Financial Derivatives Case Study

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Banc One wanted to manage its interest rate exposure without using swaps, what could it do? Specifically, how could it move from being asset-sensitive to either neutral or mildly liability-sensitive without using swaps? What are the pros and cons of using swaps vs. these other means of adjusting the bank's interest rate sensitivity? What impact do they have on the bank's interest rate sensitivity, liquidity, accounting ratios, and capital ratios? Make sure you work through the Appendix to the case.

Yes, if Banc One wanted to manage interest rates without swaps it could do it. The bank could attempt to match the duration of its assets with the duration of its liabilities. In addition, the bank would need to match the interest rate exposure of its assets and liabilities on the balance sheet. For example, the assets on the balance sheet may be predominately fixed while the liabilities are floating. This could cause significant distortions to the performance of the company if the floating rates are not properly offset on the asset side of the balance sheet. In this case it order to move from being liability-sensitive to asset-sensitive the bank would need to make more floating rate loans to offset the floating rate liabilities it has to pay.

Through the use of swaps, this process is much easier and less time consuming. This is particularly true for Banc One, who has a stated strategy of acquiring other banks. The bank also remains relatively decentralized after acquisition. The bank only coordinates its processes, reporting, and auditing standards with acquired banks. Banc One however, allows the acquired company to operate on a standalone basis. It is therefore difficult to match liabilities and assets on an individual basis throughout the company. Swaps can therefore be used to allow for a more seamless and integrated approach to interest rate management.

When used swaps have a positive impact on many of the companies reported financial ratios. However, it has a negative impact on their actual financial ratios in some instances. Swaps and other derivative contracts are considered "off-balance sheet" transactions. Therefore in many instances, companies may not be required to report the asset or liability on the balance sheet for reporting purposes. Therefore any ratio involving debt will be altered to look more favorable than it actually is. Capital ratios would also appear more favorable as current capital rules favor the use of derivatives. Below is a summary of the relevant ratios with and without the use of derivatives.

Banc One without balance sheet adjustment

Banc One with balance sheet adjustment

Net Int. Margin

6.22%

4.58%

Net Int Margin

excluding swaps

5.52%

4.58%

Return on Assets

1.53%

1.06%

Return on Equity

17.89%

15.42%

Net Income

1.14

0.98

What are AIRS? How do they work? Why is Banc One using them so extensively?

Amortizing Interest Rate Swaps are tools used to simulate investments in mortgage securities. Due to the fact that the AIRS product attempts to replicate a mortgage security, Bank One is exposed to prepayment risk. Generally speaking, when interest rates fall, holds of mortgage securities are exposed to contraction risk. This risk is associated with lower interest rates. As interest rates are low, borrowers tend to prepay their loan obligations. This prepayment risk has two consequences for Banc One. First the proceeds received must be reinvested at a lower interest rate. Second, the yield is lower than it otherwise would have been without this prepayment feature. Within the AIRS product, the notional amount would be reduced or amortized if interest rates start to fall. Much like the mortgage backed securities they mimic, as interest rates fall, the AIRS product would amortize faster, thus causing the bank to reinvest proceeds at a lower rate.

It appears Banc One is chasing yield in order to enhance its earnings. In previous attempts, the bank entered into synthetic swaps to enhance its yield on fixed income securities. The bank appears to be doing the same here with its AIRS product line. With the AIRS product line, the swap spread over treasury securities is 120 basis points as oppose to 100 basis points utilizing a CMO. However, although the spread is higher, these exotic derivatives are exposed to prepayment risk. Interest rates during this period have been declining. As a result the AIRS product may be amortizing faster, and losing its yield advantage.

What are basis swaps? Why has Banc One recently significantly increased its basis swap position?

Banc One increased its basis swap position primarily due to its emphasis on managing earning sensitivity to interest rates.

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Management recently changed its policy of earning management to allow for variation. However, due to its policy change and mandates, large swings in earnings would require growing amounts of swaps. In addition, Banc One was a serial acquirer of other banks with earnings growth that was greater than Banc One's. These banks once acquired, occasion would raise Banc One's asset sensitivity above its target range. Banc One responded to this trend of increasing asset sensitivity by engaging in swap activity to reduce the banks sensitivity to interest rates. Although these derivative instruments decreased the company's earnings sensitivity to interest rates, it increase its sensitivity mismatches between floating rates. For example, some of Banc One's floating rate assets were based on the prime rate, whereas come of its derivatives were based on the rate changes in LIBOR. A basis swap was therefore used to reduce this floating rate mismatch between the assets on the balance sheet. Through the use of basis swaps, the company could effectively transform a floating rate into a fixed rate.

How might its derivatives portfolio be damaging the bank's stock price? What exactly are analysts and investors worried about?

Derivatives, by definition, derive a portion of their value from an underlying asset. There are three significant problems within the derivative portfolio at Banc One that pertain to the underlying asset within the contract. First, investors are concerned with mortgage exposure with the AIRS product. This product is designed to mimic investments in mortgage securities. The mortgages that are remaining however, have significant prepayment risk. Ordinary, the lower tranche of the security would absorb any of these loses. Once that tranche is elevated the mezzanine tranche would then absorb losses. This is followed by the most senior tranche. This form of credit enhancement is designed to protect investors from specific risks they wish to eliminate. For example, the lower tranche, in exchange for a higher rate, will accept prepayment risks. However, interest rates are declining. As interest rates decline the company is exposed to greater prepayment risk. This ultimately reduces the yield on the investment.

Second, many swaps and derivative contracts do not appear on the balance sheet. These contracts are often off-balance sheet transactions. The asset and liability are not on the balance sheet, yet, the income is present on the income statement. Under these circumstances, Banc One seems more profitable than it actually is. Investors may be worried the company is attempting to hide something from the public. This information asymmetry is causing investors to worry about what they do not know within the company.

Third, investors are worried about counterparty risk. The company has engaged in many contracts that are interconnected and confusing. It is difficult therefore to ascertain who the counterparties of these transactions are and if they have the financial strength to pay the obligations of the bank. This is particularly true for the AIRS product which is relatively unique relative to the other derivative contracts the company is engaged in. The company has very strong risk management techniques in place. These policies include posting of collateral and marketing the contract to market. The company requires all counterparties to put up additional capital in the price of the contract has an adverse change. Each company that is counterparty to Banc One has a credit rating of A, indicating a solid standing. Investors however, are not aware of these risk management policies. They are therefore unnecessarily discounting the stock.

What should McCoy do?

McCoy should educate investors about the relevant risk and rewards of the use of derivatives. McCoy should also note the core franchise with or without the derivatives has outstanding operating performance relative to peers. I believe McCoy should show the performance of the company with the derivatives on the balance sheet and without the derivatives on the balances sheet. It appears that investors are suffering from information asymmetry. They are simply uncertain about the performance and exposure of derivatives on the Banc One balance sheet. Due to this uncertainty, investors have demanded a higher risk premium to discount the company's earnings by. This higher risk premium compensates investors for the greater uncertainty caused by the lack of transparency regarding derivatives. Because this risk premium is higher, the cash flows of the company are now lower on a discounted basis, thus causing the stock decline. To alleviate this concern, McCoy must be transparent about what are the drivers of earnings growth….....

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