Pub. 11 2014 Issue 3

O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S - H E L P I N G N E W M E X I C O R E A L I Z E D R E A M S Fall • 2014 11 B ankers faceunique challenges as theprospect of higher interest rates grows closer, although no one knows exactly when or how much rates will rise. Economists project that the Federal Reserve will begin raising rates in mid-2015, but ultimately, the performance of the economy between now and then will determine whether this is the case. Here’s the crux of the challenge for bankers: lenders must manage interest rate risk in the face of all the uncertainties regardinghigher rates, anddependingupon the structure of a loan, theymust alsomanage credit risk. The forward curve can be a useful tool for predicting where interest rates will be in the future. While the predictions of the forward curve may or may not turn out to be correct, it does give an idea of market expectations for future interest rate levels. Understanding the interplay between future interest rates and credit portfolios can help a bank manage both profitability and risk. Here’s an example that illustrates how a bank might use the forward curve and the implications of measuring risk and Future Shock reward. If a bank offers a $1 million, 25- year amortizing, 5-year adjustable fixed rate loan to a borrower, and prices the first five years at 3.50%, and then adjusts the next five years to the 5-year CMT plus 2.00%, what can the forward curve teach us? First, the bank needs to consider the amount of loan outstanding after five years of amortization. In five years, on a 25-year am schedule, the outstanding balance will be reduced by 13%. Will the borrower be able to refinance $870,000 at the new interest rate? Will the value of the collateral, the amount of cash flow and strength of the support allow the bor- rower to refinance the credit? Most banks subject loans to interest rate sensitivity tests to test if there will be sufficient cash flow to service the debt. Banks typically shock cash flows allowing for 100, 200 and 300bps interest rate movement upward and downward, us- ing current interest rates. Given that the most recent charts released by the FOMC indicate more than half of its members expect Fed Funds rates to be between 2 and 3% by the end of 2016, is a shock of 300bps from today’s rates sufficient to measure the implications for the borrow- er, the collateral and therefore the credit five years into the future? In addition to a shock at today’s rate, if a loan will refinance in five years at a spread to a benchmark rate, then the loan should be shocked to the forward curve. Today’s forward curve would in- dicate that this credit would re-price at an interest rate over 6%. How would the borrower’s cash flow look with a 300bp shock form 6%? One would hope that the borrower’s cash flow would improve along with an economy that has improved enough to merit higher interest rates. Risk manag- ers should consider whether borrower’s cash flows will increase enough to absorb a higher interest rate. Otherwise, this structure could represent a future Trou- bled Debt Restructuring. Play around with various assumptions before boarding a loan and using the for- ward curve as a guide. As with all things based on future expectations, it is unlike- ly that it will turn out to be 100% correct, but this type of analysis will help you ex- plore a range of possible outcomes that can benefit you bank through a changing interest rate environment. n By Elizabeth VanArsdel, First Vice President of Fixed Income and Communications, PCBB NMBA ASSOCIATE MEMBER