Practical Guide to Asset Sensitivity

Banks use several techniques to convert some of their asset-sensitivity to current period earnings.

Download the Complete Guide Here

Financial Institutions Case Study: Asset Liability Management

Our Client:

A regional bank with a newly issued brokered CD portfolio.

Situation:

Our client was asset-sensitive and had just issued 5yr brokered CDs that paid a fixed rate of interest. The client lends to borrowers at a floating rate of interest plus a credit spread, with a nominal floor. The net interest margin (NIM) would benefit from rising rates in the future, but in the short-term NIM was compressed by the long-term funding rate relative to the floored variable rate loan portfolio.

Summary:

Chatham Financial assisted the client with alternative hedging scenarios to reduce the impact of its relatively high, fixed-rate long-term funding. The client was considering a receive-fixed swap vs. a floating rate with sold floor based on the Prime rate, with the intention to designate the combined swap/floor against its floating rate commercial loan portfolio. Chatham’s analysis and price indications showed that the client would not realize substantial economic benefit from selling the floor in their loan portfolio – leaving significant value on the table. In addition, the client could not assert that it was probable that the hedged principal balance would be outstanding for the life of the swap, jeopardizing its ability to receive hedge accounting. As an alternative, Chatham proposed that the client execute a receive-fixed swap based on LIBOR without the embedded floor and designate the swap as a hedge of the fixed-rate liabilities.

Outcome:

The client executed the receive-fixed swap designated as a fair value hedge of the fixed-rate CDs. In so doing, the client converted its 5yr fixed rate funding back to a floating rate at 3-month LIBOR plus a spread, meeting their objective to relieve short-term pressure on their NIM.

Real Estate Case Study: Debt Ratio

Our Client:

A public real estate company specializing in asset management in the hospitality sector.

Situation:

Our client had paid down a significant portion of their floating rate line of credit, leaving them with a fixed/floating rate debt ratio higher than they desired. With hotel assets essentially re-pricing daily, the client wanted to increase their floating rate exposure on the liabilities side to better match the characteristics of their assets.

Summary:

We discussed entering into a receive-fixed swap to rebalance their fixed-floating mix. A secondary benefit of this strategy was that it allowed them to reduce their current interest expense due to the steepness of the yield curve; the receive fixed swap synthetically transformed a higher fixed rate obligation into a lower floating rate obligation, based on an historically low current LIBOR setting. Because this client is a public company, there were significant accounting considerations in determining which source of underlying debt to hedge, with the goal being to minimize any potential earnings impact the swap could have. As a fair value hedge, it was important to consider the term of the debt and the characteristics of their available bonds and/or mortgage debt. Common features, such as prepayment options, equity clawback provisions, and call options can create inefficiency or potentially preclude a client from applying hedge accounting and can lead to earnings volatility if not properly addressed.

Outcome:

The client was able to execute an effective hedge that achieved their desired fixed-floating profile. While the interest rate environment at the time made receive-fixed swaps an attractive product for many companies looking for upfront interest savings, in this case the company was positioned to take advantage of these savings as part of a larger risk management strategy.

Private Equity Case Study: Emerging Markets

Our Client:

A large private equity firm contemplating an emerging markets acquisition.

Situation:

A private equity fund was in a competitive bid situation to acquire a retail store chain in Eastern Europe. While the deal appeared attractive in local currency, it was uncertain when translated in USD. In addition, hedging seemed unattractive because forward exchange rates reflected the deep depreciation of the local currency.

Summary:

The investment team’s objective was to determine the most cost-effective hedging strategy, the likely key drivers of the local currency and the maximum exposure to their returns should their equity be unhedged. Chatham Financial was able to assist in exploring various hedging strategies including forwards, options and inflation-linked instruments. Also, we assisted in researching various macroeconomic data for the country to develop correlations against the investor’s base currency, modeling pro-forma financial statements using real (inflation adjusted) forward rates and quantifying the range of IRR and terminal value USD if the equity was unhedged.

Outcome:

Once the cost of hedging and risk of equity returns were considered, the firm was able to make an informed risk-adjusted bid for the business. While the firm ultimately lost the bid for the firm, the investment committee was able to establish firm norms and expectations around how to best evaluate bids in emerging markets.

Derivatives Regulation Case Study: Regulatory Compliance Assessment

Our Client:

A Fortune 100 technology company with international operations and multiple hedging programs involving exchange-traded and over-the-counter (OTC) derivatives across different asset classes, including foreign exchange, interest rates, and credit.

Situation:

The company was concerned about the impact of new derivatives regulations on its hedging programs, including how the parent company and numerous subsidiaries might be classified under Title VII, what new regulatory requirements might apply, and the extent to which hedging costs may increase due to new regulatory requirements. The client’s hedging programs spanned multiple global regulatory jurisdictions and included several different entities including both financial and nonfinancial entities.

Summary:

Chatham conducted an in-depth review of the hedging programs, spending two days onsite at the client’s premises to interview stakeholders within the company, including representatives from treasury, risk, operations, legal, and accounting. In addition, Chatham did a comprehensive assessment of the client’s use of derivatives and how the proposed OTC derivatives regulations could affect its derivatives risk management strategy in terms of work flow, transaction cost, liquidity, and operations.

Outcome:

Chatham completed and presented a comprehensive impact analysis to senior management which identified over a dozen areas of impact, including the extent to which inter-affiliate transactions would be regulated, the impact of clearing, and the applicability of certain exemptions under Title VII. Chatham proposed several potential solutions for the identified problem areas, and detailed over 30 action items for the client, including recommending specific modifications to hedging programs which could reduce the costs of regulatory compliance. Based on these findings, the client has initiated, in collaboration with Chatham, a corporate communications strategy and a full implementation plan of the actions to ensure full regulatory compliance.

Corporate Case Study: Tracking & Reporting for Hedges

Our Client:

A global musical instruments manufacturer and distributor who actively manages FX and interest rate risk exposures.

Situation:

The company was managing over 1,500 derivative instruments in Excel and was applying hedge accounting for more than half of their derivatives portfolio. They were applying a hedge accounting methodology that caused some earnings volatility and wanted to evaluate whether another approach, such as regression for effectiveness assessment and hypothetical derivative method for measurement, could produce better results. The period end process was taking longer than our client wanted, and, unfortunately, it was necessary to enter and maintain every derivative into multiple systems or spreadsheets.
The company was seeking to implement a hedging, hedge accounting & derivative reporting solution that would:

  • Ease the administrative burden of tracking and reporting derivative transactions
  • Eliminate risk of errors in tracking and reporting portfolio performance
  • Produce GAAP compliant valuations (including CVAs) in a timely manner each period end
  • Integrate with the company’s other relevant systems
  • Provide all hedge accounting designations, journal entries, effectiveness testing, disclosures, valuations and customized reporting in an automated and timely manner

Outcome:

The company sought Chatham’s hedging and hedge accounting technology solution in order to address the risks and objectives identified. We successfully loaded the company’s transactions into Chatham’s systems, including accounting treatments, journal entry balances, and valuation history, including CVAs. Chatham and the company worked in partnership to redesignate certain hedging instruments, apply methodologies that were more ideal for the goals and objectives of the company, and train the company treasury and finance staff in multiple areas.
From kickoff to complete implementation, including performance of parallel testing, the process took less than 4 months. Management’s goals were achieved and the company now has a seamless, easy to use, and best practice solution for all of their derivative needs.

Derivatives Regulation Case Study: Clearing Selection

Our Client:

A regional bank that uses derivatives for asset-liability management and offers hedges to its customers in connection with variable-rate loans.

Situation:

The client, who will be required to centrally clear certain derivatives transactions, hired Chatham to evaluate and help in the selection of futures commission merchants (FCMs), with whom the client will need to establish a relationship in order to be able to access clearing houses for the central clearing of derivatives trades.

Outcome:

Chatham conducted an independent RFP (request-for-proposal) process for the client involving eight FCMs. The RFP assessed fee schedules, creditworthiness, initial margin estimates and complementary services available to customers. The client received a full analysis and evaluation of the FCM proposals customized to align with the client’s specific needs. The RFP evaluation was presented to the client’s senior management team which, based on these findings, was able to select the FCM that was ideally suited to their specific needs. The client, with Chatham’s guidance, is currently in the process of negotiating clearing-related documents to formalize the relationship.

Private Equity Case Study: Currency Challenges

Our Client:

A large private equity firm executing an acquisition in a developed economy.

Situation:

A private equity consortium had agreed to acquire a North American company. Due to the state of debt capital markets, a substantial portion of the debt capital structure was denominated in USD with floating rates.

Summary:

The consortium and company needed to determine the best way to address the currency mismatch between cash flow and interest expense, as well as the optimal way to create a higher percentage of fixed rate debt. Chatham Financial educated the team on the use of cross-currency swaps, created transparency in the execution process of the hedging transactions, and assisted in the negotiation of the key documentation for the derivatives to ensure no hedge counterparty stood ahead of other secured lenders to the business.

Outcome:

The consortium was able to remove the currency mismatch between cash flows and debt service, allowing the company to have certain interest expense despite the significant volatility of the exchange rate. In addition, Chatham’s involvement in the process ultimately saved the sponsors multiples of our fee at execution.

Corporate Case Study: Interest Expense & Currency Risk

Our Client:

A software firm with contracts in multiple currencies, a complicated legal structure and unique debt structures.

Situation:

The company had recently increased leverage from a negligible amount to roughly 50% of its enterprise value in a recapitalization, compounding the currency risk. The company was trying to determine the best way to hedge its exposure to a CAD loan with interest payments based on a USD LIBOR index, as well as how to manage its currency risk across multiple currencies.

Summary:

Chatham Financial assisted the company in developing a hedging strategy for its debt by explaining the various hedging structures that could be used to create the appropriate hedge of the firm’s interest rate risk. To help the management team obtain an understanding of its currency risk, we worked to isolate the various cash flows by currency and ran sensitivity analysis to determine that 80% of the currency risk could be mitigated by hedging a single currency pair.

Outcome:

Chatham helped execute interest rate swaps of various tenors and types to help isolate the interest rate risk, and executed foreign currency forwards to isolate the company for foreign currency movements over the coming year. The company was able to have a clear understanding of its interest expense and foreign currency risk, which allowed it to ultimately budget and plan accordingly in advance of a volatile year.

Real Estate Case Study: Mezzanine Debt

Our Client:

A nationwide owner of hotels.

Situation:

Our client’s hotel portfolio was leveraged with a number of long-term low fixed interest rate loans. Since the origination of the original first mortgage debt, increases in operational efficiency for the portfolio resulted in improved portfolio cash flow. Our client’s desire was to use the increased cash flow as a borrowing base to create additional liquidity for new capital investments in the portfolio.

The prepayment penalties associated with refinancing the first mortgages along with the faltering CMBS market made a conventional refinancing cost prohibitive, and market turmoil made traditional, low-leverage, mezzanine debt unavailable. The client engaged Chatham to find a capital partner.

Summary:

As is typical with our engagements, Chatham’s role started with the strategic planning of the transaction and continued until the deal closed. We spent time with the client running multiple scenarios to determine the portfolio’s sensitivity to shocks in revenue and changes in interest rates. The goal of the analysis was to ensure that any transaction would leave the client with an appropriate level of debt and fixed/floating mix for the hospitality industry, and make certain that the debt maturities were appropriately staggered to minimize refinancing risk.

Once the appropriate capital structure was agreed upon, Chatham created the underwriting and analysis necessary to approach a small number of potential partners who had the capability, experience and flexibility to meet our client’s needs.

After a capital partner was identified and agreement was reached on terms that were mutually acceptable to our client and the capital partner, Chatham proceeded to work with counsel to negotiate the final documents in the agreement and get the necessary consents from stakeholders in the existing financings.

Outcome:

Our client closed a deal with a single capital partner who not only delivered the desired loan size and structure, but also provided the necessary flexibility and capabilities to deal with the complexities of the transaction. The closing provided our client the liquidity to pursue investments in the portfolio at a time when many of its competitors were cutting investments to their hospitality portfolios.