1. Building Partnerships. Serving Communities. Maximizing Liquidity at Minimum Cost 2005 CUNA CFO Council May 16, 2005 Presented by: James B. Eibel, CFA Vice President FHLB-Indianapolis (317) 465-0423

2. Building Partnerships. Serving Communities. 2 Goals 1.An interactive discussion of strategic liquidity management 2.Be provocative

3. Building Partnerships. Serving Communities. 3 Presentation Outline 1.What is liquidity risk? 2.Liquidity and opportunity cost 3.ALM and liquidity management 4.Case study and discussion

4. Building Partnerships. Serving Communities. 4 Liquidity 1.The text book says … 2.Your regulators say … 3.Your board says … 4.You and your management team say …

5. Building Partnerships. Serving Communities. 5 “ If the members want a product, we need to find a way to offer it. We are in the risk management business. ” Credit Union CFO

6. Building Partnerships. Serving Communities. 6 “ Credit unions should consider the potential risk exposure as they explore opportunities to better serve their members. ” NCUA Letter 03-CU-11

7. Building Partnerships. Serving Communities. 7 Liquidity Risk “ Liquidity risk is the funding risk that, due to a lack of sufficient stable sources of funds, a credit union will be unable to continue meeting member demands for share withdrawals and/or new loans. ” NCUA Letter 00-CU-13

8. Building Partnerships. Serving Communities. 8 Deconstructing Liquidity Risk 1.“ Funding risk ” 2.Caused by a “ lack of sufficient stable sources of funds ” 3.Resulting in inability to meet “ member demands for share withdrawals and/or new loans. ” NCUA Letter 00-CU-13

9. Building Partnerships. Serving Communities. 9 Sources of Liquidity Primary liquidity –Cash and short term investments –Projected cash flow from loans and securities –Deposit growth Alternative liquidity sources –Borrowing lines –Sales, securitization, and participations

10. Building Partnerships. Serving Communities. 10 Cash/Total Assets Institutions >$100 Million Assets As of 3 rd Quarter 2004, averages were 6.9% and 2.9% respectively for credit unions and banks.

11. Building Partnerships. Serving Communities. 11 Liquidity is Not a Free Good Primary liquidity has an opportunity cost Alternative sources of liquidity may have operational costs (fees, systems, and staff time) Goal: Minimize cost while maintaining funding reliability for all contingencies

12. Building Partnerships. Serving Communities. 12 Opportunity Cost of Primary Liquidity Yield Pick-up

13. Building Partnerships. Serving Communities. 13 ALM and Liquidity Management Liquidity management is a subset of ALM Effective liquidity management requires the use of dynamic scenario analysis –Cash flow projections by scenario –Contingency funding plans by scenario

14. Building Partnerships. Serving Communities. 14 Contingency Funding Policies and Practices The Importance of “ Fire Drills ” Test & documents borrowing lines Test & document loan sales and/or participations

15. Building Partnerships. Serving Communities. 15 Asset Composition and Liquidity Key Issues Cash flow certainty Collateral value SEG concentration Marketability –Sale –Securitization –Participation

16. Building Partnerships. Serving Communities. 16 Callable Bonds Agencies, Corporates, MBS, & CMOs Cash flow certainty is exchanged for a higher initial yield –Amortizing vs. bullet structures FHLB collateral value is 85%-95% of market value for agencies, MBS, and CMOs Marketability issues: –Price volatility of bullet structures –Bid/ask spreads for thinly traded issues (beware of the Hotel California)

17. Building Partnerships. Serving Communities. 17 Investment CDs Cash flow certainty is high, unless CD has an embedded call option FHLB cannot use CDs for collateral CDs are illiquid, but withdrawal option is often cheap relative to fair market value

18. Building Partnerships. Serving Communities. 18 Car Loans Cash flow certainty is relatively high even for longer-term loans (40% turnover) FHLB cannot use for collateral Can be packaged and sold, but execution may be an issue

19. Building Partnerships. Serving Communities. 19 Home Equity Loans Cash flow volatility may be an issue –Unextended HELOCs (approximately 50%) –Closed-end loans similar to comparable duration mortgages FHLB collateral value 50%-70% Can be packaged and sold

20. Building Partnerships. Serving Communities. 20 Mortgages Cash flow can be unpredictable –Portfolios generally turnover 10%-20%, unless rates fall FHLB collateral value approximately 80% of market value Can be sold, securitized, or participated

21. Building Partnerships. Serving Communities. 21 Average Lives for Mortgage Products (Data in Years) Data based on Wall Street dealer prepayment estimates for agency mortgage-backed securities

22. Building Partnerships. Serving Communities. 22 Member Business Loans Cash flow may be an issue with credit lines Some MBLs have collateral value –SBA guaranteed portions –Commercial real estate –Ag loans May be participated

23. Building Partnerships. Serving Communities. 23 Liability Composition and Liquidity Key Issues Optionality –Impact on term structure –Impact on rates paid Reliability SEG Concentration

24. Building Partnerships. Serving Communities. 24 Non-maturity Deposits “ It is not possible to predict with any certainty what the future balances in non-maturity accounts will be, how long they will remain open, or what future rates will be paid to members on these accounts. ” NCUA Letter 03-CU-11

25. Building Partnerships. Serving Communities. 25 Non-maturity Deposit Issue Shares, drafts, and money market accounts represent a significant portion of credit union funding NMDs are relatively insensitive to interest rates and can be priced accordingly –Term structure depends on pricing policies and customer behavior Do you have the liquidity capacity to withstand disintermediation if rates rise?

26. Building Partnerships. Serving Communities. 26 Non-maturity Deposit Assumptions What Qualifies as Conservative? Increasing term structure Value at Par/ Floating Rate McGuire Performance Solutions Example Checking account average life estimates can vary from 1 day to 10 years.

27. Building Partnerships. Serving Communities. 27 Time Deposits Largely rate driven –Funds can generally be attracted for a price –Rate sensitivity tends to increase with term length Early withdrawal option –With interest rates near historic lows, withdrawal penalties are as well

28. Building Partnerships. Serving Communities. 28 CD Interest Penalty Analysis How far out-of-the-money is the option? Based on immediate change in rates Offer Rate

29. Building Partnerships. Serving Communities. 29 FHLB Advances History of reliability (9/11 and S&L Crisis) Clout in global debt markets Customized to match individual needs Optionality controlled by borrower Requires collateral

30. Building Partnerships. Serving Communities. 30 Corporate Credit Union Lines Lack of history and market access May lend against collateral FHLB cannot More competitive on overnight and short borrowings

31. Building Partnerships. Serving Communities. 31 Brokered CDs Product offerings may be limited Withdrawal option generally limited Does not require collateral Tend to be most expensive wholesale option

32. Building Partnerships. Serving Communities. 32 Repurchase Agreements Generally short term Secured by high quality security collateral Counterparty risk

33. Building Partnerships. Serving Communities. 33 Federal Reserve Window Reliable, but “ The Lender of Last Resort ” Catastrophic liquidity backstop

34. Building Partnerships. Serving Communities. 34 Putting it All Together Cash flow budgeting Contingency funding (beyond cash flow) –Deposit pricing strategies –Saleable assets –Borrowings

35. Building Partnerships. Serving Communities. 35 Congratulations! You are the new CFO at Lending Community CU Previous CFO has “ Left to pursue other interests ” –She was unable to persuade board and regulators that she could manage the organization ’ s liquidity position LCCU pays well and recognized your talent You were hired to: –Formulate a liquidity plan consistent with their mission ( “ Lend, lend, and lend some more ” ) –Articulate liquidity plan to management, board, and regulators –Implement the plan

36. Building Partnerships. Serving Communities. 36 Your New Assignment as CFO: LCCU Assets Cash and short term:$80 million First mortgages:$400 million HELOCs (50% extended):$50 million Car loans:$320 million SBA loans:$100 million P, P & E:$50 million Total Assets$1 billion Liabilities Money market:$200 million Shares:$200 million Share drafts:$200 million Retail CDs:$175 million FHLB borrowings:$100 million Brokered CDs$15 million Corporate CU overnight:$10 million Total Liabilities$900 million Equity$100 million Liabilities & Equity$1 billion Ratios ROA:1.2% ROE:12% Net Worth:10% Loan/shares:112% Loans/assets:87% Borrowings/assets:12.5% Projected loan growth:12% Projected deposit growth:10%

37. Building Partnerships. Serving Communities. 37 Liquidity Risk Questions 1.Does LCCU have “ funding risk? ” 2.Does LCCU have a “ lack of sufficient stable sources of funds? ” 3.Is LCCU unable to meet “ member demands for share withdrawals and/or new loans? ” From NCUA Letter 00-CU-13

38. Building Partnerships. Serving Communities. 38 Liquidity Management is a Strategic Competency Risk/reward optimization Improved decision-making & resource allocation Improved budgeting and forecasts Improved management of regulatory risk