FHLBInsider

By James Eibel, consulting manager, assistant vice president

"Drive your business or it will drive thee."

--- Benjamin Franklin

The previous issue of the Insider included a table listing returns on equity (ROE's) resulting from various spreads over advances and capital ratio combinations. As capital ratios increased, spreads required to generate a given ROE also increased. This illustrated the cost of holding excess capital. It's simply more difficult to generate competitive ROE's if you have a lot of "E." The culprit is the equity multiplier in this equation:

ROE = ROA x Equity Multiplier

= Net Income/Assets x Assets/Capital

All financial institutions should seek to manage both interest and non-interest margins in order to maximize return on assets (ROA). The problem is that maximizing ROA does not necessarily maximize ROE. ROE can only be maximized through the prudent management of both ROA and the equity multiplier.

The equity multiplier represents the amount of assets supported by each dollar of capital. For any given ROA, the smaller the amount of capital, the higher the ROE will be. The power of this concept is illustrated by the following example.

Suppose that you are an investor considering a stock purchase in either First Underwater or Second Underwater Bank of Atlantis. The institutions are almost identical, to the point of generating 1.0% ROA's year after year. The only significant difference between the two is that First Underwater has managed its equity multiplier at a constant of 10 (capital equals 8% of assets). If both institutions had the same stock price, which institution would you invest in?

The difference in equity multipliers would result in ROEs of 10% at First Underwater Bank and 12.5% at Second Underwater Bank. In effect, excess capital at First Underwater Bank has cost stockholders 25% of their total return.

How Much is Enough?

How much capital is enough? The answer depends on your business strategy. Institutions planning on making acquisitions need to accumulate excess capital. Beyond special strategic considerations, maintaining a "well capitalized" designation (as defined by the FDIC) should be a goal to keep deposit premiums to a minimum. For most financial institutions the optimal capital-to-assets ratio lies somewhere between 6% and 9%. Ratios in this range generally provide the best balance between regulatory and profitability needs.

If your institution is holding excess capital, you have plenty of company. Three possible solutions are:

• paying out a special dividend
• buying back stock, or
• using leverage.

The first two options are relatively easy to execute, but may not convey a positive message to the market. Increasing the payout ratio sets a precedent and implies that you cannot find a way to deploy the capital more profitably internally. A stock buy-back suggests that the best investment available to your institution is its own stock. Depending on your stock's historical performance, this may or may not be the message you wish to send.

Optimizing capital with leverage involves making familiar funds management and investment decisions to achieve controlled growth. The liabilities can be either wholesale or retail. The assets can be either loans or securities.

On the funds management side, it is difficult to acquire new deposits without excessively bidding up deposit rates. A convenient and economical solution is using advances from the Federal Home Loan Bank.

On the asset side, both loans and securities have their advantages. Loans usually produce better spreads and result in new customer relationships. Additional loans could be generated through aggressive pricing, offering new products, or simply, holding loans that are currently being sold. If loan demand is a problem, securities can be used. Securities have the advantage of being more liquid, preserving the option to unwind or alter the leveraging strategy in the future. Among the many possibilities, floating rate CMOs are attractive in a rising rate environment.

Leveraging CMO Floaters

CMO floaters come in many varieties. Most frequently, they are tied to the London Interbank Offered Rate (LIBOR). These adjustable rate securities have the advantages of having only lifetime caps to contend with, being easy to fund with advances, and producing attractive spreads. Since there are no periodic caps, the CMO floater adjusts the whole amount when rates increase (if the lifetime cap has not been reached). The Federal Home Loan Bank offers LIBOR based advances that can be used to match fund these securities. The advances are typically priced at LIBOR plus or minus five basis points (bp). At the time of this issue, CMO floaters were priced to yield 120-200 bp over LIBOR. These securities typically have lifetime caps between 9% and 10%. The risk inherent in these caps should be carefully evaluated. Remember, a capped-out floater is essentially a long term fixed rate mortgage that can only adjust down. Unless you are the First Underwater Bank of Atlantis, this is not an attractive possibility.

Speaking of First Underwater Bank, CMO floaters could be a tool to leverage its excess capital. Before we dive in, it must be noted that leverage strategies should be carefully analyzed, documented, and cleared with your board of directors and regulators before execution.

Let's assume that the management of First Underwater has done its home work and has developed a strategy to instantaneously grow the $100 million institution to $125 million with CMO floaters. In mid-December 1994, PAC CMO floaters with average lives of about eight years and lifetime caps of 9.5% were priced to yield one month LIBOR plus 150. At that time, the one month LIBOR rate was 6.125% and the Federal Home Loan Bank was offering LIBOR-based advances at two bp over the index, producing an initial spread of 148 bp. Assuming the floaters perform as anticipated for the first year, the leveraging results would be as follows:

New CMO floaters $25,000,000

X Spread over funding 1.48%

Add'l. pretax interest inc. $370,000

Less taxes at 34% rate ($125,800)

Additional net income $244,200

Since First Underwater Bank has steadily produced 1% ROAs, it can be assumed that normal operations would produce $1 million in net income. Therefore, a total of $1,244,200 in net income would be generated. If it is assumed that the additional net income is paid out as dividends, the institution's ROE would jump from 10% to 12.44% ($1,244,200) net income/$10,000,000 in equity). In addition to the 244 bp increase in ROE, ROA would hold steady at about 1% ($1,244,200 net income/$125,000,000 assets) after the leveraging.

Generally, leverage strategies result in some tradeoff between ROA and ROE. While First Underwater's floater CMO strategy appears to be a winner, the impact of different interest rate scenarios should be considered before execution.

This article has been presented for educational purposes only.  The FHLBI is not a financial or investment advisor.   It is solely the reader's responsibility to evaluate the risk and merits of any funding strategy or business proposal.

Copyright 1995, Federal Home Loan Bank of Indianapolis