Pub. 5 2014 Issue 3

fall 2014 11 West Virginia Banker While the consideration of returns is certainly part of the mix, management should also contemplate other characteristics such as liquidity, average life, duration, and cash flow. In fact, the creation and maintenance of stable, predictable cash flows may very well be a community banker’s best defense against interest rate risk. It follows, then, that the securities that are contained within the portfolio must behave themselves; that they act like they are supposed to and not subject the rest of the household to mutinous behavior. No teenage truculence allowed. Straighten Up and Fly Right! Unfortunately, some securities, not unlike brain-addled ado- lescents, have trouble remembering the rules. This becomes a particularly significant concern when confronted with a volatile interest rate environment. Portfolio managers who chased the marginally higher yields of long-term, callable agency deben- tures 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 house- hold that all of that cash flow that was supposed to be coming in may not be here for a while. Like maybe ten years. And, oh yeah, duration has now quadrupled and our heretofore modest EVE volatility has become a little excessive. Like policy-breach- ing excessive. Oops! The list of potential bad actors also includes certain kinds of mortgage-backed securities (MBS) and collateralized mortgage 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, portfolio managers 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, when managed properly, can be your best friend as you try to satisfy the needs and requirements 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. n For more information, contact Lester Murray at The Baker Group: 800-937-2257 www.GoBaker.com, or email: lester@GoBaker.com. Note: Mr. Murray will make a presentation, “Managing Interest Rate RiskforOptimalBankPerformance,”duringtheWVBACFOConference, November 18-19.” Since 1979, we’ve helped our clients improve decision-making, man- age interest rate risk, andmaximize 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. *The Baker Group LP is the sole authorized distributor for the products and services developed and provided by The Baker Group Software Solutions, Inc.