1 Swaps – Meeting Demand for Fixed-Rate Loans Bob Newman, CFA March 19-20, 2014

2 Derivatives – The Perception

3 Derivatives – The Reality  Interest rate transactions are a highly effective and efficient way to manage financial risk  Most interest rate transactions are not overly complex or opaque  The interest rate derivatives market is highly liquid with broad bank participation

4 LIBOR Fixed Rate What is an Interest Rate Swap? An agreement between two parties in which one party agrees to pay a fixed rate of interest and the other agrees to pay a floating rate of interest on an agreed upon notional amount No principal changes hands, simply an exchange (“swap”) of interest payments for a set period of time Swap rate is derived from market expectations LIBOR is the foundation of the swap market A swap agreement is a separate contract from the loan Borrower Bank

5 Issue: Long-Term Fixed-Rate Loan Pricing Borrower Perspective  Market interest rates hovering near all-time lows  Rumblings of rate increases in the air + =  Borrowers demanding long-term fixed-rate pricing

6 Issue: Long-Term Fixed-Rate Loan Pricing Bank Perspective  Market interest rates hovering near all-time lows  Margin compression due to loans re-pricing + =  Banks willing to accommodate borrowers out 10 yrs or longer

7 Can Swaps Solve This Problem?  Swaps can help, but……  Swaps are a powerful tool to manage interest rate risk…  Convert 10-15y fixed to L + spread  …but not a “magic bullet”:  Swaps cannot convert an unprofitable fixed-rate into a PROFITABLE floating rate  “What are our peers doing that we’re not doing?”

8 Borrower Fixed Rate Loan 4.75% FHLB Fixed Rate Advance 3.25% Match-Funded Fixed-Rate Loan – FHLB A Fixed-Rate Loan Funded with a Matching FHLB Advance Matching FHLB advance rate for 15y/15y structure = 3.25% Market prepayment penalty for early extinguishment Fixed-Rate Loan for 15y/15y structure = 4.75% Bank nets a spread of 1.50% Potential risk of loss on prepayment unless penalty matches FHLB advance Would an interest rate swap provide a different answer? $5mm Loan Bank Net Spread = 1.50% Loan Terms  $5 million loan  15 year term  15 year amortization  Minimum Spread = 1.50%

9 Short-term Funding Swapped to Fixed “Synthetic” Match Funding Dealer Bank FHLB 1m LIBOR 2.75% Advance Terms $5 million FHLB funding 15 year maturity 15 year amortization Monthly pay FHLB Funding Swap 1-month advance Key Considerations – Cash Flow Hedge Funding, or suitable replacement debt, must remain outstanding through the life of the swap Matching swap and debt terms exactly minimizes/ eliminates ineffectiveness 1.Bank borrows $5 million in wholesale funding from FHLB monthly and rolls the advance 2.Bank executes a pay-fixed swap at 2.75% and receives 1- month LIBOR for fifteen years 3.FHLB 1-month advance rate is converted to 2.75% 15- year funding via the swap (+/- basis difference) 4.The 2.75% 15-year swap rate compares favorably to the FHLB 15-year advance rate of 3.25% 5.Save 50 bps by funding short and using swap to lock rate 6.Swap provides Bank with 2-way prepay make-whole instead of 1-way penalty in term fixed-rate advance

10 Borrower Fixed Rate Loan 4.75% Fixed Rate Swap 4.75% 1mL bps Fixed-Rate Loan Swapped to Floating Behind the Scenes Fixed-rate loan is effectively converted to a floating rate 15y/15y LIBOR swap rate = 2.75% today 4.75% fixed = 1mL % floating (2.16% yield today) No fee income recognized – all economics built-into spread over LIBOR Loan hedged with swap needs market-based prepay provision Essentially embedding the worst feature of direct swap into the loan $5mm Loan Premium BankDealer Bank

11 Loan Terms  $5 million loan  15 year term, L + 175bps  15 year amortization  PV01 = $3,840 Back-to-Back Swap Program Sell the Swap to the Borrower 1.Borrower enters into loan with Bank, paying L % 2.Borrower executes “retail” swap with Bank, paying fixed at 4.75% and receiving L % (offsetting the loan payment) 3.Bank enters into “wholesale” swap with Dealer Bank, passing on fixed rate exposure, leaving Bank with variable rate loan % is 25 bps higher than what Dealer Bank expects to receive; therefore, Dealer Bank pays Bank the present value of 25 basis points or $96,000 5.All-in economics = 200 bps spread (175 in margin; 25 PV in non-interest income) Dealer Bank BankBorrower  (Loan) LIBOR % 4.75%  (Retail Swap) LIBOR % 4.75%  (Wholesale Swap)  $96,000 (25 bps x $3,840) Pricing as of 3/18/14

12 Summary Direct Match-Funding with FHLB 50 basis points more expensive due to liquidity premium in term fixed advance Swaps (borrower gets lower rate / bank gets better spread): Directly with Borrowers Fee income opportunity More explaining/documentation for borrower Eligibility requirements and suitability/sophistication Fixed-Rate Loan (behind the scenes) No fee income / hedge accounting designation and testing Need market-based prepayment language Balance Sheet Hedge Works best with short-term borrowings / market-linked funding Hedge accounting designation and testing

13 How Do I “Break Ground” on Hedging? Lay the Foundation Board and Management Education Hedging Policy and Approval Set up Swap Counterparty – Documentation Regulatory/Accounting groundwork Assess IRR / Borrower Demand-Suitability Build the House Balance Sheet Hedging Program Structure-Execute-Designate-Document Borrower-Facing Swap Program Implementation-Training Product “on shelf”

14 Questions?

15 Chatham Financial Corp. 235 Whitehorse Lane Kennett Square, PA Bob Newman, CFA Contact Information