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  • Writer's pictureKeri Crooks

Things that make you go Hmmmm...

Now Is the Time to Do Our Homework on Deposits

I frequently find myself singing this popular 1990s refrain from C&C Music Factory during my travels. This oftentimes occurs when a passenger seated in the row behind me uses the space next to the head or arm rests for their feet (sometimes socked, other times bare). Or as I watch from the window with a view of the arrival gate as numerous unsuccessful attempts are made to attach the exit jet bridge to the plane.


Whatever the occurrence, this musical hit (which ultimately reached #4 on the Billboard Top 100 list) has a catchy beat and speaks to life’s encounters that force them to question certain situations, and suggests the need to take a closer look at what is happening around them.


Current happenings within the banking industry represent such encounters, and 2024 will undoubtedly present things that should make you go Hmmmm.


With a client base that covers every state in this country – and a 100% independent perspective – DCG has a passion for sharing what we hear and see in our daily experiences as well as our common sense “thought process.” A current strategy directed at financial institutions centers around bond loss trades. These transactions are being shown with frequency to financial institutions, and calls received by DCG from financial institutions asking us to opine on these proposals from their brokers have not abated.


The final quarter of this year may nudge financial institutions towards strategies that can further improve future earnings, margin, rate sensitivity, or specific liquidity metrics.


This is the exact time to take a closer look at ALL return and risk dynamics associated with this strategy, while also recognizing that all financial institutions are not created equal… what can make sense for one, will not for another.


Furthermore, liquidity and interest rate risk topics have dominated the financial press, board rooms, management meetings, earnings calls, and regulatory findings in 2023; however, asset quality is changing and moving into focus with aforementioned stakeholders.


From the Editor

With the recent passing of investing legend Charlie Munger, I was reminded of this quote:


“I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.”


The message is clear. There is tremendous value in garnering a thorough understanding of a contradictory perspective. If nothing else, identifying the “counterpoints” of an issue helps evaluate the deficiencies of your own assumptions and beliefs.


Very early on during the FOMC tightening cycle, banks started to contemplate the efficacy of taking losses on their bond portfolios. Given the hyper attention paid to this issue by the media and regulatory community, there are strong proponents on both sides of the “Loss Trade” argument.


Does it make sense to incur a day 1 economic loss by selling investments? Or are we essentially taking losses every day we refuse to restructure? If there was ever a time to apply Munger’s advice, this is it!


Fortunately, in this month’s Bulletin, DCG Managing Director Keri Crooks outlines some key points to consider before executing a “loss trade” transaction. She urges institutions to fully understand the proposed “earn back” period and the reality that those assumptions can change significantly if market rates move in the wrong direction. More importantly, she encourages institutions to evaluate the influence of the transaction on current and prospective capital levels. And she reminds us that cycles always change, and why it’s critical to understand how much capital “buffer” one is willing to “eat up” with one of these transactions.


With the year drawing to a close and this issue front and center for a number of ALCO committees, we hope you take Munger’s advice and understand all facets of this transaction prior to execution.


Vin Clevenger, Managing Director


"You lose me at loss."

The above was an actual statement from a successful CEO in the fourth quarter of 2006. The FOMC had hiked interest rates 17 times between 2004 and 2006, to a high of 5.25 percent. We were at the ALCO meeting, joined by investment brokers who were advocating a bond loss trade that would “hit” the bank’s earnings and capital in the current quarter but improve future earnings and margin.


The CEO’s words were few, but the message important: this transaction has a negative net present value (NPV).


Roll the clock forward to 2023 and this same CEO of a publicly-traded stock bank announced a repositioning of the investment portfolio and a pre-tax loss on the sale of securities to improve margin and future earnings, while still maintaining healthy net income and capital.


This highlights the very REAL pressure on stock banks to improve their margin, future earnings forecast, and shareholder value!


If contemplating a loss transaction, ensure you have fully evaluated all facets of the transaction, especially:

  • The assessment of the “earn back” periods provided by the broker over a wide range of future interest rate scenarios

  • Resulting capital and stressed capital metrics

The following outlines discussions and further analysis DCG has facilitated with high-performing institutions that have decided to either execute or reject bond loss transactions.


The goal posts matter.


A bond loss trade typically includes selling low-yielding securities and using the “proceeds” to:

1. pay down wholesale funding

2. increase cash balances

3. reinvest into higher yielding bonds

4. some combination of the above

Utilizing the proceeds upon sale of the bonds for any of the above options serves the purpose of increasing the margin today but at the expense of capital (the loss is absorbed today, in full).


Typical loss trade spreadsheets and proposals include notation on the “earn-back” period, which is heavily dependent on the characteristics of the bonds to be sold, but also dependent on what you plan to “swap” into. Often the broker analysis will look like as simplistic as this example:

The above example was shared by a third party broker with an institution that desired a “reward” of: increased margins today, higher future income on an annual basis, reduced duration, and unrealized losses. Looks like this proposal checks all the boxes?


So where’s the risk?


Here is something that makes you go “Hmmmm”… This analysis misses the larger risk. It takes 71 months – nearly 6 years – to recoup the day one $5MM loss to capital while also assuming that the reinvestment yield on short-term bonds or cash stay at current levels over an entire 6 year earn back timeframe!


Further discussion with this team led to more analysis (not provided with the proposal) showing that any decline to market rates as the short-term bonds (buy / reinvestment component) rollover significantly extends the likelihood of ever earning back the loss.


Just a 1.00% decline in market rates and short-term bond and /or cash yields extends the recoup period to 8 years!

I will point out that some institutions have found ways to shorten the earn back period to something more palatable and within their tolerance while also protecting against their greatest long term rate risk: falling interest rates. Others have decided to sell assets with gains to offset these losses. The details of sale and buy side matter in these transactions.


Capital will be King, once again


A critical consideration in the analysis of a loss trade should be centered around the fact that the current cost of capital is high, and the uncertainty of asset credit quality is elevated and perhaps gaining momentum.


Third quarter industry data demonstrates that Loan charge-offs and Past Dues are beginning to accumulate across most lending sectors and more losses are expected, bringing the health of loan portfolios into focus.


Many are increasingly concerned that this is not just “normalization” of credit but the beginning stages of a more concerning trend. Recent discussions highlight that overall allowances, capital, and loan credit quality are moving into focus with added concern that more challenging times are ahead on the earnings and capital front for the industry.


This is evident most recently as Loan origination volume on average has slowed (1% for the month of September) with institutions becoming more selective and focused on developing profitable relationships and preserving capital and liquidity. 


To fully analyze the impact of a loss trade on current and projected capital levels, your ALCO committee must contemplate key questions, including:

  • Can future credit events still be absorbed by your new capital position, post loss trade?

  • How much of a buffer above internal policy remains? Regulatory limits?

  • Where do you stand in relation to the Community leverage ratio (CBLR, CCULR), if applicable?

The following capital and credit stress test scenarios are examples of what financial institutions can leverage to facilitate discussion around loss trade proposals.

These two separate and different capital profiles show capital metrics after varying levels of stressed factors resulting in future loan losses.


Just like liquidity and interest rates have changed in 2023, credit cycles do change as well.


In both examples, it is important for management to understand the buffer (or lack thereof) above internal capital policies, the community bank leverage ratio (assuming the institution desires to stay above that and forgo risk-based capital reporting), and regulatory well capitalized.


As with any balance sheet management strategy, ensure it is accomplishing its intended objectives. Is it designed to: reduce interest rate risk, reduce risk in economic value of equity model, alleviate regulatory findings, improve future earnings and/or manage stakeholder expectations?


But also recognize that there is no free lunch, and the risk of a bond loss strategy to capital today and future capital (just like future earnings considerations) should be part of the fully fleshed out analysis.


While the pressure of public perception and stakeholder expectations is significant for public stock banks, DCG’s recent experience has proven that many of these institutions have invested significant time into thorough analysis and discussion around earn back periods, which are subject to change with market rates.


Furthermore, the quantification of any loss relative to future income and future capital level under potentially stressed scenarios is also an important part of the diligence process.


Cycles change, so it is a good time to ensure your capital buffers are where they need to be… and revisit the risk and return of all viable strategies heading into 2024. But above all, ensure your committee fully comprehends all facets of any potential transactions so they aren’t singing “Things that make you go HMMM…” a few years from now!


For more insights from Darling Consulting Group, click here.



Keri Crooks is a Managing Director at DCG. She joined the DCG team in 2002 and presently consults directly with ALCO groups and boards of directors at banks and credit unions in the area of asset liability management with the goal of enhancing high-performing institutions. She takes a hands-on approach to develop strategies to best fit the risk profile for each bank’s balance sheet, while also balancing trends and pressures alive in the current industry.

Additionally, Keri remains actively involved in advancing Liquidity360°®, DCG’s proprietary liquidity risk management software, and is a frequent author on balance sheet management topics.

Keri received a B.S. in business administration/finance from the University of Massachusetts at Lowell and currently resides in southern New Hampshire with her family.


© 2023 Darling Consulting Group, Inc.


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