Building Partnerships. Serving Communities. Maximizing Liquidity at Minimum Cost 2005 CUNA CFO...

Building Partnerships. Serving Communities.

Maximizing Liquidity at Minimum CostMaximizing Liquidity at Minimum Cost

2005 CUNA CFO Council2005 CUNA CFO Council

May 16, 2005May 16, 2005

Presented by:

James B. Eibel, CFA

Vice President

FHLB-Indianapolis

(317) 465-0423

2


Goals

1. An interactive discussion of strategic liquidity management

2. Be provocative

3


Presentation Outline

1. What is liquidity risk?

2. Liquidity and opportunity cost

3. ALM and liquidity management

4. Case study and discussion

4


Liquidity

1. The text book says…

2. Your regulators say…

3. Your board says…

4. You and your management team say…

5


“If the members want a product, we need to find

a way to offer it. We are in the risk management

business.”

Credit Union CFO

6


“Credit unions should consider the potential risk

exposure as they explore opportunities to better

serve their members.”

NCUA Letter 03-CU-11

7


Liquidity Risk

“Liquidity risk is the funding risk that, due to a

lack of sufficient stable sources of funds, a credit

union will be unable to continue meeting

member demands for share withdrawals and/or

new loans.”


8


Deconstructing Liquidity Risk

1. “Funding risk”

2. Caused by a “lack of sufficient stable sources of funds”

3. Resulting in inability to meet “member demands for share withdrawals and/or new loans.”


9


Sources of Liquidity

• Primary liquidity– Cash and short term investments– Projected cash flow from loans and securities– Deposit growth

• Alternative liquidity sources– Borrowing lines– Sales, securitization, and participations

10


Cash/Total AssetsInstitutions >$100 Million Assets

0%

2%

4%

6%

8%

10%

12%

14%

Cas

h/A

sset

s

10th 20th 30th 40th 50th 60th 70th 80th 90th

Percentile

Credit Unions Banks

As of 3rd Quarter 2004, averages were 6.9% and 2.9% respectively for credit unions and banks.

11


Liquidity is Not a Free Good

• Primary liquidity has an opportunity cost

• Alternative sources of liquidity may have operational costs (fees, systems, and staff time)

Goal: Minimize cost while maintaining funding reliability for all

contingencies

12


Opportunity Cost of Primary Liquidity

24

68

4

8

12

16

6

12

18

24

8

16

24

32

10

20

30

40

0

5

10

15

20

25

30

35

40

RO

A R

educ

tion

(bps

)

2% 4% 6% 8% 10%

Excess Liquidity

1%

2%

3%

4%

Yield Pick-up

13


ALM and Liquidity Management

• Liquidity management is a subset of ALM

• Effective liquidity management requires the use of dynamic scenario analysis

– Cash flow projections by scenario– Contingency funding plans by scenario

14


Contingency Funding Policies and PracticesThe Importance of “Fire Drills”

• Test & documents borrowing lines

• Test & document loan sales and/or participations

15


Asset Composition and LiquidityKey Issues

• Cash flow certainty

• Collateral value

• SEG concentration

• Marketability– Sale– Securitization– Participation

16


Callable BondsAgencies, Corporates, MBS, & CMOs

• Cash flow certainty is exchanged for a higher initial yield

– Amortizing vs. bullet structures

• FHLB collateral value is 85%-95% of market value for agencies, MBS, and CMOs

• Marketability issues:– Price volatility of bullet structures– Bid/ask spreads for thinly traded issues (beware of the Hotel

California)

17


Investment CDs

• Cash flow certainty is high, unless CD has an embedded call option

• FHLB cannot use CDs for collateral

• CDs are illiquid, but withdrawal option is often cheap relative to fair market value

18


Car Loans

• Cash flow certainty is relatively high even for longer-term loans (40% turnover)

• FHLB cannot use for collateral

• Can be packaged and sold, but execution may be an issue

19


Home Equity Loans

• Cash flow volatility may be an issue – Unextended HELOCs (approximately 50%)– Closed-end loans similar to comparable duration

mortgages

• FHLB collateral value 50%-70%

• Can be packaged and sold

20


Mortgages

• Cash flow can be unpredictable– Portfolios generally turnover 10%-20%, unless

rates fall

• FHLB collateral value approximately 80% of market value

• Can be sold, securitized, or participated

21


Average Lives for Mortgage Products(Data in Years)

0

2

4

6

8

10

12

Years

5 yr. balloon 1.8 3.3 4

7 yr. balloon 1.9 4.0 5.2

10 Year 2 3.2 4.3

15 Year 2 4.2 6.1

30 Year 2.2 5.9 10.1

Down 1% Flat Rates Up 3%

Data based on Wall Street dealer prepayment estimates for agency mortgage-backed securities

22


Member Business Loans

• Cash flow may be an issue with credit lines

• Some MBLs have collateral value– SBA guaranteed portions– Commercial real estate– Ag loans

• May be participated

23


Liability Composition and LiquidityKey Issues

• Optionality– Impact on term structure– Impact on rates paid

• Reliability

• SEG Concentration

24


Non-maturity Deposits

“It is not possible to predict with any certainty

what the future balances in non-maturity

accounts will be, how long they will remain

open, or what future rates will be paid to

members on these accounts.”


25


Non-maturity Deposit Issue

• Shares, drafts, and money market accounts represent a significant portion of credit union funding

• NMDs are relatively insensitive to interest rates and can be priced accordingly

– Term structure depends on pricing policies and customer behavior

Do you have the liquidity capacity to withstanddisintermediation if rates rise?

26


Non-maturity Deposit AssumptionsWhat Qualifies as Conservative?

Increasing term structure

Value at Par/Floating Rate

McGuire Performance Solutions

ExampleChecking account average life estimates can vary from 1 day to 10 years.

27


Time Deposits

• Largely rate driven– Funds can generally be attracted for a price– Rate sensitivity tends to increase with term

length

• Early withdrawal option– With interest rates near historic lows, withdrawal

penalties are as well

28


CD Interest Penalty AnalysisHow far out-of-the-money is the option?

0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00% 2.25% 2.50% 2.75%

1 year

2 years

3 years

4 years

5 years

CD

Ter

m

6 Month Interest Penalty Break-even

5.00%

4.00%

3.00%

2.00%

Based on immediate change in rates

Offer Rate

29


FHLB Advances

• History of reliability (9/11 and S&L Crisis)

• Clout in global debt markets

• Customized to match individual needs

• Optionality controlled by borrower

• Requires collateral

30


Corporate Credit Union Lines

• Lack of history and market access

• May lend against collateral FHLB cannot

• More competitive on overnight and short borrowings

31


Brokered CDs

• Product offerings may be limited

• Withdrawal option generally limited

• Does not require collateral

• Tend to be most expensive wholesale option

32


Repurchase Agreements

• Generally short term

• Secured by high quality security collateral

• Counterparty risk

33


Federal Reserve Window

• Reliable, but “The Lender of Last Resort”

• Catastrophic liquidity backstop

34


Putting it All Together

• Cash flow budgeting

• Contingency funding (beyond cash flow)– Deposit pricing strategies– Saleable assets– Borrowings

35


Congratulations!You are the new CFO at Lending Community CU

• Previous CFO has “Left to pursue other interests”– She was unable to persuade board and regulators that she

could manage the organization’s liquidity position

• LCCU pays well and recognized your talent• You were hired to:

– Formulate a liquidity plan consistent with their mission (“Lend, lend, and lend some more”)

– Articulate liquidity plan to management, board, and regulators– Implement the plan

36


Your New Assignment as CFO:LCCU

AssetsCash and short term: $80 million

First mortgages: $400 million

HELOCs (50% extended):$50 million

Car loans: $320 million

SBA loans: $100 million

P, P & E: $50 million

Total Assets $1 billion

LiabilitiesMoney market: $200 million

Shares: $200 million

Share drafts: $200 million

Retail CDs: $175 million

FHLB borrowings: $100 million

Brokered CDs $15 million

Corporate CU overnight: $10 million

Total Liabilities $900 million

Equity $100 million

Liabilities & Equity $1 billion

RatiosROA: 1.2%ROE: 12%Net Worth: 10%Loan/shares: 112%Loans/assets: 87%Borrowings/assets: 12.5%Projected loan growth: 12%Projected deposit growth: 10%

37


Liquidity Risk Questions

1. Does LCCU have “funding risk?”

2. Does LCCU have a “lack of sufficient stable sources of funds?”

3. Is LCCU unable to meet “member demands for share withdrawals and/or new loans?”

From NCUA Letter 00-CU-13

38


Liquidity Management is a Strategic Competency

• Risk/reward optimization

• Improved decision-making & resource allocation

• Improved budgeting and forecasts

• Improved management of regulatory risk

Building Partnerships. Serving Communities. Maximizing Liquidity at Minimum Cost 2005 CUNA CFO...

Documents

Transcript of Building Partnerships. Serving Communities. Maximizing Liquidity at Minimum Cost 2005 CUNA CFO...