Pub. 8 2018-2019 Issue 3

O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S - H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S November • December 2018 11 and dropped with interest rates. This actually shows that banks havemuchmore inter- est rate risk during periods of falling rates than they do during periods of rising rates. Chart 1 The reason banks are somuchmore asset sensitive is because banks don’t portfolio long-term fixed rate mortgage production any longer. So, asset durations are much shorter than they were in the 80s. They also fund most of their balance sheets with core deposits and core deposit rates significantly lag FOMC rate hikes. Additionally, banks have massively increased core deposits over the last decade. Colorado banks currently fund 81% of their balance sheets with core deposits (Chart 2). That is up from 66% in 2009. That protects banks even more against higher rates. Chart 2 If we could go back and do things differently, we would have gone back to periods when the FOMC was nearing the top of a rate cycle (98-00, 06-07) and extended fixed rate loans and we would have purchased longer duration bonds. The longer assets would have locked in yields and would have protected NIM during the ensuing years when rates were falling. Another benefit to this strategy would have been the gains in the bonds. Rates fall because the economy is struggling and Fed is accommoda- tive. Banks are typically experiencing higher credit losses during these downturns. By purchasing longer duration bonds during high rate periods we layer in bonds at higher yields but we also increase the gains that can offset credit losses. Many banks did just that during the 2008-10 down turn. What To Do Now? So, here we sit today with the Fed Funds rates up 200bps since 2015. And once again we see banks trying to shorten asset durations to defend against more rate hikes. This is exact- ly the time to extend asset durations instead of shortening. We are not try- ing to call an end to rate hikes but 10 year Treasury futures, one year from today, forecast 8bps (3.06% to 3.14%) of increase and themarket is only fore- casting between 3 and 4 more FOMC hikes. So, the market is starting to predict slower growth and an end to rising rates. Some economists are even starting to forecast recessionary pressure in 2019. No one will ever be able to forecast an exact peak in rates but these are the times in history when your bank would have been well pro- tected by layering in longer duration loans and bond purchases. Go back and look at the history of your banks NIM and see if it moved with rates. If it did then take the op- portunity to be competitive and offer some good customers longer (5-7 year) fixed rate loans. When you are buying bonds look at extending the duration of those purchases. Make sure and layer in call/prepay protected bonds. Discounted MBS, CMOs and CMBS are great choices because if rates fall the discounts are accreted up to par and if rates rise they still provide monthly cash flow for reinvestment. n