Industry Insights

December 3, 2018
Hedging to Cope with Interest Rate Uncertainty
By Ira Kawaller, Managing Director, HedgeStar

Most market observers face a conundrum. After seeing a change in prices in virtually any market, it’s difficult to discern whether said change reflects the beginning or continuation of a trend in that direction, or if the change is a temporary distortion soon to be reversed. With interest rates, however, we have a unique consideration – the Federal Reserve (the “Fed”).

The Fed has unparalleled influence in this sector, and seasoned forecasters know better than to ignore the Fed’s public statements. As of this writing, the Fed is unambiguously projecting interest rate increases. Of course, this projection rests on an expected continuation of the current economic expansion, as well as a sanguine outlook for inflation. While both of these forecasts will likely be tested at some point in the future, the Fed can be expected to signal any revision of its sensibilities if and when they were to change. Until then, however, higher interest rates seem most likely.

The more relevant question, then, is not whether interest rates will rise, but rather how high they are likely to go. Answering this question requires at least enough humility to admit that nobody knows for sure – not even the Fed. That said, interest rate futures markets offer clues as to consensus expectations for a variety of benchmark interest rates. For example, with one of the most actively traded futures contracts, three-month LIBOR is one such benchmark rate. These contracts effectively reveal where this key interest rate is expected to be at three-month intervals over the next 10 years. And while futures prices adjust with trading every day, they offer explicit, objective forecasts at any point in time.

We can also look to bond and note futures, fed funds futures and swap futures for analogous forecasts of other benchmark interest rates. Besides offering rate-specific forecasts, these various futures prices serve as the foundation for pricing a broad array of over-the-counter interest rate derivatives.

Building a Hedge
While it’s generally understood that interest rate derivatives can protect against rising or falling interest rates, the starting point for the protection derives from futures pricing curves as of the date the derivative is transacted. Thus, if a hedger wanted to use a derivative to lock in an interest rate today, the rate that would be available to that firm would be consistent with the consensus forecast. In other words, the hedger seeking to lock in rates would have to accept the consensus forecast rate as its hedging objective – regardless of whether the spot interest rate happens to be higher or lower than that consensus forecast rate at that time.

Depending on the nature of the exposure, the difference between current spot interest rates and the implied forecasted rates underlying interest rate derivatives might be adverse or beneficial. These days, for instance, with consensus forecasts anticipating rate increases, hedging with derivatives tends to impose somewhat of a cost for hedging against rate increases, while at the same time offering a benefit to entities faced with the opposite risk of falling interest rates. (If you can borrow today at 5%, but the market offers the opportunity to lock up a future funding cost of 5.5%, you’re forced to accept a 50 basis point penalty; on the other hand, if you can invest at 5% today, that same derivative would let you invest in the future at 5.5%, thereby offering a 50 basis point benefit.)

Consider the case of a commercial entity that expects to issue three-year debt in the coming four months, where the prospect of higher interest rates has stimulated interest in entering into an interest rate swap to lock in the interest rate on an intended funding. Three critical questions would have to be asked:

1. What benchmark interest rate can be secured for the three-year period starting in four months? (This question distills to getting a quote for the fixed rate on a forward starting three-year swap.)
2. What is the credit spread that the firm would likely bear, relative to this benchmark interest rate?
3. Given the expected all-in rate (i.e., the swap’s fixed rate plus the expected credit spread), what portion of the interest rate exposure that the firm is facing should be hedged?

In the current environment, this all-in interest rate should be expected to come in at a rate higher than the cost of funds that the company would bear if it were to issue debt today. This higher-than-today’s interest rate might discourage the company from hedging, but it shouldn’t preclude it. The appropriate question is how much of the exposure should be addressed with a derivative, given the fixed rate level that the derivative allows the firm to access?

Dealing with Uncertainty
Along with the implied fixed rate available with the derivative, a complementary consideration is the business judgement as to the probabilities associated with interest rates ultimately falling below, reaching or rising above the implied rates underlying the derivative. It should be clear that if the market for swaps allowed this prospective borrower to lock in an all-in cost of funds at, say 5%, while at the same time expecting rates to rise even higher, hedging would be particularly attractive. On the other hand, hedging would be less attractive if the firm didn’t expect market interest rates to rise above 5%. Extending this line of thinking further, it may be interesting to realize if the consensus forecast reflected in the pricing of the derivative were actually realized (which shouldn’t be expected), the swap wouldn’t generate any payoff whatsoever – the company would realize identical earnings regardless of whether it hedged or not.

Unfortunately, the calculus becomes more complicated because we live in a world of uncertainty. The idea of not hedging at all because we don’t expect market rates to surpass the threshold of the implied forecast of the derivative is problematic because we might be wrong. Thus, even if we might not believe the rate will move beyond that critical value, it may still be reasonable to hedge some portion of an existing exposure. Put another way, even though the market conditions force the hedging entity to lock-in an implicit rate increase dictated by the price of the swap, it’s the probability that interest rates could move even higher that would justify hedging, even at a seemingly elevated interest rate.

Employing the swap serves to eliminate the uncertainty that would otherwise prevail if the exposure were left unhedged. With the swap, the company should have a high degree of confidence that the anticipated all-in funding costs initially calculated would be realized (subject to accurately forecasting the credit spread) for the portion of the exposure that the company chooses to hedge.

Managing a Hedge
Thus far, the discussion has focused on how much to hedge at the start of the hedging process, but hedging deserves reconsideration both periodically and whenever economic circumstances change in material ways. Suppose, for example, an initial hedge was initiated to protect against a rate increase that ultimately materializes. But suppose further that with time remaining before the hedge expires, the market has evolved, and now it now seems more likely that interest rates could retreat. Does it make sense to maintain the hedge in the face of these changed circumstances? Probably not. As time passes and perceptions change as to the probabilities associated with adverse price moves, or if the company’s risk tolerances change, the degree of hedge coverage could be adjusted – either up or down. Critically, just because a derivative contract hasn’t expired doesn’t necessarily mean it’s prudent to maintain hedge coverage.

Clearly, an orientation that favors a dynamic hedge adjustment process could open the door for abuse. Consider the case of the company that starts out with a hedge of 50% of some exposure. Assume that the firm perceives the risk as being more pressing, thus adjusting its hedge coverage to 75%. Later, the company reassesses conditions and decides that the expected adverse rate move has run its course such that rates now are expected to move beneficially. With this reassessment, the firm decides to reduce its hedge coverage down to 25%.

Throughout this adjustment process, this firm could represent that it is mitigating risk, albeit at varying degrees. Still, while it might be appropriate to observe these kinds of hedge adjustments over weeks or months, an objective observer would likely have a problem with these kinds of adjustments if they were made over the course of a single trading day! The moral here is that hedge adjustments should be implemented on the basis of some previously devised plan that reflects the company’s risk management orientation and policies. Thus, a mechanical rule that imposes an objective discipline on the hedge-adjustment process is preferable to ad hoc assessments relating to adjusting hedge positions. Unfortunately, it’s not clear that any single rules-based approach will be appropriate in all circumstances.

When considering an objective hedge management plan, it’s critical to be sensitive to two opposing concerns: if you’re starting with partial hedge coverage and interest rates move adversely, it’s natural to want to increase the degree of hedge coverage; on the other hand, at some point, the prospect of interest rates achieving a top (or bottom) might gain greater currency. Prudent managers will periodically review their hedge coverage and adjust their plans accordingly, reflecting a forward-looking orientation as to the changing probabilities associated with future interest rate changes.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Ira Kawaller is a Managing Director of HedgeStar, a Minnesota-based consulting firm that specializes in derivatives strategies, valuations and hedge accounting services.


November 19, 2018
How to Determine Millennial Borrowers' Credit Worthiness
By Joseph Lowe, Marketing Manager, Sageworks

When assessing the potential risks a borrower presents an institution’s portfolio, the typical starting point for most lenders is the “five Cs of credit” – capacity, character, capital, collateral and conditions. But as a younger generation, burdened with excess debt, becomes the prime demographic for commercial and consumer loans, community banks and credit unions may want to reconsider that approach if they want to capture this increasingly important segment.

Judging by the numbers, the American economy is on an uptick. The national unemployment rate sits at its lowest rate since 2000 (3.9%), the average FICO credit score is at its highest point ever (704) and median household income is at its highest mark in over 30 years ($61,372). In addition, young borrowers’ share of the lending market is growing.

Despite these positive figures, however, the financial outlook for young borrowers is not on par with the national averages. For example, the average FICO credit score for young borrowers (ages 21-34) is 638, while the average income for Millennials is $35,592.

Given these disparities, it will be difficult for community institutions to grow revenue if they choose not to factor in metrics other than the five Cs when analyzing young borrowers. Let’s take a look at the five Cs of credit in consideration with the young borrower market.

Capacity – Young borrowers earn an average salary of $35,592 and owe an average of $25,000 in student loan debt alone, making for a poor debt-to-income (DTI) ratio.

Character – Young borrowers’ average credit score of 638 is considered fair or poor for most financial institutions that rely on credit scores as the only gauge of character.

Capital – Young borrowers are spending more on bills than previous generations, leaving less money to put toward loan payments.

Collateral – Young borrowers are postponing major purchases such as homes and cars, opting instead for renting and public transportation.

Conditions – Young borrowers are starting new businesses, which, due to their limited credit history and high debt burden, can be too risky of a loan for community banks and credit unions to offer.

In light of these realities, community financial institutions looking for a share of the up-and-coming young borrower market may consider including supplemental factors within their credit analyses and implementing technology to better evaluate credit risk.

Analyzing a young borrower’s entire relationship through global cash flow
Global cash flow refers to a lender or credit analyst’s ability to review a borrower’s financial relationships with his or her peers in the community and, more importantly, the financial institution. Rather than solely focusing on the borrower’s financial history as a key determinant of creditworthiness, financial institutions can determine how businesses, properties and family members connected to the young borrower will affect credit risk for the institution.

For example, consider a loan application from a young borrower named Jack for a $5,000 commercial loan to pay equipment costs for a moving business. When analyzing his financial statements, you see that not only does Jack make a lower-than-average income of $29,000 per year, but he also owes a total of $25,000 in student loans. Your initial reaction is to deny the line of credit. However, upon reviewing the global cash flow analysis, you realize that his student loans have a guarantor on the account – his mother, Linda. Linda earns an income of $110,000 annually and has a credit score higher than 750. She co-owns two businesses with other prominent community members and has banked with your institution for 20 years.

By considering relationships through global cash flow, you have more evidence to potentially justify the line of credit and offer the loan to Jack based on conditions that mitigate his credit risk. By using global cash flow analysis, lenders can identify opportunities, increase defensibility of loan decisioning and take informed, calculated risks.

Using technology to determine credit worthiness
In a recent article published by the Wharton School of the University of Pennsylvania, Benjamin Keys, Wharton professor of real estate, and Richard K. Green, director of the University of Southern California’s Luck Center for Real Estate, both pointed to technology as a way for banks and credit unions to pull in other factors during credit analysis to provide supplemental evidence that borrowers can repay loans.

Implementing credit analysis technology allows lenders to identify portfolio risks based on both internal factors (such as probability of default) and external factors (such as data from other financial institutions) through automated credit risk models and APIs. APIs layer on another source of bank data for lenders to include within credit analysis as well – third-party data.

An automated commercial credit risk model can determine credit worthiness using predictive financial factors and limited data entry from lenders or credit analysts. Furthermore, automated credit risk models can quickly compare probability of default with broader industry trends and examine the industry’s risk to the institution. For young adults with limited access to capital, a better understanding of industry trends can provide another factor to be taken into account when examining credit.

As the demographics of community financial institutions’ customers shift to younger borrowers with less credit history and higher DTI than previous generations, it’s important for banks and credit unions to focus on more ways to help them find good risks that represent profitable growth from a core of young borrowers.


Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

As a commercial lending marketing manager at Sageworks, Joseph Lowe helps educate bankers on ways to optimize their lending and credit risk processes.



October 22, 2018
Hedge Accounting: A Q&A with Dan Morrilll and Ryan Henley


As the FASB’s hedge accounting standard continues its march to implementation – and with early adoption permitted – many companies may be wondering exactly how the changes will impact their operations. To get a better handle on life under the new rules, FMS checked in with Dan Morrill of Wolf & Company and Ryan Henley of Stifel for a quick summary of the changes to be aware of and the opportunities that may emerge for financial institutions.

Q: Which institutions would you expect to see the greatest impact from the hedge accounting changes?
A: While the accounting changes improved upon hedge relationships of several types, predominantly the rule changes allow for much greater flexibility in hedging fixed-rate instruments (converting fixed-rate assets or liabilities to floating), otherwise known as a fair value hedge. Given the current rate environment, institutions that would benefit most are those that have a risk to shrinking net interest margins in a continued rising rate environment as funding costs increase and fixed-rate asset yields remain constant.

Q: What are some of the new opportunities that have emerged as a result of these changes?
A: There are two primary strategies currently employed as a result of the changes. First, institutions are hedging assets that typically are offered in the market in a generic fixed-rate form. Fixed-rate loans or bonds of a longer maturity can now be converted to floating-rate asset classes by entering into an interest rate swap utilizing the new hedging rules. Secondly, institutions can create funding strategies paired with these same hedging alternatives to arrive at a cheaper funding profile for a given interest rate risk position.

Q: For those institutions that were hedging under the old rules, how significant will these changes be?
A: FASB’s effort significantly simplifies the accounting results (in constructing, measuring and monitoring) of hedge relationships. For institutions with legacy hedge relationships, this would apply to both future hedging strategies they would employ, as well as the opportunity to amend existing hedging relationships upon adoption. It will simply lead to a cleaner hedging platform for the institution going forward.

Q: Which change in particular do you see as having the most impact on the operations of banks and credit unions?
A: The ability to now hedge fixed-rate assets (swap fixed-rate instruments to float) gives an institution a tremendous amount of flexibility in product offerings to its client base. If the institution’s core market desires a longer-term fixed-rate product (in the consumer or commercial space), management can originate into this demand and then subsequently adjust the interest rate risk of the product without client involvement and in a clean accounting manner.

Q: Are there any effects of these changes that might be seen as a negative?
A: Generally speaking, most accounting changes carry with them a set of considerations or consequences that are not always favorable. Importantly, ASU 2017-12 was an attempt to rectify previous issues within hedge accounting. As a result, the rule really only improves upon the legacy framework. In our opinion, there are no negative consequences, as it affords greater flexibility than before.

Q: What should institutions be doing to prepare for these changes, or to make sure they’re in the best possible position to take advantage of them?
A: It is important to note that a significant number of institutions are currently early adopting the standard to take advantage of these rules. Why is this so important? Because it is likely that a competitor will be employing the strategies mentioned above due to the added flexibility. There are considerations upon adoption that must be analyzed, such as whether the institution has any legacy hedge relationships. If so, should these relationships be amended upon adoption (leaning on the transition provisions of the rule), and does the institution have investment securities classified as held-to-maturity that are eligible to be transferred to available-for-sale as permitted by the standard? If so, does it make economic sense to do so for each eligible instrument? These are some of the questions to be asking now.


Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Authors

Ryan Henley is a Managing Director and the Head of Depository Strategies at Stifel. In this position, he provides ongoing analysis and balance sheet strategies to financial institutions and portfolio managers nationwide, as well as a broad variety of analysis related to economics, interest rates, investments and interest rate risk management strategies.

Dan Morrill is a Principal at Wolf & Co. and is responsible for the firm’s Professional Practice group. In addition to leading the Audit and Accounting Committee, Dan conducts training on technical issues, performs quality control reviews, participates in learning and development initiatives and conducts technical research.



October 15, 2018
Strategic Uses for Customer Profitability
By Brad Dahlman, Sr. Product and Consulting Services Manager, ProfitStars

As accounting/finance professionals, we spend the majority of our time focused on delivering accurate financial reporting, but less time determining how the information will be used by the business units tasked with driving the institution’s success.

As a result, accounting/finance managers often want to have deep conversations about Funds Transfer Pricing (FTP) methodologies or the benefits of full absorption costing rules. While having good business rules is key to providing accurate results, it is equally important to focus on how front-line employees should be using customer profitability data to effectively drive business decisions..

Identification and Protection of Key Clients
In the more than 100 customer profitability installations I have overseen, it has been universally true that over 180% of a financial institution’s profitability comes from the top 20% of clients. This dramatic concentration of profit among relatively few clients demonstrates the importance of identifying these key clients and putting in place strategies to ensure they never leave your institution. While most well-run institutions have a good idea of who many of their top clients are, there are always some surprises – especially with deposit/service clients that don’t go through credit underwriting processes.

In Figure 1, a well-performing $800-million bank shows average profitability for each client in the top 10% as $4,623 annually. Losing any of these clients will certainly hurt, so the organization must:

1. Identify them
2. Assign relationship officers to these key accounts
3. Put in place programs or rewards to ensure the client is satisfied, including providing key profit information to tellers and personal bankers so they can properly address fee waiver requests
4. Track lost “key” clients


Figure 1: Profit Is Highly Concentrated



Effectively Pricing New Transactions
The second use for customer profitability data is in pricing new transactions. As new business requests (loan or deposit) are considered, institutions with a customer profitability system should:

1. Understand current profitability (i.e. “before”)
2. Price the new transaction, considering various pricing scenarios and terms
3. Assess the “after” – or post-approval profitability – to ensure an adequate return (profit/ROE)
4. Provide only those options to the client that meet targeted profitability thresholds

Segmentation and Marketing Strategies
The third major use for customer profitability data is by the marketing department. Accurate customer profitability data is often loaded into CRM/MCIF systems, as opposed to using rudimentary CRM/MCIF tools to determine profitability. With this accurate data imported into the application, the data is then used to segment clients and develop marketing campaigns targeted around both product usage and profitability data.

While many CRM/MCIF systems have basic profitability analysis included, it is essential to have one consistent view of profitability for use by finance/business leaders, tellers or other front-line personnel, as well as marketing. As such, data from a sophisticated profitability system should ideally be fed into the CRM/MCIF system.

Evaluation of Relationship Managers’ Performance
The fourth major use for customer profitability data is evaluation of relationship managers’ performance. The concept here is to determine the value of a relationship manager’s portfolio at the beginning and end of the year to assess profit improvement.

In most institutions today, relationship manager goals often revolve around production goals like growing loans and/or deposits. While growth is indeed a positive measure, we also want to make sure these goals align with profitability goals. Without profitability targets, relationship managers will be incentivized to simply “price down” transactions to win business that could negatively affect the institution’s overall financial performance. In other words, not all deals are profitable!

When a relationship manager has profitability growth goals, he or she is encouraged to find ways to make transactions profitable. Access to customer profitability data and effective pricing tools are key elements in this process.

Summary
Customer profitability systems have been available in the market for many years. However, the number of financial institutions that have accurate, sophisticated customer profitability systems and use them in the manners described above are few.

In my experience, community bank clients who actively use their customer profitability systems have experienced between 8-10 basis points of additional profitability over their peers. As your institution considers future growth and profit objectives, it is therefore worth asking this basic question: “Do we provide our front-line staff with the information to effectively engage with clients to grow profitability?”

If the answer to this question is “no,” perhaps 2019 should be the year your organization explores customer profitability and pricing solutions.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Brad Dahlman is a Senior Product and Consulting Services Manager for ProfitStars focusing on the importance and uses for relationship profitability. In addition to developing a customer profitability system in the late 1990s, Brad has personally led the installation of customer profitability solutions at over 100 financial institutions over the past two decades. He has a broad background in banking and has held various positions in finance, audit, operations and technology with several mid-sized community banks.


October 1, 2018
FMS Quick Poll: Views On Fintech
By Financial Managers Society

Thanks to dozens of think pieces and the OCC’s recent decision to offer a new special charter, fintech may be one of the buzziest issues in the banking industry right now. But when it comes to actually working with or competing against these potential new players, just how many FMS members actually have a fintech bee in their bonnets? If the results from our latest Quick Poll are any indication, the buzz is more of a low hum for now.

Among the 76 respondents to our poll (80% from banks/thrifts and 20% from credit unions, ranging in asset size from $199 million or less to $9.99 billion), 18% see financial technology companies solely as potential partners, 12% see them only as competitors and 61% see them as both potential partners and competitors (Figure 1). Meanwhile, a small segment (8%) says fintech players are neither partners nor competitors, and one respondent wrote it to note, with compelling honesty, that his institution was actually not yet sure exactly how to view fintech players.

FIGURE 1: WHAT IS YOUR INSTITUTION’S VIEW OF FINTECH PLAYERS?



With a cumulative 79% seeing fintech players as possible partners, it is perhaps not surprising that more than one in four respondents (26%) report already working with a fintech firm on some strategic initiative (Figure 2). Another 39% note that while they are not yet collaborating with a fintech partner, they’re interested in doing so and looking for potential opportunities. The remaining 34%, however, have no plans to partner with a fintech company at this point.

FIGURE 2: IS YOUR INSTITUTION CURRENTLY WORKING WITH A FINTECH PARTNER ON A STRATEGIC INITIATIVE?



Whether currently working with a fintech partner or just considering doing so, we wanted to know which areas of the institution were most likely to benefit from a fintech collaboration, and P2P payments (63%) and digital account opening (58%) were the runaway favorites, with mobile banking (34%), mobile bill pay (28%) and online bill pay rounding out the top five (Figure 3). Among the 16% of respondents who selected “other” for this question, several see fintech companies as ideal partners for streamlining or digitizing lending services, while other write-ins included “business intelligence” and “customer/member analytics.”

FIGURE 3: WHICH AREAS DO YOU SEE AS THE MOST LIKELY FOR A PARTNERSHIP WITH A FINTECH COMPANY?



For those respondents already working with fintech partners, when asked what types of initiatives they were focusing on several reported that they are indeed utilizing fintech know-how to streamline and automate their loan processes – from improving loan workflow to building a small business lending portal.

In many respects, FMS members in this Quick Poll echoed the findings from our larger industry-wide proprietary research project from earlier this year. In Community Mindset: Community Bank and Credit Union Viewpoints 2018, nearly half of the 400 community bank and credit union leaders surveyed saw fintech players as both potential partners and competitors, while 32% viewed them only as potential partners and 20% saw them strictly as competitors.

Thank you to everyone who took the time to share their thoughts in this FMS Quick Poll!





September 24, 2018
Evaluating the Liquidity Within Your 1-4 Family Portfolio
By Mark Cary, Sr. Vice President, FTN Financial Capital Assets

As loan-to-deposit ratios and liquidity ratios reach five-year highs and lows, respectively, now is the time to take stock of all of your potential liquidity options. While most liquidity contingency funding plans include options for raising deposits, selling investment securities or obtaining other funding (such as FHLB advances), one often overlooked option as a valuable source of potential liquidity is the 1-4 family first lien mortgage portfolio.

As loan-to-deposit ratios and liquidity ratios reach five-year highs and lows, respectively, now is the time to take stock of all of your potential liquidity options. While most liquidity contingency funding plans include options for raising deposits, selling investment securities or obtaining other funding (such as FHLB advances), one often overlooked option as a valuable source of potential liquidity is the 1-4 family first lien mortgage portfolio.

Got Liquidity?
In 2014, the national marketing arm for the dairy industry retired the popular “Got Milk?” ad campaign that featured celebrities in milk moustaches, but let’s use a twist on the once-popular ad campaign to highlight the need for liquidity in today’s market. Figure 1 below highlights the increasing loan/deposit ratios for banks. This increase, coupled with an increasing cost of funds, can put a real strain on liquidity (and earnings).


Figure 1: U.S. Commercial Banks and Savings Banks (250M-$25B) - Loans-To-Deposits Ratio


Cost of Funds Is Also Rising (Significantly)
As Figure 2 indicates, cost of funds – which is comprised largely of interest-bearing deposits – has increased recently, and it does not seem like this will be ending anytime soon. With digital deposits on the rise and the availability of information on the internet about competing deposit accounts, the war for deposits will likely be more intense than it has ever been.


Figure 2: U.S. Banks ($250M-$25B) - Cost of Funds, Trailing 8 Quarters


Traditional Sources May Not Be Enough
While it has yet to be seen, the impending war for deposits may cause financial institutions to consider sources of liquidity outside of their usual arsenal. Normally, a financial institution’s potential remedies for a shortfall in funding include, but are not limited to:

1. Selling Available-for-Sale (“AFS”) securities
2. Raising rates on deposits
3. Tapping non-core sources such as brokered deposits, FHLB advances or other lines
4. Loans from correspondent banks


As rates rise, the costs for implementing the above strategies could get very expensive. A potentially more efficient option is the liquidity that resides within the on-balance-sheet portfolio of 1-4 family mortgage loans.

The 1-4 Family On-Balance-Sheet Portfolio as an Alternative
The 1-4 family loan portfolio represents an often overlooked source of potential liquidity. Of all loan product types, the 1-4 family portfolio often includes the most liquid and most price-efficient loans from a secondary marketing standpoint, and can be segregated into three separate liquidity grades as follows:

Agency Grade
Loans in this category meet all the general criteria for purchase by one of the agencies (Fannie Mae or Freddie Mac) subject to a loan file documentation review. These are loans that were agency-eligible at origination or could be agency-eligible as the loans season or some corrective action is taken.

Private Grade
Loans in this category may meet one or more of the criteria for being eligible for purchase by the agencies, but are acceptable for purchase by private investors (usually other financial institutions) subject to a loan file documentation review. These loans would be subject to standard secondary marketing guidelines as related to FICO score, LTV, DTI, etc.

Portfolio Grade
The loan data fails one or more criteria for purchase in the standard secondary mortgage market. The loan may be a good credit risk and a performing asset, but from an economic perspective, its profile indicates it should be retained in the portfolio rather than being sold in the secondary market. In other words, the price to sell into the secondary market is quite a bit lower than the value to hold the loans to term.

Agency and private grade loans are collectively referred to as “investment grade” and are the MOST LIQUID loans within the entire loan portfolio. Over 80% of the loans in the average portfolio meet these criteria, representing a large source of untapped liquidity.

Strategies to Improve Liquidity Using Whole Loans
As with any strategy involving the balance sheet, it is important to understand all potential options. When evaluating funding strategies, one additional option to consider is the sale of a pool of loans. Strategies utilizing whole loan sales can be structured as follows:

1. Bulk seasoned MBS securitizations using one of the agencies (Fannie Mae or FHLMC) as a guarantor
2. Whole loan transactions from one institution to another
3. Participation transactions

Each of these strategies can be accomplished on a serviced, released or retained basis

Another “Liquidity” Arrow in Your Quiver

When preparing your Liquidity Contingency Plan, it is important to include the 1-4 family portfolio as a potential source of liquidity along with other more traditional sources. Doing so will provide you with another arrow in your liquidity quiver.


Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Mark Cary is a senior vice president and loan sales manager for FTN Financial Capital Assets, drawing on his more than 30 years of experience in the a financial institution industry to assist clients in developing strategies to better manage their loan portfolios. He is a member of the AICPA and the Tennessee Society of Certified Public Accountants, and is an adjunct professor in the Finance, Insurance and Real Estate Department of the University of Memphis.


September 3, 2018
Manage Vendors to Manage Risk
By Terry Ammons, Systems Partner, Porter Keadle Moore

Banking at its core is the business of managing risk for others. From deposit accounts to payment options and loan products, the entire culture of an institution is centered on identifying, controlling and responding to risk. Despite this, however, one area where the financial services industry is still struggling to succeed is vendor risk management.

Today, third-party vendors are ubiquitous within modern businesses, and financial institutions are no different. Working with technology partners requires institutions to accept a certain level of risk that must be managed both internally and externally. While regulatory, compliance and security issues still resound as top priorities for bankers, when choosing to work with new tech providers, the best approach to risk management is not avoidance, but a deeper understanding that helps the institution identify, prioritize, control and respond to any event that may cause a business interruption.

The hard truth is that responding to risk after a breach or incident has occurred is potentially more expensive – to the bottom line and to reputational brand equity – than implementing the necessary steps to safeguard the institution from the beginning.

Not All Vendors Are Created Equal
While regulatory compliance is not specific to banking, compared to most other industries, banks and credit unions have a much higher bar to reach when developing internal risk management programs. Federal regulators are closely evaluating the institutions they are charged with overseeing, and bankers must be vigilant in holding risk management programs to the highest level of scrutiny. Since a disaster in one area of the bank or credit union can affect the entire institution, risk management is an enterprise-wide concern and should be dealt with as such. This includes incorporating risk management efforts into the institution’s culture, organization, processes, technologies, personnel and physical infrastructure.

The first step toward creating a successful vendor management program is to categorize risk on a sliding scale of priority. Some institutions mistakenly apply the same level of risk to each of their vendors – regardless of the service provided, the level of access granted or the type of data shared. This can be a time-consuming and oftentimes damaging approach, as some vendors pose a larger threat to an institution than others. For example, some vendors will pull more sensitive information from a bank, which naturally necessitates a higher level of scrutiny on the bank’s part. By categorizing vendors based on risks, institutions can help focus their efforts and better ensure that nothing slips through the cracks.

Build Your Safety Net
While an institution may lack direct control over its vendor and their systems, it is nevertheless the institution’s responsibility to ensure that proper safeguards are in place to protect itself, its customers’ information and the integrity of the institution/vendor relationship. After evaluating and determining the risk profile of each vendor, the institution must conduct its own due diligence to ensure that the vendor is upholding its end of the contract.

The vendor bears some responsibility here as well. Regardless of risk assignment, a vendor must provide documentation that demonstrates its security arrangements and controls. While this usually occurs in the beginning of a vendor relationship, institutions should require their partners to provide quarterly and annual reports and analysis of their systems to satisfy not only the institution’s requirements, but its regulators as well.

Ideally, evaluation will be an ongoing effort that does not impede day-to-day operations. After all, even if everything is in place in the beginning of the relationship, those same controls may not necessarily be sufficient in the future. Specialized access to consumer information not only requires protections to be in place, but also to evolve with the changing cybersecurity landscape.

The relationship between vendor and banker needs to be a symbiotic one. For example, banks and vendors alike should work closely to outline the steps necessary to ensure services are restored in the event of an outage, with both organizations assuming responsibility for their part of the equation. To create a comprehensive due diligence program, vendors should provide their own internal and external IT audits to validate the controls they have in place. While this is the ideal, it is too rarely the reality.

Response Tactics
With an extensive range of risk touch points for financial institutions, even seemingly innocuous events such as missing a patch or an employee clicking a malicious email link can lead to enterprise-wide threats. Thus, a bank or credit union’s risk management strategy must also include steps for how to mitigate damage once a breach has occurred. Even with a robust due diligence process and regular audits to ensure compliance, an event can occur – hackers, unfortunately, are still very good at their jobs.

There are a few options to deal with an interruption once it has occurred: remediation, mitigation and acceptance. With an effective risk management and vendor management program in place, these attacks will be limited in scope and occurrence, but still may cause an inconvenience for the institution at the least and a breach of sensitive data in the most severe instances. It is at this point that an institution can learn firsthand where any missteps may have occurred, and if the vulnerability was previously unknown. Of course, every institution wants to avoid this situation, but when and if it does occur, it is certainly better to emerge with more robust controls and an example to assist other institutions in protecting themselves.

There is a balancing act between evolving business requirements and meeting the latest security standards – one that provides little room for error. Integrity of data must be ensured on the vendor’s side, with the institution setting expectations early on in the relationship, and then reevaluating those expectations throughout the life of that partnership. There is no finish line in reaching and maintaining compliance – it is an ever-moving target that requires constant monitoring.


Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Terry Ammons, CPA, CISA, CTPRP is Systems Partner at Porter Keadle Moore (PKM), an Atlanta-based accounting and advisory firm serving public and private organizations in the financial services, insurance and technology industries.






Have a topic you want to share? 

We’d love to hear from you:
Mark Loehrke
Editor and Director, Publications and Research
Direct: 312-630-3421
Email: mloehrke@FMSinc.org