Pub. 9 2014-2015 Issue 1

May | June 2014 13 Extraordinary Service for Extraordinary Members. L IKE A TYPICAL HOUSEHOLD, A TYPICAL COMMUNITY BANK has a variety of diverse characters under its roof. It might be expected, then, that these diverse characters occupy their time with diverse activities. If a bank is to operate as a happy household, it’s important that all the members of that household get along with each other. It also might be nice if their various activities work in harmony—or, at the very least, don’t work against each other. Like so many things, this can be easier said than done. Inmost community banks, it falls to the ALCO Committee to ensure that the disparate activities of lending, investing, and funding are all working together. Sometimes the magic works, and sometimes it doesn’t. During those times when there is an element of discord in the house, it may have more to do with the nature of the business than with the commit- tee’s oversight. When loan demand is soft and the available supply of high-grade borrowers is small, are we going to deny a loan to a creditworthy applicant because the terms they request aren’t exactly consistent with the committee’s ideal? Probably not. Are we going to discourage a long-time customer from doubling his MMDA balance when what we really need are 30-month CDs? Probably not. So, to a degree, the complexion and the characteristics of a community bank’s balance sheet are in the hands of others. Those others would be your customers. Wonderful people though they may be, they’re probably not overly concerned with the challenges you face in running the bank. Why Can’t We All Just Get Along? Fortunately, there’s one element on the balance sheet in which your customers play no role in building. The invest- ment portfolio is yours alone to administer and, if handled effectively, can serve to compensate for those borrowers and depositors whose preferences and desires may not be consistent with management’s big picture. If handled inef- fectively, however, the imbalances resulting from efforts to accommodate customers may become more pronounced. Put another way, an unbridled quest for yield alone could potentially worsen a bad situation. If a portfolio manager acts without first checking with his housemates, he may find himself exiled to the garage. While the consideration of returns is certainly part of the mix, management also should contemplate other character- istics such as liquidity, average life, duration, and cash flow. In fact, the creation and maintenance of stable, predictable cash flowsmay verywell be a community banker’s best defense against interest rate risk. It follows, then, that the securities contained within the portfoliomust behave themselves—they must act like they are supposed to and not subject the rest of the household to mutinous behavior. No teenage truculence allowed. Straighten Up & Fly Right! Unfortunately, some securities, not unlike brain-addled adolescents, have trouble remembering the rules. This be- comes a particularly significant concern when confronted with a volatile interest rate environment. Portfolio managers who chased themarginally higher yields of long-term, callable agency debentures are now facing the unpleasant realization that call options don’t always get exercised. They have put themselves in the awkward position of having to explain to the rest of the household that all of the cash flow that was sup- posed to be coming inmay not be here for awhile—like maybe 10 years. Oh, and by the way, duration has now quadrupled and our heretofore modest EVE volatility has become a little excessive, like policy-breaching excessive. Oops! The list of potential bad actors also includes certain kinds of mortgage-backed securities (MBS) and collateralizedmort- gage obligations (CMOs), the pre-payment characteristics of which have become drastically altered by rising mortgage rates. While space does not allow for a thorough discussion of the universe of mortgage-backed securities, portfoliomanag- ers should remember that not all MBS are created equal, and doing one’s homework regarding the characteristics of the underlying loans can go a long way in avoiding the deleterious effects of excessive cash-flow volatility and the resulting risks to average life extension or contraction. The investment portfolio, whenmanaged properly, can be your best friend as you try to satisfy the needs and require- ments of unintentionally uncooperative customers, while at the same time managing the interest rate risk profile of the balance sheet. But, if investment decisions and security selections are carried out as if in a vacuum, your bank’s road to domestic bliss could get a little rocky.  The Baker Group LP is the sole authorized distributor for the products and services developed and provided by The Baker Group Software Solutions Inc. Since 1979, we’ve helped our clients improve decision- making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizing software and products developed by Baker’s Software Solutions, combined with our solid investment experience and advice, makes us the investment firm of choice for many community financial institutions. For more information, visit www.GoBaker.com or contact Lester Murray at The Baker Group at 800-937-2257 or lester@GoBaker.com . Your Bond Portfolio Does Not Live Alone Lester Murray , The Baker Group