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January 29, 2013 by Steve Williams Steve Williams

Liquidity, Pricing and Tail Risk … Oh My!

Man, is it dangerous out there, Gonzo bankers – a really strange and spooky industry. Aging and bloated Western empires are spending money faster than their submissive central bankers can print it. Banks are being asked to conduct business and guard shareholder capital in an environment where true market signals and pricing have been overrun by government bureaucrats wielding Keynesian econometric models.

There’s no doubt about it: margin compression will hurt banks even more in 2013 than it did in 2012, and there’s no creative strategy that can be hatched before the first-quarter earnings call to make things better. Here’s the basic calculus of this bizarre and messed-up situation:

130129aLiquidity Abounds – the banking industry’s loan-to-deposit ratio has gone from a heated 93% in September 2007 down to 70% in September 2012.

This translates into $2.3 trillion less in loans on bank balance sheets than five years ago. Cash and securities have increased roughly $1 trillion each since the financial crisis started.

130129bPricing Moves Down – because the banking industry is awash in liquidity and solidly capitalized, many institutions have gotten aggressive on loan pricing very quickly. Across the nation, lenders are bemoaning the shrinking spreads on multifamily, commercial and auto deals. They are also beginning to see credit terms loosen (guarantors, debt coverage) while these institutions are still working classified loans from the last crisis. Importantly, the most aggressive lenders are putting out longer-term loans (10 – 15 year maturity) with fixed rates that are hard to imagine will be “in the money” for the life of these assets.

130129cTail Risk Still Around – despite the assurances of our central banking witch doctors, shrewd investors are still fearful that the grand “re-inflation” being pursued in the global economy will create an unforeseen “tail risk” – meaning the possibility that conditions or market psychology suddenly change and assets (namely bonds) lose their value significantly and abruptly. As Richard Barley wrote in Sunday’s Wall Street Journal, “By keeping rates ultra-low, central banks including the Federal Reserve may have created a ticking time bomb.” The chart below illustrates the incredible growth of net flows of bond purchases that have occurred at the expense of equities over the past five years.

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Today’s extremely low yields make bonds highly sensitive to rising interest rates. For instance, a 2% rise in 10-year Treasury bond rates takes out roughly 17% of the bond’s value. For financial institutions that have 200%-400% of their capital in bonds, such losses would not go unnoticed. Every week, I like to pull up a 50-year history of the 10 –year bond yield to remind me of the uncharted waters we float in today.

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So while world leaders try this week at Davos to say we’ve dodged a bullet in the U.S. and Eurozone economies, I still like to soak up the counterpoints from smart ones like Jim Grant, David Einhorn, and Kyle Bass to remember there is a possibility that our mainstream market assumptions could crumble quickly. Even if not the likely scenario, I believe the tail risks are serious enough to weigh into a bank’s blended balance sheet strategy.

What’s a Gonzo Banker to Do?

For bank executives staring out their windows at this bizzaro world, there are no easy answers. However, there are five major strategies that should be employed to manage through this environment as best possible.

Strategy #1: Identify and Innovate Your Niches
In a world gone mad with asset yields, the first step for bankers is to acknowledge areas where they have competitive niches and ask, “Are we maximizing the growth opportunity in this area?” For instance, if a bank has a niche in garbage truck lending or warehouse financing, it should challenge management to determine if additional resources (sales, underwriting) and marketing approaches (trade advertising, direct marketing) could drive more production. Oftentimes, banks sit on a niche but fail to attack its growth from an entrepreneurial standpoint. If the bank has a good mouse trap, then expand production and distribution fast.

Strategy #2: Dig for Pockets of Contrarian Credit Risk
While spreads have been literally sucked out of the nicest deals out there today (e.g., fully leased large apartments), bank credit officers should have serious debates about where a slightly increased risk appetite could spur up new sources of production. Dare I say it, but some community banks that have carefully resumed lending to homebuilders in solid growth markets are seeing some nice production pickups. Warehouse lending and finance rediscount structures have allowed banks to participate indirectly in the growth of non-traditional assets. Importantly, high paid credit officers shouldn’t just be prolific finding the types of deals they don’t want to do, but also the more hairy deals where the market may be missing how to manage the credit risk to earn a nice risk-adjusted return.

Strategy #3: Create a Balance Sheet Allocation for ‘Market-Competitive’ Deals
Across the country, bankers sit in asset/liability management meetings arguing if they should price their loans fully loaded according to their slick profitability model or marginally priced to anything that can beat the yields in that sorry and continually growing bond portfolio. The trick , however, is that both answers are right and wrong. Pricing at fully loaded spreads with today’s competition will take production to a trickle, and pricing everything on the margin? See the previous reference to ticking time bomb. The best strategy is to look hard at the overall composition of the balance sheet and negotiate an allocation of production where the lenders can hit the market at very competitive rates. This “blue light special” approach can actually get lenders off their duffs when they know that only the first $40 million booked will be able to use special “market competitive” pricing. Once the bucket is filled, the bank should be prepared to lose its share of deals but smile and hold the confidence that its “tails” are better protected than competitors who marginally price everything.

Strategy #4: Identify Where Pricing Can Drive Strategic Cross-Sell
Bankers like to brag that they form deep relationships with their clients and aren’t interested in a cheap and tawdry “transaction.” Today’s rate environment provides a great opportunity for bankers to walk the walk. As much as possible, executives should reward pricing strategies designed to drive deeper relationships. Banks and credit unions that have special consumer loan rates for active checking customers is one example. Creating a portfolio jumbo mortgage product for Private Banking customers with an explicit goal of cross-selling deposit and wealth services is another example. One caveat: banks often forget to formally track the desired cross-sell performance and hold officers accountable for real results. Leap of faith pricing around the promise of relationships should not be allowed.

130129fStrategy #5: Define Your Tail Risk Indicators and Establish Contingency Plans
Finally, bank executives shouldn’t simply wait around for potential shocks to the bond market. Instead, management should develop a simple dashboard report for asset/liability meetings called the Tail Risk Indicator Report. This would provide snapshots of yield curve movements with bond and futures spreads, and provide commentary from both mainstream and rebel market experts on whether we face inflation, deflation or that dream Downy soft return to prosperity that the monetary wizards are attempting to orchestrate. The point of this agenda item is to develop “what if” plans and be ready to move with bold decision-making when things start to turn. In fact, the quick footed who take some losses early when a cycle changes often avoid the big bath that occurs when everyone realizes the music has stopped. Notice the chart here showing how 2006 subprime mortgage bonds dipped from 100 down to 30 cents on the dollar by early 2009. Wouldn’t it have been great to get out in late ’07 at 80 cents on the dollar?

130129gIf I had a bond portfolio that was 350% of my shareholder equity, I would be all about preparation and mental drills right now. The job of bankers has historically been to take care of customers, manage credit and keep the examiners off their backs. Today, however, we have all been asked to operate under the specter of unprecedented low rates and the fear that a new “Black Swan” may emerge from our leaders’ aggressive attempts to smooth over previous bubbles. We can’t be frozen. We have to hit the streets and make some deals. Yet, we also must do business with a more thoughtful approach to how we price assets and just how much we need to protect our tail for unknown events down the road.
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