Professional Documents
Culture Documents
uA
u Demonstrate
How These Tools Are Currently Used By Banks to Ease Margin Compression on the Liability Side of the Balance Sheet
u Many
banks are struggling with high cost longer term funding pressures have increased as the yield curve rallied
u Margin
As assets repriced downward, spreads have plummeted sometimes to < 0 !!! Margin compression may get worse if rates rise, funding costs increase and assets purchased today extend
u Many
How can banks take advantage of todays environment to ensure these borrowings will be refinanced at low rates?
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Recent quotes from a prominent small-cap bank analyst: "Net interest margin pressure is a given We see the dominant story for 1Q03 as the continuing (but slowing) margin compression. The Small-Caps have fought against the effect of margin compression on income with balance sheet growth, fee income initiatives and expense controls. We expect this battle to continue in the first quarter, but perhaps with less success than in recent periods.
Characteristics of a Swap: Range of maturities Can be based upon a variety of floating rate indices Allows banks to transform fixed rate instruments into floating or vice versa
Loan
Fixed
Swap
Fixed
Borrower
Bank
LIBOR
Lehman Brothers
LIBOR
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What is a forward starting swap? A contractual exchange of interest payments between two parties that starts on a future date Vanilla Swap April 2003 April 2008 Forward Feds Funds Target LIBOR & Starting Swap January 2004 January 2009
3.50% Bank Bank Floating Lehman Lehman Brothers Brothers Bank Bank
What is a swaption? The right to enter into an interest rate swap with a predetermined fixed rate on some future date for a one time premium (fee)
Characteristics of a Swaption: Right to pay fixed (payer) or receive fixed (receiver) Range of option expiry Range of maturities on underlying swap Forward Feds Funds Target LIBOR & Starting Swap January 2004 January 2009 3.75% Bank Bank Floating
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Swaption Forward Starting Swap w/ ability to walk away Fixed Rate: 3.75% Premium: 200bp
Bank Bank
Floating
u
Forward Starting Swap Exchange of one cashflow for another starting in future
Forward Starting Swap LIBOR & Feds Funds Target January 2004 January 2009 3.75%
Bank Bank
Floating
u
Payer Swaption Forward swap with right to walk away (for upfront premium)
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Swaption Right to Pay 3.75% for 3mL January 2004 January 2009 Premium: 200bp
Using Swaps and Swaptions to Hedge Against Higher Future Funding Costs
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Illustration
Battling Margin Compression
Illustrative Example FHLB Advance $10m 1/1/99 1/1/04 (~9 months from today) 6.00%
Assumptions The bank intends to roll the funding into a new 5-year advance We assume that the bank can fund at Libor flat The bank wishes to hedge against an increase in rates
The banks risk: $50,000 per year per 50 basis point increase in rates
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Illustration
Battling Margin Compression
Illustrative Example FHLB Advance $10m 1/1/99 1/1/04 (~9 months from today) 6.00%
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7.5
5.0
5.5
4.0
4.5
3.0 2.0 1.0 Jan-00 Jul-00 Feb-01 Aug-01 Mar-02 Sep-02 SWAP 2Y rate SWAP 10Y rate Inter-Meeting Rate Changes SWAP 5Y rate FF Target
SWAP 5Y rate FF Target SWAP 10Y rate Inter-Meeting Rate Changes SWAP 2Y rate
3.5
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Cost of Funds
Elim. Risk Leveraging 3.65% 3.65% 3.65% 3.65% 3.65% 3.65% Elim. Risk Forward Swap 3.88% 3.88% 3.88% 3.88% 3.88% 3.88% Limit Risk Swaption 1.82% 2.82% 3.82% 4.40% 4.40% 4.40% Limit Risk Rate Collar 3.67% 3.67% 3.67% 4.12% 4.12% 4.12%
7.00% Do nothing 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% -2% -1% 0% 1% 2% 3% Rate Shock Limit Risk Swaption Limit Risk Rate Collar Elim. Risk Leveraging Elim. Risk - Forward Swap
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Unhedged Profile
rates
u Mechanics:
Market view: Rates will remain low or fall N/A Premium: None
u Pricing: u Upfront
Market Yield
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The bank enters into long-term funding now, and invests in short security
u Result:
Unhedged Profile
u Mechanics:
Probability
Bank enters into 5.75yr funding today Bank purchases 9-month asset Incurs negative spread immediately
u Market u Pricing:
view: None
Market Yield
Market Yield
3.65% (2.25%)
Probability
Hedged Profile
Cost of Funds Market Yield Market Yield
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The bank eliminates market rate risk by locking in the forward yield
u Result:
Unhedged Profile
u Mechanics:
Probability
Bank pays fixed on forward swap On 1/1/04, the bank enters into 5yr floating rate funding at 3mL flat
u Market u Pricing: u Upfront
Market Yield
Market Yield
Hedged Profile
u Accounting: u Risk:
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Mechanics of a Forward Starting Swap 1. Bank enters into a pay fixed 5yr swap at 3.88% starting 1/1/04
Lehman Brothers
3.88%
Bank
$$
Lender
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The bank locks in a worst-case cost of funds, but retains the upside if rates fall
u Result:
Unhedged Profile
u Mechanics:
Probability
View: Rates may fall, but could possibly be substantially higher Premium: Yes
u Upfront u Pricing:
Market Yield
Market Yield
Unhedged Profile
Probability
Market Yield
Cash flow hedge. No income volatility. Cost of option amortized over term of borrowing.
Market Yield
Market Yield
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Mechanics of a Forward Starting Swap 1. Bank buys a payer swaption on a 5yr swap starting on 1/1/2004 w/ a 3.88% strike 2. Bank exercises the option only if 5yr rate is higher than 3.88%
January 2004 January 2009
If Rates Fall
If Rates Rise
Premium
Premium
$$
$$
Bank Bank
Low Market Rate
Lender Lender
3.88.%
Bank Bank
3mL
Lender Lender
3mL
A payer swaption gives the bank the right, but not the obligation, to pay fixed on a 5yr swap starting on a future date.
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The bank ensures funding costs will remain within a specified band of rates
u Result:
Unhedged Profile
u Mechanics:
Bank buys a payer swaption and sells a receiver swaption at a lower strike rate
u Market
View: Rates may be substantially higher, but probably not substantially lower Premium: None
Market Yield
u Upfront u Pricing:
4.12%
9m into 5yr receiver strike: 3.67% Cash flow hedge. No income volatility.
u Risk:
Cost of Funds
5. Combination Strategies
Battling Margin Compression
Forward swaps & swaptions can be the building blocks of customized strategies
u 50/50
Example: Swap + Swaption u Result: Lock-in worst case 4.14% COF u Mechanics: Buy payer swaption with $5m notional Pay for swaption by entering into a forward starting swap on $5m at offmarket rate u Market View: Want protection vs. much higher rates, with no cash outlay u Pricing: Payer swaption strike rate: 3.88% Premium on $5m ($): $119k Premium on $5m (p.a.): 52bp ATM forward swap rate: 3.88% Off-mkt forward swap rate: 4.40% u Upfront Premium: None
Rate Shock
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7.00% Do nothing 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% -2% -1% 0% 1% Rate Shock 2% 3% Leverage and Invest short Forward Starting Swap
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Accounting Considerations
Battling Margin Compression
Hedge is recorded at fair value The offsetting entry is to Other Comprehensive Income (OCI) Changes in fair value are not reflected in income in forward period By hedging the risk of swap rate changes, the bank will experience no income statement volatility (no ineffectiveness) Premium paid (if any) should be amortized over the life of the hedged funding
Key Results No income impact during forward period Any cost of hedging is recognized over the life of the new borrowing
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Accounting Considerations
Battling Margin Compression
The bank has some maturity flexibility around issuance Under the latest FAS 133/138 developments, the bank can hedge a particular advance and alter its maturity without creating income statement problems if the decision is made at the rollover date For example, if the bank locks in the 5 year swap rate, it may be able to: 1. Issue a 7 year financing and recognize the hedge gain/(loss) over the first 5 years of the new financing 2. Issue a 2.5 year financing. In this case it would recognize the hedge gain/(loss) over a 5 year period on the assumption that it will need to refinance the 2.5 year financing upon maturity
Note that Lehman Brothers is not an accounting advisor please discuss the accounting treatment with any/all hedging transactions with your auditors and internal accounting professionals prior to transacting.
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Summary
Battling Margin Compression
u Margin u Rates
are near historical lows, and may rise dramatically when the economic recovery gets its legs significant rise in rates could hinder bank profitability
uA
u Swaps
and swaptions are powerful tools that can help mitigate margin compression and maximize profit going forward
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I, David Covey, hereby certify (1) that the views expressed in this research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. Any reports referenced herein published after 14 April 2003 have been certified in accordance with Regulation AC. To obtain copies of these reports and their certifications, please contact Larry Pindyck (lpindyck@lehman.com; 212-526-6268) or Valerie Monchi (vmonchi@lehman.com; 1-011-44-207-011-8035). This presentation is based on information that is believed accurate by Lehman Brothers. It is provided for informational purposes only. Lehman Brothers specifically disclaims any obligation to publish additional information or reports in the event that the information contained herein subsequently is found to be or becomes inaccurate or incomplete. This information is not a prospectus and does not offer any securities; however, Lehman Brothers may be engaged in an offering of securities concurrently with the distribution of this document. Any and all terms governing such offering would be contained in a prospectus prepared for that purpose, a copy of which is available upon request and to which the reader should refer for more complete information about such offering. 2003 Lehman Brothers Inc. All rights reserved. Member SIPC.
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Source: LEHMANlive
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Source: LEHMANlive
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Source: LEHMANlive
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