LinkedIn Pulse: Bond Portfolio: In Search of Buried Treasure
By Bob Newman
March 14, 2017


When my kids were young we used to play a game we called “treasure hunt”. It consisted of me going to the end of the family room couch and lifting it off the ground while the kids scooped up toy cars, missing game pieces and other previously hidden gems. Sometimes we would pull off the cushions and find nickels, dimes and quarters that could be reinvested during a visit to the candy store. For financial institutions looking to improve their operating efficiency, a flashlight is typically pointed toward the couch cushion containing non-interest expenses with hopes of finding enough cost-saves to make a meaningful impact on the bottom line. But what if during the quest to uncover coins in the sofa there were dollar bills sitting on the coffee table in plain view?

At the recent Bank Director “Acquire or Be Acquired” conference, my colleague Dave Sweeney moderated a panel discussion entitled “Why Every Basis Point Matters Now” and he summarizes the key takeaways in this article. As it turns out, expanding the search from the P&L expense line to the balance sheet reveals several “dollar bills” of profitability growth potential via net interest margin expansion.

The investment portfolio is a great place to begin the treasure hunt since it typically makes up 20% to 25% of an institution’s earning assets. You might think that a change in asset allocation would be the best way to boost the yield of the bond portfolio. In reality, any strategy that focuses on altering the mix of securities in the portfolio to add reward will also involve increasing risks via longer duration, reduced credit quality or sold optionality. Because of these natural trade-offs, any near-term improvement in yield could prove costly later, making it difficult to count on the yield pick-up as found money.

Even without proactively changing the mix of securities, 25% to 33% of bonds in the typical FI portfolio will mature or be called away in a given year. This predictable turnover means that there will be a regular need to execute transactions with an intermediary in order to put newly idle cash back to work. This is where there may be some buried treasure to unearth.

When a bond transaction is executed the broker-dealer earns a mark-up for facilitating the purchase/sale and for providing some degree of advisory, whether it’s for the specific security being bought/sold or on the portfolio as a whole. Additionally, the broker-dealer may have a multi-faceted relationship that includes investment banking, research, ALM modeling and other services. In some cases these additional services are paid for with an explicit fee, but in others their cost of delivery is factored in when market transactions are executed.

Technically the mark-up is built into the price of the bond so there is no visible commission that hits the expense line on the P&L. But the net effect of the mark-up is a reduction in yield that impacts NIM. In Dave’s article he provides examples of transactions that were executed at prices that resulted in 6 to 12 basis points in sacrificed yield. He concludes that improving the efficiency of execution can potentially add 1 to 3 basis points to NIM which translates to nice improvement in ROA and ROE. Putting that into “couch cushion” perspective: a typical $1 billion community FI might uncover annual savings north of $100k after performing an analysis of its transaction execution history. Once an inventory has been taken and a value placed on the services received in the broker-dealer’s “bundle”, an institution can begin to determine if there is some buried treasure to be claimed by improving execution efficiency in the investment portfolio.

Bob Newman serves as a strategic advisor to community and regional financial institutions at Chatham Financial and Chatham Investment Advisors, a registered investment advisor providing independent investment management advice and security execution through its “Virtual Treasurer” offering.

When Mr Zero-Floor Met Mr Swap

March 2017, International Banker
By Lerika Joubert, Senior Associate, Taylor Wessing LLP & Jamie Macdonald, Chatham Financial Europe Ltd

It has become market practice for lenders to include wording in facility agreements that provides that the applicable IBOR (interbank offered rate) shall never be less than zero (a zero floor). But what happens if the transaction includes a corresponding interest rate swap (IRS)? Could the inclusion of a zero floor result in mismatches with rates payable under the swap?

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Navigating Available FX Strategies
By John Hintze, iTreasurer
August 9, 2016

In terms of deal-contingent hedges, some of the least-known banks are the best at pricing them, said Amol Dhargalkar, managing director at Chatham. He suggested members look for banks with large portfolios of deal-contingent hedges reducing their risk and pricing. It was also suggested to AT30 members that they consider using the long-haul method, which can help organizations expand hedge accounting capacity. According to Aaron Cowan, Chatham’s executive director of corporate hedge accounting, this can also be accomplished by scrutinizing the company’s organizational structure and its various currency exposures.

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FX Week
Corporates caught out by Brexit and aftermath
By Laura Matthews
August 5, 2016

“So be prepared for them, and if for some reason you are convincing yourself that it was a once-in-a-lifetime event that won’t happen again, we remind you there is a constitutional vote happening in Italy in the October timeframe, which could lead to all types of drama. After that there will be something else, and after that there will be something else, so it is really not something that can be swept under the rug any more,” Dhargalkar, Chatham Financial Managing Director, says.
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Competing for Loans: How to Win Without Taking Interest Rate Risk
By Ben Lewis
June 13, 2016

Ben Lewis covers three strategies including fixed rate loan hedging, back to back hedging and balance sheet hedging at the 2016 FMS conference in New Orleans. Download Slides

Declining Interest

June 2016, The Treasurer
By Paolo Esposito

Paolo Esposito – Director of European corporate advisory at Chatham Financial discusses the options treasurers have in the face of historically low interest rates.

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LinkedIn Pulse: Swaps on a Blind Date? Three Questions for Community Banks
By Bob Newman
April 7, 2016

As community banks look for ways to differentiate themselves from their larger counterparts, which of the following advantages would be least likely to help win over a local client when competing for business:

  • Community banks focus their attention on the needs of local families, businesses and farmers
  • Community banks channel most of their loans to the neighborhoods where their depositors live
  • Community banks offer nimble decision-making on loans because decisions are made locally
  • Community banks match up their borrowers with an unknown third party from outside the community in unsecured derivative contracts

Obviously, you would never see the last point serving as a pillar of a community bank’s mission statement or displayed on the wall as you enter its Main Street headquarters. However, this continuing low interest rate environment has created a challenging predicament. Increasing demand from borrowers for long-term fixed-rate loans and the willingness of larger banks to meet that demand has forced community banks to find a way to remain competitive. And while the problem can easily be solved with plain-vanilla interest rate swaps, many community banks have sworn off derivatives as either too complicated or as the exclusive domain of the megabanks.

Enter Third-Party Swap Programs (“TPSPs”), which are pitched as tailor-made solutions for community banks looking to avoid putting derivatives on their books and explaining how they work to their borrowers. The folks pushing the TPSP concept emphasize that their solution gives community banks the best of all worlds: a floating rate loan and no derivative on the books of the bank while the borrower has fixed interest payments by signing a very simple 4-page addendum to the note. But how does this transaction work for the client who has picked a community bank over a megabank because doing business locally is a priority? To the extent that the borrower will be entering into a long-term contractual relationship with the Third Party sight unseen, here are three questions that community bankers should ask before setting up their borrowers on a TPSP blind date:

1. Is the TPSP contract between the borrower and the Third Party an interest rate swap?
One of the main selling points of TPSPs is the absence of ISDA documentation. While that might suggest no swap exists, all parties should look closely at their obligations before making a determination. Asking an auditor or regulator might also be a good idea. If the bank is booking a bona fide 15-year floating rate loan, then the borrower signs the note and is contractually obligated to make floating interest payments. If the addendum provided by the Third Party enables the borrower to make fixed payments over the life of the loan, then it would seem that the borrower and the Third Party are going to swap fixed for floating interest payments for the life of the loan. Since the borrower is depending upon the Third Party to cover its floating rate obligation, it is taking on 15-year counterparty risk to the Third Party. And as much as everyone loves to complain about the length and complexity of ISDA documents, they were designed to protect both parties to swap contracts. Here, the “simplicity” of no collateral being posted back-and-forth means that the borrower is a party to a 15-year contract that looks a lot like an unsecured interest rate swap with its blind date partner.

2. What are the risk/reward trade-offs in a TPSP transaction?
Assuming for a moment that the community bank is not a party to an interest rate swap through the TPSP, are there any other risks involved in this three-way deal? In order to make the Third Party comfortable entering into a 15-year agreement with an unknown entity, there is likely an arrangement where the bank will make a promise to vouch for its client. As simple as that sounds, a formal guaranty of the borrower’s obligations could be construed as a credit default swap (again, you may want to check with an auditor or regulator). Alternatively, the bank may need to subordinate to the Third Party its security interest in all the collateral that supports the loan, which could complicate future workout negotiations. Since the community bank is underwriting what amounts to derivative credit exposure for the benefit of the Third Party, it would be worthwhile to understand how the rewards and benefits of the transaction are accrued and shared. Even after carefully structuring the TPSP transaction to exclude itself from the “swap,” the community bank clearly holds onto reputation risk and might be asked to intervene if the Third Party is unable to meet its future obligations under the contract (when interest rates rise).

3. What are the risk/reward trade-offs if I do the swap myself?
For the community bank considering a TPSP based on the premise that it wants to avoid swaps at all costs, now may be a good time to re-visit the “why” to that decision. Derivatives have been the subject of negative press over the years, but beneath almost every headline was a story pointing to excess speculation and not derivatives themselves. Hedge accounting was scary when it was introduced 15 years ago, but there are now well-worn paths to using swaps as a prudent risk management tool and achieving favorable accounting treatment. A growing number of community banks have recently taken the step to add swaps and caps to their interest rate risk management toolkit. After doing so, there are a number of strategies utilizing a plain-vanilla swap that yield a win-win solution for both bank and borrower. In one frequently used example, the borrower’s only contract is an old-fashioned two-party fixed-rate loan contract with its local bank, while the bank takes care of managing and accounting for the hedge behind the scenes. This might elicit thanks, not only from the borrower for sparing them a 15-year blind date, but also from shareholders when they compare the economic outcome.

Bob Newman oversees the financial institutions advisory practice at Chatham Financial, which provides comprehensive interest rate hedging expertise to over 120 depository institutions in the United States.

Understanding Today’s Low Interest Rate Environment:
A Q&A With Equity Methods and Chatham Financial

March 14, 2016

The United States is in a prolonged low interest environment. What does this mean for derivatives accounting, hedging, and financial instrument valuation? Industry experts from Chatham Financial and Equity Methods trade observations.

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LinkedIn Pulse: Foreign Exchange Risk in 2016: Laying the Foundations for Managing Value
By Victoria Bell
March 3, 2016


With the UK Referendum on EU membership scheduled for 23 June 2016, currency volatility is front and centre of many companies’ agendas. However, for businesses with multi-currency operations, volatility has been a concern for some time and the recent slide in Sterling is one of many considerations, with the US Presidential election, the stability of the Eurozone and the growth prospects for China ever present in the background.

Company boards, Audit Committees and shareholders are increasingly considering risk management strategies in relation to foreign exchange, questioning whether their current strategy remains relevant in changed and changing market conditions. Questions we hear on a regular basis include:

  • What happens to our business if GBP-USD moves 10%?
  • Why would I take risk management action/ hedge now when rates have moved against me?
  • Although I purchase from China, I pay in EUR so why should I be worried?
  • I believe rates will move back in my favour so why should I do anything?

With these questions and many others, there are no simple answers, but that is no reason to avoid a review of an existing or establishing a new risk management strategy. Solutions are available.

Fundamental underlying questions for those new to using derivatives to manage currency risk include?

  • Does senior management have a view on an acceptable amount of currency risk to take within the business?
  • Do the investor(s) and Board truly understand derivatives and how they can be used to help the company manage risk?
  • Do I have a risk management policy in place?
  • Do I have a handle on any required regulatory processes?
  • Do I have a willing and appropriate counterparty(ies) and potential credit providers?
  • Do I understand the accounting implications of any derivative transaction?

Some “no” answers might push a company simply not to address currency risk, or to accept the status quo. However we believe there are four critical building blocks for a sound approach and laying the foundations for successfully managing foreign exchange risk.

1. Education

When it comes to the topic of derivatives, there is almost always some necessary level-setting to do amongst the Board and company management, and sometimes shareholders. The key to education is keeping the conversation focused on quantifying the risk and ultimately offering simple, easy to explain alternatives to mitigate the risk:

  • Forwards – entering into a contract to buy or sell a specific value of currency at an agreed exchange rate on or by a determined future date
  • Options – purchasing a right, but not an obligation, to buy or sell a specific value of currency at an agreed exchange rate on or by a determined future date

There are more complex structures that can be utilized, but all would comprise elements of the building blocks described above. Additionally, strategies that involve more complex derivative products have more opaque pricing and often provide hedging banks the chance to include additional fees.

Getting everyone on the same page will help any finance team move forward with a more clear understanding of the benefits (and implications) of derivatives and the ways risks can be managed. This must include ensuring the accounting implications are fully understood.

2. Understanding the Value at Risk

There are three components to assessing Value at Risk, which for a corporate can be defined as the potential range out outcomes of a key metric over the course of a year.

  • Determining the Value to be managed – Revenue, EBITDA, net income/EPS, operating margins, cashflow, and equity value are all examples of metrics used by organizations. The priority(ies) will be different for companies and will be influenced by many factors including ownership (public vs. private), leverage and covenants, dividend policy, investment programmes, stage in lifecycle (particularly for portfolio companies of funds) for example.
  • Accurately measuring the Value at Risk. This is influenced by the quality of the input data, the detailed analysis and the correlation of the currencies within the business. One key flaw we often see when risk is measured is that currency pairs are looked at in isolation. The question “What happens to our business if GBP-USD moves 10%?” should not be thought about as a simple recalculation of GBP and/ or USD transactions as other currency pairs will move alongside any such move which could increase or decrease overall risk in the business.
  • Running appropriate shock scenarios is key – a 10% shock may not be high enough in some circumstances. Many currencies and commodity prices have been subject to 2 standard deviation moves over the course of the past year, thus indicating a need to truly capture “tail” risks inherent in these markets.

Failure to establish the Value at Risk accurately creates an unstable foundation and could result in an inappropriate risk management strategy which at a minimum does not achieve desired results and in the worst case can add financial risk.

3. Policy and programme approval

Just as you wouldn’t begin a long road trip without a map or GPS device, a hedging policy is critical to setting up the appropriate boundaries or ‘guardrails’ prior to entering into derivatives transactions. The hedging policy should fit hand-in-glove with the company’s overall treasury policy in terms of establishing the goal of the risk management programme (desired destination) as well as the specific tools that the investor(s)/ company will consider using (choice of road).

By identifying the risks that the investor(s) and company are attempting to manage and by making it clear that derivatives will never be used speculatively, the policy will communicate to all stakeholders that they intend to be thoughtful about choosing an appropriate hedging strategy.

The policy will be informed by the assessment of Value at Risk and materially influenced by the risk appetite/ tolerance of the Board and senior management, as well as confidence in budgets and forecasts. It will also take account of materiality and programme efficiency, as well as setting review protocols.

4. Counterparty selection

If you think of a currency derivative contract like an insurance policy that pays a claim, then you want to make sure you know who is making the promise to protect you, how likely they are to back up that promise and whether they can provide you with the best and most appropriate protection at a fair price. Whilst it is common for derivative counterparties to be the same institutions as the lenders to the company, this is not and should not always be the case:

  • Some lenders are not able to be derivative counterparties
  • Some lenders may not be competitive on pricing or terms for a multitude of reasons
  • Advice may be based on their capabilities and experiences, not on your needs.

Understanding who the potential counterparties could be and reviewing the counterparty pool should ensure the best “insurance” is purchased.

Finally, keep in mind that there is no such thing as an unregulated hedge in the era of Dodd-Frank and EMIR. Ensuring compliance is no small matter, and is critical to consider when implementing a currency hedging programme.

In the busy work streams of boards and management, finding the “right” time to address currency exposure policy is always challenging, and often it arises at crisis time, when the pain is already felt by the company. Making time now, to review your risk management policy, should reduce the risk of crisis in the future.

In the words of Johann Wolfgang von Goethe:

Knowing is not enough; we must apply.

Willing is not enough; we must do.

Victoria Bell is Director of Client Relationships for Corporates and Private Equity Funds in Europe at Chatham Financial.

Chatham Financial is an independent global leader in financial risk management providing comprehensive interest rate, foreign currency, inflation and commodity hedging expertise and comprehensive services and technology solutions to more than 2,500 companies across a broad spectrum of industries worldwide.

IEX revolution will restore trust in Wall Street

December 23, 2015,
By Michael Bontrager and Luke Zubrod

“Our firm has spent the last six years responding to Dodd-Frank’s derivatives market regulations and it is our firm conclusion that the core problem in finance cannot be regulated away. To be sure, new regulatory guiderails are an essential response to the crisis. But there are limits to the power of government action in fixing the system’s most fundamental problem – the erosion of trust.” Commentary by Mike Bontrager and Luke Zubrod. Bontrager is the founder & CEO of Chatham Financial, a global risk management advisory and technology firm in the debt and derivatives markets. Zubrod leads the firm’s public policy efforts. Chatham has no financial interest in IEX.

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