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Applying Multiple Perspectives to the “Loss Trade”


Now Is the Time to Do Our Homework on Deposits

ALM Strategy | ALCO | Interest Rates



I love those pictures where you can look at it one way and see something and then look at it another way and see something else entirely. Consider the above image.


This is one of the ten original images from the famous Rorschach Inkblot Test. Dr. Hermann Rorschach developed this “projective” psychological test to analyze a subject’s perceptions of an ambiguous image. The basic idea is that when a person sees one of these images, the mind will work hard to impose meaning on it.


In the above example, do you see two dancing elephants? Maybe two gnomes giving each other a high five? Perhaps the Space Needle in the middle? Others may see something completely different. Don’t worry; we won’t judge your interpretation.


Speaking of interpretations, what are bankers’ perceptions of their investment portfolio decisions over the past year?


 

From the Editor


As someone who can count the rounds of golf they play per year on one hand, I find myself falling into the same predictable trap at some point during each outing.


After I hit a wayward drive, I try to make some big adjustment on the next tee box. Maybe I change the ball positioning in my stance, alter my grip, or even worse, swing harder. With each successive tee shot the results get inevitably worse.


Instead of remembering what I did correctly on the first several holes, I reflexively think something must change in my swing.


Some investment portfolio managers might be asking for a mulligan in 2022. It has really felt like a tough stretch of holes. Market interest rates have rocketed, and unrealized losses have mounted. So, do we stick to the fundamentals which “got us here” for all those years, or do we now make adjustments and overhaul our approach?


In this month’s timely Bulletin, DCG Managing Director Bob Lallo analyzes some of the key considerations surrounding the “Loss Trade.” Bob doesn’t necessarily indicate there is a right or wrong answer, but he encourages a more thorough investigation into what that transaction really looks like.


Be careful of evaluating the trade to a singular focus and missing some of the other pertinent attributes of these trades.


So for those looking to get the ball back into the fairway, we hope you enjoy Bob’s timely overview on the nuances of the Loss Trade.


Vin Clevenger, Managing Director


 

If they knew that rates would increase as sharply as they ultimately did from March to September of 2022, then perhaps they would have made fewer trades in the first half of the year. Correspondingly, the negative market values on securities (particularly those designated as Available for Sale) held by virtually all financial institutions would be much smaller and have much higher yields.


However, for others, it would have been speculation not to put the excess liquidity to work at the time, given their overall risk profile.


As a result, many invested large amounts of cash from substantial pandemic deposit inflows to manage margin pressure and extreme asset sensitivity in their balance sheet position.


Whatever the logic, many are faced with negative market value adjustments on their large available for sale investment portfolios and resulting in lower GAAP equity-to-asset ratios.


This is obviously causing complications from liquidity management and corporate governance perspectives.


The Loss Trade


The “Loss Trade” enters the picture as securities have distressed market values and lower yields. To execute this strategy, an institution selects securities at lower yields for sale at a loss, with the proceeds redeployed into investments or loans at higher rates.


The institution incurs an economic loss on day 1 to reposition its earnings moving forward.


But is this a good strategy?


Like the Rorschach Test, it may be a matter of perception…or multiple perceptions to ensure the risk-return trade-offs are comprehensively identified and understood.


At a very high level, the most positive impact is enhancing future earnings and reducing negative investment market value adjustment.


The most apparent negative is taking a loss on the sale through today’s income statement.


The Loss and the Payback Period


The first consideration is determining your appetite for losses in the current year. Perhaps you have had an excellent year for earnings or have other non-recurring offsets. Taking the loss will reduce current earnings and, therefore, have an initial negative impact on capital. Quantifying tolerable loss is the first step before we look to options for cash redeployment.


What is the acceptable timeframe to recoup the loss? Most investors consider some rule-of-thumb evaluation on a non-discounted cash flow basis. Let’s look at the following hypothetical example (please note that we have not considered taxes for simplification purposes):

Please note that for the purpose of this hypothetical example, we have simplified the income computations and treated the securities sold and purchased as bullet agencies. Otherwise, you should review the projected income in varied interest rate environments for prepayments, amortization of principal, and the impact of discounts/premiums.


Most experienced portfolio managers will tell you that any recovery of less than 14-18 months is worth considering. Others consider the term of the securities sold as the proper timeframe.


These seem like relatively straightforward parameters, but are they?


Do you use net incremental added income over the sold income stream (net approach)? Do you use the gross income on new securities against the loss? If your primary motivation is to increase forward-looking earnings per share, then the net incremental pick-up would seem most logical. Yet it is only sometimes the preferred methodology.


While measuring the acceptability of the Loss Trade might be tricky enough, it is also advisable to avoid mixing in trades with gains. While common in practice, this likely dilutes the actual merits of the base loss trade and drives up the volumes of transactions (and costs), leaving you with higher portfolio churn and maybe masking a transaction with a poor return. It is what it is.


Adding other strategies like taking gains to augment the overall result is not improper; it should be a conscious decision.


However, just like the inkblot, we should ensure we understand the different perspectives of the Loss Trade and not only the earnings enhancement measure.


Interest Rate Risk Profile / Structure


One wrinkle we usually see with the Loss Trade is swapping into longer-duration assets from shorter ones. This extension alone can produce material increases in income, particularly with a positively sloped yield curve. However, depending on your profile, this kind of extension could hurt your risk profile if you have a liability-sensitive balance sheet. Your interest rate risk position and related objectives should always be a consideration.


Another perspective is structure. This is an even more important consideration in today’s environment, where an inverted yield curve indicates a recession and lower rates in the future.


For example, what if you are acquiring a mortgage-backed security or a callable bond in exchange for a bullet Agency or Treasury? In that case, you are taking on option risk as part of the trade. Are you sufficiently compensated for the risk associated with the prepayment features of those securities?


Said differently (or maybe more bluntly), the second you swap out one type of investment for another with different characteristics, the risk profile of your balance sheet inherently changes.


Credit Risk and Taxes


Credit risk can also be an added nuance in a Loss Trade. If a trade swaps out agency-backed securities or debt in favor of corporate debt or municipal securities, then a credit component must be considered.


The credit risk acquired may be acceptable in the final analysis, but it still needs proper evaluation/consideration.


Another facet of the trade may be the tax benefit or preference being acquired or relinquished. For example, suppose the trade involves municipal securities. In that case, there is usually a different tax treatment for those earnings compared to standard mortgage back and debt securities—yet another critical perspective from which to view the Loss Trade.


Is the Loss Trade Bad?


Given that investment portfolio managers are tired of looking at how far their securities are underwater, some may consider strategies involving the Loss Trade simply to make it “go away.”


Sure, better yields are available, but at what actual price (cost)? The real question is, “how much do you plan to pay (in addition to the loss being taken) to improve your current income projection, and is it worth it?”


There is a general tendency to evaluate these trades with such a singular focus on the earnings pick-up as to miss the other attributes.


In summary, the Loss Trade is neither good nor bad. But just like the inkblot, look at this trade from a few other perspectives, and you may see something different altogether.

 

For more bank and credit union insights from DCG, click here.

 

ABOUT THE AUTHOR


Bob Lallo has an extensive 35-year background in community banking. Prior to joining DCG, he served as executive vice-president and CFO for a publicly traded savings bank as well as several years as an audit manager at a worldwide public accounting firm.


Bob is a graduate of Boston College, with B.A. degrees in accounting and finance.


 

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