Something Strange Happened on the Way...

Every year bank analysts and auditors review loan fair values to prepare annual reports, SEC filings, and other year-end analyses.  A common question arising this year is ‘why are loan fair values still showing a premium given the rising interest rate environment we experienced last year?’

 Over the last six months of 2004 the Fed raised the target fed funds rate 125bp.  This tightening by the Fed has had the obvious impact on Prime and short-term yield curve rates and created the impression that we are in a rising rate environment.

 However this change in rates hasn’t had the broad impact on loan portfolio values that many expected.  As of December 2004 the average total loan premium was 1.89%.  While this is down from 3.32% at the end of the previous year, it is still well above a low point of 0.45% set in March 2000.

Determining value

There are several factors that impact the fair value of a bank’s loan portfolio: credit quality of borrowers, market rates, portfolio duration, economic conditions, etc.  Bank credit quality measurements have been improving for the past several years.  The FDIC reports that as of December 2004 the noncurrent loan rate has reached a historic low.  Given this positive change in credit quality, the two other factors that have recently had the most influence on overall fair value are market interest rates and portfolio duration.

 As market interest rates fall, financial instrument values rise.  This is true for all instruments on a bank’s balance sheet including loans, securities, deposits, and borrowings.  The impact of rate movements on value has been most obvious in securities portfolios over the past two years.  Banks have reaped the rewards of this phenomenon, posting record net income numbers by taking significant gains on the sale of securities.  However, the opposite is also true, when rates rise, financial instrument values fall.  Over the next several quarters such gains are likely to become non-existent.

 How fast a portfolio’s value rises and falls in reaction to market rates depends largely on the portfolio’s duration.  Shorter-term loan portfolios (see duration chart) tend to maintain their value in the face of changing rates, while the value of longer-term portfolios is much more sensitive to market interest rate changes.

Things aren’t always as they seem

In early March of 2005 a Washington Post columnist wrote a piece entitled, “The Mystery of Low Interest Rates.”  The column was a somewhat clever (if not tongue-in-cheek) observation of what happened to market interest rates throughout 2004 and early 2005.  He wrote, “Something strange happened on the way to higher interest rates: They declined.” ¹

 Market interest rates went through some unique and unexpected transitions in 2004.  The change in short-term rates, lead by changes in Fed Funds, followed a very straightforward and predictable path from beginning to end.  It began the year at 1.00% and stepped up five times to finish the year at 2.25%.

 Longer-term rates behaved in a more unusual way.  One such rate, the 5-year treasury, started the year at 3.27%.  At the end of March it had moved down to 2.79%.  It reversed direction over the next 3 months and moved up significantly to 3.93% by the end of June.  By the end of September it had once again moved down by more than 50bp, and by the end of the year the 5-year treasury rested at 3.60% only 49 basis points above where it started.

 Most industry analysts are surprised by the behavior of long-term rates.  It is highly unusual for long-term rates to fall despite a better economy and the Fed tightening.¹

Loan portfolio duration

The duration of a bank’s loan portfolio is also a key ingredient in determining value.  Throughout 2004 banks with shorter-term loan portfolios (see duration chart) have shown a steady decline in premium that followed the steady rise in short term rates.  The total loan premium for short-term portfolios began the year at 3.89% and trended downward to 2.37% by the end of the year.  This occurred at the same time the Fed was implementing its policy of measured increases to the overnight rate.

 The total loan premium for long-term portfolios was much more volatile during 2004.  In March 2004 the total premium was 3.99%.  By the end of June 2004 the premium had dropped to 0.86%.  This drop corresponds to the significant rise in longer-term rates like the 5-year and 10-year treasuries.  At the end of September 2004 total premium had recovered somewhat to 1.95%.  Finally by the end of the year it was back down to 0.83%.  This volatility followed the instability of longer-term rates throughout the year.

Anticipating what happens next

As we begin 2005 the Fed has already moved its overnight rate up another 25bp.  Some economists are predicting even faster moves if the Fed feels the need to keep inflation in check.  Industry analysts feel that long-term rates are still unusually low and expect them to rise appreciably in the near future.

 How will the value of your loan portfolio react?  Do you have a relatively short portfolio that will allow you to adjust your pricing and sustain a steady decrease in value?  Such portfolios will probably allow you to take better advantage of rising rates.  Or if your portfolio is relatively long are you prepared for more volatile changes in value?  Do you have strategies in place to help you maintain your margin as interest rates continue to rise? ¶

1) “The Mystery of Low Interest Rates”, Robert Samuelson, Washington Post, Wednesday, March 2, 2005; Page A17
 

This A/L BENCHMARKS Industry Report article was published
and is ©2004-2005 by Olson Research Associates, Inc.