Wednesday, December 10, 2014

YOUNGSTOWN, Ohio — It’s a highly unlikely scenario: A financial institution can have all of its borrowers repay their loans in full and on schedule and still lose money.

Why? Because its management, while nailing credit risk, grossly miscalculated the institution’s interest-rate risk.

Recall the late 1970s and early 1980s when inflation was rampant and savings and loan associations faced a crisis as the prime rate climbed, on Dec. 19, 1980, to a record 21.5%. They had issued mortgages in the neighborhood of 6% years before. Many failed as they had to fund long-term obligations that paid low rates of interest with expensive short-term borrowings. (The prime rate has been 3.25% since Dec. 19, 2008, a year into the Great Recession.)

As William Bednar, a research analyst at the Federal Reserve Bank of Cleveland, and Mahmoud Elamin, a research economist there, write in the bank’s Economic Commentary of Oct. 16, banks cannot avoid exposure to interest-rate risk.

A mismatch between the maturity structure of bank assets and liabilities lies at the heart of banking – banks lend money out for long periods, yet they finance those loans with short-term borrowing such as demand deposits. If rates fluctuate unexpectedly, banks can lose money. Managing the interest-rate risk inherent in this mismatch is critical to bank survival.

Bednar and Elamin wrote their article, they explain, because “Small banks have experienced a big spike in interest-rate risk since 2009 [more so than the 50 largest banks in the United States, which also] have been on an upward trend. … [At small banks,] the spike in exposure on the asset side is coming from an increased exposure in both securities and loans.”

Loans as a percentage of assets at small banks have declined since 2005, the authors write, dropping to 54% from 60%. Securities, such as Treasury notes and tax-free municipal bonds, have risen to 15% in early 2013 from 8% in 2001.

Bednar and Elamin conclude, “At small banks, asset maturities are getting longer and liability maturities are getting shorter, a worrisome combination.” Both large and small banks have seen an increase in interest-rate risk but it’s more pronounced at small banks.

The Business Journal interviewed executives from Cortland Banks in Cortland, Farmers National Bank in Canfield, Home Federal Savings & Loan Association of Niles, Home Savings and Loan Co. in Youngstown, and Seven Seventeen Credit Union in Warren to learn how they manage interest-rate risk.

“Interest-rate risk is our highest concern,” says David J. Lucido, senior vice president and chief financial officer at Cortland Banks, “because interest rates have been low and higher rates are on the horizon. The question is when. … We’ve been very aware of going long and funding with short-term money.”

All banks fund their loans with deposits – money their customers have in their checking and savings accounts as well as certificates of deposit. Deposits fund all of the loans that Seven Seventeen Credit Union has on its books, says Jerry J. McGee, executive vice president and chief financial officer. “We could borrow but do not,” he says. “We have not over the last decade.”

Its excess funds, that is, the difference between deposits and loans, are invested in short-term investments in government agencies such as Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corp. (Freddie Mac), and the Federal Home Loan Bank.

At Seven Seventeen, the ratio of loans to shares (deposits) is 80.21% while loans to assets stand at 69.24%, McGee reports. Its cost of funds to assets is 0.33% and cost of funds to deposits is 0.38%.

Over the last five years, Cortland Banks has seen its deposits grow. Where once 60% of deposits were used to fund its loans, that figure has increased to nearly 80%, Lucido says.

The banks and savings associations can borrow from the Federal Home Loan Bank to fund their lending, especially mortgages, and have.

“It’s a stable source of funding,” says Larry Safarek, president and CEO of Home Federal Savings. Home Federal is unusual in that it does not sell the mortgages it originates in secondary markets such as Fannie Mae and Freddie Mac but keeps them in its portfolio.

Banks are allowed to hold blue chip securities such as Dupont, Exxon Mobil and Microsoft as well but none of the banks interviewed do.

“With rates so low,” says Mark Graham, executive vice president and chief credit officer at Farmers Bank, “banks can use their deposits to fund most loans.”

Where Home Savings and Loan sells most of the mortgages it originates on the secondary market, says its vice president for finance, Troy Adair, Farmers Bank keeps the 15-year-fixed mortgages and sells its 30-year-fixed, Graham says. “We sell roughly 60% of our mortgages in the secondary market,” Graham says, “and retain approximately 40%.”

Selling mortgages while retaining the servicing aspects is one way to manage interest-rate risk. In buying the mortgages, the secondary market buyer removes the risk from the originator. It’s the buyer who must be concerned about a sudden spike in rates.

At Farmers, deposits of $913 million, more than fund its loans, $647 million, Graham reports, which means, “We have a lot of money invested” in U.S. Treasury debt, the safest investment possible. Farmers also invests in tax-exempt municipal bonds.

“Investments have some similar characteristics as loan [interest-rate] risk,” Graham points out.

Lenders also manage interest-rate risk by issuing variable-rate loan and lines of credit. It’s not as profitable but guards against the rate risk inherent in fixed-rate loans.

Another option, notes Cortland’s Lucido, are interest-rate swaps. An interest-rate swap is an agreement between two parties where one exchanges its stream of future interest payments for another based on a specified principal amount. The swap exchanges a fixed payment for a floating or variable payment linked to an agreed upon interest rate such as LIBOR.

Other than a residential mortgage, the longest fixed-rate term any of the lenders interviewed offers is 10 years – and then for commercial real estate. Durable goods such as cars, trucks and plant or office equipment have a useful life of five to seven years.

But if a commercial customer wants a fixed term of more than five years, the lender can accommodate him through an interest-rate swap.

“We get requests for seven to 10 years and longer,” says Stan Feret, senior vice president at Cortland Banks and its chief lending officer. “We’re getting more frequent requests to go longer” because customers expect a rise in interest rates in the near future “but we can’t.”

So Cortland will arrange an interest-rate swap through a third party. The customer gets the fixed rate he wants. “It’s fixed for him, variable for us and the third party takes more of the risk,” Lucido explains.

Banks have committees composed of senior managers whose members meet weekly, monthly and quarterly to review the interest rate environment. The monthly and quarterly meetings are longer and more in-depth assessments of where rates are headed.

The CFOs present computer models of the effect that rises and drops in various increments of up to 3% overnight are likely to have on their ability to attract and keep deposits and extend credit.

The committee examines the portfolios – residential mortgages, auto lending, other consumer lending, commercial and industrial lending, commercial real estate – to ensure the funds allocated are in balance, that the bank isn’t overexposed in any area.

If the members think they see warning signals, they prepare to reset rates or reduce their presence in an area of concern. Conversely, the members could see determine to have a greater presence in a portfolio that shows greater promise.

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