Interest Rate Risk Management

Scott Hildenbrand

March 26, 2013

Managing Director(212) 466-7865shildenbrand@sandleroneill.com

FMS East Coast Regional Conference

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• Changes in rates from 2009 to now

• Which scenario is worse?

Interest Rate Environment

Index 2009 2010 2011 2012 TODAYFed Funds Target 0.25% 0.25% 0.25% 0.25% 0.25%

2 Year Treasury 0.76% 1.14% 0.61% 0.25% 0.26%

10 Year Treasury 2.25% 3.30% 1.89% 1.78% 1.93%

Bank Margins ↑ ↑ ↑

Source: Bloomberg

Slow increase over time? Rates stay here for 2 years then…?

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86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Year

Fed Funds Target Rate: 1986 - 2012

Tightening Fed Fund PeriodCycle Increase (Days)

'04 - '06 4.25% 735'98 - '99 1.75% 329'94 - '95 3.00% 371'87 - '88 3.25% 336Average 3.06% 443

The past four Fed tightening cycles have seen rates rise on average 300+ basis points over 1.2 years

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• Most banks have little or no loan demand and strong deposit growth

• Do I believe my interest rate risk results with regards to deposit behavior?

• Available for Sale securities portfolio as a percentage of assets continues to increase

• Average length of the bond portfolio continues to increase as well

• Are Tangible Common Equity ratios in trouble?

• Do I understand the potential impact?

Thoughts and Questions

Interest Rate Risk Modeling

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• Persistent low rate environment for the past 4 years – how much longer will we be here?

• Every interest rate risk model run shows strong deposit base and ability to fund loan growth

• Banks have gotten comfortable with current and projected liquidity levels

• But… are we prepared for rising rates and potential deposit outflow?

• How will you fund loan growth if the economy improves and deposit base shrinks?

• Are you using your interest rate risk model as an effective “what-if” tool?

Current Interest Rate Risk Model

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-7.07%

-10.01%

-11.55%

-15.98%

-18.00%

-16.00%

-14.00%

-12.00%

-10.00%

-8.00%

-6.00%

-4.00%

-2.00%

0.00%up 300 bps up 400 bps

CURRENT NII VOL PROJECTED NII VOL

• By changing the current beta assumption from 45% to 80% , NII would decline an additional 4.48% up 300bps and 5.97% up 400bps (assumes an immediate rate shock)

• Prudent exercise to stress potential deposit competition in a rising rate/improving economy• This bank’s MMDA accounts represent only 16% of deposit base

Stressing Deposit Pricing

-4.48% change$1.6mm change

-5.97% change $2.2mm change

ESTIMATED IMPACT ON NII VOLATILITY

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ISSUE: Can we add 30 year fixed rate loans without significantly impacting the bank’s current interest rate risk position?

OPTIONS:

Overheard at ALCO…

OPTION PROS CONS

Use excess cash• Flush with deposits already• Increase yield on assets• Improve margin

• Adding duration to the asset side, which will hurt IRR in rising rate scenario

Hedge specific loans • Can immediately add floating rate assets

• Lowers initial spread• Resource-intensive

Use liability side combined with off-balance sheet

• Can use wholesale funding instead of deposits that may not be there if rates rise

• Accounting “path of least resistance”

• Cash flow hedge helps protect TCE against negative AFS mark if rates rise

• May require growing the balance sheet

• More expensive than using cash

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Can We Add Fixed Rate Loans to the Balance Sheet?

OPTION DESCRIPTION INITIAL SPREAD PROTECTS TCE IF RATES RISE?

Use excess cash Use excess cash at 0.25% to put on $50mm of 3.625% fixed rate loans

3.375%(3.625% - 0.25%)

Hedge specific loans

Swap fixed rate loans to 10 year floating rate at 1mL + 1.80%

1.750% (2.00% - 0.25%)

Use liability side combined with

off-balance sheet

1. New 7 year floating rate borrowing (currently 3mL + 0.47%)

2. Hedge with forward-starting pay fixed swap (pay 2.36% starting in 2 years until final maturity)

2.875%(3.625% - 0.75%)

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Approach:• After looking at current IRR profile, the bank wanted to ensure from an interest rate risk and

liquidity perspective that their deposit base would remain in an improving economy• Bank reviewed MM account balances at the end of 2007 and today. The growth they saw over this

time period was concerning.• They ran two “what-if” scenarios in the interest rate risk model:

– 25% of growth in MM accounts leaves the bank if rates rise 300bps– 50% of growth in MM accounts leaves the bank if rates rise 300bps

• In both scenarios, the results showed significant margin contraction and stress on liquidity

Action:• Instead of only using excess cash to fund new fixed rate loans, they decided to use only a portion of

cash and fund the other portion with long-term fixed rate wholesale funding (a combination of Options 1 and 3)

Results:• Using 50% cash and 50% wholesale funding gives an initial spread of 3.125% • Locks in long-term liquidity near all-time lows in rates• Protects TCE in a rising rate environment by combining economics and accounting (applying a cash

flow hedge to long-term floating rate funding)

Plan of Action

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• Enter into a forward-starting pay-fixed interest rate swap to “fix the rate” on new and/or newly-restructured floating rate advances

• The future rate is “locked in”, but there is no upfront cost or impact on current earnings

• The market value changes of the swap designated as “cash flow hedges” also flow through OCI, a component of Tangible Equity

• As rates rise, the swap increases in value and gains flow into OCI*, partially offsetting losses from the AFS portfolio

• The Bank is required to post collateral against the market value of the swap throughout its life, with potential for an independent amount to be posted at inception

Forward Starting Swaps

*Sandler O’Neill is NOT a licensed accounting advisor and this does not represent accounting advice. The Bank should consult their external auditors and/or accounting professionals for guidance on accounting treatment and impact of any proposed transactions.

FHLB SWAP DEALERBANK

LIBOR + spread

Fixed Rate

LIBOR + spread

Floating Rate Borrowing Swap Starting X Years Forward

Evaluating the Bond Portfolio: Impact on IRR and Capital

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Book % of Gain / Book Yield Effective Duration

Par Value Value Total (Loss) $ 3m Speed Bank's Flat +300bps

Book Value Agencies - Non-Callable (4) 4.0 1.6% 0.0 2.74% 2.65% 0.2 0.2

Market Value Agencies - Callable (14) 23.1 9.2% (0.1) 2.66% 2.68% 5.8 10.2

Agencies - Step-Ups (6) 18.9 7.6% (0.1) 2.25% 2.26% 8.0 12.3

Fixed MBS (77) 76.8 30.7% 1.7 2.13% 2.77% 3.5 5.0

Unrealized Gain/(Loss) $3,352,935 MBS ARMs (0) 0.0 0.0% 0.0 0.00% 0.00% 0.0 0.0

Unrealized Gain/(Loss) - AFS Only 3,352,935 CMO/SBA (29) 16.6 6.7% 0.4 1.24% 2.27% 2.1 4.5

Aggregate Gains 4,186,379 Corporates (2) 1.0 0.4% 0.0 3.05% 3.21% 0.0 0.0

Aggregate Losses (833,445) Municipals - Non Callable (81) 22.0 8.8% 0.4 2.75% 2.79% 0.8 1.0

Municipals - Callable (236) 86.8 34.7% 1.0 4.36% 4.10% 4.0 5.2

Other (2) 0.7 0.3% 0.0 0.00% 0.00% 0.0 0.0

Book Yield: Historical 3Mo. Speeds 2.97% TOTAL (451) 250.0 100.0% 3.4 2.97% 3.17% 3.8 5.6

Bank's Book Yield 3.17%

Effective Duration - Flat 3.8Effective Duration - +300bps 5.6Average Life 8.0

% of Total PortfolioProjected Book Yield <1% 5.3Lots smaller than 1MM 49.1Premiums with 3mo CPR > 25 15.7

PORTFOLIO STATISTICS

$246,313,200249,986,944253,339,879

PORTFOLIO SNAPSHOT SECTOR BREAKDOWN

Agencies - Non-Callable

Agencies - Callable

Agencies - Step-Ups

Fixed MBS

MBS ARMs

CMO/SBA

Corporates

Municipals - Non Callable

Municipals - Callable

Other

Current Investment Portfolio – Sector Analysis

(1) Market valuation as February 28, 2013, as provided by the Bank

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Current Notional 246,313,200 246,313,200 246,313,200 246,313,200 246,313,200Market Value $258,882,096 $253,339,879 $241,402,597 $228,715,879 $216,726,706Change in MV 2.2% - (4.7%) (9.7%) (14.5%)Gain/Loss $8,895,151 $3,352,935 ($8,584,348) ($21,271,065) ($33,260,238)Avg Life 2.3 8.0 9.1 9.6 9.7Eff Duration 1.2 3.8 5.2 5.6 5.6

Down 100 Flat Up 100 Up 200 Up 300

PRICE VOLATILITY ANALYSIS

$8,895

$3,353

($8,584)

($21,271)

($33,260)

(40,000)

(35,000)

(30,000)

(25,000)

(20,000)

(15,000)

(10,000)

(5,000)

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($t

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)Current Investment Portfolio – Price Volatility Analysis

Market valuation as February 28, 2013, as provided by the Bank

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PROJECTED ANNUAL PRINCIPAL CASH FLOWS

$ % $ % $ % $ % $ %Down 100 100,255 41% 65,506 68% 28,116 79% 16,445 86% 11,021 90%

Flat 46,091 19% 38,477 34% 20,656 43% 8,144 46% 6,780 49%

Up 100 32,954 13% 27,393 25% 18,275 32% 10,024 36% 9,426 40%

Up 200 22,995 9% 24,224 19% 18,388 27% 12,121 32% 11,062 36%

Up 300 20,282 8% 21,177 17% 19,228 25% 12,765 30% 11,648 35%

*Dol lar va lues shown on an annual bas is , percentages shown are cumulative.

Year 5Year 1 Year 2 Year 3 Year 4

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Prin

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hflow

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)Current Investment Portfolio – Cash Flow Analysis

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3.16

3.02

2.87

2.73

2.57

2.41

2.25

2.09

1.92

2.412.27

2.121.95

1.78

1.61

1.44

1.27

1.08

2.68

2.51

2.33

2.13

1.93

1.73

1.52

1.32

1.10

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3.50

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Yie

ld

% Price Decrease up 300bps

With Credit Without Credit Investment Policy Book Yield Market Yield Projected Yield

ALLOCATION LIMITS"Without Credit"

Treasury 40%Agency Debenture 40%MBS - Fixed 40%MBS - Adjustable 40%Agency CMO 40%FN DUS, GN Multifam, SBA 33%

"With Credit"Same limits as above, plus:

CMBS 40%Student Loan Bonds 40%CMBS 40%Corporates 40%GO BQ Muni 40%Private Label 40%

Current Portfolio:Market Yield : 1.79%Book Yield : 2.97%14.5% Price Decrease up 300bps

Market Yield: 1.79%

Book Yield: 2.97%

2013 Budget Projected Yield: 2.43%

17.3% Price Decrease up 300bps

Current Market: Efficient Frontier

This graph shows the MOST yield that can be earned for increasing levels of duration risk. The different curves are for investment allocations with and without credit risk.

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Quantifying Impact to the Bank’s Tangible Capital Ratio

Estimated ratio reflects market value of investment portfolio as of February 28, 2013, as provided by the BankVolatility reflects an instantaneous up 300bps shock

Estimated Tangible Common Equity Ratio

7.90%

5.89%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

2/28/13 Estimated +300 bps

As of 2/28/2013

Estimated +300 bps

Tangible Common Equity 85,301 61,503Tangible Assets 1,080,068 1,043,455TCE Ratio 7.90% 5.89%Estimated OCI Mark (PreTax) 3,353 (33,260)

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• AFS securities are one of the only instruments on bank balance sheets that are marked-to-market through equity (not through earnings)

• One of the other instruments that are treated this way are interest rate derivatives that are designated as “cash flow hedges” under ASC/815 (codification of guidance originally issued under FAS 133)

• In this interest rate environment, the preservation of tangible equity is one of the most-frequently stated goals that community banks cite for increasing their use of these derivatives

• Common qualifying cash flow hedge strategies are entering into pay-fixed interest rate swaps or purchasing interest rate caps, which are designated as hedges against wholesale funding, such as:– Floating rate FHLB advances / repo– Short term FHLB advances, repo, and / or brokered CDs– Brokered MMDA and other index linked deposit products

• If designated as effective cash flow hedges, the derivative is marked-to-market through OCI, a component of tangible equity , and as rates rise these instruments increase in value and gains flow through OCI, which can partially offset losses from the AFS portfolio

Immunizing Tangible Equity

Under Basel III as written, unrealized gains/losses on Cash Flow Hedges are backed out of Common Equity Tier 1 Capital unless the hedged item is fair-valued; under this rule, the benefit of these strategies still applies to GAAP Equity and therefore Tangible Book Value, but not to regulatory capital.

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• Bank wanted to hedge a portion of potential negative impact of AFS securities portfolio on TCE

• An immediate 300bps shock results in an approximate 2.00% change in the bank’s TCE ratio– Although this is an extreme scenario, an immediate rate shock illustrates the worst case impact to TCE

• In order to get a cash flow hedge on the books, the bank needed to find floating rate funding to apply the cash flow hedge

• Can restructure existing FHLB advances into floating rate funding, which can be done under debt modification accounting guidelines

• The newly-restructured funding was then swapped back to fixed, creating synthetic fixed rate funding

• In order to improve margin for the next two years, the bank chose to use a fixed rate swap with an effective date two years forward

• Improves +300bps TCE from sub-6% to over 6.25%

Protecting TCE in a Rising Rate Environment

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Estimated +300bps Impact of $50mm Pay Fixed Swaps

Estimated TCE Ratio

Estimated +300bps impact is based on price volatility analysis performed by Sandler O’NeillAssumes an immediate parallel rate shock and a 35% tax rate

5.89%

6.26%

5.00%

6.00%

7.00%

Estimated +300 bps With Swap+300 bps

Estimated +300 bps

With Swap+300 bps

Tangible Equity 61,503 65,779Tangible Assets 1,043,455 1,050,034TCE Ratio 5.89% 6.26%Estimated OCI Mark (PreTax) (33,260) (26,681)

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Applying a Forward Starting Swap

*New Effective Rate assumes prepayment amortized over the duration of the new borrowing.  Results may vary if prepayment is straight lined amortized to maturity or accreted as a level yield calculation.  The Bank should consult their external auditors for guidance.

Step 1: Restructure to a LIBOR-based 7 year floating rate advances

Step 2: Pay fixed on 5 year swap starting 2 years forward

CURRENT LIABILITIES ESTIMATED PREPAYMENT RESTRUCTURE RESULTS INTEREST RATE SWAP HEDGE

Existing StructureCurrent Balance

Current Rate

Maturity Date

Market Price (%)

Estimated Unwind Fee

Effective Duration

New Debt Type

New Effective

Rate* New Effective Floating Rate

New Market

Rate

PotentialRate

Change Effective Duration

NPVChange

2YNP 2m 25,000,000 2.92 02/02/15 103.40 (850,750) 1.8 7Y Floater 1.05 3mL+0.77 0.55 (1.88) 0.2 7.09%2Y Bullet 25,000,000 2.70 01/28/15 103.80 (950,000) 1.8 7Y Floater 1.10 3mL+0.82 0.55 (1.60) 0.2 9.35%

Total Restructured (2) 50,000,000 2.81 01/30/15 103.60 (1,800,750) 1.8 1.07 3mL+0.79 0.55 (1.74) 0.2

CURRENT LIABILITIES INTEREST RATE SWAP HEDGE INTEREST RATE CAP HEDGE

Existing StructureCurrent Balance

Current Rate

Maturity Date

Pay Fixed Swap Term

Fixed Swap Rate

Effective Rate Years

Unhedged New Effective Rate w Swap

Rate Change w

SwapNew

Duration2YNP 2m 25,000,000 2.92 02/02/15 2y5y 2.07 3mL+0.77 2.84 (0.09) 4.92Y Bullet 25,000,000 2.70 01/28/15 2y5y 2.07 3mL+0.82 2.89 0.19 4.9

Total Restructured (2) 50,000,000 2.81 01/30/15 2.07 3mL+0.79 2.86 0.05 4.9

IMPACT YEARS 1 - 2

Total Strategy Size: 50,000,000

Old Borrowing Rate: 2.81%

New Borrowing Rate: 1.07%

Ann. Cost of Funds Δ (%): (1.74)

Ann. Cost of Funds Δ ($): (868,649)

IMPACT YEARS 3 - 7

Total Strategy Size: 50,000,000

Old Borrowing Rate: 2.81%

New Borrowing Rate: 2.86%

Ann. Cost of Funds Δ (%): 0.05

Ann. Cost of Funds Δ ($): 26,301

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Accounting for Swaps and Caps Under ASC 815

• Not a hedging instrument– Gains/losses due to change in Fair Value of the instrument flows through earnings– This creates significant income volatility

• Cash flow hedge– Applies to pay fixed swap or purchased cap/floor to “fix” the cash flows of a floating rate liability– If no ineffectiveness is recorded, the entire change in Fair Value of the hedge is recorded on balance sheet in

Other Comprehensive Income (OCI)– Any ineffectiveness, caused by a not perfectly matched hedge, goes through income

• Fair value hedge– Applies to pay fixed swaps to convert a fixed rate asset or liability to floating– Both the hedge and hedged item are marked to market through earnings, not OCI– Ineffectiveness is expected and will go through income

There are three basic designations for a swap or cap on the balance sheet:

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Hedge Accounting vs No Hedge Accounting

• If no hedge accounting is applied the gains/losses due to change in Fair Value of the cap will flow through earnings

Example assumes a 1.30% 5 year cap purchased in the first quarter of 2010 Swings in price range from over 3% loss to 1.39% gain without any payout on the cap

• Changes in market value will not flow through OCI if no cash flow hedge accounting is applied

• Additionally, if there is a gain in the cap, it will be recognized far before actual LIBOR increases thereby creating a timing mismatch for the interest rate protection

1.30% Cap Gain / LossQuarter End Market Value LIBOR 5Y Swap % $/mm

3/31/2010 8.07% 0.29% 2.73%6/30/2010 4.70% 0.45% 2.05% -3.37% (33,700)9/30/2010 2.60% 0.29% 1.51% -2.10% (21,000)

12/31/2010 3.99% 0.30% 2.17% 1.39% 13,9003/31/2011 4.24% 0.27% 2.46% 0.25% 2,5006/30/2011 2.53% 0.26% 2.03% -1.71% (17,100)9/30/2011 0.90% 0.43% 1.25% -1.63% (16,300)

12/30/2011 0.69% 0.54% 1.22% -0.21% (2,100)

Why not just purchase a cap outright with no hedge accounting?

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