Finance blog


The Masters

April 12, 2021

I really enjoyed watching the Masters this weekend. The beauty of the golf course, even on TV, is astounding; I hope to get there some day to see it in person. I do not think I want to play that course though; I'd probably shoot very close to 200. It's truly amazing that this year's champion, Hideki Matsuyama, took only 278 shots to play the course four times. Think about that for a quick minute. How is that even possible? All the pro players are great, but to go into a tournament and make virtually no mistakes boggles the mind. Imagine all of the preparation, practice, and mental discipline that takes. If your focus lapses for even one stroke, you are done for. And yes, several players ran afoul of the famous Rae's creek or one of the many other disastrous places on that course for that very reason.

As I was watching, I couldn't help but think of something in the American banking system that is the exact opposite of the approach taken by these incredible golfers: liability management. Yes, I know that it is odd that I would be thinking about debt while watching the Masters in the comfort of my home.

As I have mentioned in earlier posts, I have had the great opportunity to sit in literally hundreds of community bank and credit union board and asset liability committee meetings. Being a neutral observer in these meetings has really given me a unique perspective. There is huge diversity in how these are run, and you notice an interesting dynamic if you are a third-party observer. Who really runs things, what's important to the institution, where is the focus…all of this, and more, comes to light if you can just sit back and observe?

I'd like to take a moment and break down what is covered in these meetings. So first, let's make it really simple: a financial institution has assets, which includes a wide array of things that they own. This includes not only physical assets like branches, building, and computers, but also includes things like cash and securities. Less well-known assets (at least to the public) are the real meat of banking: the loans, mortgages, and other stuff people owe to the bank.

In my experience, this is where the majority of time is spent in deep discussion in these meetings. If I had to classify its importance to the participants, the loan portfolio comes first, second, and third. I think this is fair. People owe the institution money in some form, whether securitized or not, and if a loan is struggling it needs to be discussed in detail to figure out what's going on. If there are serious problems, the board and shareholders need to be alerted and aware. The message of nearly all of my blog posts has revolved around ways to look at our assets in a more three-dimensional way, namely, counting the money, over time, across different interest rate scenarios. The importance of a disciplined approach to the asset portfolio cannot be understated.

Most bankers I know are also extremely interested in the credit quality of their loan portfolio, and rightly so. I have seen lengthy discussions about specific loans (of all sizes) and the challenges these businesses or individuals are facing, and what their prospects for improvement are. Fair enough. I would estimate that somewhere close to 90-95% of most board and ALCO meetings are spent thoughtfully considering the asset side of the balance sheet.

Strangely, as I sat pondering whether Hideki Matsuyama was going to make a 30-foot putt on #12 or not, I started thinking about liabilities. Odd, I know, but bear with me.

The liability side of the balance sheet is just as important as the asset side, yet so much less time is spent on it. How do banks fund themselves? Well, they borrow. If we boil down the liability side of the balance sheet it's pretty simple. It's everything the bank or credit union owes to other people. And of course, anything that is neither an asset nor a liability is leftover for the shareholders (aka. owner's equity).

Bankers cannot thrive without borrowing well, and yet this component is rarely discussed in a with the same detail that assets are.

Let's first consider this on a personal level. I have always told my kids, "Debt kills, it always has and always will." I'm not sure if I made that up or heard it somewhere, but it has a nice ring to it. On an individual basis, we know that too much debt can crush us and that is why most of us, if asked, will urge young people to keep credit card debt to a minimum. If possible, we tell them, you should pay off your credit card debt every month, otherwise it will grow and eventually crush you. It really should not surprise us that of the nearly $800 billions of credit card debt currently outstanding in the U.S. (Statista), roughly 3-4% will default. People just can't keep up. One of the small blessings of the 2020 pandemic year is that credit card debt has gone down a little, since people haven't been eating out or shopping as much. Fancy cars, new minivans, and borrowing to vacation are similarly silent debt killers.

My point to my kids is this: it's really hard to go broke if you have no debt. This is a difficult pill to swallow, especially when everyone is offering to loan you money for anything you want. And yes, there is smart debt, a reasonable mortgage or car loan does have an asset behind it and can enable meeting a fundamental need of shelter or transportation.

Hopefully you get my point. Borrowing liabilities can be extremely painful if not well thought out, which brings me back to the financial institution boardroom.

You may be the exception to the rule, but I want to challenge you to actually strategize on your borrowing portfolio. All of the same rules apply. Since most borrowings are structured, they are in many ways easier to quantify than the assets that you buy. We have many knowns: rate, time, structure. We can do the exact same analysis that we do on our assets. One advantage is that in the liability portfolio we can pick and choose our structures. For example, whether and what we choose to make our CD specials. What do we want to borrow from the FHLB? What kind of brokered liabilities should we be looking at? Don't forget slope in the curve—we can use this to our benefit.

I have said countless times, don't sell cheap options. But what if we could buy cheap options?

If the FHLB and other agencies are able to rapidly issue debt with terrible structures to their members, doesn't it seem likely that opportunities exist to issue debt to the capital markets where we—for once—could actually control an option of our own?

And, if we are versed in derivatives, and exercise the same disciplined approach as I talk about in other posts, we can use them to further design our effective debt characteristics. The key to my even writing the last sentence is the phrase "disciplined approach."

You may be wondering how I came to this point while watching the incredible golfers on TV. Because they act in their sphere like we must in ours. The pros are good at all parts of the game. When I go to the practice area at the local golf course, I almost never throw a bucket of balls in the sand trap and grind away at just that thing for an hour. Pro golfers do. I do not have the ability to shape my shot, because I am really just trying to hit it straight. Pro golfers do. The great pro golfers can actually choose to shape their shot however they want.

The great news is that you can do something just like that with your liability portfolio, but it will take some practice and effort. It will definitely improve your game and will help to create a stronger and more profitable balance sheet, allowing you to spend more time on the retained earnings and wealth of the shareholders. I know it can be done because it is being done.

The great news is that you can do something just like that with your liability portfolio, but it will take some practice and effort. It will definitely improve your game and will help to create a stronger and more profitable balance sheet, allowing you to spend more time on the retained earnings and wealth of the shareholders. I know it can be done because it is being done.

Final, final thought: Besides liabilities, while watching the Masters, my mind also wondered about the pimento cheeses sandwiches they always talk about. I need a recipe!

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