Getting Diverse Candidates to the C-Suite


*This video was originally published in Bank Director digital magazine in February, 2016.

U.S. Bank has a diverse workforce. It has a diverse board. But where it lacks diversity is the C-suite. U.S. Bank’s head of human resources, Jennie Carlson, talks about the bank’s strategy to change that.

She discusses:

  • U.S. Bank’s strategy for finding diverse candidates for the C-suite
  • The natural biases that every person has
  • Surprising demographic data that U.S. Bank found

The Risks of Banking on Mortgage-Backed Securities


1-17-Blackrock.pngMitigating the Risks of Mortgage-Backed Securities

In an environment where many investors are searching for yield, mortgage-backed securities (MBS) have generated significant interest. With higher yields, lower duration, and either implicit or explicit guarantees from the U.S. government against loss of principal and interest, MBS appear to be an attractive option relative to the broader Barclays U.S. Aggregate Bond Index.

Of course, MBS carry the additional risk of negative convexity, which can drive duration higher as interest rates rise (i.e. extension risk) and lower as interest rates fall (i.e. prepayment risk). While investors are compensated for this risk in the form of higher yields, the impact of duration extension in a rising rate environment should not be underestimated. Extension risk, however, can be mitigated through diversification into non-negatively convex bonds such as non-callable (i.e., bullet maturity) corporate securities.

A Word on Negative Convexity

The negative convexity in MBS is driven by the option that borrowers hold to repay their loan at any time. While similar to embedded call options in many corporate bonds, the negative convexity associated with the homeowner prepayment option is a more prevalent feature of MBS than corporate bonds. And while investors are compensated for the risk associated with negative convexity in MBS, the compensation earned for holding convexity risk is not significantly different than the compensation investors receive for holding investment grade credit risk.

Modeling the Potential Impact of Extension Risk

In a recent paper, we modeled the expected impact of extension risk for an MBS investor, and examined how rate changes effected the duration and total return of the Barclays MBS index. Our analysis demonstrated that:

  • The duration of a diversified set of mortgage pools can be expected to significantly extend in a rising rate environment.
  • Conversely, we found that the durations of investment grade corporate bonds and treasuries did not materially change when rates moved. When they did, the direction of the duration changes were inverse to rate moves (the indices are positively convex).
  • Because of this positive convexity, the modeled losses for treasury and corporate indices were much lower relative to the MBS index even though they carry lower yields and their (initial) durations were approximately equal.

MBS Extension in the Spring of 2013

While scenario analyses are helpful for understanding how securities may react to changes in rates, they rely on assumptions that may not be observed in practice. However, empirical data illustrating the impact of MBS duration extension can be observed in the sharp rise in rates between May and June of 2013 when the 5-year U.S. Treasury (UST) yield rose from 68 basis points (bps) to 139 bps.

Beginning in May with a duration of approximately 2.6 years, the Barclay’s MBS index declined 2.48 percent over the next two months as rates rose. Meanwhile, the Barclays 1-5 Year UST index and the Barclays 1-5 Year Corporate index, which had similar durations at the beginning of May, only declined by 0.87 percent and 1.54 percent respectively.

MBS duration extension was the most striking result of the surge in rates, with the duration of the MBS index climbing two years from 2.61 to 4.54 years. An investor holding the index at the beginning of May who was comfortable with a duration of 2.6 years, might have felt much different two months later when the duration extended to more than 4.5 years.

Change in MBS duration vs. changes in 5-year UST rates1-17_Blackrock_chart.png

Source: BlackRock, using Bloomberg data as of June 30, 2013. Past performance does not guarantee future results.

Conclusion: Managing Negative Convexity Through Diversification

In stable rate environment, MBS should provide an attractive return relative to comparable bullet bonds (bonds that are non-callable by the issuer). However, the higher yield of MBS does not come without added risk. In volatile rate environments, MBS can be expected to underperform bullet bonds, which are positively convex. Combining the two types of securities into a portfolio helps to diversify interest rate exposure through varying rate environments, lowering the overall risk of the portfolio.

U.S. Treasuries and corporate bonds can diversify a portfolio with excessive convexity risk. Corporate bonds also provide further diversification of the sources of yield. This extra layer of diversification historically helped during rising rate environments as increases in interest rates often occur because economic conditions are improving, lowering credit risk and tightening spreads. And while corporate bonds expose investors to the idiosyncratic risk of the issuers within a credit portfolio, this can easily be mitigated through the use of a broadly diversified vehicle such as an exchange-traded fund.

Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. The information included in this publication has been taken from trade and other sources considered to be reliable. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this publication reflect our analysis at this date and are subject to change.

Drivers of Bank Valuation, Part III: Size and Diversification


6-5-13_Commerce.pngA critical function of any bank’s board of directors is to regularly assess whether their activities and those of the bank’s management are driving value. This may be defined as value for shareholders, value for the community and the perception of strength among the bank’s customers and regulators. 

In the last two installments of this series, we explored the concept of tangible book value (TBV) and its relationship with bank valuation. We also looked at internal steps, such as promoting efficiency and growing loans, which boards could take to drive more revenue to the bottom line and drive bank value. 

In this final installment, we’ll look at two additional factors that drive value in both earnings production and market perception. 

Size

The first of these is size. A bank’s size has a direct bearing on its value. The data show clearly that larger banks are perceived to be more valuable, according to the tangible indicators of open market trades of bank stocks and in bank merger pricing. In 2012, for example, there was a clear disparity in the public markets between banks with less than $1 billion in total assets (which traded below tangible book value on average) and those above $1 billion (which traded, on average, at a substantial premium to TBV). Regarding whole bank sales in 2012, banks with more than $500 million in assets sold  at a higher valuation, as a function of price to TBV, than banks smaller than $500 million in total assets (122.3 percent of TBV versus 113.6 percent). Likewise, banks with more than $1 billion in total assets sold at 129.3 percent of TBV versus 113.1 percent of TBV for banks below $1 billion in assets.

There are a number of reasons for this. Certainly greater scale means greater efficiencies, the ability to expand the customer base through a higher legal lending limit, the ability to spread the cost of carrying regulatory compliance over more assets, and the ability to offer products that smaller banks cannot afford to offer. 

A key consideration for a bank’s board should be a regular assessment of the institution’s size relative to market and the steps needed to achieve a critical mass that drives value. Small banks can achieve scale through raising capital and expanding the balance sheet organically—or pursuing mergers with compatible institutions. Either approach allows banks to grow in size, improve efficiency and grow value.

Diversification

Another approach to growing value is to diversify the balance sheet and the income statement. The data shows that more diversified banks earn more and grow TBV faster. In 2012, banks with a real estate concentration of less than 60 percent earned as much as 90 basis points more on assets than peers more concentrated in real estate. 

Community banks, in particular, are more heavily concentrated in real estate by their very nature. The recent crisis points out the limits to this business philosophy, however, and should prompt some soul searching at the board level on how to avoid putting all the bank’s eggs in lower margin baskets. Commercial and industrial loans along with consumer lending have risks, to be sure, but prudent diversification into these areas offer opportunities for higher margins, more fee business, and more low cost deposits, all of which increase a bank’s overall valuation.

The Role of the Board

Driving shareholder value, whether on an ongoing basis or in a sale, is the key rationale for running the bank in the first place. Boards should aggressively work on all fronts to drive earnings, drive efficiency, drive margin and drive value. This is hard work and not without risks. But managing risk is central to a bank board’s obligations. Setting limits and managing tradeoffs within the market environment should be active rather than passive board activity. 

This work is hard and requires careful planning and execution. But the benefits to boards, management and—importantly—shareholders, of such efforts are considerable. 

Lee’s comments are strictly his views and opinions and do not constitute investment advice.