Shifting Gears

In January New York Community Bancorp did something financial institutions are not supposed to dou00e2u20ac”it made a big-time bet on interest rates. Over the previous five years, strong loan volume and an ambitious investment strategyu00e2u20ac”where it used short-term, wholesale borrowings to fund a large portfolio of mortgage-backed securitiesu00e2u20ac”had delivered impressive earnings growth and turned the Long Island-based thrift into a darling of Wall Street.

But then New York Community upped the ante when it raised $400 million in new equity capital and used those funds to purchase mortgage-backed securities. By the end of the first quarter, the thrift’s securities portfolio had grown to $12 billion. “Not only did it make a betu00e2u20ac”it was a pretty big bet,” says James M. Ackor, a bank stock analyst at RBC Capital Markets Corp. That wager went horribly wrong in April when long-term interest rates suddenly jumped and the value of its securities holdings plummeted. Last spring, the company retained a trio of investment bankers to advise it on a possible sale, and when no seller emerged, it sold off a large chunk of securities at a loss in an apparent unwinding of the investment strategy.

New York Communityu00e2u20ac”which declined to discuss the investmentsu00e2u20ac”provides an object lesson of what can happen to institutions that violate one of the cardinal rules in banking. “A well-run bank doesn’t make bets in terms of where interest rates will go,” says Eric Heaton, a managing director in the financial institutions group at Merrill Lynch & Co. in New York. “They stay [interest rate] neutral and make money the old-fashioned way.”

Foundational shifts
That sage advice has never been more important than it is today. After reaching its lowest point in several decades, the U.S. economy is feeling a tectonic shift in interest ratesu00e2u20ac”a development that has already shaken up the banking industry. Long-term rates had already climbed appreciably by late June when the Federal Reserve Board increased the federal funds rate, which is the rate it charges on overnight loans to banks and thriftsu00e2u20ac”by 25 basis points, to 1.25%. Rates at both ends of the yield curve are expected to go even higher, and this drastically changed operating environment is giving chief executive officers and independent directors at banks and thrifts their greatest challenge since the industry’s asset-quality meltdown crisis in the early 1990s.

“It’s a dangerous time when rates start rising rapidly,” says Scott Albinson, managing director in charge of examinations, supervision, and consumer protection at the Office of Thrift Supervision in Washington, D.C. “You have to shift gears.” Although investors often shun financial stocks when interest rates begin to climb, higher rates can actually benefit banks and thrifts whose balance sheets are constructed the right way. But they can also punish institutions that bet on their direction, have become too reliant on purchased funding, or push into new businesses they don’t understand to offset declining revenues. It’s a time for prudent management and strong oversight from the board of directors. “Don’t try to outguess what the market is telling you,” cautions Dan Stevens, chief financial officer at Kansas City, Missouri-based UMB Financial Corp. “And don’t panic. Follow your experience and instincts.”

Last year, short-term rates reached their lowest point since 1949 when the Federal Open Market Committeeu00e2u20ac”which sets monetary policy at the country’s central banku00e2u20ac”cut the federal funds rate to 1%. But a surging U.S. economy has some economists fretting that inflation, which had been virtually nonexistent in recent years, might be making a comeback. This has led to widespread speculation that the recent Fed increase was merely the first shot in an expected salvo of rate hikes over the next year or so.

And where will that drive interest rates across the board? “Higher! Next question?” quips Steve East, an economist at Friedman, Billings, Ramsey & Co. in Arlington, Virginia. East expects the Federal Reserve to raise the fed funds rate at least 75 basis points this year, with another 25-basis-point increase likely in early 2005. “And they’ve got to go [up] even more than that, but I don’t have an official forecast yet,” says East.

Long-term bond rates are usually driven by inflation expectations, and East expects the bellwether 10-year U.S. Treasury bond to hit 5.5% by the end of this year. Like most economists manning the watchtowers against inflation, East is paying close attention to the economy’s strong job growthu00e2u20ac”which could result in a tighter labor market, forcing employers to pay up for workersu00e2u20ac”and also increases in the Consumer Price Index, a closely watched inflation index. “At the end of the day, what will drive yields on the 10-year [bond] is inflation,” he says.

East does anticipate that the rate on the 10-year Treasury bond will drop slightly in the first quarter of 2005u00e2u20ac”assuming the Fed succeeds in tamping down any incipient inflation. And he also expects short- and long-term rates to rise more or less in tandemu00e2u20ac”a so-called parallel shift that can be easier for financial institutions to handle.

John Silvia, senior economist at Charlotte, North Carolina-based Wachovia Corp., also expects the Fed to raise short-term rates well into next year, with the fed funds rate possibly going as high as 3.5%. Unlike East, however, Silvia expects the yield curve to flatten next year, with long-term rates dropping slightly or remaining steady while short-term rates jump precipitously. This scenario would pose a more difficult management challenge, since it quickly drives up the funding costs of those institutions heavily dependent on short-term wholesale deposits while offering them little relief on the asset side of the balance sheet in the form of higher rates on loans or securities. “The yield curve will probably flatten next year,” he says. “That should tell management that their options have changed.”

Watching the curve

The impact that rising rates will have on an institution’s profitability depends on the construction of its balance sheet and the slope of the yield curve. At the low end of the risk spectrum are institutions with high concentrations of low-cost retail deposits like checking accounts, and an earning assets mix heavily biased in favor of floating-rate commercial loans. As interest rates go up, these institutions tend to perform better since their loans will reprice faster than their deposits. Although there are numerous exceptions throughout the industry, this example is more characteristic of a commercial bank.

At the high end of the risk spectrum are those institutions with an earnings asset mix that includes a significant percentage of long-term bondsu00e2u20ac”and a heavily reliance on short-term wholesale funds or higher-cost retail deposits like certificates of deposit. As rates rise, the trading value of existing securities carrying a lower interest rate dropsu00e2u20ac”potentially saddling these institutions with substantial unrealized losses in their investment portfolios. And under current mark-to-market accounting rules, an institution may be forced to write down the value of the securities if they are categorized as available for saleu00e2u20ac”which is essentially a trading account. Although the institution would not suffer an economic loss if it held the securities to maturity, any writedown would result in a charge against its tangible capitalu00e2u20ac”which is never a minor concern. Moreover, investors tend to react poorly when banks or thrifts have large unrealized losses on their books.

These institutions are affected in another way, as well. A rise in interest rates drives up their funding costs, and since wholesale deposits reprice faster than longer-term bonds, they can find themselves caught in a margin squeezeu00e2u20ac”which can chip away at their profitability and place downward pressure on their stock price. Again, while many exceptions exist, this description is more characteristic of a thriftu00e2u20ac”and fits the basic profile of New York Community.

Folklore holds that banks and thrifts are usually hurt by rising rates, but that is not necessarily true. Interest rates on long-term bonds have already begun creeping up in anticipation of Fed tightening, which has resulted in a more steeply banked yield curve. And this has allowed institutions to get a better price for their commercial loansu00e2u20ac”particularly as the country’s economic expansion creates a greater demand for financingu00e2u20ac”or roll the proceeds from maturing bonds into higher yielding securities. “This is not an end-of-the-world scenario,” says Friedman, Billings bank stock analyst Laurie Hunsicker. “It’s a great operating environment.”

Still, the next year or so will be a difficult time for many banks and thrifts as they adapt their balance sheets and business strategies to a new interest rate environment. And some will most certainly stumbleu00e2u20ac”although perhaps not as dramatically as New York Community. The shift toward higher rates could end up being a factor in leading other institutions to consider selling out. The bank merger market has heated up noticeably this year, and Heaton says that’s not surprising. “It has always happened at a point where the U.S. economy was recovering,” he says. But he also believes the anticipated upward movement in rates was a factor in two large deals this year: Cleveland-based Charter One Financial’s decision to merge with Citizens Financial Group in Providence, Rhode Island, and New York-based GreenPoint Financial Corp.’s sale to North Fork Bancorp in Melville, New York. Both Charter One and GreenPoint are big mortgage lenders whose profitability could be hurt should a rise in rates cool off the red-hot refinancing marketu00e2u20ac”an expected scenario. “A change in the interest rate environment will lead select institutions to consider a sale,” Heaton says.

Watchful eyes

Regulators are clearly concerned about the impact rising rates will have on banks and thrifts. In March, Albinson at the OTS sent out a memorandum on management of interest rate risk with this warning to thrift chief executive officers: “With today’s interest rate environment, we believe it is an appropriate time for you to assess how your institution’s current strategy, or any new strategy you are contemplating, is likely to perform under a variety of scenarios.”

Albinson cautioned that thrifts should model the effect that various interest rate scenarios would have on their profitability, so that they could trim expenses or take other preventive measures if need be. He also said the accepted industry practice of modeling how a parallel rate shift of plus or minus 100 basis points would impact a thrift’s securities portfolio is adequate for small institutions with straightforward businesses. “For larger institutions and for institutions that have a high concentration of complex securities, we strongly encourage you to perform more rigorous types of scenario analyses, such as nonparallel shocks to the yield curve,” Albinson wrote. “In conducting scenario analysis, you should try to envision a worst-case situation.”

“They should be doing war games for whatever might occur,” agrees Robert Albertson, chief strategist at New York-based Sandler O’Neill & Partners, “because what does occur always seems to surprise them.”

Thrifts should expect OTS examiners to look closely at their risk management processes this year. “In general, they will be looking to see if you fully understand the sources of risk in your investment and loan portfolios,” Albinson’s memo states. “Of particular concern is interest rate risk.” And the agency will not necessarily criticize thrifts for being conservative or reducing their risk exposure, even if their earnings decline. “If you have diminished profitability, we’re going to look at that holistically,” says Albinson in an interview. “We won’t criticize them if it’s the right thing to do. We’d rather see institutions be cautious in an uncertain environment.”

In his memo, Albinson also reminded boards of directors that they should approve broad strategies and major policies relating to market-risk management and ensure that senior managers take the necessary steps to monitor and control market risk. “The board should be informed regularly of the institution’s risk exposures,” he stressed. Indeed, Albertson at Sandler O’Neill says directors should be pressing their executives to do the same multidimensional analysis that Albinson espouses. “It’s time to get down and dirty with the geeks,” he says.

Unfortunately, that may be asking too much of many bank and thrift directors. Matt Pieniazek, president at Newburyport, Massachusetts-based Darling Consulting Group, which specializes in balance-sheet management, says most directors have a poor grasp of how rising rates will affect their institutions. “I am afraid that most of them don’t understand,” he says. Pieniazek adds that it may be unreasonable to expect outside directors who do not come from a banking background to understand all the complexities of asset/liability management. “Directors need to be willing to learn, and institutions need to make the investment to teach them,” he says. “It’s a two-way street.”

Common mistakes

Even if they don’t understand all the nuances of balance-sheet management, directors should be aware of several mistakes that banks and thrifts commonly make when a significant interest rate shift occurs.

Mistake #1: Betting on interest rates. This maxim is right up there with cautionary advice against spitting into the wind or tugging on Superman’s cape, and yet there are always those bank and thrift executives who are willing to bet on the future direction of interest rates. Case in point: New York Community, the country’s fourth-largest thrift with $26.4 billion in assets. Headquartered in Westbury, New York, the company is a leading multi-family mortgage lender in the greater New York market. By earlier this year it had amassed an enormous portfolio of longer-term securities that were supported by some $13 billion in short-term borrowings, including $9 billion in repurchase agreements with various investment banks. The decision to invest $400 million from a secondary stock offering in mortgage-backed securities occurred after New York Community’s bid to acquire GreenPoint Financial Corp. fell through and it needed to put those funds to work. Unfortunately, rising long-term rates slashed the market value of its securities holdingsu00e2u20ac”in June, RBC Capital’s Ackor estimated its portfolio to be $400 million underwateru00e2u20ac”while an increase in short-term rates threatened to drive up the thrift’s funding cost.

From 1999 through 2003, New York Community’s earnings grew at an average compound rate of nearly 70%. Ackor reasons that New York Community decided to explore a sale because it would no longer be able to meet Wall Street’s earnings expectations in a rising rate environment. However, a buyer had not materialized by early July, and the company announced that it had sold $5 billion in securities out of its trading account, resulting in a $95 million charge against its second-quarter earnings. The bank also said it would use the proceeds from the sale to reduce short-term debt, an indication that it intends to deleverage its balance sheet. By the end of the second quarter, New York Community’s investment holdings had been reduced to $8.5 billion.

Were the company’s investment decisions defensible? Kevin Timmons, an analyst at C.L. King & Associates, allows that the strategy “had become more aggressive than I would like to see for a couple of years.” Timmons says the company’s decision to use proceeds from its secondary offering to make additional investments in mortgage- backed securities “took the leverage strategy too far,” although he adds that New York Community “pretty much told everyone what they were going to do with it.” One group that may not have been fully briefed on the strategy’s risks was the thrift’s board of directors. A capital markets veteran who did not want to be mentioned by name said the decision to invest the equity capital proceeds in the securities market would not necessarily have gone to the board for its approval, although the board should have been aware of the overall investment strategyu00e2u20ac”including its risks. Executives at New York Community declined comment through a spokesperson.

Conservative wisdom says banks and thrifts should aim to be relatively neutral when it comes to interest rate risk, although it’s not unusual for institutions to tilt slightly toward being asset-sensitive when they expect interest rates to rise, or liability-sensitive when they think rates will drop. But these are nickel bets compared to New York Community’s outsized wager. “Shoot for neutrality,” says Hunsicker. “Don’t make an interest rate bet.”

Mistake #2: Living off the yield curve. Albertson at Sandler O’Neill says that banks and thrifts should remember that they’re principally in the business of making loans and generating fees from a variety of servicesu00e2u20ac”not investing in securities. “Are you running a bank or running a bond fund?” he asks. “[Institutions] should be pricing loans and deposits based on risk, with the assumption that they can make a spread on the loan.”
Banks that do earn a considerable amount of spread income from their investment activities are presented with a unique challenge when rates are trending upward. For example, because UMB Financial maintains about half of its earnings assets in securities, the bank likes the fact that long-term rates are moving up. As its existing securities mature, UMB Financial is able to reinvest the proceeds in newer securities with higher rates. But since CFO Stevens expects long-term rates to go higher still, he doesn’t want to invest too heavily now. “How to elongate the investment side without putting all our eggs in one basketu00e2u20ac”that’s the conundrum,” he says. Stevens explains that UMB Financial is turning over its securities holdings “bit by bit,” while avoiding the kind of leverage strategy that got New York Community into trouble. “This is not the time to try to be a hero in the investment portfolio,” adds Pieniazek. “This is a time to take what the market gives you.”

Mistake #3: Getting caught in a bidding war for deposits. A persistent increase in short-term rates will eventually raise funding costs throughout the industry. Even institutions with high percentages of core deposits often diversify their funding sources through such vehicles as commercial paper, trust-preferred securities, or borrowings from the Federal Home Loan Bank Systemu00e2u20ac”all of which will become more expensive in the current environment. With the rise in short-term rates, the cost of consumer funds may eventually increase as wellu00e2u20ac”but banks and thrifts should resist the temptation to get in a bidding war for depositors. Stevens says that banks in UMB Financial’s market “are buying deposits well above prudent rates,” although he wants to make sure the bank stays somewhere in the middle of the market. “We don’t want to give money away, but we also don’t want to lose deposits,” he says. “We can’t be behind the game.”

Pieniazek says that institutions often make the mistake of thinking that all their customers are rate sensitive, “which drives them to think of themselves as a commodity, and commodities always compete on rate.” Before raising rates, he suggests that banks and thrifts perform a detailed analysis of their deposit base to determine where they’re vulnerable. “It’s the larger depositors that are most likely to look,” Pieniazek says. Do they have multiple product relationships with the bank? If not, they are more likely to look for higher rates somewhere else. “They’re nothing more than glorified borrowers,” he grouses. “If they leave, so be it.” Institutions that are worried about funding their loan portfolio as the economy strengthens might want to consider using proceeds from their securities holdings as they mature to fund that growth, he adds.

Mistake #4: Jumping into a new business that you don’t understand. You might not normally associate this particular risk with a change in interest rates, but it makes perfect sense when you think of what is happening to many mortgage lenders nowadays. As the refinancing boom begins to wind down in the face of higher rates, many mortgage lenders are facing a significant revenue shortfall. The temptation is to search for another lending business to quickly move into, but Albinson worries that institutions will commit capital to a sector before fully understanding its risks or having all the necessary policies and procedures in place. “I’ve seen a lot of institutions trying to build the infrastructure while also building the portfolio,” he says. “It doesn’t work.”

For his part, Pieniazek agrees that many institutions underestimate the risk of expanding into new asset classes. “It almost appears that every bank known to man wants to be a commercial lender,” he sighs. “Everybody and his brother wakes up and says, ‘Gee, we can be a commercial banker, too.’ They think the solution is to hire a lenderu00e2u20ac”but the problem is, he’s the only guy who knows what’s going on.”

Mistake #5: Failing to adapt quickly to the changing environment. Wachovia’s Silvia complains that senior management teams at banks and thrifts often fail to reassess their earnings forecasts when the interest rate environment undergoes a fundamental shift in direction. Instead of revising them downward and taking some heat from investors, they look for other ways to meet the forecastu00e2u20ac”laying the groundwork for many of the mistakes that have been detailed in these pages. “A lot of senior bank managers don’t look at the economics,” he says. Albinson stresses that it’s important to know when to change course. “Be prepared to adjust when you’ve made a mistake and something’s not working out,” he says. “Know when to cut your losses.” And while this would be a bitter pill for many institutions to swallow, it may be necessary to retreat if that allows you to fight another day. In his letter to CEOs, Albinson offered this sobering thought: “In some situations, the more appropriate strategy may be to deleverage or shrink the balance sheet rather than obtain higher returns by taking on additional levels of risk.”

Perhaps the best advice for directors and senior managers who are trying to pilot their institutions through what could be a turbulent period ahead comes from Pieniazek. “Know how your institution will be affected by an increase in interest rates,” he says. “Make prudent decisions. And don’t let your decisions be driven by what other people are doing.”

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