Lb Ird Structuring

8/3/2019 Lb Ird Structuring

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New Jersey League of Community Bankers & FMS NY/NJ

Battling Margin CompressionLocking in Low-cost Funding and Eliminating

Borrowing Rollover Risk

Presented By:

David Covey

Senior Bank Strategist

April 16, 2003

Presentation to:


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Battling Margin Compression

Goals of This Presentation

uA Basic Introduction to Interest Rate Swaps and Swaptions

uDemonstrate How These Tools Are Currently Used By Banks to

Ease Margin Compression on the Liability Side of the Balance Sheet


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Overview The Challenge

uMany banks are struggling with high cost longer term funding

uMargin pressures have increased as the yield curve rallied

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

uMany of these borrowings mature in the next 24 months

How can banks take advantage of todays environment to ensure

these borrowings will be refinanced at low rates?


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Overview The Challenge

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.

What are equity analysts saying about small-cap banks?


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A Primer on Swaps and Swaptions


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Interest Rate Swaps

u What is a swap?

A contractual exchange of interest payments between two parties

u 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

Exchange Undesirable Cash Flow for Desirable Cash Flow

Bank

Bank LehmanBrothers

LehmanBrothers

Fixed

Floating


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Interest Rate Swaps

Swap + LoanSwap + Loan

SyntheticFixed Rate Loan

SyntheticFixed Rate Loan Bank

Bank

LIBOR

LoanLoan SwapSwap

BankBankLehman

Brothers

Lehman

Brothers

BorrowerBorrower

FixedFixed

LIBOR


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Forward Starting Swaps

u What is a forward starting swap?

A contractual exchange of interest payments between two parties that starts on a

future date

A Forward Commitment to Exchange Cash Flows

Lehman

Brothers

Lehman

Brothers

3.50%

FloatingBankBank

Lehman

Brothers

Lehman

Brothers

3.75%

FloatingBankBank

LIBOR & Feds Funds TargetForward Starting SwapVanilla SwapApril 2003 April 2008 January 2004 January 2009


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Interest Rate Swaptions

u 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)

u Characteristics of a Swaption:

Right to pay fixed (payer) or receive fixed (receiver)

Range of option expiry

Range of maturities on underlying swap

Optional Forward Starting Swap

BankBankLehmanBrothers

LehmanBrothers

3.75%

Floating

Swaption

Forward Starting Swapw/ ability to walk away

Fixed Rate: 3.75%

Premium: 200bp

LIBOR & Feds Funds TargetForward Starting Swap

January 2004 January 2009


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Swaps and Swaptions Summary

BankBankLehmanBrothersLehmanBrothers

3.75%

Floating

Right to Pay 3.75% for 3mL


Premium: 200bp

LIBOR & Feds Funds TargetForward Starting Swap


Swaption

LehmanBrothersLehmanBrothers

3.50%

Floating

BankBank

Vanilla Swap

April 2003 April 2008u Swap

Exchange of one cashflow for

anotherstarting today

u Forward Starting Swap Exchange of one cashflow for

anotherstarting in future

u Payer Swaption

Forward swap withright to

walk away (for upfrontpremium)


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Using Swaps and Swaptions to Hedge

Against Higher Future Funding Costs


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u 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

u The banks risk: $50,000 per year per 50 basis point increase in rates

Illustration

Illustrative ExampleBorrowing: FHLB Advance

Size: $10m

Issue Date: 1/1/99

Maturity: 1/1/04 (~9 months from today)

Rate: 6.00%


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Potential Risk Management Strategies

1.Do Nothing

2.Eliminate Risk through Leveraging3.Eliminate Risk Through Forward Starting Swap

4.Limit Risk Through a Swaption or Collar

5.Balance Risk Through a Combination Strategy

Illustration

Illustrative ExampleBorrowing: FHLB Advance

Size: $10m

Issue Date: 1/1/99

Maturity: 1/1/04 (~9 months from today)

Rate: 6.00%


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Why May Locking In Funding Costs Be Attractive?

Rates are near historicallows

but may rise considerablywhen the economy recovers

Swap Rates and Fed Funds Target 1992-1994

2.5

3.5

4.5

5.5

6.5

7.5

8.5

Jan-92 Jul-92 Feb-93 Aug-93 Mar-94 Sep-94

SWAP 5Y rate SWAP 10Y rate SWAP 2Y rate

FF Target Inter-Meeting Rate Changes

Swap Rates and Fed Funds Target 2000-2003

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Jan-00 Jul-00 Feb-01 Aug-01 Mar-02 Sep-02

SWAP 2Y rate SWAP 5Y rate

SWAP 10Y rate FF Target

Inter-Meeting Rate Changes


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Indicative Pricing and Strategy Comparison

All values are indicative levels as of 4/04/03

Rate Shock Do nothing

Elim. Risk -

Leveraging

Elim. Risk -

Forward Swap

Limit Risk -

Swaption

Limit Risk -

Rate Collar

-2% 1.30% 3.65% 3.88% 1.82% 3.67%

-1% 2.30% 3.65% 3.88% 2.82% 3.67%

0% 3.30% 3.65% 3.88% 3.82% 3.67%

1% 4.30% 3.65% 3.88% 4.40% 4.12%

2% 5.30% 3.65% 3.88% 4.40% 4.12%

3% 6.30% 3.65% 3.88% 4.40% 4.12%

Cost of Funds

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

-2% -1% 0% 1% 2% 3%

Rate Shock

Do nothing

Elim. Risk -

Leveraging

Elim. Risk - Forward

Swap

Limit Risk -

Swaption

Limit Risk -

Rate Collar


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1. Keep Risk: Do Nothing

u Result: Interest expense will vary withrates

uMechanics:

The bank takes no action

u Implicit Market view: Rates will remain

low or fallu Pricing: N/A

u Upfront Premium: None

The bank does not hedge, maintaining exposure to changes in rates

Unhedged Profile

Market Yield

CostofFunds

Market Yield

Probability


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2. Eliminate Risk: Leverage Strategy

u Result: Bank locks in 3.65% funding

uMechanics:

Bank enters into 5.75yr funding today

Bank purchases 9-month asset

Incurs negative spread immediately

uMarket view: None

u Pricing:

Current 5.75 year swap rate: 3.65%

Assumed 9-month asset yield: 1.40%

Carry for 9 months: (2.25%)


u Risk: Rates stay low (opportunity cost)

The bank enters into long-term funding now, and invests in short security

Market Yield

CostofFu

nds

Market Yield

Probability

Unhedged Profile

Market Yield

CostofFunds

Market Yield

Probability

Hedged Profile


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3. Eliminate Risk: Forward Starting Swap (Rate Lock)

u Result: Bank locks in 3.88% funding

uMechanics:

Bank pays fixed on forward swap

On 1/1/04, the bank enters into 5yr

floating rate funding at 3mL flat

uMarket view: No view

u Pricing: 5y swap rate 9m forward = 3.88%


u Accounting: Cash flow hedge. No

ineffectiveness or income volatility.

u Risk: Rates stay low (opportunity cost)

The bank eliminates market rate risk by locking in the forward yield

Unhedged Profile

Hedged Profile

Market Yield

CostofFunds

Market Yield

Probability

Market Yield

Costof

Funds

Market Yield

Probab

ility


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3. Eliminate Risk: Forward Starting Swap (Rate Lock)

1. Bank enters into a pay fixed 5yr swap at 3.88% starting 1/1/04

Mechanics of a Forward Starting Swap

BankBankLehmanBrothersLehmanBrothers

3mL

3.88%

LenderLender

3mL

$$

Jan 2004 Jan 2009Jan 2004 Jan 2009

2. On 1/1/04, bank borrows floating rate at 3mL for 5 years


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Market Yield

CostofFunds

4a. Limit Risk: Payer Swaption (Rate Cap)

u Result: Cost capped at 4.40%

uMechanics:

Bank purchases payer swaption

uMarket View: Rates may fall, but could

possibly be substantially higher

u Upfront Premium: Yes

u Pricing:

Swaption strike rate: 3.88%

Upfront premium: 2.38% (52bp p.a.)

u Accounting: Cash flow hedge. No income

volatility. Cost of option amortized over

term of borrowing.

The bank locks in a worst-case cost of funds, but retains the upside if rates fall

Market Yield

Market Yield

Probability

Unhedged Profile

Market Yield

CostofFunds

Market Yield

Probability

Unhedged Profile


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If RatesRise

LenderLenderBankBankLehman

Brothers

Lehman

Brothers

3.88.%

Premium$$

3mL3mL

Bank funding cost is capped

Expense: 4.40% (=3.88% + 52bp)

4a. Limit Risk: Payer Swaption (Rate Cap)

1. Bank buys a payer swaption on a 5yr swap starting on 1/1/2004 w/ a 3.88% strike

Mechanics of a Forward Starting Swap

If Rates Fall


LenderLenderBankBankLehman

Brothers

Lehman

Brothers

LowMarket

Rate

Premium $$

Bank acquires funds at market rate

Expense: Market Rate + 52bp

A payer swaption gives the bank the right, but not the obligation, to pay fixed on a 5yr swap starting on a future date.

2. Bank exercises the option only if 5yr rate is higher than 3.88%


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Market Yield

CostofFunds

4b. Limit Risk: Rate Collar

u Result: Bank ensures funding cost will bebetween 4.12% and 3.67%

uMechanics:

Bank buys a payer swaption and sells a

receiver swaption at a lower strike rate

uMarket View: Rates may be substantiallyhigher, but probably not substantially lower


u Pricing:

Net cost 0.00%

9m into 5yr payer strike: 4.12% 9m into 5yr receiver strike: 3.67%

u Accounting: Cash flow hedge. No income

volatility.

u Risk: Rates stay below 3.67%

The bank ensures funding costs will remain within a specified band of rates

Market Yield

Probability

Unhedged Profile

Market Yield

CostofFunds

Market Yield

Probability

Hedged Profile


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5. Combination Strategies

u 50/50 Example: Swap + Swaptionu Result: Lock-in worst case 4.14% COF

uMechanics:

Buy payer swaption with $5m notional

Pay for swaption by entering into aforward starting swap on $5m at off-

market rate

uMarket 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%


Forward swaps & swaptions can be the building blocks of customized strategies

Hedged and Unhedged Cost of Funds

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

-2.00% -1.00% 0.00% 1.00% 2.00% 3.00%

Rate Shock

Unhedged

Swaption Only

Combination

Strategy


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Each Strategy Results in a Different Cost-of-Funds Profile

Indicative Pricing and Strategy Comparison

New Funding

Current Funding

Rates and Assumptions

2.38%Swaption Cost (3.88% strike)

3.88%5.0 yr Swap Rate 9m Forward

3.65%Current 5.75 yr Swap Rate

3.30%Current 5.0 yr Swap Rate

1/15/03Maturity Date

5.0

6.00%

1/15/99

$50m

Expected Term (yrs)

Rate

Original Issue Date

SizeRate Shock Do nothing

Leverage and

Invest short

Forward Starting

Swap

Payer Swaption

(Rate Cap) Rate Collar

-2% 1.30% 3.65% 3.88% 1.82% 3.67%

-1% 2.30% 3.65% 3.88% 2.82% 3.67%

0% 3.30% 3.65% 3.88% 3.82% 3.67%

1% 4.30% 3.65% 3.88% 4.40% 4.12%

2% 5.30% 3.65% 3.88% 4.40% 4.12%

3% 6.30% 3.65% 3.88% 4.40% 4.12%

Cost of Funds

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

-2% -1% 0% 1% 2% 3%

Rate Shock

Do nothing

Leverage and Invest

short

Forward Starting Swap

Payer Swaption (RateCap)

Rate Collar


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Accounting Considerations

Hedge Accounting Overview

uThese hedges should be designated as Cash Flow Hedges under FAS 133

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 incomestatement 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

Hedge Accounting Overview

u 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

uMargin compression is currently a major concern of depositories

uRates are near historical lows, and may rise dramatically when the

economic recovery gets its legs

uA significant rise in rates could hinder bank profitability

uSwaps 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 ([email protected]; 212-526-6268) or Valerie Monchi

([email protected]; 1-011-44-207-011-8035).

This presentation is based on information that is believed accurate by Lehman Brothers. It is providedfor 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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Appendix: Finding Pricing on Swaps & Swaptions

Source: LEHMANlive

Click here to see the full live swap curve


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Source: LEHMANlive


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Source: LEHMANlive

Lb Ird Structuring

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