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Presentation to:

New Jersey League of Community Bankers & FMS NY/NJ

Battling Margin Compression


Locking in Low-cost Funding and Eliminating Borrowing Rollover Risk
Presented By: David Covey Senior Bank Strategist April 16, 2003

Goals of This Presentation


Battling Margin Compression

uA

Basic Introduction to Interest Rate Swaps and Swaptions

u Demonstrate

How These Tools Are Currently Used By Banks to Ease Margin Compression on the Liability Side of the Balance Sheet

Overview The Challenge


Battling Margin Compression

u Many

banks are struggling with high cost longer term funding pressures have increased as the yield curve rallied

u Margin

As assets repriced downward, spreads have plummeted sometimes to < 0 !!! Margin compression may get worse if rates rise, funding costs increase and assets purchased today extend
u Many

of these borrowings mature in the next 24 months

How can banks take advantage of todays environment to ensure these borrowings will be refinanced at low rates?
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Overview The Challenge


Battling Margin Compression

What are equity analysts saying about small-cap banks?

Recent quotes from a prominent small-cap bank analyst: "Net interest margin pressure is a given We see the dominant story for 1Q03 as the continuing (but slowing) margin compression. The Small-Caps have fought against the effect of margin compression on income with balance sheet growth, fee income initiatives and expense controls. We expect this battle to continue in the first quarter, but perhaps with less success than in recent periods.

Battling Margin Compression

A Primer on Swaps and Swaptions

Interest Rate Swaps


Battling Margin Compression

Exchange Undesirable Cash Flow for Desirable Cash Flow


u

What is a swap? A contractual exchange of interest payments between two parties

Characteristics of a Swap: Range of maturities Can be based upon a variety of floating rate indices Allows banks to transform fixed rate instruments into floating or vice versa

Fixed Bank Bank Floating Lehman Lehman Brothers Brothers

Interest Rate Swaps


Battling Margin Compression

Loan
Fixed

Swap
Fixed

Borrower

Bank
LIBOR

Lehman Brothers

Swap + Loan Synthetic Fixed Rate Loan Bank

LIBOR
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Forward Starting Swaps


Battling Margin Compression

A Forward Commitment to Exchange Cash Flows


u

What is a forward starting swap? A contractual exchange of interest payments between two parties that starts on a future date Vanilla Swap April 2003 April 2008 Forward Feds Funds Target LIBOR & Starting Swap January 2004 January 2009

3.50% Bank Bank Floating Lehman Lehman Brothers Brothers Bank Bank

3.75% Floating Lehman Lehman Brothers Brothers

Interest Rate Swaptions


Battling Margin Compression

Optional Forward Starting Swap


u

What is a swaption? The right to enter into an interest rate swap with a predetermined fixed rate on some future date for a one time premium (fee)

Characteristics of a Swaption: Right to pay fixed (payer) or receive fixed (receiver) Range of option expiry Range of maturities on underlying swap Forward Feds Funds Target LIBOR & Starting Swap January 2004 January 2009 3.75% Bank Bank Floating
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Swaption Forward Starting Swap w/ ability to walk away Fixed Rate: 3.75% Premium: 200bp

Lehman Lehman Brothers Brothers

Swaps and Swaptions Summary


Battling Margin Compression

Swap Exchange of one cashflow for another starting today

Vanilla Swap April 2003 April 2008 3.50%

Bank Bank
Floating
u

Lehman Lehman Brothers Brothers

Forward Starting Swap Exchange of one cashflow for another starting in future

Forward Starting Swap LIBOR & Feds Funds Target January 2004 January 2009 3.75%

Bank Bank
Floating
u

Lehman Lehman Brothers Brothers

Payer Swaption Forward swap with right to walk away (for upfront premium)
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Swaption Right to Pay 3.75% for 3mL January 2004 January 2009 Premium: 200bp

Battling Margin Compression

Using Swaps and Swaptions to Hedge Against Higher Future Funding Costs

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Illustration
Battling Margin Compression

Borrowing: Size: Issue Date: Maturity: Rate:


u

Illustrative Example FHLB Advance $10m 1/1/99 1/1/04 (~9 months from today) 6.00%

Assumptions The bank intends to roll the funding into a new 5-year advance We assume that the bank can fund at Libor flat The bank wishes to hedge against an increase in rates

The banks risk: $50,000 per year per 50 basis point increase in rates

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Illustration
Battling Margin Compression

Borrowing: Size: Issue Date: Maturity: Rate:

Illustrative Example FHLB Advance $10m 1/1/99 1/1/04 (~9 months from today) 6.00%

Potential Risk Management Strategies


1. Do Nothing 2. Eliminate Risk through Leveraging 3. Eliminate Risk Through Forward Starting Swap 4. Limit Risk Through a Swaption or Collar 5. Balance Risk Through a Combination Strategy

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Why May Locking In Funding Costs Be Attractive?


Battling Margin Compression

Rates are near historical lows


Swap Rates and Fed Funds Target 2000-2003
8.0 7.0 6.0
6.5

but may rise considerably when the economy recovers


Swap Rates and Fed Funds Target 1992-1994
8.5

7.5

5.0
5.5

4.0
4.5

3.0 2.0 1.0 Jan-00 Jul-00 Feb-01 Aug-01 Mar-02 Sep-02 SWAP 2Y rate SWAP 10Y rate Inter-Meeting Rate Changes SWAP 5Y rate FF Target
SWAP 5Y rate FF Target SWAP 10Y rate Inter-Meeting Rate Changes SWAP 2Y rate

3.5

2.5 Jan-92 Jul-92 Feb-93 Aug-93 Mar-94 Sep-94

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Indicative Pricing and Strategy Comparison


Battling Margin Compression

Cost of Funds
Elim. Risk Leveraging 3.65% 3.65% 3.65% 3.65% 3.65% 3.65% Elim. Risk Forward Swap 3.88% 3.88% 3.88% 3.88% 3.88% 3.88% Limit Risk Swaption 1.82% 2.82% 3.82% 4.40% 4.40% 4.40% Limit Risk Rate Collar 3.67% 3.67% 3.67% 4.12% 4.12% 4.12%

Rate Shock -2% -1% 0% 1% 2% 3%

Do nothing 1.30% 2.30% 3.30% 4.30% 5.30% 6.30%

7.00% Do nothing 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% -2% -1% 0% 1% 2% 3% Rate Shock Limit Risk Swaption Limit Risk Rate Collar Elim. Risk Leveraging Elim. Risk - Forward Swap

All values are indicative levels as of 4/04/03

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1. Keep Risk: Do Nothing


Battling Margin Compression

The bank does not hedge, maintaining exposure to changes in rates


u Result:

Interest expense will vary with


Cost of Funds

Unhedged Profile

rates
u Mechanics:

The bank takes no action


u Implicit

Market view: Rates will remain low or fall N/A Premium: None

u Pricing: u Upfront

Market Yield

Probability Market Yield

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2. Eliminate Risk: Leverage Strategy


Battling Margin Compression

The bank enters into long-term funding now, and invests in short security
u Result:

Bank locks in 3.65% funding


Cost of Funds

Unhedged Profile

u Mechanics:
Probability

Bank enters into 5.75yr funding today Bank purchases 9-month asset Incurs negative spread immediately
u Market u Pricing:

view: None
Market Yield
Market Yield

Current 5.75 year swap rate: Carry for 9 months:


u Upfront u Risk:

3.65% (2.25%)
Probability

Hedged Profile
Cost of Funds Market Yield Market Yield

Assumed 9-month asset yield: 1.40% Premium: None

Rates stay low (opportunity cost)

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3. Eliminate Risk: Forward Starting Swap (Rate Lock)


Battling Margin Compression

The bank eliminates market rate risk by locking in the forward yield
u Result:

Bank locks in 3.88% funding


Cost of Funds

Unhedged Profile

u Mechanics:
Probability

Bank pays fixed on forward swap On 1/1/04, the bank enters into 5yr floating rate funding at 3mL flat
u Market u Pricing: u Upfront

view: No view 5y swap rate 9m forward = 3.88% Premium: None


Cost of Funds

Market Yield

Market Yield

Hedged Profile

u Accounting: u Risk:

Rates stay low (opportunity cost)

Probability Market Yield Market Yield

Cash flow hedge. No ineffectiveness or income volatility.

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3. Eliminate Risk: Forward Starting Swap (Rate Lock)


Battling Margin Compression

Mechanics of a Forward Starting Swap 1. Bank enters into a pay fixed 5yr swap at 3.88% starting 1/1/04

Jan 2004 Jan 2009 3mL

Jan 2004 Jan 2009 3mL

Lehman Brothers
3.88%

Bank
$$

Lender

2. On 1/1/04, bank borrows floating rate at 3mL for 5 years

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4a. Limit Risk: Payer Swaption (Rate Cap)


Battling Margin Compression

The bank locks in a worst-case cost of funds, but retains the upside if rates fall
u Result:

Cost capped at 4.40%


Cost of Funds

Unhedged Profile

u Mechanics:
Probability

Bank purchases payer swaption


u Market

View: Rates may fall, but could possibly be substantially higher Premium: Yes

u Upfront u Pricing:

Market Yield

Market Yield

Swaption strike rate: 3.88% Upfront premium:


u Accounting:

2.38% (52bp p.a.)


Cost of Funds

Unhedged Profile

Probability
Market Yield

Cash flow hedge. No income volatility. Cost of option amortized over term of borrowing.

Market Yield

Market Yield

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4a. Limit Risk: Payer Swaption (Rate Cap)


Battling Margin Compression

Mechanics of a Forward Starting Swap 1. Bank buys a payer swaption on a 5yr swap starting on 1/1/2004 w/ a 3.88% strike 2. Bank exercises the option only if 5yr rate is higher than 3.88%
January 2004 January 2009

If Rates Fall

If Rates Rise
Premium

Lehman Lehman Brothers Brothers

Premium

$$

$$

Bank Bank
Low Market Rate

Lender Lender

Lehman Lehman Brothers Brothers

3.88.%

Bank Bank
3mL

Lender Lender

3mL

Bank acquires funds at market rate Expense: Market Rate + 52bp

Bank funding cost is capped Expense: 4.40% (=3.88% + 52bp)

A payer swaption gives the bank the right, but not the obligation, to pay fixed on a 5yr swap starting on a future date.

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4b. Limit Risk: Rate Collar


Battling Margin Compression

The bank ensures funding costs will remain within a specified band of rates
u Result:

Bank ensures funding cost will be between 4.12% and 3.67%


Cost of Funds

Unhedged Profile

u Mechanics:

Bank buys a payer swaption and sells a receiver swaption at a lower strike rate
u Market

View: Rates may be substantially higher, but probably not substantially lower Premium: None

Market Yield

Probability Market Yield

u Upfront u Pricing:

Hedged Profile 0.00%


Probability Market Yield Market Yield

Net cost 9m into 5yr payer strike:


u Accounting:

4.12%

9m into 5yr receiver strike: 3.67% Cash flow hedge. No income volatility.
u Risk:

Rates stay below 3.67%


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Cost of Funds

5. Combination Strategies
Battling Margin Compression

Forward swaps & swaptions can be the building blocks of customized strategies
u 50/50

Example: Swap + Swaption u Result: Lock-in worst case 4.14% COF u Mechanics: Buy payer swaption with $5m notional Pay for swaption by entering into a forward starting swap on $5m at offmarket rate u Market View: Want protection vs. much higher rates, with no cash outlay u Pricing: Payer swaption strike rate: 3.88% Premium on $5m ($): $119k Premium on $5m (p.a.): 52bp ATM forward swap rate: 3.88% Off-mkt forward swap rate: 4.40% u Upfront Premium: None

Hedged and Unhedged Cost of Funds


7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -2.00% Unhedged Swaption Only Combination Strategy -1.00% 0.00% 1.00% 2.00% 3.00%

Rate Shock

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Indicative Pricing and Strategy Comparison


Battling Margin Compression

Each Strategy Results in a Different Cost-of-Funds Profile


Cost of Funds
Rates and Assumptions Current Funding Size Original Issue Date Maturity Date Rate New Funding Expected Term (yrs) Current 5.0 yr Swap Rate Current 5.75 yr Swap Rate 5.0 yr Swap Rate 9m Forward Swaption Cost (3.88% strike)
Rate Shock -2% -1% 0% 1% 2% 3% Do nothing 1.30% 2.30% 3.30% 4.30% 5.30% 6.30% Leverage and Invest short 3.65% 3.65% 3.65% 3.65% 3.65% 3.65% Forward Starting Payer Swaption Swap (Rate Cap) 3.88% 1.82% 3.88% 2.82% 3.88% 3.82% 3.88% 4.40% 3.88% 4.40% 3.88% 4.40% Rate Collar 3.67% 3.67% 3.67% 4.12% 4.12% 4.12%

$50m 1/15/99 1/15/03 6.00%

5.0 3.30% 3.65% 3.88% 2.38%

7.00% Do nothing 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% -2% -1% 0% 1% Rate Shock 2% 3% Leverage and Invest short Forward Starting Swap

Payer Swaption (Rate Cap) Rate Collar

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Accounting Considerations
Battling Margin Compression

Hedge Accounting Overview


u These

hedges should be designated as Cash Flow Hedges under FAS 133

Hedge is recorded at fair value The offsetting entry is to Other Comprehensive Income (OCI) Changes in fair value are not reflected in income in forward period By hedging the risk of swap rate changes, the bank will experience no income statement volatility (no ineffectiveness) Premium paid (if any) should be amortized over the life of the hedged funding

Key Results No income impact during forward period Any cost of hedging is recognized over the life of the new borrowing

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Accounting Considerations
Battling Margin Compression

Hedge Accounting Overview


u

The bank has some maturity flexibility around issuance Under the latest FAS 133/138 developments, the bank can hedge a particular advance and alter its maturity without creating income statement problems if the decision is made at the rollover date For example, if the bank locks in the 5 year swap rate, it may be able to: 1. Issue a 7 year financing and recognize the hedge gain/(loss) over the first 5 years of the new financing 2. Issue a 2.5 year financing. In this case it would recognize the hedge gain/(loss) over a 5 year period on the assumption that it will need to refinance the 2.5 year financing upon maturity

Note that Lehman Brothers is not an accounting advisor please discuss the accounting treatment with any/all hedging transactions with your auditors and internal accounting professionals prior to transacting.

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Summary
Battling Margin Compression

u Margin u Rates

compression is currently a major concern of depositories

are near historical lows, and may rise dramatically when the economic recovery gets its legs significant rise in rates could hinder bank profitability

uA

u Swaps

and swaptions are powerful tools that can help mitigate margin compression and maximize profit going forward

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Battling Margin Compression

I, David Covey, hereby certify (1) that the views expressed in this research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. Any reports referenced herein published after 14 April 2003 have been certified in accordance with Regulation AC. To obtain copies of these reports and their certifications, please contact Larry Pindyck (lpindyck@lehman.com; 212-526-6268) or Valerie Monchi (vmonchi@lehman.com; 1-011-44-207-011-8035). This presentation is based on information that is believed accurate by Lehman Brothers. It is provided for informational purposes only. Lehman Brothers specifically disclaims any obligation to publish additional information or reports in the event that the information contained herein subsequently is found to be or becomes inaccurate or incomplete. This information is not a prospectus and does not offer any securities; however, Lehman Brothers may be engaged in an offering of securities concurrently with the distribution of this document. Any and all terms governing such offering would be contained in a prospectus prepared for that purpose, a copy of which is available upon request and to which the reader should refer for more complete information about such offering. 2003 Lehman Brothers Inc. All rights reserved. Member SIPC.

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Appendix: Finding Pricing on Swaps & Swaptions


Battling Margin Compression

Click here to see the full live swap curve

Source: LEHMANlive
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Appendix: Finding Pricing on Swaps & Swaptions


Battling Margin Compression

Source: LEHMANlive
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Appendix: Finding Pricing on Swaps & Swaptions


Battling Margin Compression

Source: LEHMANlive
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