Where Do Banks’ Investment Portfolios Go From Here?

Intro: Alvin Community Bankers grow themselves, their team and their profits. This is the Community Bank Podcast. Now, here are your hosts, Eric Bagwell and Tom Fitzgerald.

Eric: Welcome to the Community Bank Podcast. This is Eric Bagwell, director of sales and marketing with the correspondent division at CenterState Bank. Thanks for joining us. The day after the election, today Tom Fitzgerald, who normally host with me the director of strategy and research here in the corresponded division. He has actually recorded a conversation with Greg Rains and Nathan Goodnight. They are two of our bond salesmen here in the division, and they are going to talk about what you need to be doing in your bond portfolio and kind of the outlook post-election leading up to the end of the year. So, we will go ahead and play that conversation right now.

Tom: This is Tom Fitzgerald, director of strategy and research for CenterState Bank, and we are joining you the day after the election. So, this is sort of our post-election show. The unfortunate thing is we don’t really have a lot of definitive results to give you. There’s still several States that are out and counting. The market though, seems to like it both in the stocks and the bonds. I think the stocks like it because they see sort of a result coming this week, whether it’s tomorrow or Friday, they see that result coming. The bond market likes it, I think because the Republicans will retain the Senate, and I think that will keep if there’s a Biden administration, that’ll sort of keep them in check from any grand fiscal stimulus package that they might be considering.

So again, for today, anyway, both the stocks and the bonds are rallying on the election results or tentative election results. This episode we are going to kind of take a look at investment portfolio management in the current environment. This this is our third show of this type, and we’ve been doing them about once every two or three months, and so it’s kind of time again, it just sort of coincides with the post-election outlook. I think basically given sort of what we’re going to see, whether it’s a Biden administration or whether Trump retains, but with the Senate still on the hands of the Republicans, which looks pretty much a sure thing at this point.

I still think we’re going to be range bound in the treasury market, you know, I think, you know, obviously we’re having a big rally today. We were kind of approaching 1 percent on the 10 year yesterday, but that’s kind of turned around with the election. So again, I still think we’re going to be range bound. I think the fed is still going to keep the anchor at the front end at zero, and any action will be on the long end, but if rates started to climb too much, I think the fed would step in pretty quickly, and keep that rate increase from getting too out of hand in their view.

So anyway, with that backdrop, as far as rates and kind of what we know so far with the election, I want to introduce our two guests today. The first is Nathan Goodnight. I kind of view Nathan as sort of the Kevin Costner character in Dances with Wolves. He’s in our Dallas office, he’s sort of he’s our pioneering location out there, and so he’s sort of fending off the Indians and fending off the wild animals. So, Nathan, how are you doing today?

Nathan: Hey, I’m doing good. You know, I haven’t had that reference yet, but I really liked it, so thanks.

Tom: I think it fits, especially out in Texas, you know, you sort of in that wild West, you know, even though Dallas it’s certainly been developed much more than where Kevin Costner was holed up out West as well. Also joining me today is probably the dean of our salesforce and that’s Greg Rains, he’s in our Birmingham office. Greg, how are you doing today?

Greg: Well, not feeling really Danish, but it’s a beautiful day in Birmingham. Blue skies outside, traffic is flowing, commerce is happening and we get the election behind us. I think we’ll be in great shape.

Eric: That’s right. Kind of get through this, survive this week and kind of let the dust settle and see where we are from there. Anyway, I really wanted to kind of pick your brains, both of you as far as, you know, what we’ve got with investments and kind of where to go with those investments. Given, the post-election outlook this is sort of playing off. We did a live stream event about a month ago, I think, October 15th, and so we had basically a look at rates where we thought the economy was going to go, and then we kind of went from there into what to do with your investment portfolio, given these low rate environments, and it was kind of a unique way to approach the subject.

We had a panel and of Greg, Nathan and a couple other sales reps, and so we really were able to kind of pick apart a lot of the investment ideas and strategies that have been going through the market in the last couple of months and really kind of try to find out what is best for the banks given this environment. So we were just want to kind of go back and reprise some of those questions for our listeners that weren’t able to attend the live stream and kind of see where you guys think you know, things are going to go, and I’ll kick it off with you, Nathan, and just kind of, you know, sort of this overall general question of what do you do in this environment, and then kind of relatedly, you know, what are some of the pitfalls that you would also avoid in this environment as well?

Nathan: Right. Yeah. So it’s funny, and I’m going to sound a little bit like a broken record here, and I hope I should, and we all should, because really the advice that we would give you today in this environment is going to be really similar to the advice I would give you back when the economy was expanding and you were starting to see loan growth, like you’ve never seen before. You know, we have the investment portfolio as a part of our overall balance sheet, and if we completely neglect that part of our balance sheet in this interest rate environment, or even in the interest rate environments that we had back in you know, mid 2019, all the way up until the recession that happened because of the pandemic, but if you look at the balance sheet and you think, all right, well, we’re going to continue to make loans.

Maybe not as much as we were, and we’re going to continue to invest, but maybe is it a little bit less than we did before, but at the end of the day, you’re still doing some of both. You’re still making loans and you’re still investing in the investment portfolio. So, I continue to tell clients, remain fully invested, you know, unless there’s some liquidity event coming up or you believe there’s going to be some type of cashflow disruption coming up, then maybe you keep some of your funds in cash, but overall continue to remain invested. So, there’s the broken record part that you’re going to hear from me and probably Greg and anyone else in our group is to remain fully invested.

So, when you look at the investments and we’re looking at a world now where the treasury is just now moved to below the 10 year treasury just now move below 80 basis points. We know yesterday, we almost hit 90, and now we’re below 80. It makes it pretty difficult to find something attractive in this market, but I would continue to say, we can still find some products that are going to provide again, here’s another broken record thing that spread component right over what we’re paying for the cash to come into the bank and we’re able to invest in. So, it’s tough from a nominal perspective to look at a 77 basis point 10 year treasury and say, gosh, that’s so low.

What should I invest in? But we want to remember and go back to think we need to be investing in all interest rate environments. We were lending in all interest rate environments. We’re taking deposits in all interest rate environments, and we’re not only focused on the nominal rate. We’re going to be focused again on that spread. So, what is our spread component going to look like? So, then we had start to get into individual investments, which I think we can talk about a little bit later, but overall theme in this environment make sure to stay invested.

Don’t sit on the sidelines because of the fed is being pretty transparent. That cash is going to stay basically the same rate that we’ve had now for the past, what is it? Six months since they cut rates, probably not going to change. So, if we sit in cash, that’s not a good investment, and when you look at something longer out the curve and into spread products, mortgages, munis, agencies, et cetera.

Eric: Let me turn it now to you, Greg, and kind of just ask you another kind of overall overarching question is what should banks be doing now that they’re not doing in your view as to, you know, both from an investment perspective, as well as the whole balance sheet?

Greg: Now, I kind of, first of all, reiterate what the wolf whisper just told us, which I think is sage advice coming from a younger man than me that has got it right. You take kind of what the portfolio gives you. We’re all a little bit of a broken record right now. We’ve been saying this a few months, it feels like few years. The balance sheet changed a lot this year, has changed primarily in the deposit side, and what happens on the deposit side carries over to the asset side as far as we’re concerned, thanks for a little [inaudible 9:09] initially to extend credit. They’ve kind of unfrozen that a little bit, so that’s happening, but what’s happened now in the second quarter predominantly, and we’ve seen it bleed over to the third, and I think we’ll even see another peak in this early next year is growth in demand deposits.

If you’re growing demand deposits and they’re sticky and they’re longer duration deposits the way we measure them in ALM, then you’ve got an excuse to push duration out in bonds, and that’s where you get your yield more safely than extending into credit. So, staying away from corporates, looking at the municipal sector, and it depends on whether you’re a Sub S Bank, a C-Corp, whether you’re taxable, non-taxable but you’ve got a pretty good array of instruments. We’ve got a great muni desk, and if you look at what’s out there, general market stuff is predominant for banks that are taxable.

The C-Corps, VQ stuff goes to the Sub S Banks, and that’s become more of just a, you know, if you think about a good gumbo. We used to consider munis kind of cayenne pepper we put in the gumbo. Now, I think it’s primary ingredient. We can’t make the whole gumbo out of that ingredient, but we need a healthy dose of it, and the reason we need it is we’re not getting dealed reliability on the other products, and those are the products are called wage, NCs mortgage, securities, direct mortgages, and also CMOs. The CMO piece I think is best filled by low coupon synthetics.

The MBS piece is probably going to be stuff in the two and a half, 3 percent to range, probably 30 year bonds more there we’re looking for special stats, and then we get to the munis we’re going to have a little longer than we were. We know that, but we feel like we’ve got a great opportunity to do that because of the liability side. So, I think Nathan’s right though. I sound very much like a broken record.

Nathan: Right, but that’s where we should be though, right? I mean, everything you just said is exactly the right type of products to be looking at, and in this environment, it makes it so tough for us as bankers to think, well, gosh, if interest rates rise and I’m investing you know, longer term assets, those assets are going to be underwater. Well, we’ve talked about this on our live stream last week that, you know, the fortunate thing about running our banks are we’re not judged. We’re not a mutual fund, we’re not a hedge fund, we’re not a pension fund. We don’t have someone in the background saying, hey, what’s your mark to market today?

What’s the change here in liquidity from your unrealized gain or loss position? We just want to look at it that we have enough adequate cashflow coming back to us that we can meet our future loan demands and that if we need to, and the need arises that we do have those specific securities available in the portfolio to liquidate, and if you’re running and managing your portfolio correctly and working with someone like Greg or myself, we have all kinds of models and analytics available to ensure that your portfolio is not only designed and positioned for today’s interest rates, but also for interest rate shock. So, interest rates move a 100 basis points higher, interest rates move 200 basis points higher.

What are we looking like from a cashflow perspective; therefore, we can still meet that liquidity. So anyway, all this to be said is, Greg is exactly right. This is a great time and the time to go and put on duration in the investment portfolio, and these are going to be in those type of instruments that are going to have virtually no credit risk. So, you’re going to be eliminating the credit risk piece. You really are going to be the only way to get to this additional spread is by doing that. If we stay short, the curve has some steepness, but if you’re in the first couple of years of the yield curve, there’s just no yield to be had. So, looking at duration, selectively making sure it fits in the overall portfolio is something that Greg and I want to make sure that we work with on all of our clients. So that way it’s fits well within their cashflow structure. Not only in today’s interest rates, but what could happen in the future. Yeah.

Eric: Well, let me ask you two, both of you mentioned munis, and is there any concern let’s say that there’s really not a stimulus 2.0 that comes out, or if it does it doesn’t really address any of the issues for the state and local municipalities. Do you all have any issues as far as like, concerns about GOES or, you know, that may be seeing lower tax revenues because of kind of the bumpy recovery, or is it, you know, maybe we stick more with water and sewer or some type of the essential, you know, revenue type bonds. Do you all have any concerns there at all? Stocks [inaudible 13:38].

Greg: The interesting thing about, think you had to go back to 2009 and Meredith Whitney, again another broken record statement here, but stating that we’re going to have all these failures, we were in a pretty deep financial crisis at the time, and we had less failures than we had the previous year, which was nothing too. It’s very unlikely to see happen anytime soon, if there are latent problems that occur with tax GEOS, you can continue to increase in the millage until you kill the community. That takes a long time to kill the community. Limited tax doesn’t mean the opposite of unlimited.

It just means that there’s a limit to how much they can increase the millage annually without referendum, and there’s still the option for the referendum. So, and water and sewer. Yeah. People got to have water and sewer. So, I really don’t think credit issues are going to creep into the munis sector in a big way. Nathan, I don’t know what you think.

Nathan: No, I completely agree. I look yet muni bonds, you know, GEOS essential service revs. Those are the types of bonds that if you go back and look at, I mean, not to say that history is going to repeat itself or a great indicator of the future, but I mean, we got to go back and look at, even in our last recessions and go and look at specific muni sectors, how did those muni sectors perform? You know, what was the level of bankruptcies? What was the level of defaults? You know, realistically it’s a non-existence, I mean, it really is.

If you’re doing your proper credit work upfront it’s non-existent, and even then, let’s just say that we get into a credit today, and because of some events that we don’t see now, that municipality is impacted greater than what we would expect, and so let’s just say that there’s a large employer that made up a large percentage of the tax base and that GEO when they come out of that city or that municipality. Well now there’s this additional stress, this additional burden on those who remain. So, let’s just say that that becomes you know, maybe an impaired type credit. Well, the thing about munis is really interesting.

It’s so well broadcast as far as their financials and the information that they have to make available to us. It’s not going to be a surprise. If Walmart decides to pull out of Decatur, Oklahoma, and no longer is paying taxes there. We’re going to see this from the public view, right? Walmart says, they’re pulling out of Oklahoma and these specific areas, well, then we pride as working alongside you. Then the bank investment portfolio manager can come back and say, you know, we’re seeing some events take place here. They’re isolated in certain pockets of the country.

You know, we may want to start looking at lowering our exposure to these types of municipalities, and again, this is an extreme scenario, but it’s just goes back to the point that Greg mentioned, you know, people talked about municipality credits, defaulting. As long as you’re doing your due diligence upfront and maintaining the strict type of credit standards in the municipal bond portfolio. I think it’s something that’s just going to be a non-event, and if there is anything it’s going to be isolated to very specific areas and maybe even a specific type of event, you know, hurricane natural disaster, things like that that are probably only temporary, but not going to be something that’s going to impact the majority of your portfolio.

Eric: I would add too that, you know, when you look at the funding sources for a lot of these issues, you know, property taxes are way up there, and one sector that’s really been doing well this year, very well is the real estate market. You know, it’s with the low rates and so on, it’s continued to be red hot for this year, and I think, you know, property values are clicking up at about 4 and 5 percent per annum. So, you know, that tax flow is still continuing to come in, and so I think it kind of buttresses the case that, you know, those revenue streams are still pretty strong for, you know, most of those issuers.

Let’s kind of turn now, we’ve been talking munis and more general, let’s kind of turn it to the mortgage back market, and obviously, you know, prepays are the number one you know, risks that we face right now in mortgages. Are there other ways Greg? Have you started evaluating mortgage backs differently now in light of kind of where we are with the level of yields and where rates are? Is it, you know, other things that considering today that maybe you didn’t consider a year ago?

Greg: We start a conversation this morning with a customer is a great example of this. He had an underperforming bond and it really had more to do; it was two things that were causing this bond to appear to be performing badly in his bond accounting. We can’t really use bond accounting nowadays to evaluate what the true performance of a bond is. We can use it to evaluate how it’s impacting us and maybe change some of the methodology. In this case we changed this methodology, and what I mean by that is we are evaluating bonds differently. I’ll explain that in a minute.

Bond accounting methodologies can sometimes accelerate the premium amortization to a point that the yields go negative or go really low, so we got to be careful there. What’s happening in our valuation of the MBS bonds right now, we started out looking at things that we thought, limited prepayment speeds, and we’ve changed, and the thing we’ve changed to the biggest single factor appears to be loan size. So, if we look at the average weighted loan size, the maximum loan size, and we keep that below, say 175,000, 150, that has a massive impact.

If we pair that with a high credit score and a low loan to value, and we pull away from California loans and look carefully at the servicers then, and make sure we’re using services that are not quick or, you know, Loans Rocket Mortgage for instance, and we also look at loans originated in New York and Florida, for instance, there’s a taxation of refinancings. There’s a fee for refinancing that causes you know, re- STIF to drop quite a bit more people to benefit from refinancing there. So, a combination of those things seems to keep us a little bit out of trouble because we’ve got to pay the premium. If we’re going to buy that standard pass through. Nathan, I don’t know if you’ve seen the same thing.

Nathan: Man, in this environment, it’s making it tougher because there’s no such thing as a discount and mortgage back right now, right? Even the lowest coupon mortgage available still is going to be right now, if I’m looking at my screen, it’s going to be over a 101 dollar price as of today. So, if you think about that, all right, so the lowest premium I can get is still one point premium, and that’s going to be the cheapest to deliver longest duration, most optionality.
That means that the more options that the home loan, the homeowner owns is still going to be a point. So, it’s exactly what you said, Greg.

We got to be focused on the underlying attributes of each individual tool that are going to help us have that sustainable cashflow for the life of the investment because right now that’s something that’s going to be really key because if interest rates and the rates that a homeowner’s able to go out and achieve are still at historic lows. Well, that’s one factor of refinance, right? So, we got the refinancing. Well, let’s just say that someone got into their loan a year ago and says, you know what?

I just don’t even want to go to the bank. I don’t even want to refinance, well, that’s not going to cause a refinance event, but what causes a prepayment could be when they say, you know what, we’re going to upgrade our house. We’re going to go get that bigger house out in the suburbs that we’ve been dreaming up. So, there’s a free payment event. Doesn’t happen with refinancing, but moving out of the home. Or you may have someone else that says, hey, I’m finally going to take that job in Nebraska, and so there’s another event because they’ve left the home, and then the other that happens sometimes that, you know, could be coming up here because of what’s happened with the recession that we’re still in, just coming out of still to be determined, is that foreclosure. Right.

So even though refinance is a key, we still want to look at each individual mortgage back pool and look at all these different attributes to come up with what we believe is going to create a blended and stable cashflow for the life of the bond. You know, that not only protects us from refinance ability, but then what type of borrowers are they, you know, first first-time home buyers, is that a refinances? Is it an investment property? What’s their FICA? What’s the LTV?

So, all of these different data points that are available to us that we go through and analyze, you know, thousands of mortgages a day, we take all those into consideration to come back and say, based on all of those, here are the best bonds that we believe on these projections using these assumptions are going to perform the best for your portfolio, provide this much stable yield and this much cashflow.

Eric: Yeah, and that’s a lot to consider, and that’s why, you know, you guys do such a great job and kind of bringing those issues to your clients to say, you know, this is you kind of, I’m sure you guys sift through dozens of bonds and pools to look at. Okay. Here’s one that I think meets a lot of those criteria that I’ll take and show my customers, and it’s interesting, you know, we kind of, we talked earlier about adding duration and that’s one of the areas where you go to get yield. We talked about the liquidity and the balance sheets that are, you know, the banks kind of concerned about.

I need to invest this. I don’t want to sit, you know, earning 10 basis points, but I don’t know if that if that money is going to leave today or, or a year from now during our live stream, we did, we had a series of poll questions that were interactive. So, our audience could kind of react and give us answers and feedback to the question, and it was interesting. One of the questions was which of these risks are you more willing to take to achieve your bond portfolio goals? And the three possibilities were duration, risk, credit, risk, or optionality, and by far and away duration risk, 82 percent, was the clear favorite.

So that’s the risk that at least these viewers, these investment managers would take in order to try to achieve their portfolio goal, which in this case is probably the higher yield, and that makes a lot of sense because, you know, we’ve talked about it already earlier in the show, you look at the liquidity on bank balance sheets that kind of automatically makes them a little more asset sensitive. So again, when you look at it holistically for the whole balance sheet, you probably can afford a little more duration in the in the bond portfolio, just because of that fact alone.

I’m sure you guys probably, you know, Nathan and Greg, you probably bring that up all the time when, you know, somebody starts to balk at, oh, I don’t want a five year, six year, seven year average life, you know, pool on my books. You probably have to go through that little exercise to explain. You’re a lot more asset sensitive than you probably thought you are, at least in this environment. You had those talks with some of your clients?

Greg: It’s a daily conversation, and it’s also, you know, what we’re watching happening is the PPP loan forgiveness grant status is probably getting pushed off a little bit. In a lot of cases, we’re not going to see as much of that come back until next year as we had hoped, but that too is going to also change the balance sheet structure. I really like to look at the asset liability driven kind of questions and answer those questions, and like I said, the deposit, the change in positive structure thanks to the big banks, maybe not doing a good job on PPP or other reasons that cause people to migrate small banks.

We’re seeing a ton of growth in small banks right now, and that structure is very, it is an asset sensitive growth model and does offer room for this, and then that’s the first question I ask is how much capacity do you have? What kind of capacity do you have for duration? Nathan, I don’t know if you’re seeing that among your clients also.

Nathan: Yeah, very similar, and it’s a daily conversation. It seems like us as bankers. I think when we were, you know, initially brought into the banking industry, they said, you know, offering long-term fixed rates is bad. Locking in long-term assets is bad, but really, and truly, you know, we rely heavily on, like you mentioned, Greg on, you know, asset liability modeling, and most of the time come to find out a bank who says, I can’t put this on. This would destroy our bank if interest rates were to move higher or really probably actually would benefit you in all intents and purposes, if interest rates move higher.

So it’s one of those, that’s a balance because I may be able to tell you and prove out on a report that your bank is going to do better if interest rates move higher and say that this bond is actually perfectly fine, or this loan that you put on is perfectly fine with this type of duration, but most of the time, you know, it’s one of those that we find where we’re coming to a happy medium. I may say you can put on the duration, higher duration bond. The banker says shorter, and we ended up somewhere in between, and I still think that’s a good decision versus doing something too short or not doing anything at all, but again, you know, one strategy that we’ve deployed here recently that I think is extremely beneficial is doing a pairing of two trays at the same time.

So we’ve done this in our own banks investment portfolio, and I’ve advised and had some clients that could do the exact same thing, and so an example would be something this maybe a lower coupon, a mortgage back, which in theory should have a longer duration, right, because there’s a less refinance ability because of the homeowners are in the lower rate, and you couple that, or pair it with a hierarchy coupon mortgage back. So that’s going to be a bond in this environment. It should have a shorter duration faster pre-payments because the homeowners are paying a higher rate. So, when you take the lower coupon MBS and the hierarchy coupon MBS, and you blend those together, you’re actually creating an instrument that’s going to be somewhat of a hybrid of both, right?

Then that average life works out to be what I would consider to be the sweet spot, maybe in that four to seven year type range for an investment, and it also protects you from interest rates moving higher on the higher coupon, and if interest rates stay the same or move higher on the low from the lower coupon, absolutely getting killed from a market value perspective. So, I mean, duration is one of those things that we as banks, you know, it’s tough to get our minds around, and it seems like we always like to look in the rear view mirror of, man, why don’t I put more duration on you back in October, 2018, why didn’t I go buy the 30 year treasury?

You know, well, we, we don’t know what’s going to happen in the future, but we do know by just looking at history and what we’ve seen our balance sheets do in different interest rate environments, I believe we can take on more duration than what we think.

Eric: I would add too on that, another one of the questions that we asked during our live stream was, you know, a year from now, where do you see rates moving? The clear winner in that was basically level. So, you had either higher, lower or level, three quarters of our audience said level, and so it could, you know, again, a situation, of course, nobody has a crystal ball, but at least that’s kind of was the preponderance of answers from our group that, you know, was asked the question. Also, too, I would add, you know, when you look at our job numbers, now, we’re kind of, you know, we’re expected to get about 500,000 to 600,000 a month at the next jobs report.

You know, when you look at what we’ve kind of recovered since the March, April, you know, collapse we lost 22 million jobs during those two months. We’ve picked up about 12 million, so we’ve got about 10 million still in deficit, and if you’re picking up 500,000 a month, that’s going to be, you know, you’re looking at least two years to kind of recoup those lost jobs, and some of those lost jobs are not going to be coming back, obviously for certainly in some of the service industries that are kind of modifying how they do their business these days. So again, to me, that speaks to a lower for longer outlook.

The feds probably going to be at zero for the, you know, they’ve kind of already broadcast they’re going to be at zero through 23, and the long end, I just think that they’re going to try to keep that from getting too far out of hand, again, the real estate market’s been one strong market this year. They don’t want to kind of, you know, the kill, the goose that laid the golden eggs, so to speak.

So I think, you know, like you said, Nathan, and Greg too, you know, duration risk is probably, if you’re going to choose a risk to take right now, it’s probably duration risk, and I think, you know, that may be a hard sell for some customers, but I really think, you know, we’ll probably be down here at these levels for quite some time, and so, like you said, better, better to be invested than just sitting in cash and earning, you know, 10 basis points or so. Anyway, guys, I want to thank you. I think that’s you know; we’ve taken enough time from our listeners. I want to thank you guys for taking your time with me today.

Nathan and Greg, it’s been, I think very informative, and I hope that listeners come away with a few tidbits from this, and maybe we’ll circle back in a few months in early 21 to kind of take a look at, you know, after the dust settled from the election and kind of see where we are at that time. So again, guys, we’ll call you back in a few months and get your thoughts at that time. Thanks again for coming, and we appreciate your insights.

Nathan: Thanks. [inaudible 30:36].