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The Quarterly Review of Interest Rate Risk

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The Quarterly Review of Interest Rate Risk The Quart erly Revi ew of Interest Rate Risk 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 valua- tion 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.
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