Class 5, Chap 8

 Interest rate risk  types ▪ Price risk ▪ Reinvestment risk ▪ Refinancing risk  Repricing gap – a simple measure 2

 At bond funds At bond funds 3

 How do banks make their profits?  Why is the margin usually positive?  Assets are usually long-term loans – mortgages, C&I, consumer  Liabilities are usually short term – deposits, commercial paper, repos  Longer-term assets usually earn higher interest  Maturity Mismatch  The maturity of FI’s assets and liabilities do not match 4 Margin = r(assets) – r(liabilities) Usually pay a higher rate because they are long-term but the rate is usually fixed Usually pay a lower rate because they are short- term therefore their funding cost will vary

 IRR is the risk that a firm will lose money if interest rates change  This is a fundamental business risk that FI’s take on when they choose to operate as a financial institution  Asset transformation – transform short-term liabilities into long-term assets  Types of interest rate risk:  Price Risk: Variation in market prices caused by unexpected changes in interest rates. Think of gains or losses on a trading portfolio.  Refinancing Risk: The risk that FI’s funding costs change. The interest rate at which FIs can borrow e.g. the rate on deposits, commercial paper, and repos  Reinvestment Risk: The risk of a change in the rate the FI receives on investments (mortgages, C&I loans, consumer loans) 5

6 Example: A bank has an outstanding 10 year interest only loan with principal of $100,000 maturing in 6 months. The interest rate on the existing loan is 7.3% pa. Currently, mortgage rates are at 6%. Suppose the bank funds the loan with 1 year CDs that pay approximately 3%. 7.3%6% Assets 100, Liabilities $100,000 CD 3% $100,000 CD 3% $100,000 CD 3% $100,000 CD 3% $100,000 CD 3% Margin = 7.3% – 3% = 4.3%Margin = 6% – 3% = 3%

7 Example: An FI has a 10 year $100,000 interest only loan outstanding. The interest rate on the existing loan is 7.3% pa. Suppose the FI finances the asset with 1 year commercial paper. Assets Liabilities $100,000 CP 2.5% $100,000 CP 5% $100,000 CP 3.3% $100,000 CP 3.7% $100,000 CP 3% 7.3% Margin = 7.3% – 3% = 4.3% Margin = 7.3%–2.5% = 4.8% Margin = 7.3%–5% = 2.3% Margin = 7.3%–3.3% = 4% Margin = 7.3%–3.7% = 3.6%

HOMESIDE LENDING 8

9 To increase globalization NAB acquires HomeSide in 1998 for $1.2 billion The 5 th largest mortgage bank in the US at the time When acquired HomeSide had 100 billion in loan servicing rights (receivables) on its books

1. From an increase in the cost of purchasing new mortgages 2. From changes in Mortgage Servicing Rights (MSR) 10

 Fifth-largest mortgage banking company in the U.S.  The company’s business activities consist primarily of:  Mortgage production ▪ Originates and purchases residential single family mortgage loans through multiple channels, including correspondents, strategic partners, mortgage brokers, co-issue partners, direct consumer telemarketing, affinity programs, and online mortgage services.  Servicing ▪ Servicing administration comprises the collection and remittance of monthly mortgage principal and interest payments, collection and payment of property taxes and insurance premiums, and management of certain loan default activities.  Secondary marketing ▪ consists of the sale of residential single family mortgage loans as pools underlying mortgage-backed securities guaranteed or issued by governmental or quasi-governmental agencies or as whole loans or private securities to investors.  Risk management. 11 In 1996 Homeside had 85% of its portfolio in mortgage pools purchased from correspondent lenders

Correspondent lending:  The lender gets credit lines from banks. They make draws to issue new mortgages and pay off their credit lines after selling the loan.  The loan is sold with the servicing rights Problem:  When the supply of loans from correspondent lenders decreases banks compete for loans and drive up the price 12

 1999 – 2000 loan volume fell dramatically after the boom  Decreased supply of mortgages allowed correspondent lenders to charge more for mortgages  This decreased the rate of return (yield) on mortgage transactions  Homeside’s profits decreased due to reinvestment risk  Return on investment – The funds recovered from mortgage sales were reinvested to buy additional mortgages for a higher price. These were then sold for a similar price  Financing costs – the rate on credit lines likely remained constant or decreased by less than the yield on mortgage transactions 13

 HomeSide’s business also consists of a portfolio of mortgage servicing rights  Mortgage Servicing Rights:  The servicer collects a percentage of the mortgage rate  The servicer performs the following tasks : ▪ Collection and remittance of monthly mortgage principal and interest payments ▪ Collection and payment of property taxes and insurance premiums ▪ Management of certain loan default activities 14

15 Decreasing mortgage rates result in more prepayments as loans are refinanced

How are MSR valued?  There is no secondary market price for MSRs  They are valued using a discounted cash flow model  Complication: How many loans are prepaid and when?  HomeSide included the prepayment rate as an input to the model – the rate was assumed and may not have been realistic 16

 In 2000 the prepayment rate increased far beyond what was assumed (Interest Rate Error)  HomeSide lost MSR cash flows from loans they did not own  HomeSide reinvested the prepaid funds on the mortgages that they owned but at much lower mortgage rates  The lower mortgage rates reduced the value of new MSRs relative to old MSRs which caused National Australia Bank (NAB – the parent) to report 400 million in write downs 17

 Another provision (write down) of $1.16 billion against MSR was taken on September 3 rd ($590 million write-off of goodwill).  $400 million of provisions resulted from an interest rate assumption error, as also acknowledged by NAB’s CEO, Frank Cicutto (during an interview with Alan Kohler, a member of Australian media): 18

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 HomeSide Lending: a US mortgage subsidiary of NAB, purchased in  Failed to protect itself against a series of official interest rate cuts in the U.S.  Result:  biggest ever corporate write down in Australia’s history  20% drop in NAB share price  Interest Rate Risk is a BIG risk endangering the health of financial firms.  Managing it is CRUCIAL for survival! 20

REPRICING GAP 21

 Repricing Gap Model:  Basic Idea: measure how a change in interest rates will change the net interest income for the company over a specific time horizon  The time horizon is called the repricing interval  Repricing interval: is a time interval; any asset or liability that is “repriced” during this period is said to be Rate Sensitive and is included in the repricing gap for that horizon 22 Interest income from assets Net Interest Income (NII) = Interest expense from liabilities -

 Liabilities:  Refinancing - A loan issued to the FI at 10% interest comes due and must be refinanced at 12%  Variable Rate - An FI holds a variable rate loan – the loan is repriced when the rate adjusts  Assets:  Reinvestment - A mortgage issued by the FI at 7% matures and a new mortgage can be issued at 9%  Variable Rate - The FI has issued a variable rate mortgage the asset is repriced whenever rate adjusts 23

1. Define repricing interval(s) 2. Identify rate sensitive assets and liabilities for each interval 3. Sum book values of rate sensitive assets (RSA) and liabilities (RSL) in each interval 4. Calculate the repricing gap for each interval 5. Calculate the change in NII with respect to a change in interest rates for each interval  2 cases r(RSA) = r(RSL) & r(RSA) ≠ r(RSL) 24

 Recently the Federal Reserve has required commercial banks to report quarterly (in call reports) 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  Over five years 25

Assets ST Loans (6-month maturity)- 50 LT Loans (2-year maturity) month Treasuries month Treasuries year Treasuries year Mortgages year Mortgages (adjustable every 9 months) – 40 Total: $270 Liabilities & Equity Demand Deposits - 40 Savings Deposits month CDs month banker acceptances month commercial paper - 60 One-year CDs - 20 Two-year CDs - 40 Equity Capital – 20 Total: $ Sample Balance Sheet

Assets (millions) ST Loans (6-month maturity)- $50 LT Loans (2-year maturity) month Treasuries month Treasuries year Treasuries year Mortgages year Mortgages (adjustable every 9 months) – 40 Total: $270 Liabilities (millions) Demand Deposits - 40 Savings Deposits month CDs month banker acceptances month commercial paper - $60 One-year CDs - 20 Two-year CDs - 40 Equity Capital – 20 Total: $ One day Assets = $0M Liabilities = $0M

Assets (millions) ST Loans (6-month maturity)- 50 LT Loans (2-year maturity) month Treasuries month Treasuries year Treasuries year Mortgages year Mortgages (adjustable every 9 months) – 40 Total: $270 Liabilities (millions) Demand Deposits - 40 Savings Deposits month CDs month banker acceptances month commercial paper - 60 One-year CDs - 20 Two-year CDs - 40 Equity Capital – 20 Total: $ More than one day to three months Assets = $30M Liabilities = $60M

Assets (millions) ST Loans (6-month maturity)- 50 LT Loans (2-year maturity) month Treasuries month Treasuries year Treasuries year Mortgages year Mortgages (adjustable every 9 months) – 40 Total: $270 Liabilities (millions) Demand Deposits - 40 Savings Deposits month CDs month banker acceptances month commercial paper - 60 One-year CDs - 20 Two-year CDs - 40 Equity Capital – 20 Total: $ More than 3 months to 6 months Assets = $85M Liabilities = $60M

Assets (millions) ST Loans (6-month maturity)- 50 LT Loans (2-year maturity) month Treasuries month Treasuries year Treasuries year Mortgages year Mortgages (adjustable every 9 months) – 40 Total: $270 Liabilities (millions) Demand Deposits - 40 Savings Deposits month CDs month banker acceptances month commercial paper - 60 One-year CDs - 20 Two-year CDs - 40 Equity Capital – 20 Total: $ More than 6 months to 12 months Assets = $40M Liabilities = $20M

Assets (millions) ST Loans (6-month maturity)- 50 LT Loans (2-year maturity) month Treasuries month Treasuries year Treasuries year Mortgages year Mortgages (adjustable every 9 months) – 40 Total: $270 Liabilities (millions) Demand Deposits - 40 Savings Deposits month CDs month banker acceptances month commercial paper - 60 One-year CDs - 20 Two-year CDs - 40 Equity Capital – 20 Total: $ More than 1 year to 5 years Assets = $95M Liabilities = $40M

Assets (millions) ST Loans (6-month maturity)- 50 LT Loans (2-year maturity) month Treasuries month Treasuries year Treasuries year Mortgages year Mortgages (adjustable every 9 months) – 40 Total: $270 Liabilities (millions) Demand Deposits - 40 Savings Deposits month CDs month banker acceptances month commercial paper - 60 One-year CDs - 20 Two-year CDs - 40 Equity Capital – 20 Total: $ More than 5 year Assets = $20M Liabilities = $0M

33 Assets (RSA) sum Liabilities (RSL) sum Repricing Gap (RSA-RSL) Cumulative GAP One day $0M More than 1 day to 3 months $30M$60M More than 3 months to 6 months $85M$60M More than 6 months to 12 months $40M$20M More than 1 year to 5 years $95M$40M Over 5 years $20M$0M

34 Assets (RSA) sum Liabilities (RSL) sum Repricing Gap (RSA-RSL) Cumulative GAP One day $0M More than 1 day to 3 months $30M$60M$-30M More than 3 months to 6 months $85M$60M$25M$-5M More than 6 months to 12 months $40M$20M $15M More than 1 year to 5 years $95M$40M$55M$70M Over 5 years $20M$0M$20M$90M Positive Gap – Reinvestment Risk: More assets than liabilities are being repriced Negative Gap – Refinancing Risk: More liabilities than assets are being repriced

35 Assets (RSA) sum Liabilities (RSL) sum Repricing Gap (RSA-RSL) Cumulative GAP One day $0M More than 1 day to 3 months $30M$60M$-30M More than 3 months to 6 months $85M$60M$25M$-5M More than 6 months to 12 months $40M$20M $15M More than 1 year to 5 years $95M$40M$55M$70M Over 5 years $20M$0M$20M$90M Cumulative Gap (CGAP)- Is the gap for one day to T (the given time period): A common cumulative GAP (CGAP) of interest is one-year repricing gap includes all assets that will be repriced within one year

Assets ST Loans (6-month maturity) - $50 LT Loans (2-year maturity) - $25 3-month Treasuries - $30 6-month Treasuries - $35 3-year Treasuries - $70 30-year Mortgages - $20 30-year Mortgages (adjust. every 9 months) – $40 RSA= =$155M. CGAP= =$15M Liabilities Demand Deposits – $40 ?? Savings Deposits – $30 ?? 3-month CDs - $40 3-month banker acceptances - $20 6-month commercial paper - $60 One-year CDs - $20 Two-year CDs - $40 Equity Capital - $20 RSL= =$140M. Gap Ratio: CGAP/Assets=15/270=5.6% 36 Alternative 1 year CGAP calculation

Basic Case – Interest rates for assets and liabilities change by the same amount  Suppose rates increase 1% for both RSAs and RSLs. Expected annual change in net interest income (NII):  NII = CGAP ×  R = $15 million × 0.01 = $150,000  Suppose rates fall 1% for both RSAs and RSLs. Expected annual change in NII:  NII = CGAP ×  R = $15 million × = $-150,000 37

Interest rates for assets and liabilities change by different amounts  If changes in rates on RSAs and RSLs are not equal,  NII = (RSA ×  R RSA ) - (RSL ×  R RSL ) =  Interest Revenue -  Interest Expense  Example: Suppose that in the previous example, rates increase by 1.2% on RSAs and by 1% on RSLs:  NII = (RSA ×  R RSA ) - (RSL ×  R RSL ) =  Interest Revenue -  Interest Expense = ($155 million × 1.2%) - ($140 million ×1%) = $460,

39 Given the following balance sheet: a)Calculate the value of 1 year rate-sensitive assets b)Calculate the value of 1 year rate-sensitive liabilities c)Calculate the cumulative 1 yr repricing gap d)Find the 1 year GAP ratio e)Calculate the change in net interest income (NII) i.For a 3% rate increase (both assets & liab.) ii.For a change of 2% asset, -1% liabilities Short-tem loans (1yr) 150 Long-term loans month T-bills month T-notes year T-bonds year mortgage 120 (fixed rate) 30 year mortgage 140 (adjusts every 9 months) 970 Equity Capital220 Demand Deposits 40 Passbook savings130 3 month CDs140 6 month CP160 Bankers Acceptance 120 (3 month) 1 year time deposits120 2 year time deposits Assets Liabilities

 Ignores the market value effect  Assets and liabilities are recorded at their book-values which is the original cost or sale price (historical) – this value is constant  In fact, present values of virtually all assets and liabilities on a balance sheet change as interest rates change.  Ex: A 5 year zero coupon bond was bought with YTM of 9.7% currently the YTM is 5% but the book value is still 9.7%  Over-aggregative!  Distribution of assets & liabilities within individual buckets is not considered. Mismatches within buckets can be substantial. 40

 Ignores effects of runoffs  Banks continuously originate and retire consumer and mortgage loans. Runoffs may be rate-sensitive. ▪ A 30 year mortgage could only have one year left to maturity. However, since it is a 30 year mortgage, it is listed on the books as a 30 year mortgage and would not be considered a RSA at the one year horizon  Ignores off-balance sheet instruments, which are also affected by interest rate changes. 41

 Types of interest rate risk  Price risk  Refinancing risk  Reinvestment risk  Repricing GAP – measures a banks exposure to interest rate risk 42