The Sun Still Shines!

The elections are over, and the sun appeared on the horizon Wednesday morning as scheduled.  “Status quo” is the phrase being used to forecast the next four years.  Unfortunately, the current state of affairs will not continue for that long.  Rising taxes, continued implementation of Obamacare, sequestration, shrinking asset yields and international problems could combine to make 2015 very different than 2012.

So what do we, as bankers, do now?  My guidance over the last few months has been to wait until the election results were in, and then wait another week to see how the markets react.  We’re now in that week of waiting, and waiting is still wise.  But at some point, we must set a course for deploying excess funds, either into loans at rates below our traditional comfort level or into securities with huge premiums or painfully low yields (or both).

I have no great wisdom to impart on the asset side of the balance sheet, but I do want to speak forcefully on liability pricing.  The Federal Reserve has committed to a Zero Interest Rate Policy for another 30 months, and the troika responsible for that commitment just received a four year contract extension.  The old adage “Don’t bet against the Fed” is more appropriate now than ever.  Here’s the forceful part:

If you are paying more than 0.50% on a one year CD, stop!

I feel safe predicting that asset yields will continue to fall.  Most of our nonmaturity deposit rates are near zero (or should be!).  If your market demands CD rates above the cost of replacement funds (FHLB Dallas 1 year bullet advance @ 0.48% this morning, QwickRate 1 year CD offerings in the 0.40% range, brokered CDs priced similarly), shift your funding to the cheaper sources.  It’s an easy way to boost a sagging NIM.

When promoting this strategy, I often hear “My regulators don’t like those funding sources.”  Perhaps that is true, but the 2010 Interagency Policy Statement on Funding and Liquidity Risk Management states:

“An institution should establish a funding strategy that provides effective diversification in the sources and tenor of funding.  It should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providers to promote effective diversification of funding sources.

Funding should also be diversified across a full range of retail as well as secured and unsecured wholesale sources of funds, consistent with the institution's sophistication and complexity.”

If an examiner gives you grief over your prudent use of wholesale funding sources, point them back to their own regs.  You should have policy limits in place for each category of wholesale funds, as well as a limit on aggregate wholesale funding.  The last four ratios on our monthly Funds Management Report address these items, and there should be no shame in the appropriate use of wholesale funds.

The other response I get sounds something like “But, I’m taking care of my customers” or “I don’t want to lose my customers”.  I understand this concern, but the price of taking the “safe” route and paying up on deposits could be huge.  If you want to pay a core customer who has large, low-cost deposit balances or large high-yield loan balances a bit more on a CD, no problem.  Just don’t overpay for the rest of your CDs.  Rate shoppers (local and foreign) should have your bank on their Do Not Call list.  Their funds are not core – regardless of the FDIC’s definition – and will rarely be cheaper than wholesale funding sources.

If you have a competitor overpricing his CDs, share this article with him or send me his contact information.  I would be glad to help him save some money while normalizing your market’s deposit rates.  That’s a Win-Win situation in a Lose-Lose market.

One other parting thought:  If you own some of the long MBS the Fed continues to overprice via QEinfinity, take some gains and redeploy the proceeds into products that are not as overpriced.  I have seen several recent portfolio restructurings that resulted in minimal change to duration, yield and credit risk while providing a nice pop to current year earnings.  I’ll be glad to tell you more if you are interested.

The Sky Isn’t Falling, YET!

“Don’t worry.  Unrealized losses on investment securities are just a book entry.  They don’t have any impact on your regulatory capital ratios.  You intend to hold the securities to maturity (or call), so you won’t ever recognize the loss.”

“Those silly mark-to-market rules won’t get any tougher.  The lessons learned from the Lehman failure will prevent any extensions of mark-to-market accounting.”

Not so fast, my friend.  The banking agencies have released a Notice of Proposed Rulemaking addressing implementation of Basel III that includes a summary of the impact of the NPR on community banks.  The biggest impact, by far, is the inclusion of Accumulated Other Comprehensive Income (AOCI) in all regulatory capital calculations.  For those of you who are more than a few years removed from your last accounting class or Call Report seminar, the biggest component of AOCI for most banks is Unrealized Gain/Loss on Available for Sale Securities.

Under the current proposal, AOCI would be phased into the capital calculations 20% per year beginning in 2014, with complete recognition by 2018.  Over that same period, market interest rates are likely to rise, creating a significant unrealized loss in bond portfolios with longer durations.  By 2018, then, bankers could find themselves with less regulatory capital than they expect, at a time when regulatory capital minimums are increasing.  (The impact of Basel III’s higher capital requirements for the big banks and the trickle-down impact on community bank capital ratios is another concern for another commentary.)

The sky is falling!  What do we do!?!  Relax.  You have options.  We can deal with this situation.  Here are a few thoughts, assuming that the current NPR survives the onslaught of critical comment letters you and your banker friends will write (you will write them, won’t you?):

1. We can reclassify some or all of our AFS bonds as HTM and avoid recognizing AOCI
2. We can sell our most price sensitive bonds (hopefully while they have gains) to avoid the price risk and corresponding capital impact
3. We can hope that our most price sensitive bonds (Agency Step-Ups, perhaps) are called before the phase-in makes a significant impact on our capital ratios (probably 2015-2016)
4. We can hold more capital to offset the expected AOCI loss
5. We can move some of our most price-sensitive bonds to our holding company (this one is tricky – ask me for details if you are interested)
6. We can adjust our security purchase strategy to avoid making the situation any worse and let the current portfolio roll inward

I expect there will be a lot of discussion of this topic in coming weeks.  Creative securities dealers will probably come up with some interesting strategies, so don’t rush to solve tomorrow’s problem, today.  Remember – the sky won’t fall until at least 2014 (unless the Mayans were right)…

Observations from the APC Family of Banks

I’ve had lots of “What are you seeing in your other banks?” questions from clients recently.  Here are a few general observations:

1. NSF fee incomes are significantly lower than last year.  Some of the Q1 weakness may be related to tax refunds, but most of it appears to be driven by the amazing phenomenon of people not spending money they don’t have.  This is a good thing for our economy (in the long term), but it slows economic recovery and lowers bank profits.  And as an answer to the inevitable follow-up question, I don’t know of any good new sources of fee income.
2. Loan demand is still soft in most markets, although the I-10 corridor in LA and MS is beginning to show signs of life.  There is still too much product (money) chasing too little demand (loans), so price continues to fall.  Long term fixed rates (under 5% for 10 years) are being offered in some markets, and I worry a lot about the interest rate risk implications of these products.  If you can stay short on balloon date (three to five years, seven at most) on solid credits, the low rate won’t kill you.  If you can get an origination fee, even better.
3. Deposit volumes continue to grow, and most of the growth is in nonmaturity products.  This is a good mix trend, but bankers need to make sure their rates are not too high.  With overnight funds at 0.25% and extremely low securities yields, why are you paying north of 0.50% on any deposits unless loan demand is strong?  If deposit volumes are growing and you don’t have a good plan for deployment, think about lowering rates – again.
4. Several of our banks are already experiencing earnings and balance sheet performance well above or below plan.  If these variances are expected to continue, consider a mid-year plan revision to avoid criticism about the inaccuracy of your plan.

Dealing with Examiners

I want you to get up right now, go to your windows, open them and stick your head out and yell ‘I’m as mad as hell and I’m not going to take this anymore!’  Things have got to change.  But first, you’ve gotta get mad!  You’ve got to say, ‘I’m as mad as hell, and I’m not going to take this anymore!’  Then we’ll figure out what to do about the depression and the inflation and the oil crisis.  But first get up out of your chairs, open the window, stick your head out, and yell, and say it:  “I’M AS MAD AS HELL, AND I’M NOT GOING TO TAKE THIS ANYMORE!”  (Peter Finch as Howard Beale in Network (1976))

OK, so yelling at examiners is not a good idea.  I got your attention, though, right?  Now, you need to do the same with your examiners.  I’ve heard of and read too many off-the-wall statements from examiners lately to hold this in any longer.  A few suggestions for you as you prepare for your next exam:

1. Be prepared.  You need to know more about how your bank operates than the examiner.  Understand your liquidity, forward liquidity and contingent funding plans.  Understand your Earnings at Risk and Economic Value of Equity posture.  Call us if you want a refresher course on either one.
2. Don’t fall prey to the “Gotcha! Game”.  If an examiner interrupts your day with a series of rapid-fire questions on a technical topic, delay your response.  “I’m right in the middle of something – can I get back to you in 30 minutes?” is an easy escape clause.  Then, prepare your response (call in reinforcements as appropriate) and reverse the Gotcha! by catching the examiner off guard when you are ready to talk.
3. Do not accept inaccurate or unsubstantiated statements.  Stand your ground and argue (politely) for your position.  If you can’t resolve the issue, ask the examiner to put his concerns in writing (in the Report of Examination) so that you can respond.  
4. Be nice, but be firm.  Examiners are people, too.  Sometimes, emotions or opinions (or supervisors) override common sense and logical thought.  Don’t kill the messenger, but don’t accept the message if it isn’t reasonable.
5. Respond, in writing, to your Report of Examination.  Go on record with your side of the story.  The manager of a baseball game doesn’t expect to get a bad call changed by arguing with the umpire.  His performance is designed to rally the team and increase his chances on the next close call.  The exam is over, and you aren’t going to change the result, but you can make your case for the next exam cycle.  I was told recently that a client’s response letter had been widely circulated by examiners and was the “talk of the office”.  We would be glad to help you write a measured, appropriate response to your next Report of Examination (or other regulatory communication).

The Fiscal Cliff

Fed Chairman Bernanke told a group of senators yesterday that scheduled end of programs including the Bush tax cuts, the payroll tax holiday and extended unemployment benefits, as well as budget cuts that are set to take effect in January of 2013 would have a negative effect on the economy.  This statement is similar to one he made at a news conference last month: “It is very important to say that if no action were to be taken by the fiscal authorities, the size of the fiscal cliff is such that there is, I think, absolutely no chance that the Federal Reserve could or would have any ability whatsoever to offset that effect on the economy”.  Anyone up for a one year extension on some or all of the Bush tax cuts?  Might such an extension become an election year gimmick?  Eventually, we must deal with the unholy trinity – tax increases, entitlement reform and a significant reduction in government spending.  Or, we can just follow the lead of French and Greek voters and elect anti-austerity candidates.  Surely someone will bail us out…

Am I Giving Away My Secrets?

I has a client ask if posting my APC Client Commentaries on this blog was equivalent to giving away information to the world instead of sharing it only with paying clients.  A good question, I thought, from a financially astute banker who cared about my revenues, his expenses, or both.  The short answer is NO.  While I do post some good "client only" commentaries here, they are usually uploaded to the blog weeks or even months late (although I do put the original date on the post, for context).  And, there is a lot of good info that never makes it onto the blog.  So, if you like what you see and aren't a current client, please visit the following websites and learn what we can do for you and your institution.

American Planning Corporation

National Capital, L.L.C.

Curative Advisors, LLC

An Interesting Investment Structure

Currently, Qwickrate and other listing services are offering long term CD rates over 2.0%.  The top ten 120 month (yes, that’s a ten year maturity) offerings on Qwickrate average 1.97%, meaning you could deploy as much as $2.5 million and pick up 1.75% over Fed Funds.  At this point, you should be asking “Why in the world would I want to lock in that low a rate for ten years, Jeff?”  The answer:  because the early withdrawal penalty is usually only a few months of interest, allowing you to cash in at will without substantial penalty.
When this investment idea first came up, I was uncomfortable with the idea of a banker taking advantage of another banker and breaking the terms of a contract.  The more I think about it, however, the more I like it.  The counterparty is, through the terms of his contract, selling you a put right as a part of the CD.  The cost of the put is the early withdrawal penalty, set by the seller.  If you were to employ this investment strategy, you would have to contact each institution to get a copy of the CD agreement, as Qwickrate does not list each institution’s early withdrawal penalty information.  I would also recommend making note of your intent to make an early withdrawal in your ALCO minutes to avoid examiner criticism.  We will model your embedded put option in our IRR model if you buy any of these long CDs.