The Quarterly Review of Interest Rate Risk

The Quart erly Revi ew

Volume 13, Issue 1 The Quarterly Review First Quarter, 2008 of Interest Rate Risk

Office of Examinations, Supervision, and Consumer Protection Risk Modeling and Analysis Division First Quarter Sees Continued Sensitivity Decline

Between December 31, 2007 and March 31, 2008, Interest Rate Sensitivity Measure interest rates declined and the yield curve steepened signifi- 450 cantly. The most dramatic 400 90th Percentile changes occurred at the lower 350 Special points of interest: end of the curve with both the 300 • 30-yr mortgage commitment rate three-month and six-month declines 33 basis points rates dropping 198 bps. Rates 250 declined for the 12-month by Median 200 • Treasury yield curve drops and 179 bps to 1.55%. The five- steepened in the first quarter year Treasury rate declined 99 Basis Points 150 with a dramatic decline in short- bps to 2.46%. The ten-year 100 10th Percentile term rates Treasury rate went from 4.04 percent to 3.45 percent and the 50 • First quarter median interest rate 30-year Treasury rate declined 0 sensitivity declines with post- from 4.45 percent to 4.30 per- Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 shock NPV ratios improving cent - declines of 59 bps and • Asset durations shorten and 15 bps, respectively. liability durations lengthen During the quarter, the conforming fixed rate loans federal funds rate was lowered 30-year mortgage rate on declined from 5.96 percent to to 2.25 percent at the end of the • Comparative Regional Analysis 5.63 percent. The target for the (Continued on page 7) • Feature article discusses valuation challenges, regulation, and evolving standards of practice Valuation Challenges, Regulation, and Evolving Standards of Practice

1 Charts in this issue: The last year has been a tumul- investment (HFI ) portfolios. collateral (e.g., Option ARMs; tuous time for banks and finan- This pricing difficulty has not jumbo v. conventional; etc) of cial markets in general. After a been limited to headline products, questionable or difficult to ascer- Interest Rate Sensitivity Measure 1 lengthy period of economic ex- such as CDOs, auction-rate secu- tain quality. Investors are in- pansion, secular declines in credit rities, and other complex struc- creasingly aware that collateral Interest Rates and Yield Curves 8 spreads, and ample market liquid- tured investments and loans; and structure may price differ- ity, the on-set of credit concerns indeed, banks have had a difficult ently, and investors continue to has created significant market time finding appropriate prices find transparency into the under- ARM Market Share of Originations 8 turbulence, reductions in credit for less exotic instruments in- lying collateral pools that make availability, and the need for cluding various types of CMOs, up many of these instruments ARM Share of Thrift Portfolios 8 increased capital. RMBSs, and private-label mort- non-existent or remarkably diffi- Uncertainty over the scope, gage loans and securities. cult to obtain. Duration and NPV Measures 9 depth, and duration of the current Price discovery has been The lack of transparency and turmoil has kept many investors hampered by significantly re- access to more granular levels of on the sidelines. During this duced volumes of trading in detail, when combined with re- Industry Risk Measures and TB13a 10 period, banks and other financial credit-sensitive instruments, par- duced faith in rating agency as- S-Rating Matrix intermediaries have struggled to ticularly in vintages (e.g., 2006 sessments of default-risk and the Comparative Trends in the Five 11 value various balance sheet prod- and 2007), underwriting type concomitant uncertainty around OTS Regions ucts – including trading inven- (e.g., low-doc; Alt-A; etc), and forecasted credit exposure, has tory, warehouse positions, avail- served to reduce confidence in Aggregate and Regional Appendi- 12-17 1 For purposes of this article HFI and HTM (“held able for sale (AFS), and held-for- (Continued on page 2) ces to maturity”) are considered as interchangeable.

Page 2 The Quarterly Review of Interest Rate Risk

Valuation Challenges, Regulation, and Evolving Standards of Practice (continued)

(Continued from page 1) were in for a bumpy ride. “…virtually no plausible stress cially for complex assets that various product markets, and Since then, the difficulties scenario can justify prices this traded in illiquid markets. By in some cases in the structure of fair value measurement low!” all accounts, FAS 157 seems of the broader market infra- have continued to create a This apparent disconnect to have reduced that flexibil- structure itself. Consequently, variety of challenges for man- between “price” and “value” ity. investors and dealers are con- agement, and in many cases illustrates an important aspect Fortunately for many serving capital and liquidity in accounting losses have been of FAS 157. Under FAS 157, institutions, current fair value an effort to weather the storm recognized resulting in reduc- “fair value” is defined as the accounting does not require and bid-side pricing for many tions in accrual earnings and exit price that would be re- loans designated as HFI to be products has been hard to capital. Given these market ceived to sell an asset or paid carried at fair value. That said, come by. This has resulted in circumstances, pressure has to transfer a liability in an the OTS has received a num- a broader use of “mark-to- mounted within banks to place orderly transaction at the ber of questions regarding how model” valuations, or what in assets within accounting cate- measurement date. In other the concept of “fair value” accounting parlance is now gories that permit more man- words, the “intrinsic value” of should be applied to the calcu- well known as “level 2” and agement flexibility in valua- a security (i.e., present value lation of pre-shock Net Port- “level 3” valuations. tion assumptions, or in some of all future cash flows) is not folio Value (NPV) capital Meanwhile, the account- cases to transfer and hold as- considered when assigning fair ratios for interest rate risk ants and regulators are asking sets at historical cost. While value. This highlights an im- modeling purposes, in particu- banks to raise capital, recog- appropriate in some cases, the portant point: lar for loans that are HFI. nize losses, and proactively question is raised as to the This article will seek to identify, measure, and control efficacy of valuations in cate- “Price is what someone is clarify our position on this their inherent and expected gories permitting more man- willing to trade at; value is issue and explain why it is risk exposures. As evidenced agement discretion (i.e., what something is worth in- important to accurately esti- by the surge in discussion whether the principle of con- trinsically” mate value for all items on the around valuation issues - both servatism is being applied and balance sheet, regardless of formal and informal - regula- assumptions are sufficiently While the philosophy of their accounting designation. tors and accountants are in- justified by market facts) and fair value has been that these More recently, OTS’s long- creasingly interested in valua- whether and how to estimate two units are generally the standing, market-based phi- tion integrity and internal bank reasonable values for assets same, there is a rising chorus losophy is being emphasized pricing and valuation prac- held in categories that, for of market participants who across other Agencies as well. tices2. This is particularly accounting purposes, allow for believe that price and value Indeed, the Committee of important for bank supervisors historical cost estimates. This can and often do diverge in European Bank Supervisors given that the value of assets same question is being raised periods of stress. That is, in (CEBS) has noted that: and liabilities is critical in within and across markets. periods of major disruption, determining the financial Regardless of accounting “exit prices” don’t accurately “…institutions [need] to apply safety, soundness, capital ade- designation, events that have reflect the intrinsic value of the same valuation processes quacy, and resolution risks of a unfolded in recent months expected cash flows. This and diligence when valuing bank. reinforce a central theme: difference between price and financial instruments irrespec- In the third quarter 2007 measuring fair value during value explains, in part, why tive of the accounting catego- issue of this publication, we times of market stress is a many firms are holding onto ries that they have been allo- provided a primer on Financial challenging exercise. This has positions and transferring AFS cated to or whether the fair Accounting Standard (FAS) been painfully clear to many and trading assets and liabili- values are purely used for dis- 3 157, Fair Value Measure- thrift executives forced to take ties to Level 2 and Level 3 closure.” ments, and described its im- large impairment and valua- categories, and why some pact on the Schedule CMR tion write downs on AAA- analysis has shown that current We will also discuss our reporting process. At that rated securities backed by market prices for some assets observations regarding recent time, the full effects of the option ARM and sub prime imply loss and recovery sce- industry valuation practice and standard on the industry were mortgage collateral during the narios that are implausible. share some concerns and rec- unknown given that most insti- first and second quarters of Although FAS 157 did not ommended actions prompted tutions had not opted for early 2008. Performing securities introduce the concept of “fair by those practices. adoption and the current pe- held in AFS or trading, and value”, prior to its issuance riod of turbulence was still in with ample credit protection firms seemed to have a higher OTS’s Approach to Measur- its early stages. Nonetheless, and low likelihood of principal degree of flexibility in deter- ing Interest Rate Risk reported results from the early loss, were being priced as low mining what constituted “fair Pursuant to OTS Thrift adopters indicated that we as 70 and 80 cents on the dol- value”. Rarely did firms mark 3 See page 13 of CEBS, June 18, “Report on 2 See Table-1 at the end of the article for a lar. As many thrift executives an asset down to a value lower Issues regarding the valuation of complex and summary of fair value proposals and/or observa- have repeatedly pointed out, than its intrinsic value, espe- illiquid financial instruments” . tions from three important regulatory groups. (Continued on page 3)

VolumePage 3 12, Issue 4 The Quarterly Review of Interest RatePage Risk 3

Valuation Challenges, Regulation, and Evolving Standards of Practice (continued)

(Continued from page 2) more simplistic, deterministic other financial intermediaries in approaches are not always Bulletin 13a, Management of “economic value of eq- reducing, hedging, or eliminat- straightforward (even in calm Interest Rate Risk, Investment uity” (EVE) approaches, ing excessive risk concentra- periods) and many lessons will Securities, and Derivatives wherein cash flows are dis- tions. In these organizations, undoubtedly be learned, behav- Activities (TB13a), the level counted by risk-free (or near valuation uncertainties in the ior modified, and new require- of interest rate risk at an insti- “riskless” rates), and values banking and trading book con- ments promulgated as a result tution is a function of both 1) and risk-measures are not cali- veyed important signals to sen- of the recent turmoil. More- an institution’s pre-shock NPV brated to observed market ior management, signals that over, in the case of valuation, capital ratio levels. are unavailable in firms that certain assets and liabilities rely on less rigorous practice. such as mortgage servicing and 2) its sen- “Where market pricing is not While cog- sitivity meas- nizant of the These firms worked to reduce rights (MSRs) and non-maturity available, a rigorous, documented, or eliminate heterogeneous deposits may not have readily ure (i.e., the and disciplined process should be in pricing and degree to valuation diffi- valuation practices across dif- observable market prices or place to create reasonable ferent lines-of-business and may suffer from severe liquid- which NPV culties in peri- approximations of asset and liability sought to create a “level playing ity constraints. As such, OTS capital is af- ods of stress, value. The ultimate objective is to field” for performance measure- recognizes that in some cases it fected by OTS has none- create a fair estimate of market ment and reporting. is unavoidable that certain as- changes in theless long- value for an institution’s assets and While some in the industry sets and liabilities be marked- interest rates). believed that by liabilities - without regard to believe fair value and fair value to-model, a process by which The higher an instilling a mar- accounting and regulatory capital accounting to be the “bane of one uses a model and a set of institution’s ket-based rules.” the industry’s woes”, more reasonable, market-based pre-shock valuation disci- reasonable thinking recognizes “observable” or “unobservable” NPV capital pline through- that while not perfect, excel- assumptions to produce a value ratio, the more interest rate out an organization a bank will lence in an internal valuation (note: these are often level-2 or risk an institution can afford to be better able to identify areas process and rigorous risk pric- level-3 assets under the FAS carry. Thus, the calculation of of emerging risk, risks that ing practice is necessary for 157 hierarchy). pre-shock NPV capital - an might otherwise go unde- prudent balance sheet manage- It is important to note that estimate of market value (note: tected. As pointed out by the ment and enterprise risk gov- the OTS generally expects the not market capitalization) - is Senior Supervisors Group ernance. This is especially true principle of conservatism to critical to assessing the overall (SSG) March 6, 2008 report: in a market environment that is apply to values used to calibrate level of interest rate risk at an traditionally somewhat short- pre-shock NPV, especially for institution. “The ability to capture evolv- sited in rewarding short-term level-3 assets such as MSRs OTS has long advocated ing market conditions in risk accrual (i.e., “accounting”) and other complex instruments the use of a market-based ap- measures can provide early- earnings. Given that risk mani- with unobservable valuation proach when calculating pre- warning indicators that prompt fests through time and accrual inputs and no active market. shock NPV capital, regardless management to review a firm’s income and various accounting This is not to imply that OTS and without consideration of risk profile.”4 gains are often more immediate, expects arbitrarily conservative U.S. GAAP accounting con- banks need measures of eco- adjustments to fair value esti- vention. In other words, all The SSG also observed nomic value - not just perform- mates; rather, that when deter- values used in the calibration that banks with a consistent ance - in order to bring longer- mining value for more complex, of an interest rate risk model application of valuation princi- term risk-taking into proper illiquid instruments the institu- should be based on observed ples across their organizations focus. In fact, firms with strong tion’s risk management is ad- market prices whenever feasi- performed better, avoided crip- valuation disciplines may have vised to err on the side of con- ble. Where market pricing is pling losses, and created a been less damaged by market servatism rather than optimism. healthy level of skepticism for turbulence than others. Re- This also ties into emerging not available, a rigorous, docu- more illiquid and complex cently, in fact, some firms have standards in Europe where both mented, and disciplined proc- products. In particular, these considered dropping out of the CEBS and the recently formed ess should be in place to create companies were more aware of Institute of International Fi- International Accounting Stan- reasonable approximations of the fragility of some of the nance (IIF) over this very issue, dards (IAS) Board expert task asset and liability value. The Agency ratings for more com- with the IIF petitioning regula- force on valuation are consider- ultimate objective is to create a plex structures, tracked and tors, members of Congress, and ing how liquidity and model fair estimate of market value understood underwriting and others to alter fair value ac- risk (i.e., uncertainty) may or for an institution’s assets and concomitant valuation concerns counting rules and move the may not be used to ascertain, liabilities - without regard to in some of the more innovative industry back toward an histori- document, and disclose fair accounting and regulatory affordability products, and cal cost-based approach for value (or a range of fair value capital rules, which can some- tended to move in advance of various instruments. (s)). In periods of stress, OTS times bias or distort estimates While moving backward expects that the rigor and gov- 4 See page p. 15 of the Senior Supervisors of value. This approach can Group (SSG) report entitled, “Observations on does not seem the right direc- and often does differ from Risk Management Practices During the Recent tion, it is clear that valuation (Continued on page 4) Market Turbulence”.

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Valuation Challenges, Regulation, and Evolving Standards of Practice (continued) ernance of internal pricing and is important to realize that the preemptively to reduce exposure books of business. As noted else- valuation processes to increase, pre-shock NPV capital ratio on and where senior management where in this article, firms that and that banks will continue to your bank’s Interest Rate Risk has not established risk toler- apply a rigorous valuation disci- apply concerted effort to deter- Exposure report may be over- ances on the range of valuation pline, not just an “earnings” (i.e., mine, use, and report the fair value stated. As such, we caution you uncertainty arising from credit P&L) discipline, have typically of assets and liabilities, even when against using such estimates for spread volatility (i.e., basis risk), fared better through the recent such value must be estimated internal accounting, risk assess- counterparty risk, and market turbulence. A solid valuation proc- through the use of models. ment, or public disclosure pur- illiquidity factors. Unfortunately, ess provides important signaling to senior management and requires a poses. early indications suggest that Calculating the Pre-Shock NPV far more robust appreciation for many institutions may need to product complexities and market Capital Ratio in the OTS’s OTS and the Use of Internal strengthen their practices in the NPV Model issues than simple “yield-cost- Models area of valuation. spread” perspectives. Cash flow In order to measure a bank’s Pursuant to TB13a, institu- The following are a variety interest rate risk each quarter, the modeling of instrument character- tions with total assets in excess of sound principles that banks are istics is the preferred method for OTS uses hundreds of market- of $1.0 billion are required to encouraged to consider in an based interest rates and price valuation, and OTS naturally shuns possess an internal interest rate effort to improve their internal the use of short-cut approaches to quotes, and calibrates and applies risk model. Banks with assets valuation processes. These prac- valuation that do not properly con- sophisticated term-structure and under this threshold should like- tices are by no means all inclu- sider instrument-level cash flows option-adjusted spread (OAS) wise have their own in-house sive and result from observed (e.g., copula-based approaches to risk models to a bank’s reported model depending on the com- weaknesses at a variety of banks pricing credit risk in structured position. However, given the plexity and materiality of risk made during the course of several investments). Senior management level of aggregation used within exposure. In all cases, OTS en- recent OTS examinations, where must ensure that sufficient funding the OTS reporting vehicle (i.e., courages the use of rigorous OTS examiners have looked is provided to encourage and sup- Schedule CMR), the difficulty in valuation and risk technologies closely at banks’ internal valua- port “price discovery” by groups changing official reporting proc- when and where appropriate. tion models, practices, and con- that heretofore may not have had a esses, and data collection require- With an internal system, the limi- trols. central role in valuation (e.g., ALM and treasury groups). This may ments - as well as the natural tations of the OTS NPV Model require staffing the group(s) with limitations of a model designed • Senior management, inter- discussed above are not a con- additional experience, particularly to handle hundreds of banks - we nal/external audit, and risk straint, and banks often can mod- around specialized products (e.g., are forced to assume that all management should seek to ify their model to capture credit- structure) and credit-sensitive in- mortgages reported on Schedule improve the valuation disci- spread and liquidity risks. Ac- struments (e.g., private-label; syn- CMR are highly liquid instru- pline and practice across the cordingly, we expect institutions dications; CRE; CMBS). Such a ments with low credit-risk (e.g., entire banking book, regard- that have implemented internal process may also entail enhancing conventional, prime-based less of accounting classifica- models to apply the appropriate the alignment of treasury and risk loans), an assumption of question levels of stratification necessary functions such that these groups tionable merit in the current envi- to accurately measure risk expo- are able to incorporate information Consistent with prior OTS ronment. Said differently, the sure and to use benchmark values from all businesses in risk pricing guidance (i.e., TB-13a), the OTS production NPV model (e.g., FTP), valuation, and balance that - whenever feasible - are Agency expects banks to apply a does not adequately capture based on observable prices and sheet risk control. As noted by the 5 market-based approach toward the credit risk . Therefore, recent SSG: orderly market-transactions, even estimation of base-case pre-shock market disruptions in pricing and if market volume is at or near net portfolio value. That is, for valuation have not been suffi- “…[successful firms] created historic lows. While prices stem- banks that are required to use inter- ciently captured in the OTS NPV internal pricing mechanisms that ming from distressed sales or nal models – either due to size or model since Agency TBA pricing provided incentives for individual forced liquidation may not be complexity – there is no difference – at least so far - has remained business lines to control activities viewed as valid exit prices, the for OTS as to the integrity of that might otherwise lead to sig- fairly stable. existence of historically low pric- valuation discipline that should be nificant balance sheet growth or As a result of these simplify- applied to banking versus trading ing is not necessarily evidence of unexpected declines in capital.” ing assumptions, if your institu- books. While practically speaking a distressed market, and therefore tion’s loan portfolio contains - and given the daily P&L impact cannot be ignored. Both the SSG and CEBS note non-agency eligible instruments of trading exposure - the internal that the independence, scope, and (e.g., jumbo, Alt-A, and sub- “risk governance” and Current Industry Practice quality of valuation processes are prime loans), non-traditional, “management” may be dramati- Good valuation practice can critical, and that sufficient re- credit-sensitive instruments (e.g., cally different across these lines of have implications in periods of sources should be applied to sup- option ARMs, Flex-Pay loans), business, the OTS expects banks to market stress on a firm’s finan- port model approval, review, price apply similar integrity to or is concentrated in illiquid cial position, particularly where verification, and stress testing. “valuation” processes across these level-3 assets (such as MSRs), it risk management has not acted

5 Historically, the intersection of market and credit risk wasn’t as pronounced as in today’s “originate-to-distribute” model of financial risk management. As a result of industry advancements, OTS • Banks should create is in the process of testing models that do, in fact, jointly capture market and credit risk. In these beta-test models, which we would ultimately like to roll-out to the industry, we are able to jointly (Continued on page 5) model prepayments and default in a competing risk framework. Banks interested in these test models may contact their OTS Regional Capital Markets Specialists for more information.

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Valuation Challenges, Regulation, and Evolving Standards of Practice (continued)

(Continued from page 4) parency and senior management factors, the frequency of their meaningless. OTS also noted the “market-sensitive” (i.e., risk involvement is echoed in the SSG update(s), and the transparency importance of data management, sensitive) escalation proc- report: regarding their impact was often error-checking, and control. In esses for valuation results lacking. Also, the rigor with one particular instance, sub-prime and risk control, including “…[senior managers] did not which these factor adjustments loans were mapped to the wrong more frequent reporting to rely on the hope that business would occur on HFI and HTM cohort resulting in a significant senior management lines would make decisions indi- portfolios was often much lower over-estimation of value. Banks vidually that would benefit the than the rigor applied to AFS and should ensure that the manner in Successful firms had a proc- firms exposure collec- trading portfolios. OTS expecta- which values are applied to bank- ess in place that required en- tively.” [emphasis added] tion is that banks will be rigorous ing book assets and liabilities are hanced frequency of senior level in estimating such factors regard- reasonable and that the number of reporting to discuss valuation By aggressively monitoring less of accounting classification. price points used in the process problems – actual and anticipated the balance sheet and enterprise Banks should ensure that valua- are granular enough to fairly rep- - and other issues as the markets risks, the bank’s senior manage- tion processes are applied consis- resent aggregate portfolio risks. became more volatile. Successful ment was often able to respond in tently and on a timely basis. Key valuation considerations, firms fostered a culture of a more thoughtful and disciplined When market events require more such as vintage, loan-to-value, “debate-and-confirm” such that fashion to investors and rating frequent updates, or changes to FICO, and geography, must be internal constituents could chal- agencies, and usually had good internal processes and models, considered when defining pricing lenge valuations across various valuation and risk reports at hand OTS expects the firm to have cohorts. There should also be lines of business. In one case, in order to answer questions. control processes and governance sufficient rigor applied to ensure senior managers received a daily Having a control process that is architectures in place, including that reported results are sensible, “market signal” report that high- quick to recognize market signals, policies, that will address the and that data quality and integrity lighted areas of elevated risk, when combined with an internal bank’s approach and internal has been maintained throughout along with narrative from line-of- valuation process that is also management expectations. the modeling process. business (LOB) risk managers as tightly coupled with market risk to major concerns and issues re- pricing/valuation, results in a • Risk managers and portfolio • Valuation staff and risk lated to their portfolio’s value and more accurate and timely re- modeling and valuation managers should ensure risks. This report opened needed sponse to emerging issues. groups must ensure suffi- that internal valuation proc- transparency across various lines cient granularity and rea- esses are not over-reliant on of business and allowed for chal- sonable segmentation of “one source” of informa- lenges to be made across other- • Bank risk management pricing cohorts tion, or one methodology, wise silo’d portfolios and risk should ensure that all criti- when generating estimated groups. LOBs with elevated risk, cal risk factors impacting Given the size of many port- values and pricing due perhaps to a spike in inter- valuations are updated on a folios, it is often the case that bank funding spreads, were asked timely and regular basis, matrix and cohort pricing is ap- Many firms that had invested to estimate market pricing and both for banking and trad- plied. This is especially true in super-senior CDS positions other market action on a more ing book positions. These within the banking book. In some were overly reliant on one-model frequent basis. Often senior man- updates should reflect cur- cases, OTS examiners have ob- and, often, one or few sources of agers would convene more fre- rent market conditions served a lack of granularity to the input data for generating valuation quent meetings as market events cohorts being used. Firms used estimates. In some cases, the unfolded and discuss emerging On some reviews, we noted only a handful of bonds or other firms had to quickly switch from issues and impact to the loan that banks were using broker- traded instruments (i.e., loans) to one modeling paradigm to an- warehouse, pricing disputes on quotes and consensus pricing represent base-case values for all other, often without sufficient the collateral desk, and abrupt services as starting points for balance sheet products. In other review of results. In hind-site, it changes to risk spreads in secon- estimating value. While certain circumstances, critical elements is clear that firms should have dary market trading for mortgage questions exist relating to the required for the proper segmenta- contingency plans for models bonds and loans that were of simi- acceptable nature of some of these tion of cohorts were missing. For such that the firm is more adap- lar nature to those carried on- quotes6, most firms understood example, vintage (i.e., year of tive to disruptions in the market. balance sheet. Senior manage- these weaknesses and would at- origination) is a critical factor This may mean having a “bench” ment viewed values and market tempt to modify these price when pricing mortgage and other of models that can be applied to a movements as being inter-twined quotes to consider contractual and credit-sensitive product. In some portfolio, position, or transaction. and recognized that equity and product features unique to the cases, internal pricing models Such contingency can also sup- debt investors, and the official underlying positions. In many failed to consider vintage. In port valuation benchmarking and sector, would use these signals to cases, the banks would do a rea- other examples, the number of enhance model risk measurement infer asset, capital, and earnings sonable job creating the adjust- pricing cohorts was so small as to and control. During the turbu- quality at their bank. This prac- ment factors; however, the inter- render the application of the lence, several firms were over- tice of internal discussion, trans- nal control and review of these valuation process somewhat reliant on inputs that depended on

6 The CEBS paper, referred to elsewhere in this article, points out that under FAS 157 and IAS 39, additional guidance is needed to ascertain whether, in fact, a broker quote (usually an liquid markets and/or the origina- indication) is sufficient to comply with the accounting requirement of an “active market”. The same question applies to consensus pricing services. Determination of “active market” likely (Continued on page 6) includes consideration of spreads, volumes, number of counterparties, two-way prices, and other factors.

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Valuation Challenges, Regulation, and Evolving Standards of Practice (continued)

(Continued from page 5) lem suggested.” TB13a contains Management contained in Appen- tion of new product for “proxy” quantitative guidelines for assess- dix B of TB13a. We also encour- pricing. Such process weaknesses ing the level of interest rate risk. age you to read the Senior Super- should normally be picked-up in But we have long stressed to OTS visors Group’s publication on new product approval processes; examiners that blind adherence to lessons learned during this period however, this is an area that – like these guidelines is not desirable. of turbulence, and believe that valuation – needs further enhance- Rather they should be viewed as a those interested in valuation- ment. Many new product ap- starting point for the assessment related issues will benefit by proval processes are “awareness” process. studying the Committee of Euro- exercises rather than risk manage- pean Banking Supervisors report ment exercises. A lesson learned on valuation practices. is that effective new product ap- Conclusion If you have any questions, proval processes should include In the end, we expect exam- please contact us or your regional instrument complexity, market iners to exercise judgment when capital market specialist noted on liquidity, and model contingency assigning an “S” rating, and con- the bottom of your institution’s planning within its scope, espe- sideration of valuation accuracy is Interest Rate Risk Exposure Re- cially for complex and new instru- a key element of this judgment. port – Executive Summary. ments with little trading history. This includes undertaking a com- prehensive review of the quality Sensitivity of Ratings in the of your bank’s pricing and interest - by Scott Ciardi and Thomas Current Environment rate risk management practices. Day While it is easy for us to As such, we strongly encourage ۞ opine on various sound practices you to review the guidelines for and lessons learned, we do want Sound Practices for Market Risk to convey that we recognize and Table-1 appreciate the difficulty of finding the appropriate benchmark prices during this period of market disruption. But for reasons we have outlined above, we believe that the pre-shock NPV capital ratio is a critically important internal and supervisory metric, for purposes of IRR certainly, but also as a measure of capital adequacy and – performed properly – as a ba- rometer for inherent and expected credit risk. We believe all banks should have a disciplined approach toward valuation and believe that a market-based approach, although imperfect, is better than the alternative (i.e., historical cost-basis). Keep in mind, however that although the existence of a low pre-and post-shock NPV capital ratio may be cause for supervisory concern, it may not necessarily indicate an interest rate risk prob- lem. Instead, a low pre- and post- shock NPV capital ratio may be indicative of a capital adequacy, asset quality, or earnings issue. As noted in TB13a, “only when an institution’s low Post-shock Ratio is, in whole or in part, caused by high interest rate sensitivity is an interest rate risk prob-

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First Quarter Sees Continued Sensitivity Decline (continued)

(Continued from page 1) creases in delinquency rates the first quarter from 0.39 quarter from 2.46 percent in first quarter from 4.25 per- were in 1-4 family mort- percent in the prior quarter, the first quarter a year ago, cent at the December quarter gages and construction but was down from 0.51 but was down from 4.59 end. An additional rate cut loans, and these increases percent in the first quarter a percent in the fourth quarter. was made on April 30 with reflect the continued weak- year ago. Return on average Noninterest expense in the the federal funds target rate ness in the housing sector. equity (ROE) was a negative first quarter was higher due lowered to 2.00 percent. Capital measures for the 1.80 percent in the first to write-downs of goodwill Given the fact that most industry continue to be well quarter, up from a negative by several large thrifts. Gen- OTS-regulated banks are in excess of minimum regu- 23.48 percent in the fourth eral and administrative ex- liability-sensitive (meaning latory requirements. Equity quarter, but down from 9.35 pense, the largest compo- that they fund longer term capital at the end of the first percent in the first quarter a nent of noninterest expense, assets with shorter term ma- quarter was 9.05 percent of year ago. increased 26 basis points to turities), the interest rate assets, down from 10.70 In the first quarter, the 2.66 percent of average as- changes that occurred dur- percent year-over year, and net interest margin increased sets in the first quarter from ing the quarter improved the from 9.26 percent in the to 276 basis points from 261 2.40 percent in the compara- interest rate risk profile of prior quarter. At the end of basis points in the fourth ble year ago quarter. the typical thrift. Lower the first quarter, only three quarter, but was down from Thrifts remain focused interest rates typically in- thrifts were less than ade- 277 basis points in the com- on residential mortgage crease the value of fixed rate quately capitalized from a parable quarter a year ago. lending, with 49.4 percent of mortgage loans and trigger a regulatory standpoint. Keep Loan loss provisions in- assets invested in 1-4 family corresponding increase in in mind, however, regula- creased to 2.01 percent of mortgage loans at the end of preshock capital. tory capital does not neces- average assets in the first the first quarter, down from First quarter results for sarily reflect mark-to-market quarter from 1.44 percent in 51.8 percent one year ago. the nation’s thrift industry values on assets and liabili- the fourth quarter and from Of these 1-4 family mort- improved from the results of ties. 0.33 percent in the first gage loans, 7.8 percent are the fourth quarter, but the Net losses in the first quarter a year ago. The re- home equity lines of credit, continued housing market quarter were $617 million, cent increases in loss provi- up from 6.2 percent one year downturn resulted in losses an improvement from net sions reflect the increase in ago. Holdings of consumer in earnings and profitability, losses of $8.75 billion in the non-current loans stemming loans decreased to 5.6 per- and declining asset quality fourth quarter, but down from the housing market cent of assets from 5.9 per- measures throughout the from net income of $3.61 downturn and the deteriora- cent a year ago, and multi- first quarter of 2008. Dur- billion in the first quarter tion of loans originated in family mortgages decreased ing the first quarter, thrifts one year ago. Last quarter the past several years. over the year from 4.3 per- set aside a record $7.6 bil- was the first quarterly loss Total fee income, in- cent of assets to 4.2 percent lion in loan loss provisions, reported by the thrift indus- cluding mortgage loan ser- at the end of the first quar- or 2.01 percent of average try since a special assess- vicing fee income and other ter. Commercial loans in- assets. That was up from ment was collected in the fee income, was unchanged creased to 4.0 percent of 1.44 percent ($5.5 billion) in third quarter 1996 for the in the first quarter from the assets at the end of the first the previous quarter and Savings Association Insur- comparable year ago quarter quarter from 3.5 percent one 0.33 percent ($1.2 billion) in ance Fund. Higher loan loss at 1.11 percent of average year ago. the first quarter one year provisions drove the losses assets, but was down from Total thrift industry ago. in the first quarter. 1.15 percent in the fourth mortgage originations Troubled assets (non- Profitability, as meas- quarter. Other noninterest (which include multifamily current loans and repos- ured by return on average income was 0.60 percent of and nonresidential mort- sessed assets) were 2.06 assets (ROA), was a nega- average assets in the first gages) were $133.7 billion percent of assets, up from tive 0.16 percent in the first quarter, up from a negative in the first quarter, down 21 1.66 percent in the fourth quarter, an improvement 0.51 percent in the fourth percent from $169.2 billion quarter and 0.80 percent a from a negative 2.31 percent quarter and from 0.39 per- in the first quarter a year ago year ago. Delinquencies for in the fourth quarter, but cent in the first quarter a and down 20 percent from most loan types increased down from 0.97 percent in year ago. $166.6 billion in the prior over the past year and con- the comparable year ago Noninterest expense quarter. tinued to rise in the first quarter. The median ROA increased to 2.77 percent of An estimated ten per- quarter. The largest in- increased to 0.43 percent in average assets in the first (Continued on page 8)

Page 8 The Quarterly Review of Interest Rate Risk

Interest Rates and ARM Market Share

Interest Rates CMT Yield Curves

Maturity in Months 12 24 60 120 360 6.5 4.75

4.25 5.5 30 Year Mortgage 3.75

4.5 3.25 10 Year CMT

Percent 2.75 Percent 3.5 2.25

2.5 1.75 1 Year CMT 1.25 1.5 Maturity Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 September 30, 2007 December 30, 2007 March 31, 2008

ARM Market Share of Originations ARM Share of Thrift Mortgage Portfolios

50% 65%

45% 64% 40%

35% Thrifts 63% 30%

25% 62% ARM Portfolio Percentage Percent 20% Percent 61% 15% All Lenders

10% 60% 5%

0% 59% Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08

First Quarter Sees Continued Sensitivity Decline (continued)

(Continued from page 7) The volume of mortgage Deposits and escrows fell ter improved the interest rate cent of thrift originations refinancing, as a percentage by four percent over the year risk profile of the typical were ARMs in the first quarter, of total originations, remained to $913 billion from $953 thrift. Lower interest rates down from 12 percent in the strong in the first quarter as billion. As a percentage of typically increase the value of comparable year ago quarter, borrowers converted adjust- total assets, deposits and es- fixed rate mortgage loans and but up from nine percent in able rate mortgages to fixed crows decreased to 60.3 per- trigger a corresponding in- the prior quarter. The ARM rate mortgages. Refinancing cent from 64.0 percent one crease in preshock capital. share for all lenders was esti- activity accounted for 50 per- year ago. Federal Home Loan Similarly, lower mortgage mated at eight percent in the cent of thrift originations in Bank advances were up from rates increased the likelihood first quarter, eight percent in the first quarter, up from 48 14.2 percent one year ago to of refinance-driven mortgage the prior quarter, and 11 per- percent in the prior quarter, 20.4 percent of total assets. prepayments which decreased cent in the first quarter one but down from 52 percent in The interest rate changes the effective duration of most year ago. the first quarter a year ago. that occurred during the quar- (Continued on page 9)

PageVolume 9 12, Issue 4 The Quarterly Review of Interest RatePage Risk 9

Duration and NPV Sensitivity Measures

Median Effective Duration Gap Median Pre- and Post-Shock NPV Ratios

0.9 14.0

0.8 13.5

0.7 13.0 Pre-Shock 0.6

12.5 0.5 Median

0.4 Percent 12.0 Post-Shock Duration Gap Duration 0.3 11.5 0.2 11.0 0.1

0.0 10.5 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08

Estimated Change in NPV: Estimated Change in NPV: +200bp Rate Change -100bp Rate Change

480 300 271

239 400 Lose NPV Gain NPV Lose NPV Gain NPV 200 300 254 Number Number 110 200 100 100

100 22 18 17 8 12 3 2 0 0 0 <-40% -40 to -30% -30 to -20% -20 to -10% -10 to 0% 0 to 10% >10% <-10% -10 to 0% 0 to 10% 10 to 20% 20 to 30 30 to 40% >40%

First Quarter Sees Continued Sensitivity Decline (continued)

(Continued from page 8) casting. 17 basis points. The decline the first quarter. The decline fixed and adjustable rate First-quarter median in- in pre-shock NPV was influ- in the duration of assets was mortgages relative to last terest rate sensitivity fell to enced by a decline in the eq- caused by the decrease in quarter. The drop in effective 110 basis points, down from uity capital ratio at thrifts. interest rates, which increased duration of assets, in turn, led 144 basis points in the prior The number of thrifts with estimated prepayment speeds. to an industry wide decrease quarter. The median pre- post-shock NPV ratios below The first quarter saw the in- in sensitivity. It should be shock Net Portfolio Value 4.0 percent increased from dustry’s median effective noted that current prepayment (NPV) ratio fell in the first four to nine institutions. duration of liabilities increase speeds may not be as high as quarter by approximately 61 The industry’s median from 1.28 to 1.40. The de- past experience has shown or basis points while the median effective duration of assets crease in the effective dura- as high as our model is fore- post-shock ratio declined by declined from 1.61 to 1.55 in (Continued on page 10)

Page 10 The Quarterly Review of Interest Rate Risk

Interest Rate Risk Measures

Thrifts with Post-Shock NPV Ratios Interest Rate Risk Measures Under 4 Percent Industry Aggregates Last Two Quarters

11 10 NPV as % of PV of % Change % Change 9 9 9 Assets in NPV in NPV 8 7 Dec-07 Mar-08 Dec-07 Mar-08 7 6 6 +300 8.83% 7.97% -21% -19% 5 5 4 4 +200 9.70% 8.68% -12% -11% Number 4 3 3 +100 10.38% 9.21% -4% -4% 3 2 Base 10.76% 9.54% 0% 0% 1 -100 10.88% 9.65% 2% 2% 0 -200 10.80% 2% Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08

Post-Shock NPV Ratio and Post-Shock NPV Ratio and Sensitivity Measure Matrix Sensitivity Measure Matrix March 2008 December 2007

Under 101- 201- Over Under 101- 201- Over Total Total 100bp 200bp 400bp 400bp 100bp 200bp 400bp 400bp Over Over 246 139 96 7 488 188 174 141 11 514 10% 10% 6% to 6% to 102 90 52 2 246 54 90 84 4 232 10% 10% 4% to 4% to 8116 0 25 4551 15 6% 6% Below Below 22329 01214 4% 4% Total 358 242 157 11 768 Total 246 270 232 17 765

Minimal Moderate Significant High Minimal Moderate Significant High

First Quarter Sees Continued Sensitivity Decline (continued)

(Continued from page 9) of net portfolio value if rates would gain two percent if five thrifts (0.65 percent) a tion of assets coupled with the rose by 200 basis points and rates fell by 100 basis points. high rating in the first quarter. increase in the duration of approximately 65 percent of Based on TB 13a guid- The number of thrifts with liabilities resulted in a de- thrifts would experience an ance for the “S” rating for significant or high interest crease in the duration gap for increase in net portfolio value those institutions that submit- rate slightly increased from the thrift industry in the first should rates fall 100 basis ted scheduled CMR, 681 14 in the fourth quarter to 15 quarter from 0.31 to 0.14. points. The NPV model esti- thrifts (88.7 percent) initially in the first quarter. Of the thrifts that submit- mated that the thrift industry would be assigned a minimal ted Schedule CMR data in the would lose 11 percent of its interest rate risk rating, 72 first quarter, the NPV model net portfolio value if rates thrifts (9.4 percent) a moder- estimated that about 85 per- rose by 200 basis points in the ate rating, ten thrifts (1.3 percent would experience a loss first quarter, and the industry cent) a significant rating, and

PageVolume 11 12, Issue 4 The Quarterly Review of Interest RatePage Risk 11

Comparative Trends in the Five OTS Regions

Median Sensitivity by OTS Region Median Assets Duration by OTS Region

300 2.6

2.4 250 2.2

200 2 1.8

150 1.6 Basis Points Basis

Effective Duration Effective 1.4 100 1.2

50 1 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08

All Thrifts Northeast Southeast Central Midwest West All Thrifts Northeast Southeast Central Midwest West

Median Pre-Shock NPV Ratio by OTS Region Median Post-Shock NPV Ratio by OTS Region

15 13

14 12

13 11 Percent Percent

12 10

11 9 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08

All Thrifts Northeast Southeast Central Midwes t West All Thrifts Northeast Southeast Central Midwest West

Regional Comparisons

At the end of the first tivity falling the most (46 The Central Region had est, at 1.39, at quarter end. quarter, the Northeast Region basis points) and the Central the highest median post- The Southeast Region had the highest median sensi- Region’s sensitivity falling shock NPV ratio, at 11.79 had the lowest median liabil- tivity at 171 basis points, the least (23 basis points). percent, while the West Re- ity duration, at 1.23, while the while the Midwest Region The Northeast Region gion had the lowest, at 10.75 Northeast Region had the had the lowest median sensi- had the highest median pre- percent. highest, at 1.55.■ tivity at 66 basis points. shock NPV ratio at 12.99 The Northeast Region All five regions saw their percent. The Midwest Re- had the highest median asset median sensitivities fall, with gions had the lowest pre- duration, at 1.87, while the the Southeast Region’s sensi- shock NPV ratio at 11.66%. Midwest Region had the low-

Page 12 The Quarterly Review of Interest Rate Risk

Appendix A — All Thrifts

Sensitivity Measure Distribution

All Thrifts Descriptive Statistics Percent of Thrifts 18 Median = 110 Mean = 132 Standard Deviation = 102 Skewness = 1.38 Kurtosis = 3.42 12 Maximum = 793.794 Minimum = 0 Count = 768

0 0 33 66 100 133 166 200 233 266 300 333 366 400 433 466 500 533 More Basis Points

Pre-Shock NPV Ratio Distribution Post-Shock NPV Distribution All Thrifts All Thrifts Percent of Thrifts Percent of Thrifts 20 20 Descriptive Statistics Descriptive Statistics Median = 11.35 Median = 12.41 Mean = 13.48 Mean = 14.8 15 15 Standard Deviation = 9.49 Standard Deviation = 9.47 Skewness = 4.83 Skewness = 4.73 Kurtosis = 31.71 Kurtosis = 30.54 Maximum = 94.575 Maximum = 94.855 10 Minimum = 0.902 10 Minimum = 1.466 Count = 768 Count = 768

5 5

0 0 3 6 9 121518212427 5 8 11 14 17 20 23 26 29 NPV Ratio (Percent) NPV Ratio (Percent)

Asset Duration Distribution Liabilities Duration Distribution All Thrifts All Thrifts Percent of Thrifts Percent of Thrifts 20 20

Descriptive Statistics Descriptive Statistics Median = 1.4 Median = 1.55 Mean = 1.4 15 Mean = 1.58 Standard Deviation = 0.45 Standard Deviation = 0.6 Skewness = 0.46 Skewness = -0.05 Kurtosis = 2.62 Kurtosis = 3.23 Maximum = 3.961 10 Maximum = 3.853 10 Minimum = 0.007 Minimum = -2.576 Count = 768 Count = 768

0 0 -0.25 0.25 0.75 1.25 1.75 2.25 2.75 3.25 3.75 4.25 More 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 More Duration Duration

PageVolume 13 12, Issue 4 The Quarterly Review of Interest RatePage Risk 13

Appendix B — Northeast Region

Sensitivity Measure Distribution Northeast Percent of Thrifts Descriptive Statistics 18 Median = 171 Mean = 177 Standard Deviation = 99 Skewness = 0.93 12 Kurtosis = 2.32 Maximum = 660.133 Minimum = 5.068 Count = 168 6

0 0 33 66 100 133 166 200 233 266 300 333 366 400 433 466 500 533 More Basis Points

Pre-Shock NPV Ratio Distribution Post-Shock NPV Distribution Northeast Northeast Percent of Thrifts Percent of Thrifts 20 20 Descriptive Statistics Descriptive Statistics Median = 12.99 Median = 11.45 Mean = 14.52 Mean = 12.75 15 Standard Deviation = 6 15 Standard Deviation = 6.17 Skewness = 1.78 Skewness = 1.58 Kurtosis = 4.98 Kurtosis = 3.93 Maximum = 45.835 Maximum = 43.128 Minimum = 5.222 10 Minimum = 1.615 10 Count = 168 Count = 168

5 5

0 0 3 6 9 121518212427 5 8 11 14 17 20 23 26 29 NPV Ratio (Percent) NPV Ratio (Percent)

Asset Duration Distribution Liabilities Duration Distribution Northeast Northeast Percent of Thrifts Percent of Thrifts Descriptive Statistics 20 20 Median = 1.87 Descriptive Statistics Mean = 1.84 Median = 1.55 Standard Deviation = 0.6 Mean = 1.56 Skewness = -0.44 15 Standard Deviation = 0.45 Kurtosis = 1.01 Skewness = 1.16 Maximum = 3.607 Kurtosis = 5.37 Minimum = -0.464 Maximum = 3.961 Count = 168 10 10 Minimum = 0.163 Count = 168

0 0 -0.25 0.25 0.75 1.25 1.75 2.25 2.75 3.25 3.75 4.25 More 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 More Duration Duration

PageVolume 14 12, Issue 4 The Quarterly Review of Interest RatePage Risk 14

Appendix C — Southeast Region

Sensitivity Measure Distribution Southeast

18 Percent of Thrifts Descriptive Statistics Median = 93 Mean = 121 Standard Deviation = 99 Skewness = 1.34 12 Kurtosis = 2 Maximum = 570.496 Minimum = 4.105 Count = 187 6

0 0 33 66 100 133 166 200 233 266 300 333 366 400 433 466 500 533 More Basis Points

Pre-Shock NPV Ratio Distribution Post-Shock NPV Distribution Southeast Southeast Percent of Thrifts Percent of Thrifts 20 20 Descriptive Statistics Descriptive Statistics Median = 12.16 Median = 11.21 Mean = 14.7 Mean = 13.48 15 Standard Deviation = 8.67 15 Standard Deviation = 8.61 Skewness = 3.96 Skewness = 4.09 Kurtosis = 24.19 Kurtosis = 25.46 Maximum = 80.675 Maximum = 80.056 10 Minimum = 4.82 10 Minimum = 4.058 Count = 187 Count = 187

5 5

0 0 5 8 11 14 17 20 23 26 29 3 6 9 121518212427 NPV Ratio (Percent) NPV Ratio (Percent)

Asset Duration Distribution Liabilities Duration Distribution Southeast Southeast Percent of Thrifts Percent of Thrifts 20 Descriptive Statistics 20

Median = 1.43 Descriptive Statistics Mean = 1.45 Median = 1.23 Standard Deviation = 0.52 Mean = 1.26 15 Skewness = 0.51 Standard Deviation = 0.45 Kurtosis = -0.15 Skewness = 0.28 Maximum = 2.832 Kurtosis = 0.57 Minimum = 0.463 Maximum = 2.512 10 10 Count = 187 Minimum = 0.035 Count = 187

0 0 -0.25 0.25 0.75 1.25 1.75 2.25 2.75 3.25 3.75 4.25 More 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 More Duration Duration

PageVolume 15 12, Issue 4 The Quarterly Review of Interest RatePage Risk 15

Appendix D — Central Region

Sensitivity Measure Distribution Central Percent of Thrifts Descriptive Statistics 18 Median = 118 Mean = 133 Standard Deviation = 102 Skewness = 2.07 12 Kurtosis = 8.81 Maximum = 793.794 Minimum = 11.027 Count = 187

0 0 33 66 100 133 166 200 233 266 300 333 366 400 433 466 500 533 More Basis Points

Pre-Shock NPV Ratio Distribution Post-Shock NPV Distribution Central Central

Percent of Thrifts Percent of Thrifts Descriptive Statistics 20 20 Descriptive Statistics Median = 11.79 Median = 12.98 Mean = 13.91 Mean = 15.25 Standard Deviation = 9.83 15 15 Standard Deviation = 9.8 Skewness = 5.1 Skewness = 5.01 Kurtosis = 35.14 Kurtosis = 34.13 Maximum = 89.543 Maximum = 89.974 Minimum = 0.902 10 10 Minimum = 2.523 Count = 187 Count = 187

5 5

0 0 3 6 9 121518212427 5 8 11 14 17 20 23 26 29 NPV Ratio (Percent) NPV Ratio (Percent)

Asset Duration Distribution Liabilities Duration Distribution Central Central Percent of Thrifts Descriptive Statistics 20 Percent of Thrifts 20 Median = 1.58 Descriptive Statistics Mean = 1.63 Median = 1.4 Standard Deviation = 0.57 Mean = 1.42 15 Skewness = 0.7 Standard Deviation = 0.41 Kurtosis = 1.79 Skewness = 0.07 Maximum = 3.853 Kurtosis = 2.33 Minimum = 0.249 Maximum = 3.045 10 Count = 187 10 Minimum = 0.007 Count = 187

0 0 -0.25 0.25 0.75 1.25 1.75 2.25 2.75 3.25 3.75 4.25 More 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 More Duration Duration

VolumePageVolume 16 12, 12, Issue Issue 4 4 The Quarterly Review of Interest RatePage Risk 16

Appendix E — Midwest Region

Sensitivity Measure Distribution Midwest Percent of Thrifts 18 Descriptive Statistics Median = 66 Mean = 101 Standard Deviation = 91 12 Skewness = 1.53 Kurtosis = 2.69 Maximum = 509.196 Minimum = 0 Count = 162 6

0 0 33 66 100 133 166 200 233 266 300 333 366 400 433 466 500 533 More Basis Points

Pre-Shock NPV Ratio Distribution Post-Shock NPV Distribution Midwest Midwest Percent of Thrifts Percent of Thrifts 20 20 Descriptive Statistics Descriptive Statistics Median = 10.89 Median = 11.66 Mean = 13.7 Mean = 14.7 Standard Deviation = 11.14 15 15 Standard Deviation = 11.19 Skewness = 5.36 Skewness = 5.18 Kurtosis = 33.09 Kurtosis = 31.3 Maximum = 94.575 Maximum = 94.855 Minimum = 3.835 10 Minimum = 3.835 10 Count = 162 Count = 162

5 5

0 0 5 8 11 14 17 20 23 26 29 3 6 9 121518212427 NPV Ratio (Percent) NPV Ratio (Percent)

Asset Duration Distribution Liabilities Duration Distribution Midwest Midwest Percent of Thrifts Percent of Thrifts 20 20 Descriptive Statistics Descriptive Statistics Median = 1.4 Median = 1.39 Mean = 1.41 Mean = 1.42 15 Standard Deviation = 0.43 Standard Deviation = 0.62 Skewness = 0.61 Skewness = -1.02 Kurtosis = 3.61 Kurtosis = 11.09 Maximum = 3.177 Maximum = 3.784 Minimum = 0.115 10 Minimum = -2.576 10 Count = 162 Count = 162

0 0 -0.250.250.751.251.752.252.753.253.754.25More 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 More Duration Duration

PageVolume 17 12, Issue 4 The Quarterly Review of Interest RatePage Risk 17

Appendix F — West Region

Sensitivity Measure Distribution West Percent of Thrifts 18 Descriptive Statistics Median = 97 Mean = 124 Standard Deviation = 105 Skewness = 1.46 12 Kurtosis = 2.46 Maximum = 473.074 Minim um = 0 Count = 64 6

0 0 33 66 100 133 166 200 233 266 300 333 366 400 433 466 500 533 More Basis Points

Pre-Shock NPV Ratio Distribution Post-Shock NPV Distribution West West Percent of Thrifts Percent of Thrifts Descriptive Statistics 20 20 Descriptive Statistics Median = 10.75 Median = 11.92 Mean = 13.52 Mean = 14.76 Standard Deviation = 13.12 15 Skewness = 3.81 15 Standard Deviation = 13.05 Skewness = 3.73 Kurtosis = 15.29 Kurtosis = 14.88 Maximum = 78.86 Maximum = 79.562 Minimum = 1.466 10 Count = 64 10 Minimum = 1.466 Count = 64

5 5

0 0 3 6 9 12 15 18 21 24 27 5 8 11 14 17 20 23 26 29 NPV Ratio (Percent) NPV Ratio (Percent)

Asset Duration Distribution Liabilities Duration Distribution West West Percent of Thrifts 20 Percent of Thrifts Descriptive Statistics 20 Descriptive Statistics Median = 1.52 Mean = 1.5 Median = 1.39 Standard Deviation = 0.64 Mean = 1.34 15 Skewness = 0.34 Standard Deviation = 0.45 Kurtosis = 0.48 Skewness = 0.04 Maximum = 3.291 Kurtosis = -0.08 Minimum = 0.111 Maximum = 2.391 10 Count = 64 10 Minimum = 0.324 Count = 64

0 0 -0.25 0.25 0.75 1.25 1.75 2.25 2.75 3.25 3.75 4.25 More 0.25 0.5 0.75 1 1.25 1.5 1.75 2 2.25 2.5 More Duration Duration

VolumePageVolume 18 12, 12, Issue Issue 4 4 The Quarterly Review of Interest RatePage Risk 18

Glossary

Duration: A first-order approximation of the price sensitiv- NPV Model: Currently measures how five hypothetical ity of a financial instrument to changes in yield. The higher changes in interest rates (three successive 100 basis point NPV Model: Currently measures how five hypothetical the duration, the greater the instrument’s price sensitivity. For increases and two successive 100 basis point decreases ) af- changes in interest rates (three successive 100 basis point example, an asset with a duration of 1.6 would be predicted fect the estimated market value of a thrift’s net worth. increases and two successive 100 basis point decreases ) af- to appreciate in value by about 1.6 percent for a 1 percent fect the estimated market value of a thrift’s net worth. decline in yield. Post-Shock NPV Ratio: Equity-to-assets ratio, following an

adverse 200 basis point interest rate shock (assuming a nor- Post-Shock NPV Ratio: Equity-to-assets ratio, following an Effective Duration: The average rate of price change in a mal interest rate environment), expressed in present value adverse 200 basis point interest rate shock (assuming a nor- financial instrument over a given discrete range from the cur- terms (i.e., post-shock NPV divided by post-shock present mal interest rate environment), expressed in present value rent market interest rate (usually, +/-100 basis points). value of assets). Also referred to as the exposure ratio. terms (i.e., post-shock NPV divided by post-shock present value of assets). Also referred to as the exposure ratio. Estimated Change in NPV: The percentage change in base Pre-Shock NPV Ratio: Equity-to-assets expressed in present case NPV caused by an interest rate shock. value terms (i.e., base case NPV divided by base case present Pre-Shock NPV Ratio: Equity-to-assets expressed in present value of assets). value terms (i.e., base case NPV divided by base case present value of assets). Kurtosis: A statistical measure of the tendency of data to be distributed toward the tails, or ends, of the distribution. A Sensitivity Measure: The difference between Pre-shock and normal distribution has a kurtosis statistic of three. Post– shock NPV Ratios (expressed in basis points). Sensitivity Measure: The difference between Pre-shock and

Risk Modeling and Analysis Division

Scott Ciardi JeffJonathan Adams D. Jones DirectorScott Ciardi CapitalSenior Markets Financial Specialist Economist Phone:Director 202-906-6960 Phone:Phone: 202-906-6388202-906-5729 Email:Phone: [email protected] 202-906-6960 Email:Email: [email protected]@ots.treas.gov Email: [email protected] Tom Day TomHaranath Wilderman Chadive SeniorAndrew Capital CarayiannisMarkets Specialist CapitalI T Specialist, Markets NPVSpecialist Model Phone:Financial 202-906-7933 Analyst Phone:Phone: 202-906-6973202-906-6898 Email:Phone: [email protected] 202-906-6919 Email:Email: [email protected]@ots.treas.gov Email: [email protected] Andrew Carayiannis Haranath Chadive Financial Analyst I T Specialist, NPV Model Phone: 202-906-6919 Phone: 202-906-6898 Email: [email protected] Email: [email protected]

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