1. Bank Investments

2.  G & K Chp. 7  Review Economic Environment (Loans)  Types of investment securities  Evaluating investment risk  Investment strategies

3. Securities  U.S. government and agency securities –(Agencies: FNMA, FHLMC, GNMA, FCA, SBA) Mortgage-backed securities (MBSs) and collateralized mortgage obligations (CMOs) are dominant in this investment category (prepayment risk).  Municipal bonds –General obligation bonds (GOs) and revenue bonds –Taxes  Corporate bonds

4. Muni Taxes  Tax formula for munis: YTM m /(1-T) - (1.0 x Average cost of funds x T)/(1-T) = YTM TE where T = bank tax rate, the factor 1.0 is for 100% of interest expenses are not deductible from taxes (i.e., 0.20 for bank qualified munis), and average cost of funds is based on IRS rules, and YTM TE = a tax equivalent yield for comparison to taxable bonds. Example: given T = 0.34, 1.0 is used, average cost of fund = 7%, and YTM m = 8%, we have 0.08/(1 - 0.34) - [(1.0 x 0.07 x 0.34)/(1 - 0.34)] = 0.0852 or 8.52%

5. Securities Risk  Interest Rate risk  Security Specific risk

6. Interest Rate risk  Duration –Coupon Rate, YTM inverse to Duration –Maturity directly related to Duration –Assumes Parallel Shifts in YTMs !!!  Convexity (Second Derivative of Price) –Notice that price change prediction gets worse –Positive and Negative Convexity

7. Security Specific risk  Bond Ratings –Investment grade bonds (top 4 credit ratings) AAA (Aaa)  BBB (Baa) –Junk bonds (lower rated bonds) BB (Ba)  C; Default: DDD, DD, D –Estimates of the probability of default –Bondholder losses in default not captured by credit ratings

8. Investment strategies  Passive investment strategies  Aggressive investment strategies

9. Passive Investment Strategies  Space-maturity approach (ladder approach) Spread available investment funds evenly across a specified number of periods within the bank’s investment horizon. Simple and low transactions costs, but passive with respect to interest rate conditions and liquidity is sacrificed to some extent.  Split-maturity approach (barbell approach) Greater quantities of short-term and long-term securities are held. This strategy balances liquidity and higher income.

10. Passive Investment Strategies $10 1 yr 2 yrs 3 yrs 4 yrs 5 yrs Maturities of Securities Ladder Approach Barbell Approach $10 $20

11. Aggressive Investment Strategies  Yield curve strategies –Playing the yield curve –Riding the yield curve  Bond-swapping strategies –Tax swap –Substitution, or price, swap –Yield-pickup, or coupon, swap –Spread, or quality, swap –Portfolio shift