Prudent management of a community bank investment portfolio requires an approach mat starts with strategic analysis of the balance sheet, and men moves to tactical decision-making. This sort of top-down mediod first requires a look at the bank's asset/liability posture to identify exposures to interest rate risk. Once diis is done, the investment portfolio can then be used as a vehicle for managing diat risk. The Baker Group has always worked with client banks through a four-step process:
* First we look at the macro conditions of the economic environment and make observations as to where we are within the interest rate cycle.
* Second, we define the interest rate risk exposures of the bank's overall balance sheet through the use of a robust asset/liability management model.
* The third step is to identify relative value between and amongst the different bond market sectors that are pertinent to community bankers.
* The fourth and final step in the process is to drill down to the investment portfolio and do comparative analysis of individual securities to make selections that are appropriate for the unique characteristics of the bank.
Market conditions
Global financial markets have been in turmoil recendy. Remember that the sequence of events that led to the summertime market crisis began with a housing market bubble that reached its peak sometime last year. In the five-year period from 2001 to 2006, the average new home sales price soared from $167,000 to 263,000, a nearly 60 percent increase. This rapid home price appreciation led to a variety of behaviors, which were eventually to become major problems. Risky (and possibly fraudulent) lending, securitization and credit analysis practices became rampant during the final phase of the bubble as everybody wanted to cash in on a red hot housing market. The subsequent problems with subprime lending are well known and documented, but the bottom line is that markets are now acknowledging that risk is excessive. This reassessment of risk has caused spreads to widen dramatically and has brought about a powerful, ongoing flight to quality. This, as we shall see, can present some welcome opportunities for community bank portfolio managers to enhance performance and margin.
At the same time that the capital markets have seized up, we are now seeing some disturbing data on the U.S. domestic economy. The August unemployment report was particularly negative. Every component of the report indicates weakness in the labor market, which is significant because most economists have been pointing to jobs growth and income growth as the last hope for propping up an economy that is already suffering from a severe housing recession. Fed Chairman Ben Bernanke has made comments to indicate that the Fed will not ease in order to bail out the financial markets from subprime trouble, but that they will certainly provide stimulus to the economy, which now clearly needs help.
Interest rate risk
Simulation analysis based on data for U.S. community banks $50 million - $500 million in assets shows that, on average, this group of banks has clear risk exposures to falling rates. Based on the analysis, net interest margin can be expected to average 3.94 percent during the next 12 months if rates remain unchanged. Looking at moves of 200 basis points, margin would go up to 4.12 percent if rates rose, but it would fall to 3.69 percent if rates decline. Of course, the analysis is based on simulations from our call-report based A/L model (which we generally use for comparative and research purposes), not the more sophisticated model that we ordinarily use for clients. Nonetheless, the results are significant and meaningful for identifying broad trends.
Relative value
The market turbulence has been interesting to watch, but it has also resulted in rare investment opportunities for community banks. I like to think of these as margin repair opportunities. One noteworthy development is that we are suddenly seeing much higher relative yields on bonds with high grade credit quality, including those with the backing of the full faith and credit of the U.S. Treasury. New GNMA 15-year mortgage-backed securities, for example, have seen their yield advantage over five-year Treasury notes jump from 75 bps to as high as 140 bps recendy. Bank-qualified municipal bonds have also seen a substantial widening in yield spreads. In fact, the tax-equivalent yield spread on AAA bank-qualified 10-year bonds versus a durationequivalent treasury more man doubled from the levels that existed prior to the market upheaval. Nodiing has changed regarding the specific underlying credit fundamentals of the municipal issuers. It is just that the flight to quality has created enormous yield advantages for non-Treasury bonds.
This effect can be seen in other sectors as well. Yield spreads are higher even for simple bullet bonds issued by government agencies like the Federal Home Loan Bank, Freddie Mac or Fannie Mae. At this writing, those bonds show spreads around 60 basis points; nearly triple the levels seen at the beginning of the year.
Security selection
In identifying and choosing specific securities for your bank, keep in mind that every bank is different with respect to its specific characteristics and needs. Some banks are loan driven; others rely more heavily on investments for income. Some banks are extremely well capitalized; others are run on diin capital. Each institution has its own loan and deposit customers and its own economic region, which will influence the type of business it does. All of these diings must be taken into consideration before developing an investment strategy.
As to the current environment, keep in mind that numerous factors play a role in the widening or tightening of yield spreads. An increase in market volatility will affect the value of call options on agency bonds and prepayment options embedded in mortgage-backed securities. Supply and demand conditions for municipals will always have some impact on municipal yield levels. Still, the behavior of the markets recendy and the extreme reassessment of risk valuations in the wake of all the turbulence has produced spread levels that are unlikely to persist.
Community banks have been pressured by declining margins ever since the Fed began its tightening campaign in mid-2004. We have seen our marginal cost of funds quadruple, while our yield on earning assets has barely moved. Now, however, we are seeing some light at the end of the tunnel. The yield curve from two years out (the so-called "coupon curve") is steep again after a oneyear inversion. Yield spreads are wider than they have been in years, and opportunities to restructure the bond portfolio, which may not have made sense several mondis ago, might be worth revisiting now because so much has changed in valuations and yields. As planning season approaches, survey the landscape and lay the groundwork for improving performance in the bond portfolio and the balance sheet overall. BN
[Sidebar]
"Survey the landscape and lay the groundwork for improving performance in the bond portfolio and the balance sheet overall."
[Author Affiliation]
Jeffrey F. Caughron is vice president/'senior portfolio strategist at The Baker Group.
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