Managing Counterparty Credit Risk
Government Investment Of icers Association
Preconference Workshop March 26, 2014
Kellie C. Craine, CFA City of Seattle [email protected] 206-684-8345 1 Know Your Legal Counterparty Unlikely to Be The Holding Company
2 Daily Trading Delivery vs. Payment (DVP) Trading
Your broker-dealer is the counterparty in a court of law Ø Named in FOCUS report & Consolidated Statement of Financial Condi on § FOCUS Report (SEC Form X-17A-5) “Financial and Opera onal Combined Uniform Single Report” – filed monthly with SEC • Request latest from your broker + a few older ones from 2013
§ Consolidated Statement of Financial Condi on ⁻ Audited & filed annually with SEC ⁻ Consolidated at the broker level with granular informa on of its business and any subsidiaries § Can glean informa on from HC 10Q’s & 10K, but FOCUS is easiest
3 For Repurchase Agreements
Master Repurchase Agreement Ø Specifically names your legal counterparty & is most likely to be at the “broker-dealer” level, meaning as a subsidiary of a large financial ins tu on’s holding company
Choose Your Counterparty Carefully1 Ø 1st recourse in repo transac on is always to the counterparty Ø 2nd recourse in a repo transac on is to the underlying collateral Ø 3rd recourse in a repo transac on is an unsecured claim to the counterparty to recover any residual exposure a er liquida ng the underlying collateral
Understand the collateral you’re receiving for repo
1 Tanweer Khan, Global Head - Repo & Collateralized Financing, Standard Chartered Bank "Understanding Repo" Power Point presentation, 22nd April 2010 4 For Purchasing CD/Time Deposits
Bank Level Counterparty
Ø FDIC Reports – www.fdic.gov – choose your counterparty, not the bank’s “Holding Company” (HC) § Call & Thri Reports – monthly – most granular § Sta s cs on Depository Ins tu ons – quarterly
Ø Credit Union – www.researchcu.ncua.gov § Quarterly Call Report
5 Analyze Your Legal Counterparty
6
Broker Dealers
Using The FOCUS Report
7 Some Things to Keep in Mind Ø FOCUS reports are considered proprietary and are not publicly available
Ø You must request the FOCUS report from your broker- dealer. Please do not send it outside of your organization.
Ø While the FOCUS report is submitted to the SEC monthly, many dealers will not provide them to you on a monthly basis, you’ll be lucky to get quarterly reports.
Ø Many of the larger firms will post their Statement of Financial Condition on their web sites.
8 Broker-Dealer FOCUS Report Example
Cover page will name your legal counterparty
9 Source: www.sec.gov FOCUS Report List of Assets
Line items I refer to later
10 FOCUS Report List of Liabilities & Ownership Equity
11 FOCUS Report Calculation of Net Capital
Net Capital
12 Pull Information From
Individual FOCUS
Then Compare to Peers
13 Minimum Information to Consider
14 Assets
(Counterparty Name) Focus Focus
12/31/13 11/30/03 ASSETS Cash Segregated Cash AR - brokers & dealers, clearing firms AR - customers/non-customers Securities Inventory: B/As, CDs, & CP US Gov't & Canadian Gov't State & Municipal Corporate debt Corporate equity securities Options Other securities Agency Mortgage-backed securities TOTAL INVENTORY (MV) Securities Borrowed Resells PP&E Goodwill / Intangibles Secured Demand Notes Not readily marketable investments Exchange Membership Dividends & Interest Receivable Other Assets TOTAL ASSETS
Picture of my spreadsheet – Asset section 15 Assets - (line numbers from FOCUS report) Assets Total Assets (940) Cash (750) Securities borrowed (780) BA’s/CDs/CP (370) US & CN Govt Secs (380) Securities purchased under agreements to resell (840) Total Inventory (850)
Calculate: Highly liquid securities = Cash + BA/CD/CP + US/CN Govt Highly liquid securities as % total assets
Calculates how much cash broker can raise quickly
16 Assets - (line numbers from FOCUS report)
17 Assets - (line numbers from FOCUS report)
Note encumbered inventory
Total assets are all the way at the bottom on line # 940. 18 A Note About Encumbered Inventory (line #120) That Results From Repo & Securities Lending
Dealers don’t let trading inventory sit idly: Ø They can loan securities through securities lending Ø They can use securities as collateral for repo
So, encumbered securities are “working” securities. How liquid is encumbered inventory? Ø That’s a great question and it’s the question that keeps the regulator’s awake at night. Ø I made sure I could get securities back next day under my securities lending agreement with our custodian. Ø Caveat: the numbers include the broker’s operation and client trades. More about that on slide #21.
19 Repo & Securities Lending
For accounting, securities borrowed (780) just about = securities purchased under agreement to resell (840)
Ø The difference between the two is the contract that is used. Ø On the liability side of the balance sheet, the offsets to these will be: § Securities sold under repurchase agreements (line # 1480) § Securities loaned (line #1520)
Ø When you see these terms, it means the broker is in the business of securities lending and repurchase agreements.
20 Repo & Securities Lending Includes the Dealer’s Securities & Client Trades
Ø Repo typically refers to fixed income securities. Here the broker can finance its trading inventory by borrowing overnight cash & providing fixed income securities as collateral for its borrowing. This is the market where we participate.
Ø Securities lending typically refers to equity securities and is many times the result of the “prime brokerage” services provided to hedge funds and other institutional customers. § Some of the top prime brokers include JPMorgan, Goldman Sachs, Morgan Stanley, Credit Suisse & UBS. § Prime brokers enable hedge funds to borrow stocks and bonds (securities lending) and borrow money to purchase stocks and bonds (margin financing). For example, when a hedge fund “shorts” a stock it must borrow the securities from its prime broker.
Ø The problem for regulators and analysts is that, due to “accounting”, a portion of the prime broker activity takes place “off-balance sheet”, creating a serious lack of transparency. This transparency is what is commonly referred to as “Shadow Banking”.
21 Murky Repo & Securities Lending
So, can we honestly say repo and securities lending are “liquid”?
Ø In theory, probably yes.
Ø In practice? The regulators don’t seem to think so. § Bear Stearns & Lehman are the poster children of what can go wrong in shadow banking. § I would say in general, yes, “if” it’s related to funding the broker’s operation. § I would say “not necessarily” for whatever is related to the prime broker business.
Ø I’m not willing to include these business lines in my computation of “highly liquid” assets and liabilities.
Ø That said, I will include money market & government securities in my highly liquid calculations knowing they may be encumbered.
22 Example With Four Counterparties
CP1 is a large, strong U.S. bank HC with a large broker dealer operation Ø Information from FOCUS YE 2013 CP2 is strong credit quality foreign bank HC with a decent sized broker dealer operation Ø Information from SFC 2Q13 CP3 is a small, domestic, independent broker dealer without support of a large HC or parent Ø Information from FOCUS YE 2013 CP4 is a very large, lower credit, foreign investment HC with a very large broker dealer operation in the U.S. Ø Information from FOCUS 3Q13
23 Peer FOCUS Compare Counterparties 1 - 4
Highly Liquid Securi es
Highly Liquid Securi es CP 1 CP2 CP3 CP4 ($Millions) YE 2013 2Q13 YE 2013 3Q13 Total Assets (940) $50,379 $81,584 $8,238 $41,053
Cash/BAs/CDs/CP (370) $648 $284 $0 $0
US & CN Govt Secs (380) $20,082 $13,195 $2,440 $15,725
Highly Liquid Securi es as % total assets 41% 17% 30% 38%
CP3 & CP4 trade mostly US Govt & Agys. They do not sell money markets
24 Liabilities & Equity
(Counterparty Name) Focus Focus
12/31/13 11/30/03
LIABILITIES & EQUITY Bank Loans & Other AP - brokers & dealers, clearing firms AP - customers/non-customers Securities Sold Not Purchased B/As, CDs, & CP US Gov't & Canadian Gov't State & Municipal Corporate debt Corporate equity securities Options Other securities Agency Mortgage-backed securities TOTAL SHORT POSITIONS Securities Loaned Repos Notes payable (Long-Term Debt) Due to Affiliate/Parent Other Liabilities and accrued expenses TOTAL LIABILITIES Subordinated borrowings Retained Earnings EQUITY TOTAL LIABILITIES & EQUITY CHANGE IN EQUITY
CAPITAL COMPLIANCE Total Capital Less Non-allowable assets Less Haircuts Net Capital Excess Net Capital Net capital/Agg. debits 25 Funding - (line numbers from FOCUS report) Liabilities Total liabilities (1760) Securities sold under repurchase agreements (1480) Securities loaned (1520) Securities sold not yet purchased at market value (1620)
Note: “Securities sold not yet purchased at market value” means “short”. Brokers often sell securities short against inventory as a hedge, or for arbitrage. At some point the dealer can either buy back the securities to cover the short, and close out the position, or borrow the securities to cover the short, or “reverse” them in to cover. (I’m not going to address potential underlying prime broker activity here. Sometimes ignorance is bliss).
Ø Short securities are accounted for as of “trade date” Ø Repos/Resells/borrowed/loaned are accounted for as of “settlement date”
So, it’s not possible to discern how the short securities will resolve. 26 Liabilities & Equity
Total liabilities are at the bottom on line #1760 27 Other Liquidity Ratios to Consider With a Grain of Salt Ø Liquid assets as % of total assets where liquid assets = § (Cash + MMKs + US/CN Govts + Securities borrowed + Resells)/ Total Assets • In the case of CP1, Liquid Assets/Total Assets = 74% • In the case of CP4, Liquid Assets/Total Assets = 90% Conclusion: CP4’s assets are more liquid overall - maybe
Ø Liquid Assets/Short-term liabilities where ST liabilities = § (Securities sold not purchased + Securities loaned + Repos) • In the case of CP4 Liquid Assets/Short-term liabilities = 96% • So, if forced to sell liquid assets there would only be enough to cover 96% of short-term liabilities. § In the case of CP1 Liquid Assets/Short-term liabilities = 125.25% • So, if forced to sell liquid assets there would be more than enough to pay-off short-term liabilities. Conclusion: CP4 may have more liquid assets as % of total assets, but CP1’s liquid assets are more than sufficient to cover short-term liabilities. – maybe
Ø The best we can do is monitor change over time. Static analysis tells you nothing. It’s the same for finding value in bonds. It’s all about “relative” value.
28 Computation of Net Capital
Retained Earnings (1794)
Total Ownership Equity (1800 on balance sheet, or in computation of net capital 3480)
Total Capital (incl. sub debt) (3530) Ø Total Capital includes subordinated debt, so greater than Owner’s Equity when broker’s holding company has invested subordinated debt.
Net capital (3750) Ø Net Capital computed under SEC guidelines
29 Ownership Equity & Retained Earnings
30 Computation of Net Capital
31 Peer FOCUS Compare
Capital Ra os
Capital Ra os CP 1 CP2 CP3 CP4 (higher is be er) YE 2013 2Q13 YE 2013 3Q13
Total Capital (3530) as % Total Assets (940) 12.3% 6.03% 2.62% 1.38% Total Capital as % Owner’s Equity (1800) 159.7% 139.8% 100% 154.8% Net Capital (3750) as % Total Capital 49.5% 64.5% 68.5% 69.4% Owner’s Equity as % Total Assets 7.7% 4.3% 2.6% .89% Retained Earnings (1794) ($Millions) $2,358 $428 $0 $38.5
Ø Regulators would like Total Cap as % Total Assets = 15%!!! Ø Total capital/Owner’s Equity – gives you an idea of how much extra cushion the brokerage firm has from the holding company investment Ø Net capital/Total Capital – takes into account haircut on inventory and total amount of deductions Ø Owner’s Equity as % of Total Assets –what is left-over if firm is liquidated - Ø CP4 has almost nothing left over & very reliant on its HC Ø Retained Earnings – is the counterparty making money?
32 Peer FOCUS Compare Leverage Ra os
Leverage Ra os CP 1 CP2 CP3 CP4 (less is be er) YE 2013 2Q13 YE 2013 3Q13
Total assets/Ownership Equity (x’s) 13.0 23.2 38.2 112.5 Total assets/Total Capital (x’s) 8.1 16.6 38.2 72.7 Total assets/Net Capital (x’s) 16.4 25.7 55.8 104.7
CP4 has a whole lot of leverage! This is a subsidiary of a large Japanese holding company. The holding company is rated Baa3/BBB/BBB+ stable across the board. Historically the Japanese firms have carried much higher leverage than their U.S. counterparts. CP4 itself is not rated, but it has been around for a very long time and is a Primary Dealer for the Fed.
I would not feel comfortable putting on a repo trade with CP4. But, given its liquidity and business focus on making markets in US Treasuries, I would certainly entertain cash, regular, and even skip settlement for DVP trades for purchases of US Treasuries & Agencies. 33 Leverage From the Old Days
Leverage Ra os in 2003
Leverage Ra os German BD Swiss BD American BD (less is be er) YE 2003 YE 2003 May 31, 2003
Total assets/Ownership Equity (x’s) 45.6 26.7 36.0 Total assets/Total Capital (x’s) 29.5 16.0 19.9 Total assets/Net Capital (x’s) 94.9 38.1 71.9
Per a recent Bloomberg article, leverage for U.S. brokers “reached 40-to-1 in 2007 before falling to 22-to-1 in 2012”. But, as we can see on slide #31, some brokers continue to carry high leverage ratios.
Sources: “Shadow Banking Deals Prompt SEC Plan to Cap Leverage for Brokers”, Dave Michaels, March 20, 2014, 1:00 AM PT, www.bloomberg.com/news/2014-3-20/shadow-banking-deals-prompt-sec-to-cap-leverage-for-brokers.html; “Prime Brokerage 101”, Timothy Spangler, Forbes, Wall Street, 4/2/2013 @ 6:45PM, www.forbes.com/sites/ timoghtyspangler/2013/04/02/prime-brokerage-101/ 34 More About Leverage Ø The Fed wants more stringent limits on leverage for the largest U.S. banks that own broker-dealer operations and foreign banks with more than $50 billion in assets. § All of these players relied heavily upon emergency lending from the Fed during the crisis. Ø The SEC now wants its own capital rules to cap the amount of leverage for broker-dealers § These rules would apply to dealers that hold “customer” assets, such as custody, as opposed to smaller dealers that just pass-through trades as Principal. Ø Don’t expect any easy answers anytime soon.
35 Qualitative Factors Ø Firm reputation Ø Longevity – though this didn’t matter for our poster children Ø Primary dealer? – again didn’t matter Ø Business plan & focus Ø How involved are they in market making Ø Has the firm historically demonstrated commitment to its business? Many are cutting to the bone as we speak
36 Using The FOCUS Report
A word about Haircuts: Ø Compare the following line items:
Investment Type Asset Code Haircut Liability Code BAs/CDs/CP (370) (3680)
UST & CN Govt (380) (3690)
State & Muni Oblgs (390) (3700)
Corporate Oblgs (400) (3710)
Stocks & Warrants (410) (3720)
Op ons (420) (3730)
Arbitrage (422) (3732)
Other Securi es (424) (3734)
Total inventory (860) (3740)
37 Using The FOCUS Report
A word about Haircuts:
Ø Calculate the haircut amount (liability) as % of each inventoried amount (asset)
§ The haircut is a measure of risk – the greater the haircut, the greater amount of risk of the underlying securi es held in inventory = less liquidity Ø Calculate total haircut as % of total inventory
§ While this is reflected in Net Capital, it’s useful to see it separately § Note: not all broker-dealers will disclose the haircut for each asset class in inventory
38 Broker Dealer Analysis
Summary: Ø Update quarterly and watch for changes Ø Compare peer-to-peer - it’s “rela ve” Ø A ra o to watch is: § Change in retained earnings/Change in total capital. • Are retained earnings staying at the broker level, or ge ng up-streamed to holding company? Are retained earnings declining so holding company has to keep infusing broker opera on with capital? Ø Spend me with a Statement of Financial Condi on § This will provide more in-depth informa on regarding their off-balance sheet business, deriva ves trading & exposure, and prime broker business.
39 Broker Dealer Analysis
Summary continued: Ø Look for low leverage Ø Balanced funding Ø Liquidity Ø Avoid high risk trading inventory Ø Is the firm making money? Ø Reputation? Ø Primary dealer? If so, for how long?
For a trading counterparty your biggest concern is:
Does your counterparty have the financial wherewithal to make good on the trade?
40 Last Word For Broker Dealers
Fed Reserve Bank of Richmond President Jeff Lacker would like to see large banks meet 15% of capital to total assets:
“I don’t think we should be too focused on incentives at the holding company level”, he said, in reference to proposals for issuing unsecured debt capital. Regulators should use a resolution plan to identify when more capital is needed “in a mortgage subsidiary or a broker dealer in London.”
“Ensuring a strong group organization, with capital held in the relevant entity, would reduce the need for capital to flow through the bank holding company In the event of one subsidiary becoming distressed”.
Moral of the story: analyze your legal counterparty and don’t solely rely upon monitoring the holding company. 41 Analyzing Banks
42 Where To Find Information
Ø FDIC Reports – www.fdic.gov – choose ins tu on, not the Bank Holding Company 1) Call & Thri Reports – monthly, provides in-depth numbers, very worthwhile – this is where I spend the bulk of my me 2) Sta s cs on Depository Ins tu ons – quarterly, more general overview, easier to use if you’re pressed for me
Ø Credit Union – www.researchcu.ncua.gov 1) Quarterly Call Report 2) Some larger ins tu ons will provide financial statements on their web site
43 How to Access Statistics Reporting for Depository Institutions Using www.fdic.gov
44 Using FDIC Reports
Once on the FDIC web site, click on “Analysts” to get to their databases.
45 Using FDIC Reports
Then click on “Institution Directory”
46 Find Your Counterparty
Click on “Find Institutions”
47 Find Your Counterparty
Enter name of Counterparty then click Find
48 Find Your Counterparty
Click on FDIC Certificate Number. Note: you may need to sift through a list to find your legal counterparty
49 Various Reports To Use
50 Choose Reports
Ø Here you can choose reports from “ID Report Selections” Ø The default report date is YE 2013 at the moment, but you could choose an earlier time period Ø Then click “Generate Report” 51 Assets & Liabilities Report
Line numbers help you locate information
Ø You can choose dates to compare. This report provides YE 13 relative to YE 12. Ø Click on blue underlined headings to access more granular information
52 Performance & Condition Ratios
Important ratios such as “net interest margin”, ROA, & ROE – just use their numbers, don’t bother calculating on your own! 53 All Summary Information
Summary information gives you a bit of everything & you can drill down for more granular information. 54 Information to Look For in The Reports
Ø Cash & balances Due Ø The bank’s investment portfolio – “securities” § Fixed income investments they hold Ø Types of loans and leases § Residential, commercial, industrial, consumer § Underperforming & non-performing loans § Amount bank is contributing to loan loss allowance § Amount of loan loss reserves in excess of non-performing loans Ø Deposit Mix § Total deposits § Core deposits § Brokered deposits Ø Other funding mix § Fed Funds & Repo § FHLB advances Ø Capital § Total equity capital § Total bank equity capital § Tier 1 (core) risk-based capital § Tier 2 risk-based capital
55
Continued….
Ø Leverage ratios – use the FDIC numbers § Equity capital to assets (FDIC uses average assets line 109) § Core capital (leverage) ratio § Tier 1 risk-based capital ratio § Total risk-based capital ratio
56 Compare to Peers
Reports can be run relative to a standard peer group, or customized group of other credits your may be looking at
57 Compare to Peers
58 Compare to Peers
Ø Or you can do it the “old fashioned” way § Analyze your counterparties individually § Determine the metrics most important to you § Then build a spreadsheet for side-by-side comparison
59 The Call Report
My personal favorite!
60 The Call Report
You can access the report for your counterparty in a couple of ways
61 The Call Report
I find it easier to locate here…
62 Call Report
I strongly encourage becoming familiar with the Call Report. 63 Regardless of Which Reports You Use, Monitor Changes
64 What to Monitor – Track Changes Over Time
Standard Assets & Liabilities Report Ø Quality of balance sheet § Total assets § Total loans § Composition of loan portfolio § Performance of loan portfolio Ø Funding § Total deposits • Composition of deposits – core, brokered, interest-bearing • Total deposits/Total assets – local banks will have higher amount of deposits to assets vs. larger national banks § Fed Funds & Repo – due to higher deposits, local banks have more Fed Funds they can loan out § FHLB Advances – beware of over-reliance for funding Ø Composition of balance sheet § Total loans/Total deposits – around 65%-70% is about right § Total loans/Total assets - higher is better, sticking with their knitting
65 What to Monitor – Track Changes Over Time
All Summary Information Report Ø Earnings & Capital § Net income over time – you can find net income in the Standard Institutional Reports or the Call Report § Retained earnings over time § You will find retained earnings in Call Report, Schedule RC – Balance Sheet, line item 26 a. § Change in ownership capital – is it growing or declining? • You can find this in Call Report under “Schedule RI-A Changes in Bank Equity Capital” Ø Capital Leverage Ratios – greater leverage = more risk § Clarify: Higher leverage means assets > capital, so more capital is better, higher % of capital to assets is desirable § Regulators are in the process of increasing the ratios of capital to assets § Large banks will be lobbying against the changes over the next few years § Will not be fully implemented until 2017-2018 § Watch for information in the reports as the issue evolves
66 Example of Why to Monitor Leverage
In December 2009, McKinsey & Company released a working paper suggesting:
“tangible common equity to risk-weighted assets ratio at the onset of the crisis was the strongest predictor of future bank distress…”
This is an easy ratio for me to calculate & monitor, so I now incorporate this. Also, I like to calculate TCE/Adjusted total assets. Here is how: 1) Begin with Call Report “Schedule RC-R Regulatory Capital”, line 62 “Risk Weighted Assets”
Source: “Capital ratios and financial distress: lessons from the crisis” , McKinsey Working Papers On Risk, Kevin Buehler, Hamid Samandari and Christopher Mazingo, Number 15, December 2009. downloaded from internet: https://www.google.com/#q=mckinsey+and+company+%2B+capital+ratios+and+financial+distress
67 2.) Numbers you need for TCE
Ø Total bank equity capital (line # 26) in Summary Information, or line 28 in Call Report under “Schedule RC – Balance Sheet” § Goodwill & Intangibles (line #12) in Summary Information, or line 10a in Call Report from same schedule above § Perpetual preferred stock (line #27) in Summary Information, or line 23 in Call Report from same schedule above Ø Tangible Common Equity (TCE) = Total bank equity capital Less (Goodwill & Intangibles) Less (Perpetual preferred stock) 3.) Calculate Adjusted Total Assets Total Assets Less (Goodwill & Intangibles)
68 Put it all together The Commerce Bank of Wa., N.A., FDIC #27298 Using FDIC Summary Information Report YE 2013 & Call Report YE 2013 YE 2013 Line # All Summary Information Rpt ($Thousands) 2 Total assets $943,314 26 Total bank equity capital $90,050 12 Less: GW & Intangibles ($0) 27 Less perpetual preferred stock ($2,900) Tangible common equity (TCE) $87,150 Call Rpt Total risk-weighted assets (TRWA) $723,370 TCE/TRWA as % 12.05% TCE/Adj. Total assets 9.24%
Per the McKinsey report, banks with a TCE/TRWA ratio of less than 6.5% - 7.5% accounted for disproportionate share of distressed banks. Commerce Bank of Washington is well above this range.
69 Let’s see if it was true about the predictive value of TCE/TA before Fall of 2008…. We’ll use my former employer….Washington Mutual Period Ending WaMu Unaudited Form 10Q 6/30/08 ($Millions) Total stockholder Equity $26,086 Less goodwill (p.2): (7,284) Less preferred stock (p.2): (3,392) Tangible common equity (TCE) $309,731 Total risk-weighted assets - TRWA(p. 80) $240,193 TCE/TRWA 6.42% TCE/Adj. Total assets* 5.10%
*Note: Goodwill & Intangibles must also be subtracted from total assets before calculating this ratio.
McKinsey’s calculation holds true in this case
70 Clarification 1 I always confuse “equity” (a.k.a. ownership equity, stockholders’ equity, common equity, total equity) and capital, total capital, blah, blah, blah….. 1. Stockholders’ Equity = Total Equity = Total bank equity = Shareholders’ Equity….Really? We need that many descriptions? 2. Common equity = Total Equity/Stockholders’ Equity/et. al. Less: (preferred stock) Less: (any preferred surplus) 3. Tangible Common Equity = Common Equity minus GW & Intangibles
Whew!
“Capital” implies “debt” so, 1. Total capital = Total Equity + Debt = full meal deal
Got it?
71 Clarification 2 I also confuse Tangible Assets with a “sometimes” used term called “Adjusted” Assets, or “Adjusted Total” Assets. They’re basically the same, as far as I know: Total Assets less (GW & Intangibles) less (deferred taxes)
Here is the World Bank to the rescue, but this was written in 2009: Tier 1 capital is “broadly” defined as: Total Capital (the sum of capital) + reserves Less: (“some” intangibles such as goodwill, software expenses and deferred taxes) § sounds similar to our Tangible Common Equity, except it’s “capital”, so it includes debt
Next, per World Bank, if you want to calculate the “Tier 1” leverage ratio, which is equal to Tier 1 Capital/ “Adjusted” assets then Ø “Intangibles” must be removed from “total assets” as well to make it comparable to Tier 1 capital”. (Sound familiar? We did this on slide #68)
So, Tangible Common Equity & World Bank Tier 1 Capital simply remove the “intangibles”. If we want to compare our TCE or Tier 1 Capital to tangible assets/adjusted assets, then we need to remove the “intangibles” from total assets.
Why not just use unadjusted common equity relative to unadjusted total assets?
Source: “The Leverage Ratio: A New Binding Limit on Banks”, Katia D’Hulster, crisisresponse, PUBLIC POLICY FOR THE PRIVATE SECTOR, The World Bank Group, Financial and Private Sector Development Vice Presidency, December 2009, Note Number 11 72 Summary of My Metrics for Analyzing & Monitoring Local Banks
73 (I’ve included line numbers from the FDIC Standard Reports)
Funding Mix % of Assets & Deposits
Total Deposits (16) /Total Assets (2)
Core (retail) deposits (21) as % total deposits Brokered deposits (24) as % of total deposits FFS purchased & repo (20) as % of total assets Other borrowed funds (22) as % of total assets FHLB advances (47) as % of total assets
Ø Prefer bank with greater amount of core deposits comprising funding Ø Local credit union should have mostly core deposits Ø Beware of bank with over-reliance upon FHLB Advances or brokered deposits Ø Standard reports give you cost of funding & yield on earning assets – both of which are used to determine net interest margin
74 Net Loans & Leases Report (with line numbers provided) Loan Type as % of Total Loans Total Loans & Leases - TL (3) then calculate the following:
Construction and land development (8) % of TL Commercial Real Estate (10) % of TL Multifamily residential (12) % of TL 1-4 family residential (13) % of TL Farmland (14) % of TL Individual (19) % of TL
What kinds of loans are they making? Speculative in land development? Or, more conservative with residential loans? First mortgage loans, or second lien? Car loans, or credit cards? What are the maturity of the loans? Long, short?
75 “Performance & Conditions Ratios Report” If you don’t have time to crunch numbers, use FDIC numbers (line numbers provided below)
Performance of loan portfolio Measured by Conditions Ratios (%) Loan and lease loss provision to assets (8) – more is better Credit loss provision to net charge-offs (15) – more is better Loss allowance to loans (20) – more is better Loss allowance to noncurrent loans (21) – more is better Noncurrent loans to loans (23) – smaller is better!
I want to know how their loans are performing. Are they setting aside enough in provisions to cover loan losses, or are they ignoring reality? Are loan losses worsening, improving, stable? Are they able to recover some of their losses? I spend a lot of time in this area. 76 “Performance & Conditions Ratios Report” If you do have time to crunch numbers…
Personally I like to look at the performance of each loan type. This served me well in early 2008 as I monitored the local banks for which I owned CDs.
Ø Loan portfolios were noticeably deteriorating § Non-performing loans were increasing and allowance for loan losses were not keeping up. Net incomes were negative, so retained earnings were declining. There was no question these banks were entering a difficult operating environment. Ø I like to monitor the term of their loans as well. What are final maturi es? Are they fixed or floa ng? If floa ng, how o en do they reset?
77 “Performance & Conditions Ratios Report”
Use FDIC numbers (line numbers provided below) Performance of Bank Operations (%) (Use to Compare to Peers) Net Interest Margin (5) – higher is better Net operating income to assets (9) – higher is better
Return on assets (10) – higher is better
Return on equity (12) – higher is better
Retained earnings to average equity YTD only (13) higher better
Efficiency ratio (17) – lower is better
78 “Performance & Conditions Ratios Report”
Track Regulatory Capital Ratios Using FDIC numbers (line numbers provided below) Capital Ratios (Capital/Assets) Measured by Conditions Ratios (%) Core capital (leverage) ratio (27) Tier 1 risk-based capital ratio (28) Total risk-based capital ratio (29)
Kellie’s Fave: Total Equity/Total Assets
Another Kellie Fave: Total Capital/Total Assets
Last Kellie Fave: TCE/TRWA because it has value
Higher numbers are better. For my ratios, at least I know for sure which numbers to use.
79 Further Investigation If You Have Time
80 Guide For Community Bank Capital Rules “New Capital Rule Community Bank Guide”, July 2013 Source: Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency
Or simply Google: “new capital rule community bank guide” § Then you can click on the PDF
You’ll also see the PDF for: “OCC New Capital Rule Quick Reference Guide for Community Banks”
81
Daily Monitoring of Counterparty Exposure Holding Company Level
Beware: HC is not your legal counterparty, unless you own HC corporate debt
82 Holding Company Metrics
Don’t rely on just one metric – they need to be taken together
Ø Company Stock Price Ø 5yr CDS spread for senior debt Ø 5yr bond yield for senior debt Ø Credit Ra ngs
***Monitor rela ve to peers so outlier will be no ceable
Caveats regarding CDS spreads: Not all companies trade in OTC CDS market. For example, Royal Bank of Canada & Bank of Montreal do not have CDS – two stellar credits trade privately. OTC CDS market can be thin. Think about it, a lot of the names trade with each other and try to lay of risk from one another.
83 Summary Mitigate counterparty risk: Ø Know your legal counterparty, do the credit work & monitor regularly especially vs. peer group Ø Safekeep with strong third-party custodian Ø No term repo with over-leveraged counterparty § Make sure you know & like the collateral you’re taking Ø No extended settle trades with weak counterparty Ø Monitor holding company, but don’t rely on holding company making you whole Ø Know who your securities lending agent is trading with Ø Monitor repo counterparties used by the large Money Market Mutual Fund companies!! § If Vanguard and Fidelity stop using Broker X for repo, you should too! 84
The End!
Please page forward to see the “how to” for locating credit unions
85 How To Find Credit Unions
86 A Note About Credit Unions www.ncua.gov
87 A Note About Credit Unions
88 A Note About Credit Unions
89 A Note About Credit Unions
90 A Note About Credit Unions
91 A Note About Credit Unions
92 A Note About Credit Unions
93 A Note About Credit Unions
94 A Note About Credit Unions
95 References Belmont, David, “Managing Counterparty Risk in an Unstable Financial System”, commonfund INSTITUTE, November 2012
Board of Governors of the Federal Reserve System, Federal Deposit Insurance Company, Office of the Comptroller of the Currency, “Interagency Guidance on Leveraged Lending”, March 21, 2013
Buehler, Kevin, et al., “Capital ra os and financial distress: lessons from the crisis.” McKinsey Working Papers On Risk, Number 15, December 2009. https://www.google.com/#q=mckinsey+and+company+%2B+capital+ratios+and+financial+distress
Counterparty Risk Management Policy Group III, “Containing Systemic Risk: The Road to Reform”, The Report of the CRMPG III, August 6, 2008
FINRA, “Regulatory No ce 10-44”, Financial and Opera onal Surveillance: New Alert-Report Criterion for Leverage in FOCUS Reports, September 2010
Financial Stability Board, “Securi es Lending and Repos: Market Overview and Financial Stability Issues”, Interim Report of the FSB Workstream on Securi es Lending and Repos, 27 April 2012
Fonseca, Vladimir and Raquel M. Gaspar, “Counterparty and Liquidity Risk: An analysis of the nega ve basis”, Advance Working Paper Series N.3/2011, Advance Research Center, ISEG, Technical University of Lisbon
Horowitz, Keith, et al., “Global Banks and Brokers: Deep Dive on Repo – Buy Side to Feel Impact More than Sell Side.” Ci Research, Equi es, 10 October 2013
D’Hulster, Ka a, “The Leverage Ra o: A New Binding Limit on Banks”, crisisresponse PUBLIC POLICY FOR THE PRIVATE SECTOR, The World Bank Group, Financial and Private Sector Development Vice Presidency, December 2009, Note Number II
Jorion, Philippe and Gaiyan Zhang, “Credit Contagion from Counterparty Risk”, Paul Merage School of Business, University of California Irvine and College of Business Administra on, University of Missouri at St. Louis
J.P. Morgan Investor Services, “Leveraging the Leverage Ra o: Basel III, Leverage and the Hedge Fund-Prime Broker Rela onship through 2014 and Beyond”, 2014
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References Khan, Tanweer, Global Head - Repo & Collateralized Financing, Standard Chartered Bank, PowerPoint presenta on “Understanding Repo”, 22nd April 2010
Katz, Jack and Nichole Jordan, “Broker-dealer industry update: Highlights of recent accoun ng and regulatory issues”, Grant Thornton LLP bulle n
King, Ma , “Are the brokers broken?”, Ci , European, Quan ta ve Credit, Strategy & Analysis, Global Corporates, 5 September 2008, Via Zero Hedge
Levy Economics Ins tute of Bard College Publica ons, “Fed’s Rosengren: Banks With Broker-Dealer Units Need More Capital”, Money News, April 17, 2013, www.levyins tute.org/publica ons/?docid=1783[3/7/14 5:31:51PM]
Menezes, Ryan of Demand Media, “How to Calculate Tangible Equity From a Call Report”, The Motley Fool
Michaels, Dave, “Shadow Banking Deals Prompt SEC Plan to Cap Leverage for Brokers”, Bloomberg News, March 20, 2014, 1:00 AM PT; , www.bloomberg.com/news/2014-3-20/shadow-banking-deals-prompt-sec-to-cap-leverage-for-brokers.html
Rao, S.K., “Liquidity Risk Management – Good Prac ces for Broker Dealers”, TATA Consultancy Services White Paper
Reid, Alan G., et al., “Methodology: Ra ng Securi es Firms in the United States”, DBRS Ra ngs, May 2008
Spangler, Timothy, “Prime Brokerage 101”, Forbes, 4/2/2013 @ 6:45PM, www.forbes.com/sites/timoghtyspangler/2013/04/02/prime-brokerage-101/
Strah, Sco , et al., “The Impact of the Recent Financial Crisis on the Capital Posi ons of Large U.S. U.S. Financial Ins tu ons: An Empirical Analysis.” Federal Reserve Bank of Boston, July 16, 2013
Valladares, Mayra Rodriquez, “Why the Bank Leverage Ra o is Important”, The New York Times, DealB%k, February 28, 2014
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