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Mark Meloy:
Hello, I'm Mark Meloy, CEO of First Business Bank. I'd like to welcome you to another episode of the First Business Bank podcast. Today, we're talking about investment management. I think you'll find this to be a thought provoking conversation about what bank management should consider with their investment portfolio. It's not as simple as find it and forget it. I'm joined by Bill Uelman, president of First Business Bank Consulting Services. Welcome, Bill. So let's kick this off with your high level overview of today's topic.
Bill Uelmen:
Sure. Thanks, Mark. So today we wanted to follow up from our previous podcast on outsourcing and succession planning, and really dive a little deeper into the investment process and how banks should manage its liquidity and core investment portfolio. Previously, we discussed how the consultant can enhance the investment process, really by developing strategies with some of the key elements being establishing an investment committee, documentation of trades and investment execution. So we'd like to just talk a little bit more about that today.
Mark Meloy:
Great, great. Bill, why don't you elaborate more on why a bank should consider establishment of an investment committee?
Bill Uelmen:
Sure. So over my years of experience, I've really noticed that many banks have a void in their investment process, in that we do have a ALCO committee, a loan committee, credit committee, risk committee, et cetera, but generally we don't have a full investment committee meeting. Community banks tend to rely really on one person to manage the investment portfolio, and we talked about that a little bit last time. That creates a bit of a succession planning issue. And really by establishing this investment committee, it really opens up the decisions that we're making in the portfolio and makes it a little more transparent to management, as well as the board. So again, it takes out a bit of that key person risk. If you have one person who's qualified to manage the investment portfolio, it opens up the education and a little deeper bench essentially for the investment process at the bank.
Mark Meloy:
Yeah, I think that's a great point. I mean, you think about how bankers value things like the loan committee process and using that as a teaching tool. It's the same theory here behind why an investment portfolio, or investment committee and the management thereof can really help perpetuate that knowledge inside the bank. So what does a committee meeting consist of?
Bill Uelmen:
Yeah. So first, the committee should really consist of generally the CEO and president of the bank, the CFO. I like to have someone from the ALCO committee as well, like from the lending side of the bank or the retail deposit side, just so we get a little better feel of where the positioning is essentially of the overall balance sheet. So the committee would then meet regularly, most likely quarterly or more frequently if there's a little more activity, but essentially we would have minutes prepared for the meeting and go through and review these minutes, approve any transactions that were done, and review the board, the broker dealers' execution and timing of trades, and then have a really good discussion about the balance sheet position, liquidity forecast, and economic forecast that we see in the future, analyze the investment portfolio, the current portfolio that we have, and really one of the most important things that we really want to do in the committee is to establish a written strategy.
Bill Uelmen:
This really avoids the bank straying from this strategy and looking at bond of the day type offers from brokers. Many portfolios that I've reviewed here recently really don't have a clear cut plan. Again, it's a combination of different types of strategies based on yield, total return, spread, maybe floating or fixed rate type structures, different durations and different credits. So it really is a great way to set up a strategy for guidance and use the policy. The investment policy tends to be more of a guardrail, and essentially is a strategy that we develop both short term and long term tends to be a little more focused essentially on the balance sheet.
Mark Meloy:
Bill, you mentioned yield and total return. Can you explain a little more on that?
Bill Uelmen:
Sure. First let's talk a little bit about total return. We probably all know what this is, but just a refresher. Total return is the combination of the income that's earned on the security, plus or minus the market value adjustment of that investment over time. So community banks should be concerned about the market value of the investment, but really bottom line income is what provides margin to our balance sheet. The market value adjustment doesn't increase or decrease income, and it's not included in regulatory capital. Larger banks, defined as banks and excess of 250 billion in assets, will have potential adjustments to income and regulatory capital, when the market value changes on these banks, excuse me, on those securities. It doesn't mean that we should ignore the market value risk. It's just, essentially income and structure is what we need for the portfolio.
Bill Uelmen:
One quick example that I go back to from the great recession is that banks were buying higher coupon mortgage backed securities at really large dollar prices. And if you remember, that was a very low rate environment, again, like we're in today. In theory, these securities will provide income upfront, and then when interest rates rise, the duration extends on these securities, and the premium amortization will be amortized over a longer period of time, which will increase our income. This strategy didn't quite work. Essentially prepayments continue to be very high, and the yield on these securities was close to zero or negative in some cases. The market value did stay very close to book, or maybe even had a slight gain. So you had a nice total return, but really didn't have bottom line income. So we really want to weigh both into the decisioning when you're looking at an investment securities.
Mark Meloy:
So what are banks doing today with their investment portfolio? There's all kinds of liquidity out there. What best practices are you seeing?
Bill Uelmen:
Sure. Well again, we're back into a similar low rate environment we were right after the great recession. Fed lowered interest rates to near zero. And now we're in a situation that the Fed is being somewhat hawkish, meaning they're going to likely start raising interest rates soon. So the probabilities are calling for three to four rate hikes over the next year. Another two thereafter. From there, it really depends on how inflation really, it plays out essentially in the market.
Bill Uelmen:
We anticipate inflation to remain fairly high in 2022 and then start to normalize thereafter. So with this steep curve, we were buying more on a barbell approach, taking advantage of the higher long term rates and positioning for shorter term potential rate hikes. Today, the curve has factored in these six rate hikes we had talked about here previously over the next two years. So really the steepest part of the curve, and we'll call it the sweet spot, is more on that four to seven year part of the curve. So we're trying to concentrate more of that mid range, intermediate duration of the curve. We're buying more bullet type structures or things like treasuries. I've been buying more treasuries than I have been, probably going back 20 years. Spreads on some of the products such as municipals and mortgage backs have been relatively tight, and it just hasn't been worth some of the credit or optionality that's in the market.
Bill Uelmen:
There are some mortgage backed structure that we like, such as well structured, sequential CMOs or [Vatum 00:08:25] CMOs, or 10 or 20 year MBS securities that have really good prepayment stories built behind them. So we just want to make sure the structure of the deal really doesn't fall apart as interest rates start to go up and extend on us. So we're trying to be a little more concentrated on a well structured duration, things that give us some cash flows on the front end so that we can reinvest back as interest rates go up.
Mark Meloy:
So what role does the broker/dealer play in the investment management?
Bill Uelmen:
Sure. Our brokers really play a huge role. The selection of the brokers you've used, or we use is extremely important, really for many reasons. One, we have many conversations, many meaning probably daily or multiple times during the day, talking with a broker, talking about different investment ideas, economic advice. So, you really need to trust really and enjoy the relationship with your broker. You really don't want to have a broker that's going to try to sell you on ideas, bond of the day type offers. That's part of the reasons why we established a really defined strategy in the investment committee meeting, is that we want to stick to the strategy. If there's a new idea or a new strategy we want to follow, let's discuss it at the next committee meeting and decide what type of position we want to take in the portfolio.
Bill Uelmen:
Of course, the brokers we use should be very knowledgeable about banking and regulatory issues and not just the investment portfolios. And of course, brokers provide really great analytics support and some economic information. So they really can be a partner to us in the investment committee. And one of the things to make sure you want to do is really provide that strategy. So I mentioned that earlier. Let the broker know what your strategy is, so that they can find offers that fit within our guidelines and not necessarily things that are just within our policy. So we want to make sure they're assisting us and being part of a partnership essentially within the balance sheet.
Bill Uelmen:
And then, lastly of course, brokers are in the business to make money. So as a bond buyer, of course, I understand it and I expect them to make money, but really, I don't want them to make more than they should. The brokers have all their Bloomberg information at their fingertips. So if you don't have Bloomberg, you really have to have a really deep trust in the broker and really knowledgeable essentially on the pricing.
Mark Meloy:
In your opening comments, you talked about trade documentation. What do you recommend in that regard?
Bill Uelmen:
Sure. Well, it's really referred to a pre and post purchase documentation. If we go back roughly nine or 10 years ago, really right after the great recession, when there were some issues on some of the investments that were done at the bank level, regulators gave some guidance and was titled something about due diligence requirements and eligibility for investments in the portfolio, something like that. I can send this to anyone if you want to see a copy of the PDF from the website, but it includes things like the documentation should have a trade ticket with all the trade information, security description, settlement details, base case and rate shock yield, spreads, duration, collateral, credit information. It's really a lot of things about the security that you looked at when you analyzed the security. And it should have really notes in the documentation as well. Why you bought that security. What was the rationale essentially for that purchase.
Bill Uelmen:
And then I think is important too, is to make sure that the trade ticket that you create should have a signature or be electronically stamped approved by someone who is approved in investment policy. So they take ownership essentially of that trade. And then along with all the trade documentation, you want to have the information from the broker, the confirmation, all of the Bloomberg pages that essentially you can get from the broker, or if you have Bloomberg, print them out yourself. Include them with the trade. And then create a transaction log summary. So of all the trades you did for the quarter, essentially you have them prepared in one document, presented to investment committee, boards, regulators, et cetera. Of course today, we can save everything as PDFs, keep it all together electronically and organized within your systems.
Bill Uelmen:
And then post-purchase analysis is also important. Many banks really have a buy and hold strategy. Really don't want to create a trading portfolio or have any issues with that from the AFS or held the maturities part of the portfolio. But that doesn't mean you should not review the portfolio. I think you should continue to review the portfolio for things like credit changes with the individual investment positions, market value changes, which I know I said we're not maybe as concerned about market value changes, but if there is a large change in the market value, it does give a indication that there may be something with a credit or structure of that deal. So you want to pay fairly close attention to that.
Bill Uelmen:
And then of course, yields and optionality, prepayment on mortgages, like we talked about, can cause amortization to be amortized much faster than you anticipate, which would reduce the book yield of the portfolio. And then looking for just restructuring ideas. Sometimes things change. So the market changes and it's time to maybe restructure out of a particular credit or strategy we previously did and look at restructuring the portfolio.
Mark Meloy:
I think that's a great comment, Bill, and that post purchase analysis. I mean, we've all heard the old adage, the worst loans are made in the best of times. And I would say the same can be said about the investment portfolio as well. You can really make bad choices in the most active times.
Bill Uelmen:
Yeah. And I may have mentioned this in a previous recording too, essentially there are times you need to have an exit strategy for a particular investment, and sometimes we might have been wrong on our strategy and it's time to exit and change our strategy. So, it's very important to go back and review previous transactions and look at their history and see how they're performing. And I have noticed that. And that's how, when I talked about the amortization on some of the higher priced mortgages, many banks, when they send me their portfolios to review, they didn't realize that the individual positions were earning zero or negative. They just assumed that they were performing as they had anticipated. The nice thing about that particular strategy, which did work from a total return standpoint, is we were able to sell some of those positions, realize a gain, and made up for the negative yield we took essentially from the position. So that's the type of review and structure that you want to put into the investment committee meeting.
Mark Meloy:
So Bill, if a bank hires you as the consultant to do transactions, what can they expect?
Bill Uelmen:
Sure. Well first, it's definitely a relationship. So, we want to make sure we retain your broker/dealers and correspondent relationships. That's very important to the bank. We're not going to come in and step on that. We do have relationships with many, many brokers across the industry that give us inventories and ability to see where things are being priced, but we want to continue to work with the people that the bank knows and really enhance that relationship from a correspondence standpoint. What I try to do is I really try to set bogies or targets in the market before I execute. So I'm not trying to time the market necessarily, but there are certain tells in the market that provide some insight to me.
Bill Uelmen:
For example, here over the last couple of years during the Treasury auction, so when the Treasury issues new debt, the weeks prior to that auction, rates tend to trend up. Then at that auction, they tend to peak. And then a few weeks after the auction, the rate gradually decreases. So it gives us some opportunity to buy at a little higher levels, especially when the Fed Reserve has been really controlling the markets and keeping short term interest rates near zero. So one of the things that I really try to do when I work with a bank on the portfolio is I want the bank to treat me as their employee. So essentially I'm not a consultant or a broker. I'm really their employee. So I'm there when there's needs. I'm there when there's high liquidity at the bank and there's questions about the investment portfolio, I'm there to help discuss things through the investment committee.
Bill Uelmen:
I'm there to sit on their ALCO committee, if they so choose, to help talk about different things that other banks are doing, and trying to manage their interest rate risk. So I really do it as a full relationship, treat me as your employee and view the investment portfolio as an important part of the balance sheet.
Mark Meloy:
So as we wind this up, how can a bank benefit from hiring an investment consultant like you?
Bill Uelmen:
Sure. Oh, okay. Sure. Yeah. So one of the things is pricing. So we mentioned, brokers are in the market to make money, and they should. That's their job. We want them to be successful and show us good offers. But sometimes you don't know if you got a good deal. It reminds me of something that, I'll go back to a bank meeting I had many years ago. On this committee, one of the directors was a car dealer in their local area. I asked him a question after the meeting, just, I think I was in the market to buy a car at the time. I asked him, just tongue in cheek, say, "Well, how do you know if you got a good deal when you bought a car?" And his response was very candid, but just said, "If you think you got a good deal, you probably did. And if you don't think you got a good deal, then you probably didn't."
Bill Uelmen:
So from the investment market, I would look at this. If you don't know if you got a good deal, you think you maybe paid too much for an investment, you probably did. So hiring a consultant opens you up to all the different inventories and the products that we can review and offer essentially, using Bloomberg and other sources, to be able to get you the best price on the deal, and really make the broker happy on their side. They get commissions and income. And then we get the best investment that we can buy.
Mark Meloy:
Thanks, Bill. That was a lot of really great information, I think some great insight into how your experience and depth of knowledge really can benefit a community bank in this whole process. Thanks again for taking time. To our guests, thanks for listening in on this conversation on the First Business Bank podcast. I invite you to learn more about us at firstbusiness.bank and experience the advantage. Have a great day and join us next time on the First Business Bank podcast.
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