|When a good investment isn't (July 2010)|
By Greg Doner
A liquidity squeeze can sink a bank as easily as a lack of capital. This issue and others discovered in the last three years have resulted in a need for Liquidity Contingency Funding Plans. These plans require an understanding of available liquidity under varying stress scenarios.
Many ALM/IRR models provide anticipated cash flows from investment portfolios under current and varying rate scenarios. That said, it is obviously quite important to correctly measure those cash flows, which makes it critical to embed the actual deal structure and correctly measure the optionality for each holding Current and future pricing under rate shocks is also a necessary input.
The investment portfolio must complement the rest of the balance sheet and not be managed in isolation. The cheapest bond available may be the most expensive for your bank if it doesn’t solve the needs of the balance sheet, interest rate risk, income statement, and the required cash flows for liquidity. All of these should be considered when adding to, or restructuring, the investment portfolio.
As an example: A bank sees an investment at a wider spread than normal—it’s a 5-year maturity and has step-ups embedded. The greater earnings, however, may be offset by the need for shorter-term liquidity; the maturity creates a gap mismatch that negatively impacts IRR; and the step-up, though apparently attractive, may be called as rates rise, causing the bank to lose the promised yield. In this case the negatives likely outweigh the seemingly increased earnings.
This is all irrelevant, however, if the underlying credit proves to be bogus, as we discovered recently with many “AAA” bonds. Those bonds defaulted, or have dramatically extended cash flows, as a result of collapse of the markets and the credit enhancements that supported those ratings. Investigate the ability of the credit or structure to stand on its own and make your own decision. If you don’t understand it thoroughly, don’t own it, despite the rating.
While discussing risk, don’t forget concentration risk. Limit holdings of any investment sector to a percentage of capital, unless it’s a U.S. Treasury bond. One bank failed because of excessive holdings in Fannie/Freddie preferreds. Once they had to mark them to market, they were out of capital. That applies as well to the mix of “available-for-sale” and “hold-to-maturity” holdings.
Banks must have an adequate amount of AFS bonds for unexpected liquidity crunches, and an adequate amount available for pledging. If a liquidity crunch hits, and no bonds are available for pledging, then a bank could be shut out of any borrowing resource or volatile liabilities that require pledging. •
Greg Doner is CEO of FIMAC Solutions LLC, which provides software-based analytic solutions and risk-based consulting to financial institutions.
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