Best Practices in Asset Liability Management

Best Practices in Asset Liability Management Frank Wilary Principal Wilary Winn LLC September 22, 2014 1

Topics Covered Best practices related to ALM modeling Best practices related to managing the ALM position 2

ALM Modeling Best Practices Explicit calculation of credit losses Refreshed FICO scores Updated loan to value estimates Accurate structured models for CMOs (Agency and private) Level yield calculations for premium expense amortization Detailed and supportable assumptions on non-maturity share behavior Use of forward curves for discounting and reinvestment ALCO ownership and control of the ALM assumptions Evolvement to Stochastic analyses on mortgage loans and investments 3

Best Practices for Managing the ALM Position Construction and management of cash flow ladders Loans Investments Non-maturity shares Share certificates Understanding tradeoffs Base case vs. rising rate environment Short term vs. long term Risk based pricing Monitoring the duration variance between assets and liabilities Detailed policies that provide early warnings of undue risk Understanding of current and proposed regulations on the business model 4

Networking Opportunities Expertise in: Investing Lending Share Pricing Risk Management Modeling Our goal for this conference LEARNING OPPORTUNITY 5

Asset Liability Management Asset and liability management (ALM) is the practice of managing risks that arise due to mismatches between assets and liabilities and earning an adequate return. ALM is also the administration of policies that address financial risks associated with changing interest rates. 6

Interesting findings in our ALM validation reviews of other vendors work Structured investments were modeled as pass-through securities Premium amortization expense on investments is ignored Coupons applied to book value instead of par balance Loan portfolio pay downs ignore amortization and prepayment conventions (straight line run off over 3 years) Base case mortgage prepayment rate is inadvertently applied to all rate shock scenarios 15 days of interest expense was inadvertently added to all share certificates upon maturity Non-maturity share behavior is unknown so modeling is based upon the 2001 NERA study or non-maturity shares are at par in all scenarios (we run these for comparative purposes) 7

Common reasons or motivations provided by potential clients for inquiries we receive about improving their ALM reporting Overreliance on step-up callable Agency securities in the investment portfolio caused the +300 shock to exceed the ALM threshold Non-maturity share behavior is unknown Credit impact on ALM position is unknown Regulatory pressure to increase ALM sophistication Organization wants to evolve its ALM understanding 8

ALM Modeling Best Practices Starts with the ALM model selection Talent level for the person selected to run the model Oversight and control to the process Similar philosophy to auto racing Car Driver Crew chief and team 9

Why we selected the ZM Desk ALM Model Allows direct modeling of credit risk using conditional default rates and loss severity assumptions for both loans and investments (Private label CMOs) Integrates with the 3 rd party software that we license Calculates on a deterministic or stochastic basis Helps meet the main objectives of Enterprise Risk Management 10

Enterprise Risk Management According to the Risk Management Association, Enterprise Risk Management ( ERM ) is the capability of an organization to understand, control, and articulate the nature and level of risks taken in pursuit of risk-adjusted returns. A comprehensive ERM framework provides mechanisms to identify, measure, and control these risks. Financial risk examples include credit, liquidity and capital. 11

Repayment - CRR Default - CDR Loss Severity Loan Assumptions for ALM By developing potential credit losses explicitly with default and loss severity assumptions at the loan or cohort level, the main objectives of Enterprise Risk Management and the current expected credit loss model ( CECL ) are met. 12

ALM Loan Assumptions (Base Case) Collateral Type CLTV CRR CDR Severity Home Equity 2nd Current 660-719 under 50% 19.5% 0.5% 0.0% Home Equity 2nd Current 660-719 50% - 75% 19.5% 0.5% 15.0% Home Equity 2nd Current 660-719 75% - 100% 18.7% 1.3% 25.4% Home Equity 2nd Current 660-719 100% - 120% 17.8% 2.2% 34.2% Home Equity 2nd Current 660-719 120% - 150% 15.5% 4.5% 100.0% Home Equity 2nd Current 660-719 over 150% 14.3% 5.7% 100.0% 13

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ALM Loan Assumptions (Base Case) Collateral Type CRR CDR Severity Used Vehicle - Direct Current 720-779 27.5% 0.1% 36.2% Used Vehicle - Direct Current 660-719 27.2% 0.3% 36.3% Used Vehicle - Direct Current 620-659 26.3% 1.4% 39.9% Used Vehicle - Direct Current 500-619 17.9% 8.7% 37.7% Used Vehicle - Direct Current under 500 4.0% 36.2% 39.4% Used Vehicle - Direct Delinquent 30-59 4.0% 45.0% 35.2% 15

ALM Loan Discount Rate Best Practices Base case discount rates should reflect known risk characteristics Higher discount rates for Delinquent loans High loan-to-value loans Loans made to borrowers with lower refreshed credit scores Base case ALM should reflect current market value Rising interest rate shocks for the loans should reflect full market increase 16

ALM Profile Comparison Single Family Mortgage 30 year fixed rate mortgage with an interest rate of 4.50% 3/1 ARM with an interest rate of 3.25% with a lifetime cap on interest rates of 6.00% and a floor equal to the initial offered rate Assuming $20 MM in production, the net interest income difference is $250,000 a year for the first 3 years Assuming the following prepayment profile: Prepayment Rate (CPR%) 300 200 100 Base 100 200 300 400 30 Year Fixed Rate 54.8% 43.2% 22.3% 7.5% 5.2% 4.6% 4.2% 4.0% 3/1 ARM 30.4% 25.1% 17.3% 10.1% 8.7% 6.8% 5.4% 5.1% The resulting economic value of equity profile is: Economic Value of Equity 300 200 100 Base 100 200 300 400 30 Year Fixed Rate 103.75% 103.37% 103.29% 100.00% 92.71% 85.77% 79.41% 73.83% 3/1 ARM 104.44% 102.25% 98.99% 101.76% 96.58% 90.43% 83.88% 78.14% 17

ALM Economic Value of Equity Profile Comparison of Various Loan Types Loan Type -100 Base +100 +200 +300 +400 New Vehicle - Direct 1.31% 0.00% -1.48% -2.92% -4.32% -5.69% Used Vehicle - Direct 1.24% 0.00% -1.43% -2.81% -4.17% -5.48% New Vehicle - Indirect 1.33% 0.00% -1.48% -2.92% -4.32% -5.68% Used Vehicle - Indirect 1.28% 0.00% -1.45% -2.85% -4.22% -5.56% 1st Mortgage 50% - 75% LTV 4.59% 0.00% -5.04% -9.36% -13.15% -16.56% 1st Mortgage 75% - 100% LTV 5.95% 0.00% -6.81% -12.65% -17.86% -22.68% 1st Mortgage 100% - 120% LTV 6.91% 0.00% -8.03% -14.12% -19.50% -24.27% Student Loans 2.33% 0.00% -2.43% -4.74% -6.93% -9.01% Home Equity 2nd 50% - 75% CLTV 2.83% 0.00% -3.08% -5.59% -8.10% -10.50% Home Equity 2nd 75% - 100% CLTV 3.17% 0.00% -3.62% -6.17% -8.71% -11.13% Home Equity 2nd 100% - 120% CLTV 3.23% 0.00% -4.10% -6.72% -9.33% -11.82% Member Business Loans 1.26% 0.00% -1.54% -3.02% -4.45% -5.84% 18

Investment Assumptions Mortgage Securities CRR by Shock Scenario Investments -100 Base +100 +200 +300 +400 CDR Severity Agency MBS 25.40 12.34 11.84 8.31 6.42 5.97 Agency CMO 29.33 13.68 11.66 8.78 6.28 5.23 Non Agency CMO 18.21 12.78 10.45 9.13 7.99 7.37 5.23 44.29 Generally fixed rate securities that produce monthly cash flow Extension risk with rising interest rates as the rate of repayment slows down Reinvestment risk in falling interest rate scenarios Easier to construct cash flow ladders compared to alternatives 19

Investment Assumptions Agency Debt If callable, determination as to when the call is likely to be exercised Anticipated call date changes based upon interest rate shock and current rate environment Bullet repayment at call date or maturity Most securities present significant extension risk and re-investment risk Does not produce monthly cash flow Call features and bullet repayment make construction of cash flow ladders difficult Overweight in this investment type produces rising rate economic value of equity variability issues (client inquiries) 20

Comparison of EVE Change by Investment Type 10.00% Percentage Price Change From Base Case 5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 100 Base +100 +200 +300 +400 Agency Debt Agency CMO Agency MBS Non Agency CMO 21

Managing ALM positions - Yield Curve R a t e 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% U.S. Treasury Yield Curve As of today, extremely low yields under 2 years. Significant duration risk beyond 7 years. Sweet spot on the curve is between 3 and 7 years. 22

Managing ALM positions Cash Flow Cash Flow Analysis - Base Scenario Assets and Liabilities Book Value 1-3 Months 4-6 Months 7-12 Months Year 2 Year 3 3 Year Cumulative Certificates of Deposit 7,366,000 2,695,000 1,233,000 3,193,000 245,000-7,366,000 Fed Funds Sold 3,500,000 3,500,000 - - - - 3,500,000 U.S. Agencies 5,410,022 - - - - 1,600,000 1,600,000 Municipal Securities 8,364,586 150,000 60,000 925,000 775,000 1,455,000 3,365,000 Agency MBS 12,011,391 623,920 543,770 894,536 1,583,477 1,408,889 5,054,592 Agency CMO 8,234,492 321,600 352,605 752,510 1,428,534 1,179,588 4,034,838 SBA Loan Pools 1,958,829 52,559 77,236 148,718 253,759 222,427 754,698 Total Investments 46,845,321 7,343,079 2,266,610 5,913,765 4,285,770 5,865,904 25,675,128 Residential Mortgage Loans 50,288,183 2,348,368 2,652,196 4,024,236 9,971,808 8,042,078 27,038,686 Home Equity 32,347,178 3,446,921 2,608,038 4,436,120 7,190,407 5,685,012 23,366,499 HELOCs 78,064,124 11,038,320 8,315,102 11,774,575 16,743,290 11,044,160 58,915,448 Consumer Loans 7,933,560 1,657,851 1,024,522 1,612,033 1,807,010 991,450 7,092,867 Loans Held for Sale 1,955,300 51,086 50,140 97,511 184,365 170,933 554,035 Total Loans 170,588,346 18,542,548 14,649,998 21,944,475 35,896,880 25,933,633 116,967,534 Total Assets 217,433,667 25,885,627 16,916,609 27,858,240 40,182,650 31,799,537 142,642,663 23

Managing ALM positions Cash Flow with Rate Shock Cash Flow Analysis - +300 Scenario Assets and Liabilities Book Value 1-3 Months 4-6 Months 7-12 Months Year 2 Year 3 3 Year Cumulative Certificates of Deposit 7,366,000 2,695,000 1,233,000 3,193,000 245,000-7,366,000 Fed Funds Sold 3,500,000 3,500,000 - - - - 3,500,000 U.S. Agencies 5,410,022 - - - - - - Municipal Securities 8,364,586 150,000 60,000 230,000 745,000 300,000 1,485,000 Agency MBS 12,011,391 566,663 444,180 777,327 1,518,112 1,346,202 4,652,484 Agency CMO 8,234,492 321,600 352,605 752,510 1,428,534 1,179,588 4,034,838 SBA Loan Pools 1,958,829 52,559 75,297 138,171 237,751 212,675 716,452 Total Investments 46,845,321 7,285,822 2,165,081 5,091,009 4,174,397 3,038,465 21,754,774 Residential Mortgage Loans 50,288,183 1,844,327 2,179,185 3,206,380 8,958,788 7,647,259 23,835,939 Home Equity 32,347,178 2,780,645 2,053,770 3,591,622 6,386,843 5,825,620 20,638,500 HELOCs 78,064,124 10,999,590 8,285,067 11,724,774 16,689,175 11,033,624 58,732,230 Consumer Loans 7,933,560 1,654,355 1,022,300 1,609,642 1,806,916 994,501 7,087,713 Loans Held for Sale 1,955,300 41,575 41,084 80,722 155,803 148,550 467,733 Total Loans 170,588,346 17,320,492 13,581,406 20,213,139 33,997,525 25,649,552 110,762,114 Total Assets 217,433,667 24,606,314 15,746,487 25,304,148 38,171,922 28,688,018 132,516,888 24

Managing ALM positions Duration Account Weighted Avg. Modified Avg. Life Yield Duration Certificates of Deposit 0.52 0.58 0.58 Fed Funds Sold 0.10 0.04 0.04 U.S. Agencies 1.75 5.35 3.29 Municipal Securities 3.44 5.29 3.62 Agency MBS 2.37 4.47 4.27 Agency CMO 1.85 3.46 3.25 SBA Loan Pools 1.71 5.60 5.11 Residential Mortgage Loans 4.19 3.95 3.30 Home Equity 5.57 2.17 1.88 HELOCs 4.36 2.08 1.85 Consumer Loans 6.08 1.15 1.02 Loans Held for Sale 3.46 n/a n/a Other Assets - - - Total Assets 4.03 2.84 2.41 25

Duration Measure of price sensitivity to interest rates. The calculation involves yield, principal repayment and present value. Higher duration implies more price volatility risk. 26

Non-maturity Share Assumptions for ALM Re-pricing beta Effective maturity Decay Surge Members have continuous and unlimited options to increase or decrease balances. These options may or may not correlate to market conditions. 27

Sources of Non-maturity Share Assumptions Historical studies of an institution s past share behavior NERA (National Economic Research Associates) study FDICIA 305 Par (thus, no assumption) 28

Quarterly Share Re-Pricing Comparison to 1 Month LIBOR 6.00 5.00 4.00 3.00 Share Drafts Regular Shares Money Market Shares 1 M Libor 2.00 1.00 0.00 29

Beta Indicates the magnitude of change the credit union would likely make in response to changes in market interest rates Calculated with a linear regression that compares the change in the dividend rate to the change in 1 month LIBOR Calculated Betas are used for the ALM analysis Account Type Beta Share Drafts 0.00 0.20 Regular Shares 0.15 0.30 Money Market 0.40 0.65 30

Effective Maturity Indicates when the last cash flow for an account type is projected to occur Derived from a second regression analysis modeling the spread between the rate index and deposit rate versus the average balance for the account type Calculation of r-squared measures how well changes in average deposit balances are explained by changes in the spread of the deposit rate to the rate index R-Squared Effective Final Maturity (years) 0 10 0.20 8 0.40 6 0.60 4 0.80 2 1.00 0 31

Financial Crisis Impact on Effective Maturity Calculation Due to the unprecedented financial crisis, non-maturity deposit balances have increased even though dividend rates were at historical lows As a result, effective maturities are calculated to be longer than in a normalized interest rate and economic environment Wilary Winn recommends using 50% to 75% of the calculated effective maturities for ALM modeling in a rising interest rate environment 32

Decay assumptions A decay rate analysis can be performed using one of two methods: a) Account number method: This method begins with a set of accounts and balances. These accounts are then tracked in order to determine what happens to the balances over time. In the process, no new accounts are considered. b) Origination date method: This method compares beginning and ending balances of all accounts by account type and also takes new accounts into consideration in order to determine a decay rate. Account numbers are generally not needed for this method. In most cases, both methods will yield roughly the same results. 33

Decay Rate Example for ALM Analysis Decay Rates by Shock Scenario Share Type -300-200 -100 Base +100 +200 +300 Share Drafts 8.50 9.17 9.83 10.50 11.00 11.50 12.00 Regular Shares 10.50 11.17 11.83 12.50 13.00 13.50 14.00 Money Markets 18.50 19.00 19.50 20.00 20.67 21.33 22.00 34

Financial Crisis and Surge Deposits As a result of the recent financial crisis, financial institutions experienced non-maturity balances increasing even with dividend rates at historic lows Investors increased their preference for liquidity leading to a surge in deposits at financial institutions across the nation These Surge deposits are projected to migrate into alternative investments in other asset classes as market interest rates increase Surge deposits should be modeled with high decay rates and higherthan-average betas to forecast the outflow of these funds 35

Surge Analysis Example Actual vs. Projected Balance Money Markets - Actual vs Projected Balances 45,000,000 40,000,000 35,000,000 Actual Balance Projected Balance 30,000,000 25,000,000 20,000,000 15,000,000 10,000,000 5,000,000-20% of the money market balance is identified as surge 36

Managing ALM positions Cash Flow Cash Flow Analysis - +300 Scenario Liabilities Book Value 1-3 Months 4-6 Months 7-12 Months Year 2 Year 3 3 Year Cumulative Free Checking 5,732,008 136,103 132,871 256,352 477,181 433,448 1,435,955 DDA Accounts 42,013,529 997,583 973,896 1,878,968 3,497,563 3,177,019 10,525,029 Commercial DDA 5,878,018 139,570 136,256 262,882 489,336 444,490 1,472,533 Money Market Accounts 35,528,016 1,005,452 976,998 1,871,830 3,436,146 3,063,373 10,353,799 Money Market Accounts - Surge 9,028,823 2,168,401 1,647,629 2,203,186 3,009,608-9,028,823 New product 1 838,693 28,138 27,194 51,682 93,359 81,447 281,820 Savings 27,064,011 907,995 877,532 1,667,729 3,012,635 2,628,235 9,094,126 Savings - Surge 10,890,037 2,615,398 1,987,273 2,657,354 3,630,012-10,890,037 Business Savings 706,198 23,693 22,898 43,517 78,611 68,580 237,299 Business Savings - Surge 284,161 68,245 51,855 69,340 94,720-284,161 New product 2 2,597,528 87,147 84,223 160,064 289,144 252,251 872,829 Total Non-Maturity Deposits 140,561,022 8,177,726 6,918,625 11,122,903 18,108,315 10,148,843 54,476,412 Total Certificates of Deposits 56,489,182 10,372,822 9,716,881 18,557,551 11,183,775 4,225,182 54,056,211 Total IRA Accounts 16,368,206 11,390,866 799,290 1,761,079 1,174,483 1,011,063 16,136,782 Total Time Deposits 72,857,388 21,763,688 10,516,171 20,318,630 12,358,258 5,236,245 70,192,992 Total Liabilties 213,418,410 29,941,414 17,434,796 31,441,533 30,466,573 15,385,088 124,669,404 37

Managing ALM positions Cash Flow Cash Flow Analysis - Base Scenario Book Value 1-3 Months 4-6 Months 7-12 Months Year 2 Year 3 3 Year Cumulative Total Assets 217,433,667 25,885,627 16,916,609 27,858,240 40,182,650 31,799,537 142,642,663 Total Liabilties 213,418,410 25,233,538 13,898,760 26,830,898 40,613,018 14,443,934 121,020,149 Net 4,015,257 652,088 3,017,848 1,027,341 (430,368) 17,355,603 21,622,513 Cash Flow Analysis - +300 Scenario Book Value 1-3 Months 4-6 Months 7-12 Months Year 2 Year 3 3 Year Cumulative Total Assets 217,433,667 24,606,314 15,746,487 25,304,148 38,171,922 28,688,018 132,516,888 Total Liabilties 213,418,410 29,941,414 17,434,796 31,441,533 30,466,573 15,385,088 124,669,404 Net 4,015,257 (5,335,100) (1,688,309) (6,137,385) 7,705,349 13,302,929 7,847,484 38

Managing ALM positions Duration Account Weighted Avg. Modified Avg. Life Yield Duration Share Drafts - no interest - 5.21 5.05 Share Drafts - interest 0.10 5.21 5.05 Money Market Shares 0.55 4.30 4.24 Money Market Shares - Surge 0.55 1.40 1.39 Regular Shares 0.35 5.05 4.94 Regular Shares - Surge 0.35 1.45 1.44 Certificates 0.76 0.95 0.94 Total Liabilities 0.44 2.60 2.57 39

Managing ALM positions Duration Account Weighted Avg. Modified Yield Duration Total Assets 4.03 2.41 Total Liabilities 0.44 2.57 Scenario Fair Value of Fair Value of Fair Value of % Change Assets Liabilities Equity from Base -300 243,691,564 214,515,470 29,176,094-1.11% -200 243,741,162 214,922,138 28,819,024-2.32% -100 242,804,213 212,861,070 29,943,143 1.49% Base 238,609,308 209,106,438 29,502,870 100 233,210,721 205,338,512 27,872,209-5.53% 200 228,006,165 201,758,064 26,248,100-11.03% 300 222,898,380 198,385,408 24,512,971-16.91% 400 218,132,599 195,206,023 22,926,576-22.29% 40

Policies ALM Policy Investment Policy Liquidity Policy Concentration Risk Policy Contingency Funding Policy 41

Recommendations for Policies State permitted variability for both short-term (NII for 1 year and 2 years) and long-term interest rate risk (EVE) under various interest rate shocks (-100, +100, +200, +300 and +400) State objectives related to managing cash flow (% of principal returned in year 1, year 2, etc.) State assumption methodology related to non-maturity deposit ALM modeling Limit the purchase of securities with call features Proactively seek out and test funding sources in conjunction with the contingency funding plan Add a derivatives policy in case it is needed in the future 42

Solutions if +300 EVE Scenario Exceeds the ALM Policy Threshold (asset duration significantly exceeds liability duration) Sell long-term fixed rates assets and/or investments Originate variable rate loans / purchase variable rate securities Extend the maturity on share certificate liabilities Extend the maturity on advances Evaluate derivative solutions 43

NCUA and Derivatives On January 23, 2014 the NCUA Board adopted a final rule that allows federal credit unions to mitigate interest rate risk with permissible derivatives 44

Permissible Derivatives Interest Rate Swaps Interest Rate Caps Interest Rate Floors Basis Swaps Treasury Futures 45

2 Year Interest Rate Swap Pay Fixed, Receive Floating Base Case Swap Cash Flows and Shock Impact on $100 MM Notional $100 MM Interest Rate Swap - Base Case Cash Flow Pay Date Pmts (Rcv) Rate (Rcv) Pmts(Pay) Rate (Pay) Net Pmts Discount PV Q2 2014 57,025 0.23% -134,970 0.54% -77,945 0.9994-77,900 Q3 2014 60,770 0.24% -134,970 0.54% -74,200 0.9988-74,111 Q4 2014 68,448 0.27% -137,969 0.54% -69,521 0.9981-69,390 Q1 2015 85,269 0.34% -137,969 0.54% -52,701 0.9973-52,555 Q2 2015 112,168 0.45% -128,971 0.54% -16,803 0.9961-16,739 Q3 2015 172,454 0.69% -137,969 0.54% 34,485 0.9944 34,290 Q4 2015 228,218 0.91% -133,470 0.54% 94,748 0.9921 93,998 Q1 2016 299,170 1.20% -134,970 0.54% 164,200 0.9891 162,409 Total / Avg 1,083,522 0.54% -1,081,260 0.54% 2,262 0 Swap Impact -200-100 Base +100 +200 +300 cash flows (1,081,260) (1,032,090) 2,262 2,005,040 4,007,818 6,010,595 46

Additional resources on derivatives can be found at our Website: www.wilwinn.com Resources include: Accounting for Derivatives White Paper NCUA Derivatives White Paper - "Should My Credit Union Use Derivatives to Manage Credit Risk?" NCUA Derivatives Webinar - April 17, 2014 Accounting for Derivatives Webinar - May 1, 2014 47

Stress Testing Example for Rising Interest Rates Increased defaults on variable rate loans due to payment shock Surge balances in non-maturity shares reinvest into share certificates Early redemption of existing share certificates Increased beta on non-maturity shares Stress testing varies by client and their business model Provides insight to help plan strategies 48

Stochastic Modeling Supply prices to solve for option adjusted spread with a Monte Carlo Simulation Works best with residential mortgage loans and securities Interest rate movement is random Binomial or trinomial lattice structure Multiple simulations (thousands) of interest rate movements are performed for estimating probability distributions Increased valuation accuracy 49

Random Paths Assuming a 4% Starting Rate and Mean Reversion 50

Contact Information Wilary Winn LLC First National Bank Building 332 Minnesota Street, Suite 1750W Saint Paul, MN 55101 651-224-1200 www.wilwinn.com 51

Services and Contact Information Private Label MBS/CMOs and Asset Liability Management: Frank Wilary fwilary@wilwinn.com Mergers and Acquisitions, Fair Value Footnotes, ASC 310-30, and TDRs: Brenda Lidke blidke@wilwinn.com Mortgage Servicing Rights and Mortgage Banking Derivatives: Eric Nokken enokken@wilwinn.com 52