Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Asset and Liability Management and Market Risk
The rates of interest the Bank earns on its assets and pays on its liabilities are generally established contractually for a period of time. Fluctuations in interest rates have a significant impact not only upon our net income, but also upon the cash flows and market values of our assets and liabilities. Our results of operations, like those of other financial institutions, are impacted by changes in interest rates and the interest rate sensitivity of our interest-earning assets and interest-bearing liabilities. Risk associated with changes in interest rates on the earnings of the Bank and the market value of its financial assets and liabilities is known as interest rate risk. Interest rate risk is our most significant market risk, and our ability to adapt to changes in interest rates is known as interest rate risk management.
On a weekly basis, management reviews deposit flows, loan demand, cash levels, and changes in several market rates to assess all pricing strategies. The Bank's pricing strategy for first mortgage loan products includes setting interest rates based on secondary market prices and competitor pricing for our local and correspondent lending markets. Pricing for commercial loans is generally based on competitor pricing and the credit risk of the borrower with consideration given to the overall relationship of the borrower. Generally, deposit pricing is based upon a survey of competitors in the Bank's market areas, and the need to attract funding and retain maturing deposits. The majority of our loans are fixed-rate products with maturities up to 30 years, while the majority of our retail deposits have stated maturities or repricing dates of less than two years.
The general objective of our interest rate risk management program is to determine and manage an appropriate level of interest rate risk while maximizing net interest income in a manner consistent with our policy to manage, to the extent practicable, the exposure of net interest income to changes in market interest rates. The Board of Directors and ALCO regularly review the Bank's interest rate risk exposure by forecasting the impact of hypothetical, alternative interest rate environments on net interest income and the market value of portfolio equity ("MVPE") at various dates. The MVPE is defined as the net of the present value of cash flows from existing assets, liabilities, and off-balance sheet instruments. The present values are determined based upon market conditions as of the date of the analysis, as well as in alternative interest rate environments, providing potential changes in the MVPE under those alternative interest rate environments. Net interest income is projected in the same alternative interest rate environments with both a static balance sheet and management strategies considered. The MVPE and net interest income analyses are also conducted to estimate our sensitivity to rates for future time horizons based upon market conditions as of the date of the analysis. In addition to the interest rate environments presented below, management also reviews the impact of non-parallel rate shock scenarios on a quarterly basis. These scenarios consist of flattening and steepening the yield curve by changing short-term and long-term interest rates independent of each other, and simulating cash flows and determining valuations as a result of these hypothetical changes in interest rates to identify rate environments that pose the greatest risk to the Bank. This analysis helps management quantify the Bank's exposure to changes in the shape of the yield curve.
The ability to maximize net interest income is dependent largely upon the achievement of a positive interest rate spread that can be sustained despite fluctuations in prevailing interest rates. The asset and liability repricing gap is a measure of the difference between the amount of interest-earning assets and interest-bearing liabilities which either reprice or mature within a given period of time. The difference provides an indication of the extent to which an institution's interest rate spread will be affected by changes in interest rates. A gap is considered positive when the amount of interest-earning assets exceeds the amount of interest-bearing liabilities maturing or repricing during the same period. A gap is considered negative when the amount of interest-bearing liabilities exceeds the amount of interest-earning assets maturing or repricing during the same period. Generally, during a period of rising interest rates, a negative gap within shorter repricing periods adversely affects net interest income, while a positive gap within shorter repricing periods positively affects net interest income. During a period of falling interest rates, the opposite would generally be true.
The shape of the yield curve also has an impact on our net interest income and, therefore, the Bank's net interest margin. Historically, the Bank has benefited from a steeper yield curve as the Bank's mortgage loans are generally priced off of long-term rates while deposits are priced off of short-term rates. A steeper yield curve (one with a greater difference between short-term rates and long-term rates) allows the Bank to receive a higher rate of interest on its new mortgage-related assets relative to the rate paid for the funding of those assets, which generally results in a higher net interest margin. As the yield curve flattens or becomes inverted, the spread between rates received on assets and paid on liabilities becomes compressed, which generally leads to a decrease in net interest margin.
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General assumptions used by management to evaluate the sensitivity of our financial performance to changes in interest rates presented in the tables below are utilized in, and set forth under, the gap table and related notes. Although management finds these assumptions reasonable, the interest rate sensitivity of our assets and liabilities and the estimated effects of changes in interest rates on our net interest income and MVPE indicated in the below tables could vary substantially if different assumptions were used or actual experience differs from these assumptions. To illustrate this point, the projected cumulative excess (deficiency) of interest-earning assets over interest-bearing liabilities within the next 12 months as a percent of total assets ("one-year gap") is also provided for an up 200 basis point scenario, as of September 30, 2020.
Qualitative Disclosure about Market Risk
At September 30, 2020, the Bank's gap between the amount of interest-earning assets and interest-bearing liabilities projected to reprice within one year was $435.0 million, or 4.58% of total assets, compared to $487.4 million, or 5.22% of total assets, at September 30, 2019. The decrease in the one-year gap amount was due to a shift in the cash flow projections on the Bank's non-maturity deposits compared to the prior year, related to the implementation of a new interest rate risk model. This change shortened the life of these liabilities and thus increased the amount of projected cash flows in the 12-month horizon compared to the previous model. This change was largely offset by lower interest rates as of September 30, 2020 compared to September 30, 2019, which increased the cash flow projections related to the Bank's mortgage-related assets. As interest rates fall, borrowers have more economic incentive to refinance their mortgages and agency debt issuers have more economic incentive or opportunity to exercise their call options in order to issue new debt at lower interest rates, resulting in higher projected cash flows on these assets.
The majority of interest-earning assets anticipated to reprice in the coming year are repayments and prepayments on one- to four-family loans and MBS, both of which include the option to prepay without a fee being paid by the contract holder. The amount of interest-bearing liabilities expected to reprice in a given period is not typically impacted significantly by changes in interest rates, because the Bank's borrowings and certificate of deposit portfolios have contractual maturities and generally cannot be terminated early without a prepayment penalty. If interest rates were to increase 200 basis points, as of September 30, 2020, the Bank's one-year gap is projected to be $(611.0) million, or (6.44)% of total assets. The decrease in the gap compared to when there is no change in rates is due to lower anticipated cash flows in the higher rate environment. This compares to a one-year gap of $(361.8) million, or (3.87)% of total assets, if interest rates were to have increased 200 basis points as of September 30, 2019.
During the current fiscal year, loan repayments totaled $1.89 billion and cash flows from the securities portfolio totaled $668.0 million. The majority of these cash flows were reinvested into new loans and securities at current market interest rates. Total cash flows from term liabilities that matured and/or repriced into current market interest rates during the current fiscal year were $2.97 billion, including $1.16 billion in term borrowings, of which $640.0 million was tied to interest rate swaps. These offsetting cash flows allow the Bank to manage its interest rate risk and gap position more precisely than if the Bank did not have offsetting cash flows due to its mix of assets or maturity structure of liabilities.
The Bank primarily uses long-term fixed-rate borrowings with no embedded options to lengthen the average life of the Bank's liabilities. The fixed-rate characteristics of these borrowings lock-in the cost until maturity and thus decrease the amount of liabilities repricing as interest rates move higher compared to funding with lower-cost short-term borrowings. These borrowings are laddered in order to prevent large amounts of liabilities repricing in any one period. The WAL of the Bank's term borrowings as of September 30, 2020 was 1.9 years. However, including the impact of interest rate swaps related to $640.0 million of adjustable-rate FHLB advances, the WAL of the Bank's term borrowings as of September 30, 2020 was 3.0 years. The interest rate swaps effectively convert the adjustable-rate borrowings into long-term, fixed-rate liabilities.
In addition to these wholesale strategies, the Bank has benefited from an increase in non-maturity deposits. Rates paid on non-maturity deposits are not expected to increase as market interest rates rise. Specifically, checking accounts and savings accounts have had minimal interest rate fluctuations throughout historical interest rate cycles, though no assurance can be given that this will be the case in future interest rate cycles. The balances and rates of these accounts have historically tended to remain very stable over time, giving them the characteristic of long-term liabilities. The Bank uses historical data pertaining to these accounts to estimate their future balances. Additionally, as we expand the commercial banking business, we expect to have the ability to obtain lower-costing commercial deposits, which could be used to reduce the cost of funds by replacing FHLB borrowings and wholesale deposits.
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With the significant decrease in interest rates during the current year, the Bank has decreased the rates on certificates of deposit and money market accounts on pace with competitors in its market areas. The Bank will continue to adjust rates as market conditions allow.
Gap Table. The following gap table summarizes the anticipated maturities or repricing periods of the Bank's interest-earning assets and interest-bearing liabilities based on the information and assumptions set forth in the notes below. Cash flow projections for mortgage-related assets are calculated based in part on prepayment assumptions at current and projected interest rates. Prepayment projections are subjective in nature, involve uncertainties and assumptions and, therefore, cannot be determined with a high degree of accuracy. Although certain assets and liabilities may have similar maturities or periods to repricing, they may react differently to changes in market interest rates. Assumptions may not reflect how actual yields and costs respond to market interest rate changes. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable-rate loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the gap table below. A positive gap indicates more cash flows from assets are expected to reprice than cash flows from liabilities and would indicate, in a rising rate environment, that earnings should increase. A negative gap indicates more cash flows from liabilities are expected to reprice than cash flows from assets and would indicate, in a rising rate environment, that earnings should decrease. For additional information regarding the impact of changes in interest rates, see the following Change in Net Interest Income and Change in MVPE discussions and tables.
More Than More Than
Within One Year to Three Years Over
One Year Three Years to Five Years Five Years Total
Interest-earning assets: (Dollars in thousands)
Loans receivable (1)
$ 2,180,950 $ 2,209,189 $ 1,087,823 $ 1,745,032 $ 7,222,994
Securities (2)
618,869 513,172 178,157 219,407 1,529,605
Other interest-earning assets 172,286 — — — 172,286
Total interest-earning assets 2,972,105 2,722,361 1,265,980 1,964,439 8,924,885
Interest-bearing liabilities:
Non-maturity deposits (3)
752,147 379,065 410,930 1,710,488 3,252,630
Certificates of deposit 1,505,599 1,199,700 315,477 468 3,021,244
Borrowings (4)
279,401 702,940 618,134 231,139 1,831,614
Total interest-bearing liabilities 2,537,147 2,281,705 1,344,541 1,942,095 8,105,488
Excess (deficiency) of interest-earning assets over
interest-bearing liabilities $ 434,958 $ 440,656 $ (78,561) $ 22,344 $ 819,397
Cumulative excess of interest-earning assets over
interest-bearing liabilities $ 434,958 $ 875,614 $ 797,053 $ 819,397
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More Than More Than
Within One Year to Three Years Over
One Year Three Years to Five Years Five Years Total
Cumulative excess of interest-earning assets over interest-bearing
liabilities as a percent of total Bank assets at:
September 30, 2020 4.58 % 9.23 % 8.40 % 8.64 %
September 30, 2019 5.21
Cumulative one-year gap - interest rates +200 bps at:
September 30, 2020 (6.44)
September 30, 2019 (3.88)
(1) Adjustable-rate loans are included in the period in which the rate is next scheduled to adjust or in the period in which repayments are expected to occur, or prepayments are expected to be received, prior to their next rate adjustment, rather than in the period in which the loans are due. Fixed-rate loans are included in the periods in which they are scheduled to be repaid, based on scheduled amortization and prepayment assumptions. Balances are net of undisbursed amounts and deferred fees and exclude loans 90 or more days delinquent or in foreclosure.
(2) MBS reflect projected prepayments at amortized cost. Investment securities are presented based on contractual maturities, term to call dates or pre-refunding dates as of September 30, 2020, at amortized cost.
(3) Although the Bank's checking, savings, and money market accounts are subject to immediate withdrawal, management considers a substantial amount of these accounts to be core deposits having significantly longer effective maturities. The decay rates (the assumed rates at which the balances of existing accounts decline) used on these accounts is based on assumptions developed from our actual experiences with these accounts. If all of the Bank's checking, savings, and money market accounts had been assumed to be subject to repricing within one year, interest-bearing liabilities which were estimated to mature or reprice within one year would have exceeded interest-earning assets with comparable characteristics by $2.07 billion, for a cumulative one-year gap of (21.8)% of total assets.
(4) Borrowings exclude deferred prepayment penalty costs. Included in this line item are $640.0 million of FHLB adjustable-rate advances with interest rate swaps. The repricing for these liabilities is projected to occur at the maturity date of each interest rate swap.
Change in Net Interest Income. The Bank's net interest income projections are a reflection of the response to interest rates of the assets and liabilities that are expected to mature or reprice over the next year. Repricing occurs as a result of cash flows that are received or paid on assets or due on liabilities which would be replaced at then current market interest rates or on adjustable-rate products that reset during the next year. The Bank's borrowings and certificate of deposit portfolios have stated maturities and the cash flows related to the Bank's liabilities do not generally fluctuate as a result of changes in interest rates. Cash flows from mortgage-related assets and callable agency debentures can vary significantly as a result of changes in interest rates. As interest rates decrease, borrowers have an economic incentive to lower their cost of debt by refinancing or endorsing their mortgage to a lower interest rate. Similarly, agency debt issuers are more likely to exercise embedded call options for agency securities and issue new securities at a lower interest rate.
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For each date presented in the following table, the estimated change in the Bank's net interest income is based on the indicated instantaneous, parallel and permanent change in interest rates. The change in each interest rate environment represents the difference between estimated net interest income in the 0 basis point interest rate environment ("base case," assumes the forward market and product interest rates implied by the yield curve are realized) and the estimated net interest income in each alternative interest rate environment (assumes market and product interest rates have a parallel shift in rates across all maturities by the indicated change in rates). Projected cash flows for each scenario are based upon varying prepayment assumptions to model likely customer behavior changes as market rates change. For the current year, multiple yields along the yield curve were less than one percent, so the -100 basis points scenario was not applicable. Estimations of net interest income used in preparing the table below were based upon the assumptions that the total composition of interest-earning assets and interest-bearing liabilities does not change materially and that any repricing of assets or liabilities occurs at anticipated product and market rates for the alternative rate environments as of the dates presented. The estimation of net interest income does not include any projected gains or losses related to the sale of loans or securities, or income derived from non-interest income sources, but does include the use of different prepayment assumptions in the alternative interest rate environments. It is important to consider that estimated changes in net interest income are for a cumulative four-quarter period. These do not reflect the earnings expectations of management.
Change Net Interest Income At September 30,
(in Basis Points) 2020 2019
in Interest Rates (1)
Amount ($) Change ($) Change (%) Amount ($) Change ($) Change (%)
(Dollars in thousands)
000 bp $ 183,596 $ — — % $ 193,329 $ — — %
+100 bp 188,084 4,488 2.44 194,093 764 0.40
+200 bp 188,417 4,821 2.63 192,111 (1,218) (0.63)
+300 bp 186,441 2,845 1.55 188,752 (4,577) (2.37)
(1) Assumes an instantaneous, parallel, and permanent change in interest rates at all maturities.
The net interest income projection was lower in the base case scenario at September 30, 2020 compared to September 30, 2019 due to lower interest rates at September 30, 2020 compared to September 30, 2019. Because the Bank's gap was positive during the current year, assets have repriced downward at a faster pace than liabilities, resulting in a lower base case net interest income projection at September 30, 2020.
The net interest income projections increase from the base case in all rising interest rate scenarios at September 30, 2020. The net interest income projection was more adversely impacted in the rising interest rate scenarios at September 30, 2019 compared to September 30, 2020, due primarily to higher interest rates at September 30, 2019. The positive impact of rising interest rates is diminished as interest rates increase. Higher interest rates decreased the projected cash flows from the Bank's mortgage-related assets, thus decreasing the positive impact of rising interest rates compared to the base case.
Change in MVPE. Changes in the estimated market values of our financial assets and liabilities drive changes in estimates of MVPE. The market value of an asset or liability reflects the present value of all the projected cash flows over its remaining life, discounted at market interest rates. As interest rates rise, generally the market value for both financial assets and liabilities decrease. The opposite is generally true as interest rates fall. The MVPE represents the theoretical market value of capital that is calculated by netting the market value of assets, liabilities, and off-balance sheet instruments. If the market values of financial assets increase at a faster pace than the market values of financial liabilities, or if the market values of financial liabilities decrease at a faster pace than the market values of financial assets, the MVPE will increase. The market value of shorter term-to-maturity financial instruments is less sensitive to changes in interest rates than are longer term-to-maturity financial instruments. Because of this, the market values of our certificates of deposit (which generally have relatively shorter average lives) tend to display less sensitivity to changes in interest rates than do our mortgage-related assets (which generally have relatively longer average lives). The average life expected on our mortgage-related assets varies under different interest rate environments because borrowers have the ability to prepay their mortgage loans. Therefore, as interest rates decrease, the WAL of mortgage-related assets decrease as well. As interest rates increase, the WAL would be expected to increase, as well as increasing the sensitivity of these assets in higher rate environments.
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The following table sets forth the estimated change in the MVPE for each date presented based on the indicated instantaneous, parallel, and permanent change in interest rates. The change in each interest rate environment represents the difference between the MVPE in the base case (assumes the forward market interest rates implied by the yield curve are realized) and the MVPE in each alternative interest rate environment (assumes market interest rates have a parallel shift in rates). Projected cash flows for each scenario are based upon varying prepayment assumptions to model likely customer behavior as market rates change. For the current year, multiple yields along the yield curve were less than one percent, so the -100 basis points scenario was not applicable. The estimations of the MVPE used in preparing the table below were based upon the assumptions that the total composition of interest-earning assets and interest-bearing liabilities does not change, that any repricing of assets or liabilities occurs at current product or market rates for the alternative rate environments as of the dates presented, and that different prepayment rates were used in each alternative interest rate environment. The estimated MVPE results from the valuation of cash flows from financial assets and liabilities over the anticipated lives of each for each interest rate environment. The table below presents the effects of the changes in interest rates on our assets and liabilities as they mature, repay, or reprice, as shown by the change in the MVPE for alternative interest rates.
Change Market Value of Portfolio Equity At September 30,
(in Basis Points) 2020 2019
in Interest Rates (1)
Amount ($) Change ($) Change (%) Amount ($) Change ($) Change (%)
(Dollars in thousands)
000 bp $ 1,301,409 $ — — % $ 1,283,429 $ — — %
+100 bp 1,290,877 (10,532) (0.81) 1,286,446 3,017 0.24
+200 bp 1,157,368 (144,041) (11.07) 1,162,151 (121,278) (9.45)
+300 bp 967,997 (333,412) (25.62) 992,060 (291,369) (22.70)
(1) Assumes an instantaneous, parallel, and permanent change in interest rates at all maturities.
The percentage change in the Bank's MVPE at September 30, 2020 was negative in all scenarios. At September 30, 2019 the percentage change in the Bank's MVPE was negative in the +200 and +300 basis point scenarios. This change was due primarily to a change in the Bank's interest rate risk model, of which the most significant impact was on the valuation of the Bank's non-maturity deposit portfolio. The model changes resulted in a shorter duration for these liabilities than was modeled at September 30, 2019, which reduced their sensitivity to changes in interest rates. The Bank's MVPE decreases as interest rates rise, as the market value for assets decreases at a faster pace than these liabilities. The negative impact to the MVPE in the rising interest rate scenarios is due to slower prepayment projections on the Bank's mortgage-related assets and investments. As interest rates increase, borrowers have less economic incentive to refinance their mortgages and agency debt issuers have less economic incentive or opportunity to exercise their call options in order to issue new debt at lower interest rates, resulting in lower projected cash flows on these assets. As interest rates increase in the rising rate scenarios, repayments on mortgage-related assets are more likely to decrease and only be realized through significant changes in borrowers' lives such as divorce, death, job-related relocations, or other events as there is less economic incentive for borrowers to prepay their debt, resulting in an increase in the average life of mortgage-related assets. Similarly, call projections for the Bank's callable agency debentures decrease as interest rates rise, which results in cash flows related to these assets moving closer to the contractual maturity dates. The higher expected average lives of these assets, relative to the assumptions in the base case interest rate environment, increases the sensitivity of their market value to changes in interest rates.
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The following table presents the weighted average yields/rates and WALs (in years), after applying prepayment, call assumptions, and decay rates for our interest-earning assets and interest-bearing liabilities as of September 30, 2020. Yields presented for interest-earning assets include the amortization of fees, costs, premiums and discounts, which are considered adjustments to the yield. The interest rate presented for term borrowings is the effective rate, which includes the impact of interest rate swaps and the amortization of deferred prepayment penalties resulting from FHLB advances previously prepaid. The WAL presented for term borrowings includes the effect of interest rate swaps. The maturity and repricing terms presented for one- to four-family loans represent the contractual terms of the loan.
Amount Yield/Rate WAL % of Category % of Total
(Dollars in thousands)
Investment securities $ 380,147 0.65 % 1.0 24.3 % 4.2 %
MBS - fixed 970,369 1.82 3.3 62.2 10.7
MBS - adjustable 210,434 2.49 3.1 13.5 2.3
Total securities 1,560,950 1.62 2.7 100.0 % 17.2
Loans receivable:
Fixed-rate one- to four-family:
<= 15 years 1,130,538 2.98 3.1 15.6 % 12.5
> 15 years 4,287,229 3.67 4.2 59.3 47.3
Fixed-rate commercial 556,195 4.14 3.5 7.7 6.1
All other fixed-rate loans 47,855 4.53 4.9 0.7 0.5
Total fixed-rate loans 6,021,817 3.59 3.9 83.3 66.4
Adjustable-rate one- to four-family:
<= 36 months 189,591 2.25 4.8 2.6 2.1
> 36 months 639,461 3.09 3.2 8.9 7.1
Adjustable-rate commercial 273,465 4.75 6.6 3.8 3.0
All other adjustable-rate loans 100,662 4.23 2.5 1.4 1.1
Total adjustable-rate loans 1,203,179 3.43 4.2 16.7 13.3
Total loans receivable 7,224,996 3.57 4.0 100.0 % 79.7
FHLB stock 93,862 4.64 1.9 1.0
Cash and cash equivalents 185,148 0.09 — 2.1
Total interest-earning assets $ 9,064,956 3.18 3.6 100.0 %
Non-maturity deposits $ 3,170,164 0.20 6.1 51.2 % 39.7 %
Retail/business certificates of deposit 2,766,461 1.83 1.5 44.7 34.6
Public unit certificates of deposit 254,783 0.74 0.5 4.1 3.2
Total deposits 6,191,408 0.95 3.8 100.0 % 77.5
Term borrowings 1,793,000 2.31 3.0 22.5
Total interest-bearing liabilities $ 7,984,408 1.26 3.6 100.0 %
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