CHAPTER12 Introduction to Asset Liability Management What is in this Chapter? INTRODUCTION SOURCES OF INTEREST-RATE RISK Mortgage-backed Securities (MBS)

INTRODUCTION Asset liability management (ALM) interest rate risk: The interest-rate risk arises from the possibility that profits will change if interest rates change. liquidity risk: The liquidity risk arises from the possibility of losses due in the bank having insufficient cash on hand to pay customers. Both risks are due to the difference between the bank's assets and liabilities.

INTRODUCTION The best illustration of ALM : U.S. savings and loan (S&L) crisis Savings and loan banks: retail banks, receive retail deposits and make retail loans For many years, interest rates stable. Deposits for around 4% (floating rate), and they lent 30-year mortgages paying about 8% at fixed rates. Then in the 1980s, the Federal Reserve allowed interest rates to float. Short-term interest rates rose to 16%.

Many deposit customers withdrew their funds or demanded the higher rates The rate of mortgages is fixed with 8%, however the rate of deposits is floating and the banks have to pay 16% to deposit customers This causes the banks a lot of loss and go to bankrupt

INTRODUCTION Several keys of the above example The rate of deposit is floating and the rate of mortgage is fixed The deposit (loan) is more (less) sensitive to interest rate Or, the deposits (one kind of banks’ liabilities) is rate- sensitive and the mortgage (one kind of banks’ assets) is rate-insensitive.

The interest rate risks will rise when the RSL (rate- sensitive liabilities) is not equal to RSA (rate-sensitive assets) Question: How to evaluate the size to rate sensitivity?

Duration of First National Bank's Assets and Liabilities Duration in year (or in %) 0.4 X (5/100)

Review: Duration Analysis for Bonds

Duration in year (or %)=duration in dollars (or $)/V (the initial value) (Duration in dollars) x (change in interest rate)= the change of V in dollars ($) (Duration in year) x (change in interest rate)=the change of V in percentage (%) The change of V in dollars=(the chance of V in %) x the initial value (V)

10 Duration Gap Analysis %  V   DUR   r r  5%, from 10% to 15%   Asset Value= %  P  Assets =  2.7 .05  $100m =  $13.5m  Liability Value= %  P  Liabilities =  1.03 .05  $95m =  $4.9m  NW=  $13.5m  (  $4.9m) =  $8.6m DUR gap = DUR a  [L/A  DUR l ] = 2.7  [(95/100)  1.03] = 1.72 %  NW =  DUR gap   r =  1.72 .05 = .086 =  8.6%  NW= .086  $100m =  $8.6m

Example of Finance Company

Duration Analysis If r  5% Duration Gap Analysis DUR gap =DUR a  [L/A  DUR l ] =1.16  [90/100  2.77] =  1.33 years %  NW=  DUR gap X  r =  (  1.33) .05 =.0665 = 6.5%

Managing Interest-Rate Risk Strategies for Managing Interest-Rate Risk In example above, shorten duration of bank assets or lengthen duration of bank liabilities To completely immunize net worth from interest-rate risk, set DUR gap = 0 Reduce DUR a = 0.98  DUR gap = 0.98  [(95/100)  1.03] = 0 Raise DUR l = 2.80  DUR gap = 2.7  [(95/100)  2.80] = 0

INTRODUCTION liquidity risks This is the challenge of ensuring that the bank has sufficient liquid assets available to meet all its required payments, including the possibility of a "run on the bank." A run on the bank occurs when deposit customers lose confidence in a bank's creditworthiness and rush to the bank to take out their savings before the bank collapse

In most developed countries, this risk is greatly reduced by deposit insurance backed by the government. In the United States the Federal Deposit Insurance Company (FDIC) guarantees that retail depositors will be compensated up to $100,000 if their bank fails

INTRODUCTION By modeling and understanding ALM risks: banks seek to minimize the risks and know how much to charge customers to cover the capital consumed by the risks. Another important aspect of ALM is determining the fair, risk-minimizing interest rates that should be charged internally between the bank's business units when the lend funds to each other.

SOURCES OF INTEREST-RATE RISK Many banks in emerging-market countries have a large portion of their balance sheets in the form of loans denominated in U.S. dollars Both the structural interest rate and the structural FX positions are managed in the ALM framework

The primary cause of structural interest-rate risk is: customers want both long-term loans and quick access to any deposits This leaves banks in a position in which they are receiving long-term, fixed-rate interest payments from borrowers and paying short-term, floating-rate interest to depositor.

SOURCES OF INTEREST-RATE RISK Figure 12-1a illustrates a possible scenario Figure 12-1b shows the net interest income (NII), i.e., interest income minus interest costs

SOURCES OF INTEREST-RATE RISK Figure 12-1c: noninterest expenses are partially floating Figure 12-1d : the result is the net earnings for the bank

SOURCES OF INTEREST-RATE RISK The measurement of ALM risks is made more difficult than the management of a simple bond portfolio. because of the indeterminate maturities of assets and liabilities. The indeterminate maturity describes the uncertainty as to when customers will make or ask for payments We will discuss the above behaviors in detail in the following discussion Uncertain prepayment and withdraw behaviors

SOURCES OF INTEREST-RATE RISK What are the differences between the risk of the structural interest-rate position and the market risk of the trading room? In the trading room, all transactions are clearly structured. With bonds, the maturity is known, and the term is fixed by the contract underlying the security. With options, the expectation is that every option will be exercised to maximize the advantage to the holder

In contrast, ALM products such as mortgages and deposits have many implicit or embedded options that make the values dependent not only on market rates, but also on customer behavior. For example, customers have the option to withdraw their deposit accounts whenever they wish, or to prepay a mortgage early if they find a cheaper mortgage elsewhere.

MAIN PRODUCT CLASSES HELD IN ALM PORTFOLIOS The main classes of products for asset liability management are the following: Assets Retail personal loans Retail mortgages Credit-card receivables Commercial loans Long-term investments Traded bonds Derivatives

MAIN PRODUCT CLASSES HELD IN ALM PORTFOLIOS Liabilities Retail checking accounts Retail savings accounts Retail fixed-deposits accounts Deposits from commercial customers Bonds issued by the bank

Mortgage-backed Securities (MBS) In the United States, there is a large market of traded mortgage-backed securities (MBS) 不動產 抵押貸款債券 In an MBS, the payments from many mortgages are pooled together. This pool of payments is then used to guarantee payments on several tranches of bonds The tranches can also be split as to whether they are entitled to the interest payments only (IO) or principal payments only (PO)

Mortgage-backed Securities (MBS) The value of a tranche principal payments increases when prepayments increase because the cash flows happen sooner Tranches entitled to interest payments drop significantly in value when prepayments occur because the interest-payment stream stops The valuation of payment streams therefore depends heavily on customer behavior.

Mortgage-backed Securities (MBS) The Public Securities Association (PSA) has published a standard for the expected conditional prepayment rate (CPR) 固定提前清償率 It says that 0% are expected to prepay in the first month, rising linearly to 6% per annum at month 30 Thereafter, each year 6% of the remaining borrowers are expected to prepay An MBS with a prepayment rate matching this profile is said to be at 100% PSA. An MBS with twice the prepayment rate would be at 200% PSA

Mortgage-backed Securities (MBS) A term related to CPR is the SMM (single monthly mortality rate) This is the percentage of the remaining poll that prepays each month The CPR and SMM are simply related:

Figure 12-2 shows the amount of principal outstanding on a 20-year, 8% mortgage, assuming that the installments are equal and there is no prepaymen Mortgage-backed Securities (MBS)

Figure 12-3 shows the same mortgage but with prepayments at 100% PSA >100% PSA: in each year, 6% of the remaining borrowers are expected to prepay With prepayment, the stream of interest payment is reduced With prepayment, the principle payment will increase first and drop in the last

Mortgage-backed Securities (MBS) Table 12-1 shows the NPV of the principal and interest payments for different speeds of prepayment > Notice that as the PSA increases, the value of the principal payments increases, and the value of the interest payments decreases

Mortgage-backed Securities (MBS) The PSA standard is a very simple model. The main simplification is that in reality, the prepayment rate is strongly affected by changes in interest rates. When market rates drop, new mortgages have lower interest payments, and homeowners are tempted to refinance their homes by taking out a new mortgage and prepaying the old one In other words, the prepayment is not a constant and is related with interest rate

Mortgage-backed Securities (MBS) The value of the option to prepay is the difference in the NPV of the two alternative sets of interest payments, minus the strike price The strike price includes any prepayment penalties and the plain hassle involved in refinancing A typical prepayment function can be approximated as a logistic function:

Mortgage-backed Securities (MBS) >The value equals one when x equals negative infinity and equal to zero when x equals positive infinity >the function has the shape of S curve between one and zero

Mortgage-backed Securities (MBS) The prepayment rate as a percentage of the PSA can be modeled as follows: 100% PSA: in each year, 6% of the remaining borrowers are expected to prepay r is the market-refinancing rate >if r decrease, then prepayment rate? a, b, c and d are constant

Mortgage-backed Securities (MBS) >Typical values for the parameters are given in the equation above >This function is shown in Figure 12-4

Mortgage-backed Securities (MBS)

Constant prepayment rate: 6% in each year The non-constant prepayment rate and the prepayment rate is negatively relative with interest rate Figure 12-5 shows the effect of rate changes on the NPV of principal-only (PO) payments. >The sudden drop in value occurs in the region where prepayment rates drop and the average time for the cash flows increases dramatically

Mortgage-backed Securities (MBS) >As the rate begins to increase from 6% to 8%, the value drops because of the greater discounting >From 8% to 10% as rates increase, so does the value of the security. This is because there are significantly fewer prepayments of principal, and therefore more interest payments Once the prepayment rate stabilizes at a new low level, the discounting effect again begins to dominate Hint: the interest rate has two effects: (1) the discounting effect (2) prepayment effect!!

MAIN PRODUCT CLASSES HELD IN ALM PORTFOLlOS The example above shows that the change in value of an MBS can be a complex function of interest rates In reality, the value of an MBS is even more complex because customer payments are also path dependent They are path dependent because the prepayment rates depend not only on the current market rate, but also on the previous rates

Mortgage-backed Securities (MBS) If rates have previously been low, most of the financially sophisticated borrowers will have already prepaid, and a renewed drop in rates will not cause a significant increase in prepayments The accurate valuation of mortgage-backed securities is highly complex and the subject of many trading models, but the key points to be aware of are as follows:

Mortgage-backed Securities (MBS) Mortgage-backed securities can be structured to have values that are very complex functions of interest rates. The value of an MBS is greatly dependent on the prepayment rate. The prepayment rate is a complex function of interest rates. The response to changes in interest rates can have significant negative convexity; i.e., the value can rise as rates rise.