatively related to change in interest rates Ch 8-15 ©McGraw-Hill Education. 15 Unequal Changes in Rates If changes in rates on RSAs and RSLs are not equal, the spread changes In this case, - Ch 8-16 ©McGraw-Hill Education. 16 Unequal Rate Change Example Example 8-2: RSA rate rises by 1.2% and RSL rate rises by 1.0% - = ($155 million × 1.2%) - ($155 million × 1.0%) = $310,000 Ch 8-17 ©McGraw-Hill Education. 17
Weaknesses of Repricing Model Weaknesses: Ignores market value effects of interest rate changes Overaggregative Distribution of assets and liabilities within individual buckets is not considered Mismatches within buckets can be substantial Ignores effects of rate-insensitive runoffs Bank continuously originates and retires consumer and mortgage loans Runoff of rate-insensitive asset/liability is rate-sensitive Ch 8-18 ©McGraw-Hill Education. 18 Weaknesses of Repricing Model Continued Off-balance-sheet items are not included when considering cash flows Hedging effects of off-balance-sheet items not captured Example: Futures contracts Ch 8-19 ©McGraw-Hill Education. 19 The Maturity Model Explicitly incorporates market value effects For fixed-income assets and liabilities: Rise (fall) in interest rates leads to fall (rise) in market value The longer the maturity, the larger the fall (rise) in market
value for interest rate increase (decrease) Fall in value of longer-term securities increases at diminishing rate for given increase in interest rates Ch 8-20 ©McGraw-Hill Education. 20 Maturity of Portfolio Maturity of portfolio of assets (liabilities) equals weighted average of maturities of assets (liabilities) that make up the portfolio Principles stated on previous slide regarding individual securities apply to portfolios, as well Typically, maturity gap, MA – ML, > 0 for most banks and thrifts Ch 8-21 ©McGraw-Hill Education. 21 Effects of Interest Rate Changes Size of the gap determines the size of interest rate change that would drive net worth to zero Immunization Maturity matching, MA - ML = 0 Note: Doesn’t always protect FI against interest rate risk Ch 8-22 ©McGraw-Hill Education.
22 Leverage Leverage affects ability to eliminate interest rate risk using maturity model Example: $100 million in assets invested in one-year, 10% coupon bonds and $90million in liabilities in one-year deposits paying 10%. Maturity gap is zero, but exposure to interest rate risk is not zero. Ch 8-23 ©McGraw-Hill Education. 23 Duration Matching of maturities can still result in interest rate risk due to the timing of cash flows between assets and liabilities not being perfectly matched FI can only immunize against interest rate risk by matching average lives of an assets and liabilities See Chap. 9 Ch 8-24 ©McGraw-Hill Education. 24 Term Structure of Interest Rates Compares market yields or interest rates on securities Assumes all characteristics (i.e., default risk, coupon rate, etc.)
are the same, except for maturity Most common shapes of yield curve for Treasury securities Upward-sloping Downward-sloping, or inverted Flat Ch 8-25 ©McGraw-Hill Education. 25 Unbiased Expectations Theory At a given point in time, yield curve reflects market’s current expectations of future short-term rates Long-term rates are geometric average of current and expected short-term interest rates (1 +1RN)N = (1+ 1R1)[1+E(2r1)]…[1+E(Nr1)] Ch 8-26 ©McGraw-Hill Education. 26 Liquidity Premium Theory Weaknesses of unbiased expectations theory Assumes investors are risk-neutral Doesn’t recognize that forward rates aren’t perfect predictors of future interest rates Liquidity premium theory Allows for future uncertainty Implicitly assumes that investors prefer short-term securities
Ch 8-27 ©McGraw-Hill Education. 27 Market Segmentation Theory Investors have specific preferences in terms of maturity Securities with different maturities are not perfect substitutes Investors are risk averse to securities that do not meet their maturity preferences Yield curve reflects intersection of demand and supply of individual maturities Ch 8-28 ©McGraw-Hill Education. 28 Market Segmentation and Determination of Slope of Yield Curve ©McGraw-Hill Education. Ch 8-29 29 Maturity Model Weaknesses
Two major shortcomings Does not account for the degree of leverage in the FI’s balance sheet Ignores the timing of the cash flows from the FI’s assets and liabilities Ch 8-30 Ch 8-30 ©McGraw-Hill Education. 30 Overview This chapter discusses a market value-based model for managing interest rate risk, the duration gap model Duration Computation of duration Economic interpretation Immunization using duration Problems in applying duration ©McGraw-Hill Education. Ch 9-31 31 Price Sensitivity and Maturity In general, the longer the term to maturity, the greater the sensitivity to interest rate changes The longer maturity bond has the greater drop in price because the payment is discounted a greater number of times ©McGraw-Hill Education. Ch 9-32
32 Duration Duration Weighted average time to maturity using the relative present values of the cash flows as weights More complete measure of interest rate sensitivity than is maturity The units of duration are years To measure and hedge interest rate risk, FI should manage duration gap rather than maturity gap ©McGraw-Hill Education. Ch 9-33 33 Macaulay’s Duration where D = Duration measured in years CFt = Cash flow received at end of period t N= Last period in which cash flow is received DFt = Discount factor = 1/(1+R)t ©McGraw-Hill Education.
Ch 9-34 34 Duration Since the price (P) of the bond equals the sum of the present values of all its cash flows, we can state the duration formula another way: Notice the weights correspond to the relative present values of the cash flows ©McGraw-Hill Education. Ch 9-35 Semiannual Cash Flows For semiannual cash flows, Macaulay’s duration, D, is equal to: ©McGraw-Hill Education. Ch 9-36 Duration of Zero-Coupon Bond Zero-coupon bonds: sell at a discount from face value on issue, pay the face value upon maturity, and have no intervening cash flows between issue and maturity Duration equals the bond’s maturity since there are no intervening cash flows between issue and maturity For all other bonds, duration < maturity because here are intervening cash flows between issue and maturity
©McGraw-Hill Education. Ch 9-37 37 Duration of Consol Bonds A bond that pays a fixed coupon each year indefinitely Have yet to be issued in the U.S. Maturity of a consol (perpetuity): Duration of a consol (perpetuity): Dc = 1 + 1/R ©McGraw-Hill Education. Ch 9-38 Features of Duration Duration and maturity Duration increases with maturity of a fixed-income asset/liability, but at a decreasing rate Duration and yield Duration decreases as yield increases Duration and coupon interest Duration decreases as coupon increases ©McGraw-Hill Education. Ch 9-39 Economic Interpretation Duration is a direct measure of interest rate sensitivity, or elasticity, of an asset or liability: -D Or equivalently, ΔP/P = -D[ΔR/(1+R)] = -MDdR
where MD is modified duration ©McGraw-Hill Education. Ch 9-40 Economic Interpretation Continued To estimate the change in price, we can rewrite this as: ΔP = -D[ΔR/(1+R)]P = -(MD) × (ΔR) × (P) ©McGraw-Hill Education. Ch 9-41 41 Dollar Duration Dollar value change in the price of a security to a 1 percent change in the return on the security Dollar duration = MD × Price Using dollar duration, we can compute the change in price as ΔP = -Dollar duration × ΔR ©McGraw-Hill Education. Ch 9-42 Semi-annual Coupon Bonds With semi-annual coupon payments, the percentage change in price is calculated as: ΔP/P = -D[ΔR/(1+(R/2)]
©McGraw-Hill Education. Ch 9-43 Immunization Matching the maturity of an asset with a future payout responsibility does not necessarily eliminate interest rate risk Matching the duration of a fixed-interest rate instrument (i.e., loan, mortgage, etc.) to the FI’s target or investment horizon will immunize the FI against shocks to interest rates ©McGraw-Hill Education. Ch 9-44 Balance Sheet Immunization Duration gap is a measure of the interest rate risk exposure for an FI If the durations of liabilities and assets are not matched, then there is a risk that adverse changes in the interest rate will increase the present value of the liabilities more than the present value of assets is increased ©McGraw-Hill Education. Ch 9-45 Immunizing the Balance Sheet of an FI Duration Gap: From the balance sheet, A = L+E, which means E = A-L. Therefore, DE = DA-DL. In the same manner used to determine the change in bond prices, we can find the change in value of equity using duration. DE = -[DA - DLk]A(DR/(1+R)) ©McGraw-Hill Education. Ch 9-46
Duration and Immunizing The formula, DE, shows 3 effects: Leverage adjusted duration gap The size of the FI The size of the interest rate shock ©McGraw-Hill Education. Ch 9-47 Example 9-9 Suppose DA = 5 years, DL = 3 years and rates are expected to rise from 10% to 11%. (Thus, rates change by 1%). Also, A = 100, L = 90, and E = 10. Find DE. DE = -[DA - DLk]A(DR/(1+R)) = -[5 - 3(90/100)]100[.01/1.1] = - $2.09. Methods of immunizing balance sheet. Adjust DA, DL or k. ©McGraw-Hill Education. Ch 9-48 Immunization and Regulatory Considerations Regulators set target ratios for an FI’s capital (net worth) to assets in an effort to monitor solvency and capital positions: Capital (Net worth) ratio = E/A A) = 0: DA = DL DA = kDL ©McGraw-Hill Education. Ch 9-49
Difficulties in Applying Duration Model Duration matching can be costly Growth of purchased funds, asset securitization, and loan sales markets have lowered costs of balance sheet restructurings Immunization is a dynamic problem Trade-off exists between being perfect immunization and transaction costs Large interest rate changes and convexity ©McGraw-Hill Education. Ch 9-50 Convexity The degree of curvature of the price-yield curve around some interest rate level Convexity is desirable, but greater convexity causes larger errors in the duration-based estimate of price changes ©McGraw-Hill Education. Ch 9-51 Basics of Bond Valuation Formula to calculate present value of bond: ©McGraw-Hill Education. Ch 9-52 Impact of Maturity on Security Values Price sensitivity is the percentage change in a bond’s present value for a given change in interest rates Relationship between bond price sensitivity and maturity is not linear As time remaining to maturity on bond increases, price
sensitivity increases at decreasing rate ©McGraw-Hill Education. Ch 9-53 Incorporating Convexity into the Duration Model Three characteristics of convexity: Convexity is desirable Convexity and duration All fixed-income securities are convex ©McGraw-Hill Education. Ch 9-54 Modified Duration & Convexity DP/P = -D[DR/(1+R)] + (1/2) CX (DR)2, or DP/P = -MD DR + (1/2) CX (DR)2 Where MD implies modified duration and CX is a measure of the curvature effect CX = Scaling factor × [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield] Commonly used scaling factor is 108 ©McGraw-Hill Education. Ch 9-55 Calculation of CX Example: convexity of 8% coupon, 8% yield, six-year maturity Eurobond priced at $1,000 CX = 108[(DP-/P) + (DP+/P)] = 108[(999.53785-1,000)/1,000 + (1,000.46243- 1,000)/1,000)]
= 28 ©McGraw-Hill Education. Ch 9-56 Contingent Claims Interest rate changes also affect value of (off-balance sheet) derivative instruments Duration gap hedging strategy must include the effects on off- balance sheet items, such as futures, options, swaps, and caps, as well as other contingent claims ©McGraw-Hill Education. Ch 9-57 Asset and Liability Management FIN 6102 Ferriter – Spring 2018 Debt Securities A Debt Security is a claim on a specified periodic stream of cashflow. Debt Securities are often called fixed-income securities because they promise either a fixed stream of income or one that is determined by a formula. A typical bond requires semi-annual payments for the life of the bond. These are called coupon payments. The interest rate that determines the coupon payment is called the coupon rate. When a bond matures, the issuers repays the debt by paying the bond’s par value (also known as the face value). If no face value is given, assume $1000 for the face value Zero-Coupon Bonds
Bonds are usually issued with a high enough coupon rate to induce investors to purchase the bond. However there are zero- coupon bonds, where the buyer only receives the face value at the maturity date but receive no coupons payments. When these bonds are issued they are priced considerably lower than the par value. They may be issued by federal, state or local governments or by corporations. Then there are the tax exemptions. If issued by a government entity, the interest generated by a zero-coupon bond is often exempt from federal income tax, and often from stateand local income taxes too. Accrued Interest and Quoted Prices The bond prices quoted in financial papers are not the actual prices that an investors pays for the bond. This is because the quoted price doesn’t include the interest that accrues between coupon payments. Accrued Interest = Annual Coupon Payment/2 *Days since last coupon/Days between payment For example, a bond with a coupon rate of 8%. The annual coupon payment is $80 and the semi-annual coupon is $40. 30 days have passed since the last coupon payment. What is the the accrued interest? $40 x (30/182) = $6.59 This value would be added to the quoted price when the bond is sold. Call Provision and Callable Bonds Some corporate bonds are issued with a call provision. A call provision allows the issuers to repurchase a bond at a specified call price before the maturity date. Why might a company issue
a callable bond? When corporate bonds are issued in a high interest rate environment, they will most likely issue bonds with a high coupon rate. Over the course of the bonds life, interest rates might fall. A corporation might take advantage of the call provision to retire the bond early and issue a new bond at a lower coupon rate Callable Bonds typically come with a period of call protection, an initial period of time when the bond cannot be called. The option to call a bond is useful to the issuer, but what is beneficial to an issuer is detrimental to bond holders. To compensate for this, callable bonds are often issued with higher coupons and promised yield to maturity than non callable bonds. Convertible bonds Convertible bonds give bondholders an option to exchange each bond for a specified number of shares. The conversion ratio is the number of shares for which each bond may be exchanged. For example, a convertible bond is issued at a par value of $1,000 and is convertible in 40 shares of stock. If the current stock price is $20 it is not profitable to convert. As $20*40 = $800 is less than the par value of the bond. If the stock price increases to $30, the conversion is profitable ($30*40 = $1,200) The market conversion value is the current value of shares for which the bonds may be exchanged. Convertible bond holders benefit from price appreciation of the company’s stock. Because of this benefit, convertible bonds tend to have lower coupon rates and lower yields to maturity. Floating Rate Bonds Floating rate bonds make interest payments based on some measure of current market rates. For example, the might might be adjusted annually to the current T-bill rate plus 2%. If the One year T-Bill rate is 4%, then the coupon rate over the next
year will be 6%. The major risk with floating-rate bonds is that while the spread between the market interest rate and the floating coupon rate is fixed, the adjustment is not connected to changes in the issuing firm’s financial position. For example, if a company runs into financial distress, investors might demand a greater yield premium than is offered by the security. In this case the price of the bond will fall. Bond Pricing Bond Value = Present Value of Coupons + Present Value of par value For example consider an 8% coupon, 30-year maturity bond with a par value of $1,000, paying 60 semiannual coupon payments of $40 each. Suppose that the market interest rate is 8% annually. The present value of all the coupon payments is $904.94 and the present value of the par value is $95.06. When the market interest rate is equal to the coupon rate, the par value and equals the bond price. If the market interest rate were to rise to 10%. The bond price would fall by $189.29 to $810.71 Yield to Maturity As you may have guessed, the coupon rate and the market interest rate are rarely equal. As such bonds usually do not sell for par value. Therefore we need to measure or rate of return that accounts for both current income (coupon payments and the return of principle) and the bond price increase or decrease over the lifetime of the bond. The yield to maturity is the interest rate that makes the present value of a bond’s payments equal to its current price. This interest rate is interpreted as the average rate of return of a
bond if held to maturity. Example: An 8% coupon, 30-year bond is selling at $1,276.76. What is the yield to maturity? In this example, the semiannual yield to maturity is .03. However, yield to maturity is generally quoted as an annual figure. Therefore we must annualize the yield. 1.03^2 =1.0609. In this case the yield to maturity in 6.09% YTM vs Current Yield A bond’s yield to maturity (YTM) is the internal rate of return on the investment in the bond. YTM differs from the current yield of a bond. The current yield of a bond is defined as the annual coupon payment divided by the current price of a bond. For example, take the 8% coupon bond selling for $1,276.76. The current yield would be 80/ $1,276.76 or .0627 (6.27%). Recall that the YTM on this bond was 6.09%. This bond is considered to be selling at a premium. In this case the coupon rate is higher than the current yield which is higher than the YTM. The reason for this is that the Coupon rate is divided par value, the current yield is divided by the current price. The current yield is higher than the YTM because the YTM accounts for the capital loss as the bond will eventual repay only $1,000 at maturity. As a general rule, for premium bonds the Coupon rate > Current Yield > YTM. For discount bonds the relationship is reversed. Yield to Call Yield to maturity assumes that the bond will be held to maturity. However, a bond maybe be retired prior to that time. This is especially true if the bond has a call provision. For example, a $1,000, 30 year bond with a coupon payment of 8% has a callable provision at 110% of par value and has call protection for 10 years. If the bond currently sells for $1,150
what is the yield to call? In this example, the Yield to Call (YTC) is equal to 6.64% (3.32 x 2) and the YTM is 6.82% Yield to CallYield to MaturityCoupon Payment4040Number of Periods2060Final Payment$1,100$1,000Price$1,150 $1,150 Zero-Coupon Bonds US Treasury Bill are common for of short term zero-coupon bonds. Since these have no coupon the return on these bonds is completely from price appreciation. However, Long-Term Zero coupon bonds are usually created by separating a coupon payment stream from the principal repayment. An investor can request that the US Treasury split or strip the coupon payment from the principal repayment. In this case each component is assigned a CUSIP number, the CUSIP allows the each security to trade on the FEDWIRE system. The process is governed by the US Treasury Program called STRIPS (Separate Trading of Registered Interest and Principal of Securities) The primary purpose of strips is to appeal to different investor types. Much of the reason is related to cashflow matching. Term Structure of Interest Rate The term structure of interest rates refers to the the process of discounting cash flows of different maturities. Most often investors will plot the YTM against Maturity. This is called the yield curve. There are three common “types” of yield
curve; rising, flat and inverted. A rising yield curve is the most common in normal economic times, and it suggests that interest rates will rise in the future. The yield curve is derived from plotting zero-coupon bonds.MaturityYTMPrice15%$952.3826%$89037%$816.3048% $735.03 Yield Curve and Future Interest Rates In order to derive the Yield curve we’ll be making some assumptions. First, we assume that there is no possibility of arbitrage. Under this scenario, yields from must be identical. To see what this means, consider the following. There are two strategies, a choice to buy and hold a two year zero-coupon bond and to buy a one year zero coupon bond and reinvest in another one year zero coupon. For the two year bond, assume a 6% market rate for a holding period of years. In this case the bond price would be $890. For the second strategy, assume the interest rate for a one year holding period is 5%. What will the one year rate be in one year We can set this up as the following: $890 x 1.062 = $890 x 1.05 x (1+r) Or 1.062/1.05 = 1+r = 1.0701 or 7.01% Finding Future Short Rates Now let’s compare a three year strategy. One will be to purchase a 3 year zero coupon bond with a YTM of 7%. This bond would be priced at $816.30 The alternative strategy is to buy a 2 year zero and reinvest in a 1 year zero. We can structure this as follows 1.073 = 1.062 x 1+r 1.073/1.062 = 1+r This equals 1.09025 or 9.025%
Additionally, 1.07 = (1.05 x 1.0601 x 1.09025)1/3 Interest Rate Types One thing you might have noticed is that there are a lot of interest rates when doing these calculations. In order to differentiate between them, investors coined two terms to describe them. The spot rate refers to the yield to maturity for a zero coupon bond that prevails today. The forward rate (also called the forward yield) is the theoretical, expected yield on a bond several months or years from now. It is common to denote a forward rate as xRy this can be read as the x forward rate y years from today. Theories of the Term Structure The expectations hypothesis is the theory that the forward rate equals the market consensus expectations of what future short- term rates will be. This means that there is no liquidity preference. This can be stated as E(r) = f2 or that the expected rate in period two will be the rate in period two. Using this hypothesis is what allows use to generate a yield curve, as no other information is required aside from current spot rates. Theories of Term Structure Liquidity Preference: Essentially states that investors or buyers of fixed income securities have a preference of either short term or long term securities. Part of the reason for these preferences can be seen as attempts to match cash inflows to cash outflows. In any event, short term investors would require a premium to invest in longer term securities, or the f2 > E(r2) or the rate in
period 2 must be greater than the expected rate in period 2. Advocates of liquidity preference believe that short term investors dominate the market which pushes the short term interest rate down. Interest Rate Risk As we’ve seen bond prices move inversely to changes in the market interest rate. Therefore, bond investors are particularly concerned with the sensitivity of bond prices. We also note that bond prices are convex and therefore decreases in YTM have bigger impacts on price than increases in YTM for the same magnitude. A summary of bond price observations Bond prices and yields are inversely related. An increase in a bond’s yield to maturity results in a smaller price change than a decrease Prices of long-term bonds tend to be more sensitive to changes in interest rate. Sensitivity to price changes increases at a decreasing rate. A 30 year bond is not 6x more sensitive than a 5 year Interest rate risk is inversely related to a bond’s coupon rate The sensitivity of a bond’s price to a change in its yield is inversely related to the YTM at which the bond is currently selling. (Macaulay’s) Duration Frederick Macaulay termed the effective maturity concept the duration of a bond. Macaulay’s Duration equals the weighted average of the times to each coupon or principal payment. The weight associated with each payment time should be related to the “importance” of that payment to the value of the bond. Timing of cash flows is designated in years Wt = PV of CFt/Bond Price D = Σ T x Wt
Duration ExampleTime untilPV of CFColumn CPaymentDiscount rate =timesPeriod(Years)Cashflow5% per periodWeightColumn FA. 8% Coupon Bond10.540 $ 38.10 0.0394960.01972140 $ 36.28 0.0376150.037631.540 $ 34.55 0.0358240.0537421040 $ 855.61 0.8870651.7741Sum: $ 964.54 1.8852B Zero-Coupon10.50 $ - 00.0000210 $ - 00.000031.50 $ - 00.0000421000 $ 822.70 12.0000 $ 822.70 2.0000 Why is duration important There are three primary reasons why duration is important. First it is a simple summary statistic of the effective average maturity of the portfolio It is an essential tool in immunizing portfolios from interest rate risk Duration measures interest rate sensitivity of a portfolio Modified Duration Reason for – sign The price-yield relationship is negatively correlated; when prices go down, the implied yield goes up. The minus sign allows the modified duration to be positive for a normal bond. 23 Modified Duration Example Consider the 2-year maturity, 8% coupon bond, selling at a price of $964.54 for a YTM of 10%. The semi-annual duration of this bond is 1.8852 years. The annual duration is 3.7704.
Therefore modified duration is 3.7704/1.05 = 3.591. No suppose that the semiannual interest rate increases to 5.01% -3.591x .01% = -.03591% This would be interpreted as a .01% increase in interest rates would cause the price of a bond to fall by .03591% Rules for Duration The duration of a zero-coupon bond is its time to maturity A coupon bond can have a duration less than one. Holding maturity constant, a bond’s duration is lower when the coupon rate is higher A bond’s duration increases with its time to maturity. The duration for a coupon bond is higher when the bond’s yield to maturity is lower Duration of a perpetuity (1+r)/r Convexity Convexity Formula Duration with Convexity Example Immunization Immunization techniques refer to strategies used by investors to shield their overall financial status from interest rate risk. Many banks and thrifts have naturally occurring mismatches between their liabilities and assets. Much of there liabilities are deposits that are short term and have low duration. Bank assets
are primarily consumer and commercials loads and have higher duration. This means that banks are sensitive to changes in interest rate as they can directly effect new worth. Immunization Example Consider an insurance company offering a Guaranteed Investment Contract for $10,000 and guarantees and interest rate of 8%. If the GIC has a maturity of 5 years. The future value of the liability is $14,693.28. If the company chooses to fund the liability with a 10,000 8% coupon bond. Then as long as interest rates remain at 8% the liability will be exactly matched. But what happens when interest rate rise or fall? Immunization ExamplePayment NumberYears Remaining until ObligationAccumulated Value of Invested PaymentA. Rates Remain at 8%14800 x (1.08)^4=1088.39123801 x (1.08)^3=1007.7732802 x (1.08)^2=933.1241803 x (1.08)^1=86450804 x (1.08)^0=800Sale of Bond010800=1000014693.28A. Rates Fall to 7%14800 x (1.07)^4=1048.63723801 x (1.07)^3=980.034432802 x (1.07)^2=915.9241803 x (1.07)^1=85650804 x (1.07)^0=800Sale of Bond010800=10093.4614694.05A. Rates Fall to 7%14800 x (1.09)^4=1129.26523801 x (1.09)^3=1036.02332802 x (1.09)^2=950.4841803 x (1.09)^1=87250804 x (1.09)^0=800Sale of Bond010800=9908.25714696.03 Immunization In this example because we have successfully matched the duration of our asset with our liability we can be considered immune from interest rate risk. However, immunization investors have a risk trade off between price risk and
reinvestment risk. Price risk is essentially the capital loss or gain that occurs because of a change in interest rate. Now a key consideration with immunization is the need to rebalance. As interest rate change a portfolio manager must rebalance as the duration will have changed. Additionally, even if interest rates stay the same durations will change solely because of the passage of time. Constructing and Immunized Portfolio A bank must make a payout of $19,487 in seven years. The current market interest rate is 10%, so the PV of the payout is $10,000. The portfolio managers wants to fund the obligation with a 3 year zero coupon bond and a perpetuity paying 10%. How can the manager immunize the portfolio? Calculate the duration of the liability. In this case because it is a single payment obligation, the duration is 7 years Calculate the duration of the asset portfolio. The portfolio duration will be the weighted average of each assets duration. In this case the zero coupon bond has a duration of 3 years and the perpetuity a duration of 11 years. Asset Duration = w * 3 + (1-w)*11 Find the asset mix that sets the duration of assets equal to 7 years w * 3 + (1-w)*11 = 7 in this case w = .5 Fully fund the obligation. In this case it means that 5,000 should be invested in the zero coupon bond and 5,000 should be invested in the perpetuity. Duration Gap Analysis Duration Gap: From the balance sheet, A = L+E, which means E = A-L. Therefore, DE = DA-DL.
In the same manner used to determine the change in bond prices, we can find the change in value of equity using duration. DE = -[DA - DLk]A(DR/(1+R)) DLk is total liabilities / (Total Liabilies + Equity) or the proportion of assets funded by liabilities Suppose a manager has the following situation: Duration of Assets = 5 years and Duration of Liabilities = 3 years The current interest rate is 10% and it is expected to rise to 11% what is the impact on the net worth of the company Duration Gap AnalysisAssetsLiabilities and EquityAssets 100Liabilities 90Equity 10 First let’s calculate the potential impact on net worth. DE = -[DA - DLk] x A x (DR/(1+R)) -[5-3*.9] x 100 x (.01/1.10) or -2.09 decrease in equity What about Asset and Liability Accounts? DA = -5(.01/1.10) = -.04545 = -4.545% = 95.45 DL = -3(.01/1.10) = -.02727 = -2.727% = 87.54 New Balance SheetAssetsLiabilities and EquityAssets 95.45Liabilities 87.54Equity 7.91 Duration Gap Example Duration and Repricing Gap Example
Asset and Liability Management Fin6102 Ferriter – Spring 2018 Overview This chapter discusses insurance companies Two major groups: Life Property-casualty Financial crisis and insurance companies Size, structure, and composition Balance sheets and recent trends Regulation of insurance companies Global competition and trends Ch 6-2 ©McGraw-Hill Education. 2 Insurance and Financial Crisis Insurance companies as investors in securities Subprime mortgage pools fell in value Credit default swaps (CDS) fell AIG was a major writer of CDS securities Potential impact on other FIs that bought CDS from AIG used to justify the bailout Increased risk exposure to banks, investment banks, and insurers Ch 6-3 ©McGraw-Hill Education.
3 Insurance Companies Differences in services provided by: Life insurance companies Property and casualty insurance companies Ch 6-4 ©McGraw-Hill Education. 4 Size, Structure, and Composition Size, structure, and composition of the insurance industry: In 1988: 2,300 life insurance companies with aggregate assets of $1.1 trillion In 2010s: 830 life insurance companies with aggregate assets of $6.5 trillion in 2015 Ch 6-5 ©McGraw-Hill Education. 5 Size, Structure, and Composition Continued 4 largest life insurers wrote 33% of new business in 2014 Most policies sold through commercial banks 18% of all fixed annuities were sold by commercial banks in 2015 Ch 6-6
©McGraw-Hill Education. 6 Life Insurance Companies Significant merger activity in life insurance industry Not to same extent witnessed in banking E.g., Anthem and Signa, MetLife and American Life Insurance, etc. Competition from within industry and from other FIs Increased conversion from mutual to stockholder controlled companies Ch 6-7 ©McGraw-Hill Education. 7 Mutual vs. Stock Insurance Companies Ch 6-8 ©McGraw-Hill Education. 8 Biggest Life Insurers ©McGraw-Hill Education.
9 9 Insurance Issues Adverse selection Insured have higher risk than general population E.g., Matt has never had life insurance, but decides to buy some once he finds out he has a terminal illness Alleviated by grouping of policyholders into similar risk pools Problem for both life insurers and property-casualty insurers Ch 6-10 ©McGraw-Hill Education. 10 Types of Life Insurance Life insurance products: Ordinary life Term life, whole life, endowment life Variable life, universal life and variable universal life Group life Industrial life Credit life Ch 6-11 ©McGraw-Hill Education. 11 Ch 6-12 Distribution of Premiums, 2015
©McGraw-Hill Education. 12 12 Other Life Insurer Activities Annuities Reverse of life insurance activities Topped $325.2 billion in 2014 Private pension plans Insurers compete with other financial service companies In 2015, life insurers managed over $2.7 trillion (~40% of all private pension plans) Accident and health insurance Protects against morbidity (i.e., ill health) risk Over 168.7 billion in premiums in 2014 Ch 6-13 ©McGraw-Hill Education. 13 Balance Sheet Assets Need to generate competitive returns on savings components of life insurance policies Focus investment on long-term assets Bonds, equities, government securities Policy loans Liabilities Policy reserves to meet policyholders’ claims
Separate account business represented 38.2% of total liabilities and capital in 2015 Ch 6-14 ©McGraw-Hill Education. 14 Recent Trends Impact of financial crisis Drop in value of securities Capital losses from bonds and stocks exceeded $35 billion Historically low short-term interest rates Adverse impact on ability to lower rates on new policies Incentive to surrender existing policies Dwindling reserves led to Treasury Department extending bailout funds Late 2009 showed improvement Ch 6-15 ©McGraw-Hill Education. 15 Regulation McCarran-Ferguson Act of 1945 Confirms primacy of state over federal regulation State insurance commissions Coordinated examination system developed by NAIC Federal Reserve Supervises ~1/3 of U.S. insurance industry assets States promote life insurance guarantee funds Ch 6-16 ©McGraw-Hill Education.
16 Recent Regulatory Issues Fear of systemic risk posed by AIG 2009: Proposals to create optional federal life insurance charter Proponents of federal charter argued inconsistent regulation and barriers to innovation inherent in current system 2010: Wall Street Reform and Consumer Protection Act established the Federal Insurance Office (FIO) Ch 6-17 ©McGraw-Hill Education. 17 Web Resources For more detailed information on insurance regulation, visit: NAIC www.naic.org Ch 6-18 ©McGraw-Hill Education. 18 Property-Casualty Insurance Size and Structure Currently about 2,640 companies sell property-casualty insurance Highly concentrated
Top 10 firms have 50% of market in terms of premiums written Top 200 firms write over 95% of total premiums M&A activity is increasing concentration Ch 6-19 ©McGraw-Hill Education. 19 Types of P&C Products Fire insurance Homeowners multiple-peril insurance Commercial multiple-peril insurance Automobile liability and physical damage insurance Liability insurance (other than automobile) Ch 6-20 ©McGraw-Hill Education. 20 Premium Allocation Changing composition of net premiums written, 2014 versus 1960: Fire: 2.3% vs. 16.6% in 1960 Homeowners MP: 15.2% vs. 5.2% in 1960 Commercial MP: 6.9% vs. 0.4% in 1960 Auto L&PD: 38.6% vs. 43% in 1960 Other liability: 12.7% vs. 6.6% in 1960 Ch 6-21 ©McGraw-Hill Education. 21
P&C Balance Sheet Similar to life insurance companies; long-term securities Unlike life insurance companies; requirement for liquid assets Major liabilities: Loss reserves Loss adjustment expenses Unearned premiums Ch 6-22 ©McGraw-Hill Education. 22 Loss Risk Underwriting risk may result from: Unexpected increases in loss rates Unexpected increases in expenses Unexpected decreases in investment yields or returns Property versus liability Losses from liability insurance less predictable Example: Claims due to asbestos damage to workers’ health Ch 6-23 ©McGraw-Hill Education. 23 Loss Risk Continued Severity versus frequency Loss rates more predictable on low-severity, high-frequency lines (such as fire, auto, and homeowners) than on high-
severity, low-frequency lines (such as earthquake, hurricane, and financial guaranty) Higher uncertainty forces PC insurers to invest in more short- term assets and hold larger capital and reserves than life insurers Ch 6-24 ©McGraw-Hill Education. 24 Insurance Risks Post 9/11 Crisis generated by terrorist attacks forced creation of federal terrorism insurance program in 2002 Federal government provides backstop coverage under Terrorism Risk Insurance Act of 2002 (TRIA) Caps losses for insurance companies Ch 6-25 ©McGraw-Hill Education. 25 Long Tail Versus Short Tail Long-tail risk exposure Arises where loss occurs during coverage period but claim is not made until many years later Examples: Asbestos cases and Dalkon shield case Efforts to contain long-tail risks within subsidiaries Example: Halliburton Ch 6-26 ©McGraw-Hill Education.
26 Insurance Costs: Social Inflation Product inflation versus social inflation Unexpected inflation may be systematic or line-specific Social inflation: Unexpected changes in awards by juries Reinsurance Approximately 75 percent of reinsurance by US firms is written by non-US firms, such as Munich Re Ch 6-27 ©McGraw-Hill Education. 27 Underwriting Profitability Loss ratios have generally increased Expense ratios have generally decreased Attributed to change in distribution methods Insurers have begun selling directly to consumers through their own brokers rather than independent brokers Combined ratio: Includes both loss and expense experience If greater than 100, premiums are insufficient to cover losses and expenses Ch 6-28 ©McGraw-Hill Education. 28 Investment Yield / Return Risk Operating ratio = combined ratio after dividends minus
investment yield Importance of investment income: Causes PC managers to place importance on measuring and managing credit and interest rate risk Ch 6-29 ©McGraw-Hill Education. 29 P&C: Recent Trends Several catastrophes over 1985 - 2015 Hurricane Hugo 1989, San Francisco Earthquake 1991, Oakland fires 1991, Hurricane Andrew 1991 2004 hurricanes (Charley, Frances, Ivan, Jeanne) occurred in rapid succession and generated claims comparable to Andrew Hurricane Katrina, 2005 September 11, 2001 terrorist attacks created an insurance crisis (and heightened demand) Hurricane Sandy, 2011 Potential for crowding out market solutions (catastrophe bonds) via government actions Ch 6-30 ©McGraw-Hill Education. 30 PC Regulation PC insurers chartered and regulated by state commissions State guaranty funds National Association of Insurance Commissioners (NAIC) provides various services to state commissions Includes Insurance Regulatory Information System (IRIS)
Many lines face rate regulation Criticism over Katrina-related claims Ch 6-31 ©McGraw-Hill Education. 31 Global Issues Insurance industry becoming increasingly global Worldwide, 2011 was a bad year for both life and PC insurers Japan’s earthquake and tsunami Earthquakes in New Zealand Floods in Thailand Severe tornadoes in US Ch 6-32 ©McGraw-Hill Education. 32 Pertinent Websites A.M. Best Federal Reserve Insurance Information Institute Insurance Services Offices National Association of Insurance Commissioners Ch 6-33 www.ambest.com www.federalreserve.gov www.iii.org www.iso.com
www.naic.org ©McGraw-Hill Education. 33 Asset and Liability Management Fin6102 Ferriter – Spring 2018 Overview This chapter discusses mutual funds and hedge funds: Activities of mutual funds Size, structure, and composition Balance sheets and recent trends Regulation of mutual funds Global issues Activities of hedge funds Regulation of hedge funds Ch 5-2 ©McGraw-Hill Education. 2 Mutual Funds Diversification opportunities enhanced for small investors Economies of scale
Predominantly open-ended funds Ch 5-3 ©McGraw-Hill Education. 3 Mutual Funds Continued Rapid growth in funds during the 1990s Slower rate of growth in the industry in early 2000s than in 1990s Trading abuses and loss of confidence contributed to slowdown 20 percent drop in assets during 2008 financial crisis Ch 5-4 ©McGraw-Hill Education. 4 Mutual Funds Concluded 2015: More than 7,600 stock and bond mutual companies Total assets of $13.22 trillion More than 8,100 firms and $15.94 trillion if money market mutual funds included Ch 5-5 ©McGraw-Hill Education. 5
Size, Structure, and Composition First mutual fund: Boston, 1924 Slow industry growth, initially Factors contributing to dramatic growth Advent of money market mutual funds, 1972 Tax-exempt money market mutual funds, 1979 Special-purpose equity, bond, emerging market, and derivative funds Ch 5-6 ©McGraw-Hill Education. 6 Size, Structure, and Composition Continued Total net assets in mutual funds: 1940: $0.5 billion 1990: $1,065.2 billion 2000: $6,964.6 billion 2007: $12,001.5 billion 2008: $9,603.6 billion 2009: $11,113.0 billion 2010: $11,831.9 billion 2012: $13,052.2 billion 2015: $15,944.6 billion Ch 5-7 ©McGraw-Hill Education. 7 Structure Institutional funds
80 percent of retirement plan investments Low costs No additional distribution fees; bargaining power of retirement plan Risk levels set by retirement plan sponsors Low barriers to entry in US mutual fund industry Allows new entrants to offer funds and compete for investors Ch 5-8 ©McGraw-Hill Education. 8 Size, Structure, and Composition Concluded By asset size, mutual fund industry second most important FI group Recent interest by commercial banks and insurance companies Mellon purchase of Dreyfus As of 2015, banks managed approximately 5% of mutual fund assets State Farm (more than 9,000 agents) As of 2015, insurance companies managed approximately 5% of mutual fund assets Ch 5-9 ©McGraw-Hill Education. 9 Ch 5-10 Assets of Major FIs: 1990, 2007, 2015 ©McGraw-Hill Education.
10 10 Types of Mutual Funds Types of long-term funds: Bond funds, equity funds, hybrid funds Volatility of long-term funds share: 74.3% of mutual fund assets, 1999 2002, long-term funds dropped to 62.1% of assets, losing ground to MMMFs 72.1% in 2007, 59.1% in 2008 68.1% in 2009, 77.4% in 2015 Ch 5-11 ©McGraw-Hill Education. 11 Share of Long Term Funds If MMMFs uninsured: Higher returns September 2008: Risk aversion of investors changed Run on Reserve Primary Fund (due to Lehman Brothers link) Temporary extension of government insurance to MMMFs during the crisis Ch 5-12 ©McGraw-Hill Education.
12 Mutual Funds Continued Money market mutual funds 25.7% of assets, 1999 37.9% of assets, 2002 27.9% in 2007, 40.9% in 2008 31.9% in 2009, 22.6% in 2015 As of 2015, 43 percent of US households owned mutual funds Down from 52 percent in 2001 Ch 5-13 ©McGraw-Hill Education. 13 Ch 5-14 Interest Rate Spread and Net New Cash Flow to MMMFs ©McGraw-Hill Education. 14 14 Overview of Mutual Funds Objectives (and adherence to stated objectives), rates of return, and risk characteristics vary Examples: Capital appreciation funds
World equity Investment grade bond High-yield bond World bond Government bond Ch 5-15 ©McGraw-Hill Education. 15 Returns to Mutual Funds Income and dividends of underlying portfolio Capital gains on trades by mutual fund management Capital appreciation in values of assets held in the portfolio Marked-to-market Net asset value (NAV) Ch 5-16 ©McGraw-Hill Education. 16 Web Resources For information on the performance of mutual funds, visit: Morningstar www.morningstar.com Ch 5-17 ©McGraw-Hill Education. 17
Types of Funds Open-end fund Comparable to most corporate securities traded on stock exchanges Closed-end investment companies Fixed number of shares outstanding Example: REITs May trade at premium or discount Exchange traded funds (ETFs) Load versus no-load funds Ch 5-18 ©McGraw-Hill Education. 18 Types of Funds Continued Ch 5-19 Exchange traded funds (ETFs) Fixed number of shares outstanding May be bought/sold through broker or in brokerage account Registered with SEC as investment companies Retail investor cannot purchase/redeem shares directly from the ETF ©McGraw-Hill Education. 19 Ch 5-20 Load versus No-Load: Share of Assets ©McGraw-Hill Education.
20 20 Mutual Fund Costs Load versus no-load funds: Sales loads Generally, negative effect on performance outweighs benefits Short term versus long term investment horizon alters impact of loads on cost Fund operating expenses Management fee 12b-1 fees Front end and back end fees Class A, Class B, and Class C differences Creation of new rules by SEC Sweeping decreases in fees, 2005 and 2006 Ch 5-21 ©McGraw-Hill Education. 21 Balance Sheet and Trends Money Market Funds (MMFs) Key assets are short-term securities (consistent with deposit- like nature) 2015: $1,804.2 billion (86.8% of total assets) 2008: flight to safety, out of corporate and foreign bonds Most consumer-oriented shares have values fixed at $1 and adjust number of shares owned by the investor Significant liquidity risk highlighted during crisis Ch 5-22
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
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Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
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Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx
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Asset and Liability ManagementFin6102Ferriter – Spring 2018.docx

  • 1. Asset and Liability Management Fin6102 Ferriter – Spring 2018 Overview This chapter discusses securities brokerage firms and investment banks Activities of securities firms and investment banks Size, structure, and composition Balance sheets and recent trends Regulation of securities firms and investment banks Global issues Ch 4-2 ©McGraw-Hill Education. 2 Securities Firms and Investment Banks Securities firms Specialize in the purchase, sale, and brokerage of existing securities Retail Investment banks Specialize in originating, underwriting and distributing issues of new securities Advising on M&As and restructuring Commercial Ch 4-3 ©McGraw-Hill Education.
  • 2. 3 Securities Firms and Investment Banks Continued Growth in domestic M&A: Less than $200 billion in 1990 $1.83 trillion in 2000 In US: bottomed out at $458 billion in 2002 ($1.2 trillion worldwide) Topped $1.7 trillion 2007 ($4.5 trillion worldwide) Effects of financial crisis: fell to $687 billion in 2010 ($1.8 trillion worldwide) Worst financial crisis since 1930s, but M&A activity still greater than early 2000s Ch 4-4 ©McGraw-Hill Education. 4 Ch 4-5 Mergers and Acquisitions, 1990-2015 ©McGraw-Hill Education. 5 5 Structural Changes in Recent Years Acquisition of Bear Stearns by J.P. Morgan Chase
  • 3. Bankruptcy of Lehman Brothers Acquisition of Merrill Lynch by Bank of America Only two remaining major firms: Goldman Sachs and Morgan Stanley Converted to commercial bank holding companies in 2008 Ch 4-6 ©McGraw-Hill Education. 6 Largest M&A Transactions ©McGraw-Hill Education. 7 7 Size, Structure and Composition Dramatic increase in number of firms from 1980 to 1987 Decline of 37% in the number of firms following the 1987 crash, to year 2006 Concentration of business among the largest firms Ch 4-8 ©McGraw-Hill Education. 8 Size, Structure and Composition Continued Many recent interindustry mergers (i.e., insurance companies
  • 4. and investment banks) Role of Financial Services Modernization Act, 1999 Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley gone by end of 2008 Ch 4-9 ©McGraw-Hill Education. 9 Types and Relative Sizes of Firms National full-line firms are largest Service retail and corporate clients Three categories: commercial bank holding companies, national full-line firms, and large investment banks BOA (via acquisition of Merrill Lynch); Morgan Stanley National full-line firms specializing in corporate finance are second in size Goldman Sachs, Salomon Brothers/Smith Barney (Citigroup) Ch 4-10 ©McGraw-Hill Education. 10 Remainder of industry: Regional securities firms (subdivided into large, medium, and small) Specialized discount brokers Electronic trading firms Venture capital firms Other firms E.g., research boutiques, floor specialists, etc.
  • 5. Ch 4-11 Types and Relative Sizes of Firms Continued ©McGraw-Hill Education. 11 Ch 4-12 Top BHCs, 2014 (by brokerage fee income) ©McGraw-Hill Education. 12 12 Key Activities Investment banking Activities related to underwriting and distributing new (IPOs) and secondary (seasoned) issues of debt and equity Public and private offerings Venture Capital Market making Involves creating a secondary market Increasing importance of online trading Technology risk Ch 4-13 ©McGraw-Hill Education. 13
  • 6. Key Activities (Continued) Trading Position trading, pure arbitrage, risk arbitrage, program trading, etc. Investing Cash management Mergers and Acquisitions (M&As) Back-office and service functions Ch 4-14 ©McGraw-Hill Education. 14 Recent Trends Decline in trading volume and brokerage commissions Particularly since crash of 1987, although some recovery since 1992 Record volumes 1995-2000 Resurgence in market values and commissions during mid-2000s New market value lows in 2008-2009 Commission income also declined Ch 4-15 ©McGraw-Hill Education. 15 Recent Trends (Continued) Pretax net income over $9 billion per year between 1996 and 2000 Pretax profits soared to $31.6 billion in 2000
  • 7. Curtailed by economic slowdown and September 11, 2001 terrorist attacks Worries over securities law violations and loss of investor confidence E.g., Enron, Merck, WorldCom, etc. Financial crisis, 2008 Profits recovered, 2009 Ch 4-16 ©McGraw-Hill Education. 16 Ch 4-17 Securities Industry Pretax Profits, 1990-2014 ©McGraw-Hill Education. 17 17 Balance Sheet Key assets: Reverse repurchase agreements Receivables from other broker-dealers Long positions in securities and commodities Subject to high levels of market and interest rate risk Ch 4-18 ©McGraw-Hill Education.
  • 8. 18 Balance Sheet Continued Key liabilities: Repurchase agreements are major source of funds Payables to customers Payables to other broker-dealers Securities and commodities sold short Capital levels much lower than in depository institutions Ch 4-19 ©McGraw-Hill Education. 19 Regulation Primary regulator is the Securities and Exchange Commission (SEC) Reaffirmed by National Securities Markets Improvement Act (NSMIA) of 1996 Prior to NSMIA, regulated by SEC and each state in which the firm operated Ch 4-20 ©McGraw-Hill Education. 20 Regulation Continued
  • 9. Early 2000s saw erosion of SEC dominance Increased vigilance by state attorney generals Criminal cases brought mainly by states against securities law violators New York State vs. Merrill Lynch Spring 2003, $1.4 billion in penalties over investor abuses New rules brought by SEC for greater disclosure by analysts of potential conflicts of interest Ch 4-21 ©McGraw-Hill Education. 21 Regulation Concluded Financial Industry Regulatory Authority (FINRA) Handles day-to-day regulation Independent, not-for-profit Authorized by Congress Writes and enforces rules governing security firm activities Enhance transparency in the market Dark pools Ch 4-22 ©McGraw-Hill Education. 22 Extension of Oversight Additional oversight from US Congress Hearings focused on role of investment banks in the financial crisis Goldman Sachs bundling of toxic assets
  • 10. Ch 4-23 ©McGraw-Hill Education. 23 Extension of Oversight Continued 2010 Wall Street Reform and Consumer Protection Act Financial Services Oversight Council New authority for Federal Reserve to supervise systemically important firms Registration limits for advisors changed Regulation of securitization markets; stronger regulation of credit agencies Authority for government to resolve nonbank FIs Ch 4-24 ©McGraw-Hill Education. 24 Extension of Oversight Concluded Kenneth Feinberg (“pay czar”) given voice as to executive compensation packages Ch 4-25 ©McGraw-Hill Education. 25
  • 11. Investor Protection and Other Monitoring Securities Investor Protection Corporation (SIPC) Protection level of $500,000 October 2003 implementation of provisions of Patriot Act to combat money laundering Scrutiny of individual identities and affiliations with terrorists Ch 4-26 ©McGraw-Hill Education. 26 Global Issues Global nature of securities firms Competition between US and European firms Foreign investors’ transactions in US securities and US investors’ transactions in foreign securities exchanges increased Global concern about capital, liquidity, and leverage following the financial crisis Implications for global competitiveness Strategic alliances Exit from foreign markets Ch 4-27 ©McGraw-Hill Education. 27 Pertinent Websites Federal Reserve NYSE SEC Securities Industry Association
  • 12. SIPC FINRA Ch 4-28 www.federalreserve.gov www.nyse.com www.sec.gov www.sifma.com www.sipc.org www.finra.org ©McGraw-Hill Education. 28 Asset and Liability Management Fin6102 Ferriter – Spring 2018 Agenda Review Questions from Last Week Depository Institutions Security Brokers and Investment Firms Insurance Finance Companies Overview of Depository Institutions This chapter recognizes three major FI groups: Commercial banks, savings institutions, and credit unions This chapter discusses depository FIs:
  • 13. Size, structure, and composition Balance sheets and recent trends Regulation of depository institutions Depository institutions performance Ch 2-3 ©McGraw-Hill Education. 3 Products of U.S. FIs Comparing the products of FIs in 1950, to products of FIs in 2016: Much greater distinction between types of FIs in terms of products offered in 1950 than in 2016 Blurring of product lines and services over time and wider array of services (Refer to Tables 2-1A and 2-1B in the text) Ch 2-4 ©McGraw-Hill Education. 4 Specialness of Depository FIs Products offered on both sides of the balance sheet Offer loans Asset side Accept deposits Liabilities side Ch 2-5 ©McGraw-Hill Education.
  • 14. 5 Other Outputs of Depository FIs Other products and services in 1950: Payment services, savings products, fiduciary services By 2016, products and services further expanded to frequently include: Underwriting of debt and equity, insurance and risk management products Ch 2-6 ©McGraw-Hill Education. 6 Size of Depository FIs Consolidation has created some very large FIs Combined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs Ch 2-7 ©McGraw-Hill Education. 7 Largest US Depository Institutions Ch 2-8CompanyBanking AssetsHolding Company Assets ($ billions)J.P. Morgan Chase$2,134.1$2,448.0Bank of America1,629.52,152.0Wells Fargo1,629.51,720.6Citigroup1,337.51,829.4U.S. Bancorp414.0419.1PNC Financial Services Corp.343.6354.2Bank of New York Mellon343.6395.3State
  • 15. Street Corp.289.4294.6Capital One254.4310.6TD Bank252.4253.2 ©McGraw-Hill Education. 8 8 Commercial Banks Largest group of depository institutions Differ from other FIs in composition of assets and liabilities, as well as regulatory oversight Large and small commercial banks differ with regards to structure and composition E.g., larger banks make more commercial/industrial loans and small banks make more real estate loans Mix of very large banks with very small banks Ch 2-9 ©McGraw-Hill Education. 9 Structure and Composition Shrinking number of banks: 14,416 commercial banks in 1985 12,744 in 1989 5,472 in 2015 Mostly the result of Mergers and Acquisitions M&A prevented prior to 1980s, 1990s Consolidation has reduced asset share of smallest banks (under $1 billion) Ch 2-10
  • 16. ©McGraw-Hill Education. 10 Regulation, Functions & Structure Functions of depository institutions Regulatory sources of differences across types of depository institutions Structural changes generally resulted from changes in regulatory policy Example: Changes permitting interstate branching Riegle-Neal Act, 1994 Ch 2-11 ©McGraw-Hill Education. 11 Ch 2-12 Breakdown of Loan Portfolios ©McGraw-Hill Education. 12 12 Commercial Banks: Asset ConcentrationSize2015 AssetsPercent
  • 17. of Total1984 AssetsPercent of TotalAll FDIC Insured14,679.2100.02,508.9100.0$100M or Less93.56.0404.216.1$100M - $1B1,014.76.9513.920.5$1B - $10B1,336.89.1725.928.9$10B or more12,234.383.4864.834.5 Ch 2-13 ©McGraw-Hill Education. 13 13 Structure and Composition of Commercial Banks Limited powers to underwrite corporate securities have existed only since 1987 Financial Services Modernization Act 1999 Permitted commercial banks, investment banks, and insurance companies to merge Ch 2-14 ©McGraw-Hill Education. 14 Composition of Commercial Banking Sector Community Banks Regional or Superregional Access to federal funds market to finance their lending and investment activities Money Center Banks Bank of New York Mellon, Deutsche Bank (Bankers Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USA
  • 18. Ch 2-15 ©McGraw-Hill Education. 15 Balance Sheet and Trends Key trends since 1987 Business loans have declined in importance while securities and mortgages have increased What influences these trends? Increased importance of alternative funding via commercial paper market Securitization of mortgage loans Temporary effects: credit crunch during recessions of 1989-92 and 2001-02 Ch 2-16 ©McGraw-Hill Education. 16 Commercial Banks, June 2015 Primary assets: Real Estate Loans: $3,801.9 B C&I loans: $1,737.6 B Loans to individuals: $1,301.2 B Investment security portfolio: $3,953.0 B Of which, Treasury securities: $2,015.3 B Credit/default risk is a major exposure Ch 2-17
  • 19. ©McGraw-Hill Education. 17 Commercial Banks, June 2015 Continued Primary liabilities: Deposits: $11,108.4 billion Borrowings: $1,578.2 billion Other liabilities: $339.1 billion Inference: Maturity mismatch/interest rate risk and liquidity risk are key areas of exposure Ch 2-18 ©McGraw-Hill Education. 18 Terminology Transaction accounts Negotiable Order of Withdrawal (NOW) accounts Money Market Mutual Funds Negotiable CDs Ch 2-19 ©McGraw-Hill Education. 19
  • 20. Equity Commercial bank equity capital 11.26 percent of total liabilities and equity (2015) TARP program 2008-2009 intended to encourage increase in capital Citigroup $25 B BOA $20 B Through 2015: $245 B in capital injections through TARP Ch 2-20 ©McGraw-Hill Education. 20 Off-Balance-Sheet Activities Heightened importance of off-balance-sheet items OBS assets, OBS liabilities Earnings and regulatory incentives Risk control and risk producing Role of mortgage backed securities “Toxic” assets Expansion of oversight to unregulated OTC derivative securities Ch 2-21 ©McGraw-Hill Education. 21 Major OBS Activities Issuing guarantees E.g., letters of credit
  • 21. Typically contain an insurance underwriting element Loan commitments Derivative transactions Futures Forwards Options Swaps Ch 2-22 ©McGraw-Hill Education. 22 Other Fee-Generating Activities Trust services Correspondent banking Services generally sold as a package Types of services offered: Check clearing and collection Foreign exchange trading Hedging Participation in large loan and security issuances Ch 2-23 ©McGraw-Hill Education. 23 Key Regulatory Agencies FDIC Deposit Insurance Fund (DIF) Role in preventing contagious “runs” or panics OCC: Primary function is to charter (and close) national banks
  • 22. FRS: Monetary policy, lender of last resort National banks are automatically members of the FRS; state- chartered banks can elect to become members State bank regulators Dual Banking System: Coexistence of national and state- chartered banks Ch 2-24 ©McGraw-Hill Education. 24 Ch 2-25 Bank Regulators ©McGraw-Hill Education. 25 25 Legislation, 1927-1956 1927 McFadden Act: Controls branching of national banks 1933 Glass-Steagall: Separates securities and banking activities, established FDIC, prohibited interest on demand deposits 1956 Bank Holding Company Act and subsequent amendments specifies permissible activities and regulation by FRS of BHCs Ch 2-26 ©McGraw-Hill Education. 26
  • 23. Legislation, 1970-1978 1970 Amendments to the Bank Holding Company Act: Extension to one-bank holding companies 1978 International Banking Act: Regulated foreign bank branches and agencies in US Ch 2-27 ©McGraw-Hill Education. 27 Legislation, 1980 - 1982 1980 DIDMCA and 1982 Garn-St. Germain Depository Institutions Act (DIA) Mainly deregulation acts Phased out Regulation Q Authorized NOW accounts nationwide Increased deposit insurance from $40,000 to $100,000 Reaffirmed limitations on bank powers to underwrite and distribute insurance products Ch 2-28 ©McGraw-Hill Education. 28 Legislation, 1987-1989 1987 Competitive Equality in Banking Act (CEBA) Redefined bank to limit growth of nonbank banks Focus on recapitalization of FSLIC 1989 FIRREA
  • 24. Imposed restrictions on investment activities Replaced FSLIC with FDIC-SAIF Replaced FHLB with Office of Thrift Supervision (OTS) Created Resolution Trust Corporation (RTC) Ch 2-29 ©McGraw-Hill Education. 29 Legislation, 1991 1991 FDIC Improvement Act Introduced prompt corrective action (PCA) Risk-based deposit insurance premiums Limited “too big to fail” bailouts by federal regulators Extended federal regulation over foreign bank branches and agencies in FBSEA Ch 2-30 ©McGraw-Hill Education. 30 Legislation, 1994 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act Permits BHCs to acquire banks in other states Invalidates some restrictive state laws Permits BHCs to convert out-of-state subsidiary banks to branches of single interstate bank Newly chartered branches permitted interstate if allowed by state law Ch 2-31 ©McGraw-Hill Education.
  • 25. 31 Legislation, 1999 1999 Financial Services Modernization Act Allowed banks, insurance companies, and securities firms to enter each others’ business areas Provided for state regulation of insurance Streamlined regulation of BHCs Prohibited FDIC assistance to affiliates and subsidiaries of banks and savings institutions Provided for national treatment of foreign banks Ch 2-32 ©McGraw-Hill Education. 32 Legislation, 2010 2010 Wall Street Reform and Consumer Protection Act Financial Services Oversight Council created Government gained power to break up FIs that pose a systemic risk to the system Consumer Financial Protection Bureau created GAO to audit Federal Reserve activities Nonbinding proxy vote on executive pay Trading via clearinghouse for some derivatives Ch 2-33 ©McGraw-Hill Education. 33
  • 26. Industry Performance Economic expansion and falling interest rates through 1990s Brief downturn in early 2000s followed by strong performance improvements Record earnings $106.3 billion 2003 Performance remained stable through mid 2000s as interest rates rose Late 2000s: Strongest recession since Great Depression Ch 2-34 ©McGraw-Hill Education. 34 Savings Institutions Comprised of: Savings Associations (SAs) Savings Banks (SBs) Effects of changes in Federal Reserve’s policy of interest rate targeting combined with Regulation Q and disintermediation Effects of moral hazard and regulator forbearance Qualified thrift lender (QTL) test Ch 2-35 ©McGraw-Hill Education. 35 Savings Institutions: Recent Trends Industry is smaller overall Intense competition from other FIs E.g., mortgages
  • 27. Ch 2-36 ©McGraw-Hill Education. 36 Primary Regulators Office of the Comptroller of Currency (OCC) FDIC-DIF Fund FDIC oversaw and managed Savings Association Insurance Fund (SAIF) SAIF and Bank Insurance Fund (BIF) merged in January 2007 to form DIF Same regulatory structure applied to commercial banks Ch 2-37 ©McGraw-Hill Education. 37 Credit Unions Nonprofit DIs owned by member-depositors with a common bond Specialize in small consumer loans Exempt from taxes and Community Reinvestment Act (CRA) Expansion of services offered in order to compete with other FIs Claim of unfair advantage of CUs over small commercial banks Ch 2-38 ©McGraw-Hill Education. 38
  • 28. Ch 2-39 Composition of Credit Union Deposits, 2015 ©McGraw-Hill Education. 39 39 Global Issues Spread of US financial crisis to other countries Many European banks saved from bankruptcy through support of governments and central banks Target interest rates at or below 1 percent Links to macroeconomic performance Ch 2-40 ©McGraw-Hill Education. 40 Financial Statement Analysis Return on equity (ROE): measures overall profitability per dollar of equity Return on assets (ROA): measures profit generated relative to assets Equity multiplier (EM): measures extent to which assets are funded with equity relative to debt Profit margin (PM): measures ability to pay expenses and generate net income Asset utilization (AU): measures amount of interest and
  • 29. noninterest income generated per dollar of total assets Ch 2-41 ©McGraw-Hill Education. 41 CAMELS Ratings Composite 1: Institutions are generally sound in every respect Composite 2: Institutions are fundamentally sound, but may reflect modest weaknesses Composite 3: Institutions exhibit financial, operational, or compliance weaknesses Composite 4: Immoderate volume of serious financial weaknesses Composite 5: Extremely high immediate or near term probability of failure ©McGraw-Hill Education. DIs and Regulators Ch 2-43 ©McGraw-Hill Education. 43 Technology in Commercial Banking Wholesale banking services E.g., account reconciliation, electronic funds transfer, electronic billing, cloud computing, etc. Retail banking services
  • 30. E.g., ATMs, smart cards, online/mobile banking, tablet banking, loyalty programs, etc. Advanced technology requirements Ch 2-44 ©McGraw-Hill Education. 44 Asset and Liability Manangement FIN6102 Ferriter Spring 2018 Overview This chapter discusses types and characteristics of loans made by U.S. FIs, models for measuring credit risk, and applicable technological advances. Important for purposes of: Pricing loans and bonds Setting limits on credit risk exposure Ch 10-2 ©McGraw-Hill Education. 2 Objectives for Individual Loans
  • 31. There are two primary questions that need to be answered about individual loans. First, what is the potential return on the loan Second, what is the probability of default What options do we have to measure the probability of default? Why is credit risk important? Credit Risk is perhaps the most important consideration for a loan. Loans have a fixed and defined payment, this means that there is very limited upside and more downside compared to equity investments Because of the greater emphasis on downside risk, bond and loan markets are very focused and very responsive to changes. Credit Quality Problems Problems with junk bonds, LDC loans, and residential and farm mortgage loans Late 1990s, credit card and auto loans Crises in other countries such as Argentina, Brazil, Russia, and South Korea 2006-2007, mortgage delinquencies on subprime loans surged Emphasizes importance credit risk analysis Ch 10-5 ©McGraw-Hill Education. 5 5 Credit Quality Problems Over the early to mid 1990s, improvements in NPLs for large banks and overall credit quality
  • 32. Late 1990s and early 2000, Telecommunication and tech companies DotCom bubble – get big fast WorldCom Alan Greenspan – raises interest rates Mid 2000s, economic growth accompanied by reduction in NPL rates Mortgage crisis Increased emphasis on credit risk evaluation Ch 10-6 ©McGraw-Hill Education. 6 What is a junk bond? Many investors incorporate bondsinto their portfolios to benefit from the interest payments they typically provide. But a bond's investment value is only as good as its issuer's ability to make those payments. When a bond's credit rating falls below what's considered investment-grade level, it's referred to as a junk bond. Though junk bonds carry more risk than investment-grade bonds with higher ratings, they tend to offer much higher yields, and as such, they're an attractive option for some buyers. Bonds that have a high enough credit rating are considered investment-grade, which means that they're suitable for most investors. On the other hand, bonds with a low enough rating are considered non-investment-grade, or junk. There are three major ratings agencies used to evaluate bonds' creditworthiness: Standard & Poor's (S&P), Moody’s and Fitch These agencies analyze a number of factors, such as assets, liabilities, and cash flow management, when assigning ratings to issuers. S&P and Fitch use a similar ratings system where issuers can receive as high a rating as AA, and as low a rating
  • 33. as D. Moody's uses a slightly different system where issues can go as high as Aaa and as low as C. A bond that carries a credit rating of BB or lower by S&P and Fitch, or Ba or lower by Moody's, is considered non-investment-grade, or junk. Junk Bond Crisis From the 1970’s to the 1980’s the junk bond market grew exponentially at a a pace of around 34% per year. During this period of time junk bonds achieved a superior risk adjusted return. Essentially, junk bonds in this period were a superior investment compared to other investments with the same amount of risk. However, this period of growth came to a sudden stop in 1989. There is some disagreement as to what caused it, but most point to the collapse of the US$6.75bn buyout of UAL as the main trigger. A buyout group consists of pilots union and an investment bank sought to take United Airlines private for $6.79 billion couldn't secure the necessary loans. Others point to the Ohio Mattress fiasco, a deal that would become known as “burning bed” and remains widely considered to be among the worst deals in modern finance. The Cleveland- based company that Gibbons, Green bought for $1.1 billion in April amid criticism that it was wildly overpaying. In August, Gibbons, Green had to shelve its efforts to line up permanent financing for the acquisition when investors in the high-risk, high-yield ''junk bond'' market refused to buy the bonds The culmination of the crash is considered to be the collapse of Drexel Burnham Lambert, which was forced into bankruptcy in early 1990, largely due to its heavy involvement in junk bonds. At one point it had been the fifth-largest investment bank in the US. Credit Card and Auto Collapse
  • 34. At the close of the 1990s, against the backdrop of the economic boom, many low- and moderate-income families were struggling financially and taking on credit card debt at rates unprecedented in American history. There is growing evidence that a combination of structural and economic trends coupled with abusive credit card industry practices left working families with few options other than to borrow heavily. Between 1989 and 2001, credit card debt in America almost tripled, from $238 billion to $692 billion. The savings rate steadily declined, and the number of people filing for bankruptcy jumped 125 percent. During the 1990s, the average American family experienced a 53 percent increase in credit card debt, from $2,697 to $4,126 (all figures measured in 2001 dollars). Low-income families saw the largest increase—a 184 percent rise in their debt—but even very high-income families had 28 percent more credit card debt in 2001 than they did in 1989. With an increase in bankruptcy filings, it led to the drafting of a bankruptcy reform bill, which was considered by the Congress, and passed as Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. It made filing chapter 7 (liquidating) bankruptcy, more difficult and introduced a means-test. Effects of Deregulation Since the late 1970s, America’s credit card industry has enjoyed a period of steady deregulation. Two Supreme Court rulings, the first in 1978 and the second in 1996, effectively hobbled state usury laws that protected consumers from excessively high interest rates and fees. Aggressive Marketing Relentless Credit Extension. Between 1993 and 2000, the industry more than tripled the amount of credit it offered to customers, from $777 billion to almost $3 trillion. Lowering of Minimum Payment Requirements
  • 35. The amount of their balance customers can pay without incurring a penalty—dropped from 5 percent to only 2 or 3 percent, making it easier for consumers to carry more debt. Assuming an interest rate of 15 percent, it would now take more than 30 years to pay off a credit card balance of $5,000 by making the minimum payment. Or sometimes, never. Skyrocketing Late Fees and Penalties. Late fees have become the fastest growing source of revenue for the industry, jumping from $1.7 billion in 1996 to $7.3 billion in 2001. Late fees now average $29, and most cards have reduced the late payment grace period from 14 days to 0 days. In addition to charging late fees, the major card companies use the first late payment as an excuse to cancel low, introductory rates—often making a zero percent card jump to between 22 and 29 percent. Asian Financial Crisis The Asian Financial Crisis occurred in 1997 and affected Indonesia, South Korea, Thailand, Hong Kong, Laos, Malaysia and the Philippines. Indonesia, South Korea, Thailand being the most affected. The causes are disputed but most agree that current account deficits, foreign currency denominated debt and a fixed exchange rate contributed to the crisis. In the mid-1990s, the maintenance of fixed exchange rates encouraged external borrowing and led to excessive exposure to foreign exchange risk in both the financial and corporate sectors. Most recognize the devaluation of the Chinese Renminbi, the devaluation of the Japanese Yen as a result of the Plaza accord and a strengthen US dollar and a rise in US interest rates as triggers for the collapse. Asian Financial Crisis
  • 36. This made the United States a more attractive investment destination relative to Southeast Asia, which had been attracting hot money flows through high short-term interest rates, and raised the value of the U.S. dollar. For the Southeast Asian nations which had currencies pegged to the U.S. dollar, the higher U.S. dollar caused their own exports to become more expensive and less competitive in the global markets. The resulting panic among lenders led to a large withdrawal of credit from the crisis countries, causing a credit crunch and further bankruptcies. In addition, as foreign investors attempted to withdraw their money, the exchange market was flooded with the currencies of the crisis countries, putting depreciative pressure on their exchange rates. To prevent currency values collapsing, these countries' governments raised domestic interest rates to exceedingly high levels (to help diminish flight of capital by making lending more attractive to investors), and to intervene in the exchange market - buying up any excess domestic currency at the fixed exchange rate with foreign reserves. Neither of these policy responses could be sustained for long. Thailand On 14 May and 15 May 1997, the Thai baht was hit by massive speculative attacks. However, Thailand lacked the foreign reserves to support the USD–Baht currency peg, and the Thai government was eventually forced to float the Baht, on 2 July 1997, allowing the value of the Baht to be set by the currency market. As a result of high interest rates, Thailand's booming economy came to a halt amid massive layoffs in finance, real estate, and construction that resulted in huge numbers of workers returning to their villages in the countryside and 600,000 foreign workers being sent back to their home countries. The baht devalued swiftly and lost more than half of its value. The baht reached its lowest point of 56 baht to the U.S. dollar in January 1998. The
  • 37. Thai stock market dropped 75%. Indonesia In July 1997, when Thailand floated the baht, Indonesia's monetary authorities widened the rupiah currency trading band from 8% to 12%. The rupiah suddenly came under severe attack in August. On 14 August 1997, the managed floating exchange regime was replaced by a free-floating exchange rate arrangement. The rupiah dropped further. Although the rupiah crisis began in July and August 1997, it intensified in November when the effects of that summer devaluation showed up on corporate balance sheets. Companies that had borrowed in dollars had to face the higher costs imposed upon them by the rupiah's decline, and many reacted by buying dollars through selling rupiah, undermining the value of the latter further. Before the crisis, the exchange rate between the rupiah and the dollar was roughly 2,600 rupiah to 1 U.S. dollar. The rate plunged to over 11,000 rupiah to 1 U.S. dollar on 9 January 1998, with spot rates over 14,000 during 23–26 January and trading again over 14,000 for about six weeks during June–July 1998. On 31 December 1998, the rate was almost exactly 8,000 to 1 U.S. dollar. Indonesia lost 13.5% of its GDP that year. South Korea The banking sector was burdened with non-performing loans as its large corporations were funding aggressive expansions. During that time, there was a haste to build great conglomerates to compete on the world stage. Many businesses ultimately failed to ensure returns and profitability. The chaebol, South Korean conglomerates, simply absorbed more and more capital investment. Eventually, excess debt led to major failures and takeovers. In the wake of the Asian market downturn, Moody's lowered the
  • 38. credit rating of South Korea on 28 November 1997, and downgraded again on 11 December. That contributed to a further decline in South Korean shares since stock markets were already bearish in November. The Seoul stock exchange fell by 4% on 7 November 1997. On 8 November, it plunged by 7%, its biggest one-day drop to that date. And on 24 November, stocks fell a further 7.2% on fears that the IMF would demand tough reforms. In 1998, Hyundai Motors took over Kia Motors. Samsung Motors' $5 billion venture was dissolved due to the crisis, and eventually Daewoo Motors was sold to the American company General Motors (GM). The IMF provided US$57 billion as a bailout package. In return, Korea was required to take restructuring measures. The ceiling on foreign investment in Korean companies was raised from 26 percent to 100 percent. In addition, the Korean government started financial sector reform program. Under the program, 787 insolvent financial institutions were closed or merged by June 2003. The South Korean won, meanwhile, weakened to more than 1,700 per U.S. dollar from around 800, but later managed to recover. South Korea’s national debt-to-GDP ratio more than doubled (approximately 13% to 30%) as a result of the crisis. What is the current account? The components of the current account: goods, services, income and current transfers. 1. Goods - These are movable and physical in nature, and for a transaction to be recorded under "goods," a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in), and an import is noted as a debit (money going out).
  • 39. 2. Services - These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service, it is recorded like an import (a debit), and if money is received, it is recorded like an export (credit). 3. Income - Income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services, and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production. 4. Current Transfers - Current transfers are unilateral transfers with nothing received in return. These include workers' remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production. Mortgage Crisis of 2008 The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume risky mortgages in the anticipation that they would be able to quickly refinance at easier terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., borrowers were unable to refinance. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices fell, and adjustable-rate mortgage (ARM) interest rates reset higher. Several other factors set the stage for the rise and fall of housing prices, and related securities widely held by financial
  • 40. firms. In the years leading up to the crisis, the U.S. received large amounts of foreign money from fast-growing economies in Asia and oil-producing/exporting countries. This inflow of funds combined with low U.S. interest rates from 2002 to 2004 contributed to easy credit conditions, which fueled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. Ch 10-18 ARMs’ Share of Total Loans Closed, 1987-2014 ©McGraw-Hill Education. 18 18 Ch 10-19 Annual Net Charge-Off Rates on Loans ©McGraw-Hill Education. 19 19 Ch 10-20 Nonperforming Asset Ratio for U.S. Commercial Banks
  • 41. ©McGraw-Hill Education. 20 20 Types of Loans C&I loans: secured and unsecured Syndication Spot loans, loan commitments Decline in C&I loans originated by commercial banks and growth in commercial paper market Effect of financial crisis on commercial paper market RE loans: Primarily mortgages Fixed-rate, ARMs Mortgages can be subject to default risk when loan-to-value rises and house prices fall below amount of loan outstanding Ch 10-21 ©McGraw-Hill Education. 21 Individual (Consumer) Loans Consumer loans: personal, auto, credit card Nonrevolving loans Automobile, mobile home, personal loans Revolving loans Credit card debt (i.e., Visa, MasterCard) Proprietary cards, such as Sears and AT&T Risks affected by competitive conditions and usury ceilings Bankruptcy Reform Act of 2005 High default rates during finance crisis highlight the importance
  • 42. of risk evaluation prior to making a credit decision Ch 10-22 ©McGraw-Hill Education. 22 22 Other Loans Other loans include: Farm loans Other banks Nonbank FIs, such as broker margin loans Foreign banks and sovereign governments State and local governments Municipal bankruptcies Detroit,MI Central Falls, RI, Harrisburg, PA Ch 10-23 ©McGraw-Hill Education. 23 23 Calculating Return on a Loan Factors: Interest rate, fees, credit risk premium, collateral, and other nonprice terms, such as compensating balances and reserve requirements Return = inflow/outflow 1+k = 1+(of + (BR + ø))/(1-[b(1-RR)]) Ch 10-24 ©McGraw-Hill Education.
  • 43. 24 24 k is the promised gross return of = direct fees (origination fees) BR + ø = loan interest rate b= Compensating balance RR = Reserve Rate Note that the text displays 1+ E(r) = p(1+k) + (1-p)0 but this simplifies to the form displayed above. Return on Loan Equation Return = inflow/outflow 1+k = 1+(of + (BR + ø))/(1-[b(1-RR)]) Of = origination fee, this is the fee paid by the customer to initiate and process the loan application BR = Base rate Ø = risk premium of the customer b = compensating balance requirement RR = reserve requirement k = the gross return on the loan Example 10-1 Suppose a Bank does the following Sets a loan rate of 10% (BR = 6% and Ø =4%) Charges a .125% origination fee Imposes an 8% compensating balance requirement to be held in non-interest accounts Sets aside reserves of 10% per Federal Reserve 1 + k = 1 + (.00125+ (.06+.04))/(1-(.08)(.9) 1 + k = 1 + (.10125)/(.928) 1 + k = 1.1091 k = .1091 or 10.91%
  • 44. Expected Return on a Loan Expected return: 1 + E(r) = p(1+k) + (1- p) 0 where p equals probability of complete repayment 1- p is the probability of non-payment or default This can be considered and binomial option as there are only two possible outcomes It’s important to note that Ø and p are not completely independent Loan originators consider the probability of default when setting the risk premium. This is to compensate for default risk To an extent it can be self-reinforcing, high interest rates equal higher payments, all else equal Higher fixed payments increases the likelihood of default which leads to higher interest rates Note that realized and expected return may not be equal Example Calculate the promised return (k) on a loan if the base rate is 13%, the risk premium is 2%, the compensating balance requirement is 5%, origination fees are .5% and the reserve requirement is 10% 1+k = 1+(of + (BR + ø))/(1-[b(1-RR)]) 1+k = 1 +((.005+(.13+.02))/(1-[.05(.9)) 1+k = 1+.155/ .955 1 + k = 1.1623 What is the expected return on the loand is the probability of default is 5% Retail versus Wholesale Credit Decisions At retail Usually a simple accept/reject decision rather than adjustments to the rate Credit rationing
  • 45. If accepted, customers sorted by loan quantity For mortgages, discrimination occurs via loan-to-value rather than adjusting rates At wholesale Use both quantity and pricing adjustments Ch 10-29 ©McGraw-Hill Education. 29 29 Managing Credit Quality How do banks and financial institutions manage individual loan quality? Most banks have guidelines for various loan types Some guidelines come from outside the organization, others are internally developed Many banks use benchmarks rating to ensure market competitiveness and market share All banks have some form of Risk Model to estimate exposure to default risk Risk Models Availability, quality, and cost of information are critical factors in credit risk assessment Facilitated by technology and information Qualitative models consider borrower specific factors as well as market, or systematic, factors Borrowed-specific factors include reputation, leverage, volatility of earnings, and collateral Market specific factors include business cycle and interest rate levels
  • 46. Ch 10-31 ©McGraw-Hill Education. 31 Linear Probability Model Credit scoring models are quantitative models that use borrower characteristics to gauge an applicant’s probability of default Major weakness is that estimated probabilities of default can often lie outside of the [0,1] interval Since superior statistical techniques are readily available, there is rarely justification for employing linear probability models Ch 10-32 ©McGraw-Hill Education. 32 Altman’s Discriminant Function Z=1.2X1+ 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 Critical value of Z = 1.81 X1 = Working capital/total assets ratio X2 = Retained earnings/total assets ratio X3 = EBIT/total assets ratio X4 = Market value equity/ book value of total liabilities X5 = Sales/total assets ratio Ch 10-33
  • 47. ©McGraw-Hill Education. 33 History of Altman Z-Score The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company. There are many variants of the Altman model depending on the nature of the company and industry. None of the Altman models or other balance sheet-based models are recommended for use with financial companies. This is because of the opacity of financial companies' balance sheets and their frequent use of off-balance sheet items. Market based estimate are used instead. Example 10-23 MNO, Inc., a publicly traded manufacturing firm, has provided the following financial information in its application for a loan. Assets Liabilities and Equity Cash $ 20 Accounts payable $ 30 Accounts receivables 90 Notes payable 90 Inventory 90 Accruals 30 Long-term debt150 Plant and equipment 500 Equity (ret. earnings = $0) 400
  • 48. Total assets $700 Total liabilities and equity $700 Also assume sales = $500,000 cost of goods sold = $360,000 taxes = $56,000 interest payments = $40,000 net income = $44,000 the dividend payout ratio is 50 percent, and the market value of equity is equal to the book value. Part a What is the Altman discriminant function value for MNO, Inc.? Recall that: Net working capital = Current assets - Current liabilities. Current assets = Cash + Accounts receivable + Inventories. Current liabilities = Accounts payable + Accruals + Notes payable. EBIT = Revenues ‑ Cost of goods sold ‑ Depreciation. Net income = EBIT ‑ interest ‑ taxes. Retained earnings = Net income (1 ‑ Dividend payout ratio Part A solution Altman’s discriminant function is given by: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 X1 = (20+90+90‑30‑30-90)/ 700 = .0714 X1 = Working capital/total assets (TA) X2 = 44(1-.5) / 700 = .0314 X2 = Retained earnings/TA X3 = (500-360) / 700 = .20 X3 = EBIT/TA X4 = 400 / 150 = 2.67 X4 = Market value of equity/long
  • 49. term debt X5 = 500 / 700 = .7143 X5 = Sales/TA Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71) = 3.104 = .0857 + .044 + .66 + 1.6 + .7143 = 3.104 Part b Based only on the Altman’s Z-score, should you approve MNO, Inc.'s application to your bank for a $500,000 capital expansion loan? Since the Z-score of 3.104 is greater than 2.99, ABC Inc.’s application for a capital expansion loan should be approved. Part c If sales for MNO were $300,000, the market value of equity were only half of book value, and all other values are unchanged, would your credit decision change? ABC’s EBIT would be $300,000 - $360,000 = -$60,000. X1 = (20 + 90 + 90 ‑ 30 ‑ 30 ‑ 90) / 700 = .0714 X2 = 22 / 700 = 0.0314 X3 = ‑60 / 700 = ‑0.0857 X4 = 200 / 150 = 1.3333 X5 = 300 / 700 = 0.4286 Z = 1.2(0.0714) + 1.4(0.0314) + 3.3(-0.0857) + 0.6(1.3333) + 1.0(0.4286) = 1.0754 Since ABC's Z‑score falls to 1.0754 < 1.81, credit should
  • 50. be denied. Part d Would the discriminant function change for firms in different industries? Would the function be different for retail lending in different geographic sections of the country? What are the implications for the use of these types of models by FIs? Discriminant function models are very sensitive to the weights for the different variables. Since different industries have different operating characteristics, a reasonable answer would be yes with the condition that there is no reason that the functions could not be similar for different industries. In the retail market, the demographics of the market play a big role in the value of the weights. For example, credit card companies often evaluate different models for different areas of the country. Because of the sensitivity of the models, extreme care should be taken in the process of selecting the correct sample to validate the model for use. Logit Model Logit models Overcomes weakness of the linear probability model by restricting the estimated range of default probabilities from the linear regression model to lie between 0 and 1 Quality of credit scoring models have improved, providing positive impact on controlling write-offs and default Ch 10-41 ©McGraw-Hill Education.
  • 51. 41 Linear Discriminant Model Problems associated with discriminant analysis model: Only considers two extreme cases (default/no default) No reason to expect that the weights in a credit scoring model will be constant long-term; sensitivity to variable weights Ignores hard to quantify factors, including business cycle effects and reputation Database of defaulted loans is not available to benchmark the model Ch 10-42 ©McGraw-Hill Education. 42 Newer methods of modeling Default Risk Newer models of credit risk use a combination of financial theory and financial data to infer the possibility of default. Because of the use of financial data these are primarily used to model the credit risk of large corporate firms. Term Structure of credit risk Mortality Rate models RAROC – Risk Adjusted Return on Capital Models Option Models – Black-Scholes Term Structure Derivation of Credit Risk If the risk premium is known, we can infer the probability of default Risk premium can be computed using Treasury strips and zero- coupon corporate bonds
  • 52. p (1+ k) = 1+ i Ch 10-44 ©McGraw-Hill Education. 44 Implied Probability of Default By looking at the spread between Treasury Strips and zero- coupon corporate bonds, we can ascertain the implied probability of default. By comparing a risk-free asset to a risky asset we’ll be able to impute the difference in perceived credit risk One of the major assumptions is that there is no potential for arbitrage. p (1+ k) = 1+ i p(1+k) = Expected return on the loan: p is the probability of repayment and 1-p is the probability of default 1 + i = the risk free rate if i = 2.05% and k = 7.80% then p = (1+i)/(1+k) and 1.0205/1.078 = .94967 and 1-p = .0575 or 5.75% 10-32 The bond equivalent yields for Government of Canada and A- rated corporate bonds with maturities of 93 and 175 days are given below: Bond Maturities 93 days 175 days Government 8.07% 8.11% A-rated corporate 8.42% 8.66% Spread 0.35% 0.55% What are the implied forward rates for both an 82-day
  • 53. Government of Canada and an 82-day A-rated bond beginning in 93 days? Use daily compounding on a 365-day year basis. Part A The forward rate, f, for the period 93 days to 175 days, or 82 days, for the Government of Canada is: (1 + 0.0811)175/365 = (1 + 0.0807)93/365 (1 + f )82/365 The forward rate, f, for the corporate bond for the 82-day period is: (1 + 0.0866)175/365 = (1 + 0.0842)93/365 (1 + f )82/365 = 8.933% Part B What is the implied probability of … Asset and Liability Management for Financial Ins Ferriter FIN 6102 – Spring 2018 Interest Rates and Net Worth FIs exposed to interest rate risk due to maturity mismatches between assets and liabilities Interest rate changes can have severe impact on net worth Thrifts, during 1980s Ch 8-2 ©McGraw-Hill Education.
  • 54. 2 US Treasury Bill Rate, 1965 - 2015 ©McGraw-Hill Education. Ch 8-3 3 3 Level and Movement of Interest Rates Federal Reserve: U.S. central bank Open market operations influence money supply, inflation, and interest rates Actions of Fed (December, 2008) in response to economic crisis Target rate between 0.0 and ¼ percent Ch 8-4 ©McGraw-Hill Education. 4 Central Bank and Interest Rates Actions mostly target short term rates Focus on federal funds rate, in particular Interest rate changes and volatility increasingly transmitted from country to country due to increased globalization of financial markets Statements by Jerome Powell can have dramatic effects on world interest rates
  • 55. Ch 8-5 ©McGraw-Hill Education. 5 Repricing Model Repricing, or funding gap, model based on book value Contrasts with market value-based maturity and duration models in appendix Ch 8-6 ©McGraw-Hill Education. 6 Repricing Model Continued Rate sensitivity means repricing at (or near) current market interest rates within a specified time horizon Repricing gap is the difference between rate-sensitive assets (RSAs) and rate-sensitive liabilities (RSLs) Refinancing risk Reinvestment risk Ch 8-7 ©McGraw-Hill Education. 7 Maturity Buckets Commercial banks must report quarterly repricing gaps for assets and liabilities with maturities of:
  • 56. One day More than one day to three months More than three months to six months More than six months to twelve months More than one year to five years More than five years Ch 8-8 ©McGraw-Hill Education. 8 Repricing Gap Example Cum. Assets Liabilities Gap Gap 1-day $ 20 $ 30 $-10 $-10 >1day-3mos. 30 40 -10 -20 >3mos.-6mos. 70 85 -15 -35 >6mos.-12mos. 90 70 +20 -15 >1yr.-5yrs. 40 30 +10 -5 >5 years 10 5 +5 0 Ch 8-9 ©McGraw-Hill Education. 9 Applying the Repricing Model - Example 1: In the one day bucket, gap is -$10 million. If rates rise by 1%,
  • 57. -$10 million) × .01 = -$100,000 Ch 8-10 ©McGraw-Hill Education. 10 Applying the Repricing Model Continued Example 2: If we consider the cumulative 1-year gap, -$15 million)(.01) = -$150,000 Ch 8-11 ©McGraw-Hill Education. 11 Rate-Sensitive Assets Examples from hypothetical balance sheet: Short-term consumer loans: Repriced at year-end, would just make one-year cutoff Three-month T-bills: Repriced on maturity every 3 months Six-month T-notes: Repriced on maturity every 6 months 30-year floating-rate mortgages: Repriced (rate reset) every 9 months Ch 8-12 ©McGraw-Hill Education. 12
  • 58. Rate-Sensitive Liabilities RSLs bucketed in same manner as RSAs Demand deposits warrant special attention Generally considered rate-insensitive (act as core deposits), but there are arguments for their inclusion as rate-sensitive liabilities Ch 8-13 ©McGraw-Hill Education. 13 GAP Ratio May be useful to express interest rate sensitivity in ratio form as CGAP/Assets, referred to as “gap ratio” Provides direction and scale of exposure Example: Gap ratio = CGAP/A = $15 million / $270 million = 0.056, or 5.6 percent Ch 8-14 ©McGraw-Hill Education. 14 Equal Rate Changes on RSAs, RSLs Example 8-1: Suppose rates rise 1% for RSAs and RSLs. Expected annual change in NII, = $15 million × .01 = $150,000 CGAP is positive, change in NII is positively related to change in interest rates
  • 59. CGAP is negative, change in NII is negatively related to change in interest rates Ch 8-15 ©McGraw-Hill Education. 15 Unequal Changes in Rates If changes in rates on RSAs and RSLs are not equal, the spread changes In this case, - Ch 8-16 ©McGraw-Hill Education. 16 Unequal Rate Change Example Example 8-2: RSA rate rises by 1.2% and RSL rate rises by 1.0% - = ($155 million × 1.2%) - ($155 million × 1.0%) = $310,000 Ch 8-17 ©McGraw-Hill Education. 17
  • 60. Weaknesses of Repricing Model Weaknesses: Ignores market value effects of interest rate changes Overaggregative Distribution of assets and liabilities within individual buckets is not considered Mismatches within buckets can be substantial Ignores effects of rate-insensitive runoffs Bank continuously originates and retires consumer and mortgage loans Runoff of rate-insensitive asset/liability is rate-sensitive Ch 8-18 ©McGraw-Hill Education. 18 Weaknesses of Repricing Model Continued Off-balance-sheet items are not included when considering cash flows Hedging effects of off-balance-sheet items not captured Example: Futures contracts Ch 8-19 ©McGraw-Hill Education. 19 The Maturity Model Explicitly incorporates market value effects For fixed-income assets and liabilities: Rise (fall) in interest rates leads to fall (rise) in market value The longer the maturity, the larger the fall (rise) in market
  • 61. value for interest rate increase (decrease) Fall in value of longer-term securities increases at diminishing rate for given increase in interest rates Ch 8-20 ©McGraw-Hill Education. 20 Maturity of Portfolio Maturity of portfolio of assets (liabilities) equals weighted average of maturities of assets (liabilities) that make up the portfolio Principles stated on previous slide regarding individual securities apply to portfolios, as well Typically, maturity gap, MA – ML, > 0 for most banks and thrifts Ch 8-21 ©McGraw-Hill Education. 21 Effects of Interest Rate Changes Size of the gap determines the size of interest rate change that would drive net worth to zero Immunization Maturity matching, MA - ML = 0 Note: Doesn’t always protect FI against interest rate risk Ch 8-22 ©McGraw-Hill Education.
  • 62. 22 Leverage Leverage affects ability to eliminate interest rate risk using maturity model Example: $100 million in assets invested in one-year, 10% coupon bonds and $90million in liabilities in one-year deposits paying 10%. Maturity gap is zero, but exposure to interest rate risk is not zero. Ch 8-23 ©McGraw-Hill Education. 23 Duration Matching of maturities can still result in interest rate risk due to the timing of cash flows between assets and liabilities not being perfectly matched FI can only immunize against interest rate risk by matching average lives of an assets and liabilities See Chap. 9 Ch 8-24 ©McGraw-Hill Education. 24 Term Structure of Interest Rates Compares market yields or interest rates on securities Assumes all characteristics (i.e., default risk, coupon rate, etc.)
  • 63. are the same, except for maturity Most common shapes of yield curve for Treasury securities Upward-sloping Downward-sloping, or inverted Flat Ch 8-25 ©McGraw-Hill Education. 25 Unbiased Expectations Theory At a given point in time, yield curve reflects market’s current expectations of future short-term rates Long-term rates are geometric average of current and expected short-term interest rates (1 +1RN)N = (1+ 1R1)[1+E(2r1)]…[1+E(Nr1)] Ch 8-26 ©McGraw-Hill Education. 26 Liquidity Premium Theory Weaknesses of unbiased expectations theory Assumes investors are risk-neutral Doesn’t recognize that forward rates aren’t perfect predictors of future interest rates Liquidity premium theory Allows for future uncertainty Implicitly assumes that investors prefer short-term securities
  • 64. Ch 8-27 ©McGraw-Hill Education. 27 Market Segmentation Theory Investors have specific preferences in terms of maturity Securities with different maturities are not perfect substitutes Investors are risk averse to securities that do not meet their maturity preferences Yield curve reflects intersection of demand and supply of individual maturities Ch 8-28 ©McGraw-Hill Education. 28 Market Segmentation and Determination of Slope of Yield Curve ©McGraw-Hill Education. Ch 8-29 29 Maturity Model Weaknesses
  • 65. Two major shortcomings Does not account for the degree of leverage in the FI’s balance sheet Ignores the timing of the cash flows from the FI’s assets and liabilities Ch 8-30 Ch 8-30 ©McGraw-Hill Education. 30 Overview This chapter discusses a market value-based model for managing interest rate risk, the duration gap model Duration Computation of duration Economic interpretation Immunization using duration Problems in applying duration ©McGraw-Hill Education. Ch 9-31 31 Price Sensitivity and Maturity In general, the longer the term to maturity, the greater the sensitivity to interest rate changes The longer maturity bond has the greater drop in price because the payment is discounted a greater number of times ©McGraw-Hill Education. Ch 9-32
  • 66. 32 Duration Duration Weighted average time to maturity using the relative present values of the cash flows as weights More complete measure of interest rate sensitivity than is maturity The units of duration are years To measure and hedge interest rate risk, FI should manage duration gap rather than maturity gap ©McGraw-Hill Education. Ch 9-33 33 Macaulay’s Duration where D = Duration measured in years CFt = Cash flow received at end of period t N= Last period in which cash flow is received DFt = Discount factor = 1/(1+R)t ©McGraw-Hill Education.
  • 67. Ch 9-34 34 Duration Since the price (P) of the bond equals the sum of the present values of all its cash flows, we can state the duration formula another way: Notice the weights correspond to the relative present values of the cash flows ©McGraw-Hill Education. Ch 9-35 Semiannual Cash Flows For semiannual cash flows, Macaulay’s duration, D, is equal to: ©McGraw-Hill Education. Ch 9-36 Duration of Zero-Coupon Bond Zero-coupon bonds: sell at a discount from face value on issue, pay the face value upon maturity, and have no intervening cash flows between issue and maturity Duration equals the bond’s maturity since there are no intervening cash flows between issue and maturity For all other bonds, duration < maturity because here are intervening cash flows between issue and maturity
  • 68. ©McGraw-Hill Education. Ch 9-37 37 Duration of Consol Bonds A bond that pays a fixed coupon each year indefinitely Have yet to be issued in the U.S. Maturity of a consol (perpetuity): Duration of a consol (perpetuity): Dc = 1 + 1/R ©McGraw-Hill Education. Ch 9-38 Features of Duration Duration and maturity Duration increases with maturity of a fixed-income asset/liability, but at a decreasing rate Duration and yield Duration decreases as yield increases Duration and coupon interest Duration decreases as coupon increases ©McGraw-Hill Education. Ch 9-39 Economic Interpretation Duration is a direct measure of interest rate sensitivity, or elasticity, of an asset or liability: -D Or equivalently, ΔP/P = -D[ΔR/(1+R)] = -MDdR
  • 69. where MD is modified duration ©McGraw-Hill Education. Ch 9-40 Economic Interpretation Continued To estimate the change in price, we can rewrite this as: ΔP = -D[ΔR/(1+R)]P = -(MD) × (ΔR) × (P) ©McGraw-Hill Education. Ch 9-41 41 Dollar Duration Dollar value change in the price of a security to a 1 percent change in the return on the security Dollar duration = MD × Price Using dollar duration, we can compute the change in price as ΔP = -Dollar duration × ΔR ©McGraw-Hill Education. Ch 9-42 Semi-annual Coupon Bonds With semi-annual coupon payments, the percentage change in price is calculated as: ΔP/P = -D[ΔR/(1+(R/2)]
  • 70. ©McGraw-Hill Education. Ch 9-43 Immunization Matching the maturity of an asset with a future payout responsibility does not necessarily eliminate interest rate risk Matching the duration of a fixed-interest rate instrument (i.e., loan, mortgage, etc.) to the FI’s target or investment horizon will immunize the FI against shocks to interest rates ©McGraw-Hill Education. Ch 9-44 Balance Sheet Immunization Duration gap is a measure of the interest rate risk exposure for an FI If the durations of liabilities and assets are not matched, then there is a risk that adverse changes in the interest rate will increase the present value of the liabilities more than the present value of assets is increased ©McGraw-Hill Education. Ch 9-45 Immunizing the Balance Sheet of an FI Duration Gap: From the balance sheet, A = L+E, which means E = A-L. Therefore, DE = DA-DL. In the same manner used to determine the change in bond prices, we can find the change in value of equity using duration. DE = -[DA - DLk]A(DR/(1+R)) ©McGraw-Hill Education. Ch 9-46
  • 71. Duration and Immunizing The formula, DE, shows 3 effects: Leverage adjusted duration gap The size of the FI The size of the interest rate shock ©McGraw-Hill Education. Ch 9-47 Example 9-9 Suppose DA = 5 years, DL = 3 years and rates are expected to rise from 10% to 11%. (Thus, rates change by 1%). Also, A = 100, L = 90, and E = 10. Find DE. DE = -[DA - DLk]A(DR/(1+R)) = -[5 - 3(90/100)]100[.01/1.1] = - $2.09. Methods of immunizing balance sheet. Adjust DA, DL or k. ©McGraw-Hill Education. Ch 9-48 Immunization and Regulatory Considerations Regulators set target ratios for an FI’s capital (net worth) to assets in an effort to monitor solvency and capital positions: Capital (Net worth) ratio = E/A A) = 0: DA = DL DA = kDL ©McGraw-Hill Education. Ch 9-49
  • 72. Difficulties in Applying Duration Model Duration matching can be costly Growth of purchased funds, asset securitization, and loan sales markets have lowered costs of balance sheet restructurings Immunization is a dynamic problem Trade-off exists between being perfect immunization and transaction costs Large interest rate changes and convexity ©McGraw-Hill Education. Ch 9-50 Convexity The degree of curvature of the price-yield curve around some interest rate level Convexity is desirable, but greater convexity causes larger errors in the duration-based estimate of price changes ©McGraw-Hill Education. Ch 9-51 Basics of Bond Valuation Formula to calculate present value of bond: ©McGraw-Hill Education. Ch 9-52 Impact of Maturity on Security Values Price sensitivity is the percentage change in a bond’s present value for a given change in interest rates Relationship between bond price sensitivity and maturity is not linear As time remaining to maturity on bond increases, price
  • 73. sensitivity increases at decreasing rate ©McGraw-Hill Education. Ch 9-53 Incorporating Convexity into the Duration Model Three characteristics of convexity: Convexity is desirable Convexity and duration All fixed-income securities are convex ©McGraw-Hill Education. Ch 9-54 Modified Duration & Convexity DP/P = -D[DR/(1+R)] + (1/2) CX (DR)2, or DP/P = -MD DR + (1/2) CX (DR)2 Where MD implies modified duration and CX is a measure of the curvature effect CX = Scaling factor × [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield] Commonly used scaling factor is 108 ©McGraw-Hill Education. Ch 9-55 Calculation of CX Example: convexity of 8% coupon, 8% yield, six-year maturity Eurobond priced at $1,000 CX = 108[(DP-/P) + (DP+/P)] = 108[(999.53785-1,000)/1,000 + (1,000.46243- 1,000)/1,000)]
  • 74. = 28 ©McGraw-Hill Education. Ch 9-56 Contingent Claims Interest rate changes also affect value of (off-balance sheet) derivative instruments Duration gap hedging strategy must include the effects on off- balance sheet items, such as futures, options, swaps, and caps, as well as other contingent claims ©McGraw-Hill Education. Ch 9-57 Asset and Liability Management FIN 6102 Ferriter – Spring 2018 Debt Securities A Debt Security is a claim on a specified periodic stream of cashflow. Debt Securities are often called fixed-income securities because they promise either a fixed stream of income or one that is determined by a formula. A typical bond requires semi-annual payments for the life of the bond. These are called coupon payments. The interest rate that determines the coupon payment is called the coupon rate. When a bond matures, the issuers repays the debt by paying the bond’s par value (also known as the face value). If no face value is given, assume $1000 for the face value Zero-Coupon Bonds
  • 75. Bonds are usually issued with a high enough coupon rate to induce investors to purchase the bond. However there are zero- coupon bonds, where the buyer only receives the face value at the maturity date but receive no coupons payments. When these bonds are issued they are priced considerably lower than the par value. They may be issued by federal, state or local governments or by corporations. Then there are the tax exemptions. If issued by a government entity, the interest generated by a zero-coupon bond is often exempt from federal income tax, and often from stateand local income taxes too. Accrued Interest and Quoted Prices The bond prices quoted in financial papers are not the actual prices that an investors pays for the bond. This is because the quoted price doesn’t include the interest that accrues between coupon payments. Accrued Interest = Annual Coupon Payment/2 *Days since last coupon/Days between payment For example, a bond with a coupon rate of 8%. The annual coupon payment is $80 and the semi-annual coupon is $40. 30 days have passed since the last coupon payment. What is the the accrued interest? $40 x (30/182) = $6.59 This value would be added to the quoted price when the bond is sold. Call Provision and Callable Bonds Some corporate bonds are issued with a call provision. A call provision allows the issuers to repurchase a bond at a specified call price before the maturity date. Why might a company issue
  • 76. a callable bond? When corporate bonds are issued in a high interest rate environment, they will most likely issue bonds with a high coupon rate. Over the course of the bonds life, interest rates might fall. A corporation might take advantage of the call provision to retire the bond early and issue a new bond at a lower coupon rate Callable Bonds typically come with a period of call protection, an initial period of time when the bond cannot be called. The option to call a bond is useful to the issuer, but what is beneficial to an issuer is detrimental to bond holders. To compensate for this, callable bonds are often issued with higher coupons and promised yield to maturity than non callable bonds. Convertible bonds Convertible bonds give bondholders an option to exchange each bond for a specified number of shares. The conversion ratio is the number of shares for which each bond may be exchanged. For example, a convertible bond is issued at a par value of $1,000 and is convertible in 40 shares of stock. If the current stock price is $20 it is not profitable to convert. As $20*40 = $800 is less than the par value of the bond. If the stock price increases to $30, the conversion is profitable ($30*40 = $1,200) The market conversion value is the current value of shares for which the bonds may be exchanged. Convertible bond holders benefit from price appreciation of the company’s stock. Because of this benefit, convertible bonds tend to have lower coupon rates and lower yields to maturity. Floating Rate Bonds Floating rate bonds make interest payments based on some measure of current market rates. For example, the might might be adjusted annually to the current T-bill rate plus 2%. If the One year T-Bill rate is 4%, then the coupon rate over the next
  • 77. year will be 6%. The major risk with floating-rate bonds is that while the spread between the market interest rate and the floating coupon rate is fixed, the adjustment is not connected to changes in the issuing firm’s financial position. For example, if a company runs into financial distress, investors might demand a greater yield premium than is offered by the security. In this case the price of the bond will fall. Bond Pricing Bond Value = Present Value of Coupons + Present Value of par value For example consider an 8% coupon, 30-year maturity bond with a par value of $1,000, paying 60 semiannual coupon payments of $40 each. Suppose that the market interest rate is 8% annually. The present value of all the coupon payments is $904.94 and the present value of the par value is $95.06. When the market interest rate is equal to the coupon rate, the par value and equals the bond price. If the market interest rate were to rise to 10%. The bond price would fall by $189.29 to $810.71 Yield to Maturity As you may have guessed, the coupon rate and the market interest rate are rarely equal. As such bonds usually do not sell for par value. Therefore we need to measure or rate of return that accounts for both current income (coupon payments and the return of principle) and the bond price increase or decrease over the lifetime of the bond. The yield to maturity is the interest rate that makes the present value of a bond’s payments equal to its current price. This interest rate is interpreted as the average rate of return of a
  • 78. bond if held to maturity. Example: An 8% coupon, 30-year bond is selling at $1,276.76. What is the yield to maturity? In this example, the semiannual yield to maturity is .03. However, yield to maturity is generally quoted as an annual figure. Therefore we must annualize the yield. 1.03^2 =1.0609. In this case the yield to maturity in 6.09% YTM vs Current Yield A bond’s yield to maturity (YTM) is the internal rate of return on the investment in the bond. YTM differs from the current yield of a bond. The current yield of a bond is defined as the annual coupon payment divided by the current price of a bond. For example, take the 8% coupon bond selling for $1,276.76. The current yield would be 80/ $1,276.76 or .0627 (6.27%). Recall that the YTM on this bond was 6.09%. This bond is considered to be selling at a premium. In this case the coupon rate is higher than the current yield which is higher than the YTM. The reason for this is that the Coupon rate is divided par value, the current yield is divided by the current price. The current yield is higher than the YTM because the YTM accounts for the capital loss as the bond will eventual repay only $1,000 at maturity. As a general rule, for premium bonds the Coupon rate > Current Yield > YTM. For discount bonds the relationship is reversed. Yield to Call Yield to maturity assumes that the bond will be held to maturity. However, a bond maybe be retired prior to that time. This is especially true if the bond has a call provision. For example, a $1,000, 30 year bond with a coupon payment of 8% has a callable provision at 110% of par value and has call protection for 10 years. If the bond currently sells for $1,150
  • 79. what is the yield to call? In this example, the Yield to Call (YTC) is equal to 6.64% (3.32 x 2) and the YTM is 6.82% Yield to CallYield to MaturityCoupon Payment4040Number of Periods2060Final Payment$1,100$1,000Price$1,150 $1,150 Zero-Coupon Bonds US Treasury Bill are common for of short term zero-coupon bonds. Since these have no coupon the return on these bonds is completely from price appreciation. However, Long-Term Zero coupon bonds are usually created by separating a coupon payment stream from the principal repayment. An investor can request that the US Treasury split or strip the coupon payment from the principal repayment. In this case each component is assigned a CUSIP number, the CUSIP allows the each security to trade on the FEDWIRE system. The process is governed by the US Treasury Program called STRIPS (Separate Trading of Registered Interest and Principal of Securities) The primary purpose of strips is to appeal to different investor types. Much of the reason is related to cashflow matching. Term Structure of Interest Rate The term structure of interest rates refers to the the process of discounting cash flows of different maturities. Most often investors will plot the YTM against Maturity. This is called the yield curve. There are three common “types” of yield
  • 80. curve; rising, flat and inverted. A rising yield curve is the most common in normal economic times, and it suggests that interest rates will rise in the future. The yield curve is derived from plotting zero-coupon bonds.MaturityYTMPrice15%$952.3826%$89037%$816.3048% $735.03 Yield Curve and Future Interest Rates In order to derive the Yield curve we’ll be making some assumptions. First, we assume that there is no possibility of arbitrage. Under this scenario, yields from must be identical. To see what this means, consider the following. There are two strategies, a choice to buy and hold a two year zero-coupon bond and to buy a one year zero coupon bond and reinvest in another one year zero coupon. For the two year bond, assume a 6% market rate for a holding period of years. In this case the bond price would be $890. For the second strategy, assume the interest rate for a one year holding period is 5%. What will the one year rate be in one year We can set this up as the following: $890 x 1.062 = $890 x 1.05 x (1+r) Or 1.062/1.05 = 1+r = 1.0701 or 7.01% Finding Future Short Rates Now let’s compare a three year strategy. One will be to purchase a 3 year zero coupon bond with a YTM of 7%. This bond would be priced at $816.30 The alternative strategy is to buy a 2 year zero and reinvest in a 1 year zero. We can structure this as follows 1.073 = 1.062 x 1+r 1.073/1.062 = 1+r This equals 1.09025 or 9.025%
  • 81. Additionally, 1.07 = (1.05 x 1.0601 x 1.09025)1/3 Interest Rate Types One thing you might have noticed is that there are a lot of interest rates when doing these calculations. In order to differentiate between them, investors coined two terms to describe them. The spot rate refers to the yield to maturity for a zero coupon bond that prevails today. The forward rate (also called the forward yield) is the theoretical, expected yield on a bond several months or years from now. It is common to denote a forward rate as xRy this can be read as the x forward rate y years from today. Theories of the Term Structure The expectations hypothesis is the theory that the forward rate equals the market consensus expectations of what future short- term rates will be. This means that there is no liquidity preference. This can be stated as E(r) = f2 or that the expected rate in period two will be the rate in period two. Using this hypothesis is what allows use to generate a yield curve, as no other information is required aside from current spot rates. Theories of Term Structure Liquidity Preference: Essentially states that investors or buyers of fixed income securities have a preference of either short term or long term securities. Part of the reason for these preferences can be seen as attempts to match cash inflows to cash outflows. In any event, short term investors would require a premium to invest in longer term securities, or the f2 > E(r2) or the rate in
  • 82. period 2 must be greater than the expected rate in period 2. Advocates of liquidity preference believe that short term investors dominate the market which pushes the short term interest rate down. Interest Rate Risk As we’ve seen bond prices move inversely to changes in the market interest rate. Therefore, bond investors are particularly concerned with the sensitivity of bond prices. We also note that bond prices are convex and therefore decreases in YTM have bigger impacts on price than increases in YTM for the same magnitude. A summary of bond price observations Bond prices and yields are inversely related. An increase in a bond’s yield to maturity results in a smaller price change than a decrease Prices of long-term bonds tend to be more sensitive to changes in interest rate. Sensitivity to price changes increases at a decreasing rate. A 30 year bond is not 6x more sensitive than a 5 year Interest rate risk is inversely related to a bond’s coupon rate The sensitivity of a bond’s price to a change in its yield is inversely related to the YTM at which the bond is currently selling. (Macaulay’s) Duration Frederick Macaulay termed the effective maturity concept the duration of a bond. Macaulay’s Duration equals the weighted average of the times to each coupon or principal payment. The weight associated with each payment time should be related to the “importance” of that payment to the value of the bond. Timing of cash flows is designated in years Wt = PV of CFt/Bond Price D = Σ T x Wt
  • 83. Duration ExampleTime untilPV of CFColumn CPaymentDiscount rate =timesPeriod(Years)Cashflow5% per periodWeightColumn FA. 8% Coupon Bond10.540 $ 38.10 0.0394960.01972140 $ 36.28 0.0376150.037631.540 $ 34.55 0.0358240.0537421040 $ 855.61 0.8870651.7741Sum: $ 964.54 1.8852B Zero-Coupon10.50 $ - 00.0000210 $ - 00.000031.50 $ - 00.0000421000 $ 822.70 12.0000 $ 822.70 2.0000 Why is duration important There are three primary reasons why duration is important. First it is a simple summary statistic of the effective average maturity of the portfolio It is an essential tool in immunizing portfolios from interest rate risk Duration measures interest rate sensitivity of a portfolio Modified Duration Reason for – sign The price-yield relationship is negatively correlated; when prices go down, the implied yield goes up. The minus sign allows the modified duration to be positive for a normal bond. 23 Modified Duration Example Consider the 2-year maturity, 8% coupon bond, selling at a price of $964.54 for a YTM of 10%. The semi-annual duration of this bond is 1.8852 years. The annual duration is 3.7704.
  • 84. Therefore modified duration is 3.7704/1.05 = 3.591. No suppose that the semiannual interest rate increases to 5.01% -3.591x .01% = -.03591% This would be interpreted as a .01% increase in interest rates would cause the price of a bond to fall by .03591% Rules for Duration The duration of a zero-coupon bond is its time to maturity A coupon bond can have a duration less than one. Holding maturity constant, a bond’s duration is lower when the coupon rate is higher A bond’s duration increases with its time to maturity. The duration for a coupon bond is higher when the bond’s yield to maturity is lower Duration of a perpetuity (1+r)/r Convexity Convexity Formula Duration with Convexity Example Immunization Immunization techniques refer to strategies used by investors to shield their overall financial status from interest rate risk. Many banks and thrifts have naturally occurring mismatches between their liabilities and assets. Much of there liabilities are deposits that are short term and have low duration. Bank assets
  • 85. are primarily consumer and commercials loads and have higher duration. This means that banks are sensitive to changes in interest rate as they can directly effect new worth. Immunization Example Consider an insurance company offering a Guaranteed Investment Contract for $10,000 and guarantees and interest rate of 8%. If the GIC has a maturity of 5 years. The future value of the liability is $14,693.28. If the company chooses to fund the liability with a 10,000 8% coupon bond. Then as long as interest rates remain at 8% the liability will be exactly matched. But what happens when interest rate rise or fall? Immunization ExamplePayment NumberYears Remaining until ObligationAccumulated Value of Invested PaymentA. Rates Remain at 8%14800 x (1.08)^4=1088.39123801 x (1.08)^3=1007.7732802 x (1.08)^2=933.1241803 x (1.08)^1=86450804 x (1.08)^0=800Sale of Bond010800=1000014693.28A. Rates Fall to 7%14800 x (1.07)^4=1048.63723801 x (1.07)^3=980.034432802 x (1.07)^2=915.9241803 x (1.07)^1=85650804 x (1.07)^0=800Sale of Bond010800=10093.4614694.05A. Rates Fall to 7%14800 x (1.09)^4=1129.26523801 x (1.09)^3=1036.02332802 x (1.09)^2=950.4841803 x (1.09)^1=87250804 x (1.09)^0=800Sale of Bond010800=9908.25714696.03 Immunization In this example because we have successfully matched the duration of our asset with our liability we can be considered immune from interest rate risk. However, immunization investors have a risk trade off between price risk and
  • 86. reinvestment risk. Price risk is essentially the capital loss or gain that occurs because of a change in interest rate. Now a key consideration with immunization is the need to rebalance. As interest rate change a portfolio manager must rebalance as the duration will have changed. Additionally, even if interest rates stay the same durations will change solely because of the passage of time. Constructing and Immunized Portfolio A bank must make a payout of $19,487 in seven years. The current market interest rate is 10%, so the PV of the payout is $10,000. The portfolio managers wants to fund the obligation with a 3 year zero coupon bond and a perpetuity paying 10%. How can the manager immunize the portfolio? Calculate the duration of the liability. In this case because it is a single payment obligation, the duration is 7 years Calculate the duration of the asset portfolio. The portfolio duration will be the weighted average of each assets duration. In this case the zero coupon bond has a duration of 3 years and the perpetuity a duration of 11 years. Asset Duration = w * 3 + (1-w)*11 Find the asset mix that sets the duration of assets equal to 7 years w * 3 + (1-w)*11 = 7 in this case w = .5 Fully fund the obligation. In this case it means that 5,000 should be invested in the zero coupon bond and 5,000 should be invested in the perpetuity. Duration Gap Analysis Duration Gap: From the balance sheet, A = L+E, which means E = A-L. Therefore, DE = DA-DL.
  • 87. In the same manner used to determine the change in bond prices, we can find the change in value of equity using duration. DE = -[DA - DLk]A(DR/(1+R)) DLk is total liabilities / (Total Liabilies + Equity) or the proportion of assets funded by liabilities Suppose a manager has the following situation: Duration of Assets = 5 years and Duration of Liabilities = 3 years The current interest rate is 10% and it is expected to rise to 11% what is the impact on the net worth of the company Duration Gap AnalysisAssetsLiabilities and EquityAssets 100Liabilities 90Equity 10 First let’s calculate the potential impact on net worth. DE = -[DA - DLk] x A x (DR/(1+R)) -[5-3*.9] x 100 x (.01/1.10) or -2.09 decrease in equity What about Asset and Liability Accounts? DA = -5(.01/1.10) = -.04545 = -4.545% = 95.45 DL = -3(.01/1.10) = -.02727 = -2.727% = 87.54 New Balance SheetAssetsLiabilities and EquityAssets 95.45Liabilities 87.54Equity 7.91 Duration Gap Example Duration and Repricing Gap Example
  • 88. Asset and Liability Management Fin6102 Ferriter – Spring 2018 Overview This chapter discusses insurance companies Two major groups: Life Property-casualty Financial crisis and insurance companies Size, structure, and composition Balance sheets and recent trends Regulation of insurance companies Global competition and trends Ch 6-2 ©McGraw-Hill Education. 2 Insurance and Financial Crisis Insurance companies as investors in securities Subprime mortgage pools fell in value Credit default swaps (CDS) fell AIG was a major writer of CDS securities Potential impact on other FIs that bought CDS from AIG used to justify the bailout Increased risk exposure to banks, investment banks, and insurers Ch 6-3 ©McGraw-Hill Education.
  • 89. 3 Insurance Companies Differences in services provided by: Life insurance companies Property and casualty insurance companies Ch 6-4 ©McGraw-Hill Education. 4 Size, Structure, and Composition Size, structure, and composition of the insurance industry: In 1988: 2,300 life insurance companies with aggregate assets of $1.1 trillion In 2010s: 830 life insurance companies with aggregate assets of $6.5 trillion in 2015 Ch 6-5 ©McGraw-Hill Education. 5 Size, Structure, and Composition Continued 4 largest life insurers wrote 33% of new business in 2014 Most policies sold through commercial banks 18% of all fixed annuities were sold by commercial banks in 2015 Ch 6-6
  • 90. ©McGraw-Hill Education. 6 Life Insurance Companies Significant merger activity in life insurance industry Not to same extent witnessed in banking E.g., Anthem and Signa, MetLife and American Life Insurance, etc. Competition from within industry and from other FIs Increased conversion from mutual to stockholder controlled companies Ch 6-7 ©McGraw-Hill Education. 7 Mutual vs. Stock Insurance Companies Ch 6-8 ©McGraw-Hill Education. 8 Biggest Life Insurers ©McGraw-Hill Education.
  • 91. 9 9 Insurance Issues Adverse selection Insured have higher risk than general population E.g., Matt has never had life insurance, but decides to buy some once he finds out he has a terminal illness Alleviated by grouping of policyholders into similar risk pools Problem for both life insurers and property-casualty insurers Ch 6-10 ©McGraw-Hill Education. 10 Types of Life Insurance Life insurance products: Ordinary life Term life, whole life, endowment life Variable life, universal life and variable universal life Group life Industrial life Credit life Ch 6-11 ©McGraw-Hill Education. 11 Ch 6-12 Distribution of Premiums, 2015
  • 92. ©McGraw-Hill Education. 12 12 Other Life Insurer Activities Annuities Reverse of life insurance activities Topped $325.2 billion in 2014 Private pension plans Insurers compete with other financial service companies In 2015, life insurers managed over $2.7 trillion (~40% of all private pension plans) Accident and health insurance Protects against morbidity (i.e., ill health) risk Over 168.7 billion in premiums in 2014 Ch 6-13 ©McGraw-Hill Education. 13 Balance Sheet Assets Need to generate competitive returns on savings components of life insurance policies Focus investment on long-term assets Bonds, equities, government securities Policy loans Liabilities Policy reserves to meet policyholders’ claims
  • 93. Separate account business represented 38.2% of total liabilities and capital in 2015 Ch 6-14 ©McGraw-Hill Education. 14 Recent Trends Impact of financial crisis Drop in value of securities Capital losses from bonds and stocks exceeded $35 billion Historically low short-term interest rates Adverse impact on ability to lower rates on new policies Incentive to surrender existing policies Dwindling reserves led to Treasury Department extending bailout funds Late 2009 showed improvement Ch 6-15 ©McGraw-Hill Education. 15 Regulation McCarran-Ferguson Act of 1945 Confirms primacy of state over federal regulation State insurance commissions Coordinated examination system developed by NAIC Federal Reserve Supervises ~1/3 of U.S. insurance industry assets States promote life insurance guarantee funds Ch 6-16 ©McGraw-Hill Education.
  • 94. 16 Recent Regulatory Issues Fear of systemic risk posed by AIG 2009: Proposals to create optional federal life insurance charter Proponents of federal charter argued inconsistent regulation and barriers to innovation inherent in current system 2010: Wall Street Reform and Consumer Protection Act established the Federal Insurance Office (FIO) Ch 6-17 ©McGraw-Hill Education. 17 Web Resources For more detailed information on insurance regulation, visit: NAIC www.naic.org Ch 6-18 ©McGraw-Hill Education. 18 Property-Casualty Insurance Size and Structure Currently about 2,640 companies sell property-casualty insurance Highly concentrated
  • 95. Top 10 firms have 50% of market in terms of premiums written Top 200 firms write over 95% of total premiums M&A activity is increasing concentration Ch 6-19 ©McGraw-Hill Education. 19 Types of P&C Products Fire insurance Homeowners multiple-peril insurance Commercial multiple-peril insurance Automobile liability and physical damage insurance Liability insurance (other than automobile) Ch 6-20 ©McGraw-Hill Education. 20 Premium Allocation Changing composition of net premiums written, 2014 versus 1960: Fire: 2.3% vs. 16.6% in 1960 Homeowners MP: 15.2% vs. 5.2% in 1960 Commercial MP: 6.9% vs. 0.4% in 1960 Auto L&PD: 38.6% vs. 43% in 1960 Other liability: 12.7% vs. 6.6% in 1960 Ch 6-21 ©McGraw-Hill Education. 21
  • 96. P&C Balance Sheet Similar to life insurance companies; long-term securities Unlike life insurance companies; requirement for liquid assets Major liabilities: Loss reserves Loss adjustment expenses Unearned premiums Ch 6-22 ©McGraw-Hill Education. 22 Loss Risk Underwriting risk may result from: Unexpected increases in loss rates Unexpected increases in expenses Unexpected decreases in investment yields or returns Property versus liability Losses from liability insurance less predictable Example: Claims due to asbestos damage to workers’ health Ch 6-23 ©McGraw-Hill Education. 23 Loss Risk Continued Severity versus frequency Loss rates more predictable on low-severity, high-frequency lines (such as fire, auto, and homeowners) than on high-
  • 97. severity, low-frequency lines (such as earthquake, hurricane, and financial guaranty) Higher uncertainty forces PC insurers to invest in more short- term assets and hold larger capital and reserves than life insurers Ch 6-24 ©McGraw-Hill Education. 24 Insurance Risks Post 9/11 Crisis generated by terrorist attacks forced creation of federal terrorism insurance program in 2002 Federal government provides backstop coverage under Terrorism Risk Insurance Act of 2002 (TRIA) Caps losses for insurance companies Ch 6-25 ©McGraw-Hill Education. 25 Long Tail Versus Short Tail Long-tail risk exposure Arises where loss occurs during coverage period but claim is not made until many years later Examples: Asbestos cases and Dalkon shield case Efforts to contain long-tail risks within subsidiaries Example: Halliburton Ch 6-26 ©McGraw-Hill Education.
  • 98. 26 Insurance Costs: Social Inflation Product inflation versus social inflation Unexpected inflation may be systematic or line-specific Social inflation: Unexpected changes in awards by juries Reinsurance Approximately 75 percent of reinsurance by US firms is written by non-US firms, such as Munich Re Ch 6-27 ©McGraw-Hill Education. 27 Underwriting Profitability Loss ratios have generally increased Expense ratios have generally decreased Attributed to change in distribution methods Insurers have begun selling directly to consumers through their own brokers rather than independent brokers Combined ratio: Includes both loss and expense experience If greater than 100, premiums are insufficient to cover losses and expenses Ch 6-28 ©McGraw-Hill Education. 28 Investment Yield / Return Risk Operating ratio = combined ratio after dividends minus
  • 99. investment yield Importance of investment income: Causes PC managers to place importance on measuring and managing credit and interest rate risk Ch 6-29 ©McGraw-Hill Education. 29 P&C: Recent Trends Several catastrophes over 1985 - 2015 Hurricane Hugo 1989, San Francisco Earthquake 1991, Oakland fires 1991, Hurricane Andrew 1991 2004 hurricanes (Charley, Frances, Ivan, Jeanne) occurred in rapid succession and generated claims comparable to Andrew Hurricane Katrina, 2005 September 11, 2001 terrorist attacks created an insurance crisis (and heightened demand) Hurricane Sandy, 2011 Potential for crowding out market solutions (catastrophe bonds) via government actions Ch 6-30 ©McGraw-Hill Education. 30 PC Regulation PC insurers chartered and regulated by state commissions State guaranty funds National Association of Insurance Commissioners (NAIC) provides various services to state commissions Includes Insurance Regulatory Information System (IRIS)
  • 100. Many lines face rate regulation Criticism over Katrina-related claims Ch 6-31 ©McGraw-Hill Education. 31 Global Issues Insurance industry becoming increasingly global Worldwide, 2011 was a bad year for both life and PC insurers Japan’s earthquake and tsunami Earthquakes in New Zealand Floods in Thailand Severe tornadoes in US Ch 6-32 ©McGraw-Hill Education. 32 Pertinent Websites A.M. Best Federal Reserve Insurance Information Institute Insurance Services Offices National Association of Insurance Commissioners Ch 6-33 www.ambest.com www.federalreserve.gov www.iii.org www.iso.com
  • 101. www.naic.org ©McGraw-Hill Education. 33 Asset and Liability Management Fin6102 Ferriter – Spring 2018 Overview This chapter discusses mutual funds and hedge funds: Activities of mutual funds Size, structure, and composition Balance sheets and recent trends Regulation of mutual funds Global issues Activities of hedge funds Regulation of hedge funds Ch 5-2 ©McGraw-Hill Education. 2 Mutual Funds Diversification opportunities enhanced for small investors Economies of scale
  • 102. Predominantly open-ended funds Ch 5-3 ©McGraw-Hill Education. 3 Mutual Funds Continued Rapid growth in funds during the 1990s Slower rate of growth in the industry in early 2000s than in 1990s Trading abuses and loss of confidence contributed to slowdown 20 percent drop in assets during 2008 financial crisis Ch 5-4 ©McGraw-Hill Education. 4 Mutual Funds Concluded 2015: More than 7,600 stock and bond mutual companies Total assets of $13.22 trillion More than 8,100 firms and $15.94 trillion if money market mutual funds included Ch 5-5 ©McGraw-Hill Education. 5
  • 103. Size, Structure, and Composition First mutual fund: Boston, 1924 Slow industry growth, initially Factors contributing to dramatic growth Advent of money market mutual funds, 1972 Tax-exempt money market mutual funds, 1979 Special-purpose equity, bond, emerging market, and derivative funds Ch 5-6 ©McGraw-Hill Education. 6 Size, Structure, and Composition Continued Total net assets in mutual funds: 1940: $0.5 billion 1990: $1,065.2 billion 2000: $6,964.6 billion 2007: $12,001.5 billion 2008: $9,603.6 billion 2009: $11,113.0 billion 2010: $11,831.9 billion 2012: $13,052.2 billion 2015: $15,944.6 billion Ch 5-7 ©McGraw-Hill Education. 7 Structure Institutional funds
  • 104. 80 percent of retirement plan investments Low costs No additional distribution fees; bargaining power of retirement plan Risk levels set by retirement plan sponsors Low barriers to entry in US mutual fund industry Allows new entrants to offer funds and compete for investors Ch 5-8 ©McGraw-Hill Education. 8 Size, Structure, and Composition Concluded By asset size, mutual fund industry second most important FI group Recent interest by commercial banks and insurance companies Mellon purchase of Dreyfus As of 2015, banks managed approximately 5% of mutual fund assets State Farm (more than 9,000 agents) As of 2015, insurance companies managed approximately 5% of mutual fund assets Ch 5-9 ©McGraw-Hill Education. 9 Ch 5-10 Assets of Major FIs: 1990, 2007, 2015 ©McGraw-Hill Education.
  • 105. 10 10 Types of Mutual Funds Types of long-term funds: Bond funds, equity funds, hybrid funds Volatility of long-term funds share: 74.3% of mutual fund assets, 1999 2002, long-term funds dropped to 62.1% of assets, losing ground to MMMFs 72.1% in 2007, 59.1% in 2008 68.1% in 2009, 77.4% in 2015 Ch 5-11 ©McGraw-Hill Education. 11 Share of Long Term Funds If MMMFs uninsured: Higher returns September 2008: Risk aversion of investors changed Run on Reserve Primary Fund (due to Lehman Brothers link) Temporary extension of government insurance to MMMFs during the crisis Ch 5-12 ©McGraw-Hill Education.
  • 106. 12 Mutual Funds Continued Money market mutual funds 25.7% of assets, 1999 37.9% of assets, 2002 27.9% in 2007, 40.9% in 2008 31.9% in 2009, 22.6% in 2015 As of 2015, 43 percent of US households owned mutual funds Down from 52 percent in 2001 Ch 5-13 ©McGraw-Hill Education. 13 Ch 5-14 Interest Rate Spread and Net New Cash Flow to MMMFs ©McGraw-Hill Education. 14 14 Overview of Mutual Funds Objectives (and adherence to stated objectives), rates of return, and risk characteristics vary Examples: Capital appreciation funds
  • 107. World equity Investment grade bond High-yield bond World bond Government bond Ch 5-15 ©McGraw-Hill Education. 15 Returns to Mutual Funds Income and dividends of underlying portfolio Capital gains on trades by mutual fund management Capital appreciation in values of assets held in the portfolio Marked-to-market Net asset value (NAV) Ch 5-16 ©McGraw-Hill Education. 16 Web Resources For information on the performance of mutual funds, visit: Morningstar www.morningstar.com Ch 5-17 ©McGraw-Hill Education. 17
  • 108. Types of Funds Open-end fund Comparable to most corporate securities traded on stock exchanges Closed-end investment companies Fixed number of shares outstanding Example: REITs May trade at premium or discount Exchange traded funds (ETFs) Load versus no-load funds Ch 5-18 ©McGraw-Hill Education. 18 Types of Funds Continued Ch 5-19 Exchange traded funds (ETFs) Fixed number of shares outstanding May be bought/sold through broker or in brokerage account Registered with SEC as investment companies Retail investor cannot purchase/redeem shares directly from the ETF ©McGraw-Hill Education. 19 Ch 5-20 Load versus No-Load: Share of Assets ©McGraw-Hill Education.
  • 109. 20 20 Mutual Fund Costs Load versus no-load funds: Sales loads Generally, negative effect on performance outweighs benefits Short term versus long term investment horizon alters impact of loads on cost Fund operating expenses Management fee 12b-1 fees Front end and back end fees Class A, Class B, and Class C differences Creation of new rules by SEC Sweeping decreases in fees, 2005 and 2006 Ch 5-21 ©McGraw-Hill Education. 21 Balance Sheet and Trends Money Market Funds (MMFs) Key assets are short-term securities (consistent with deposit- like nature) 2015: $1,804.2 billion (86.8% of total assets) 2008: flight to safety, out of corporate and foreign bonds Most consumer-oriented shares have values fixed at $1 and adjust number of shares owned by the investor Significant liquidity risk highlighted during crisis Ch 5-22