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Banc one Corporation's Cio - Dick Lodge

Autor:   •  March 8, 2011  •  Essay  •  1,519 Words (7 Pages)  •  2,738 Views

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Banc One Corporation's CIO, Dick Lodge, had been using interest rate swaps to manage interest rate sensitivity since 1983. Later, when the tax reform act of 1986 eliminated the advantages offered by municipal bonds, Banc One's reliance on interest rate swaps increased. And by 1993, the notional value of Banc One's derivative portfolio had grown to $31.5 billion or more than 40% of Banc One's assets ($76.5 billion). Banc One had a strategic goal of acquiring other banks without being dilutive. The current problem facing Banc One is that its stock had fallen from $48.75 in April 1993 to $36.75 in November 1993 and was trading near the ‘walkaway' price of $34.55 in a deal to acquire Liberty National ($4.7 billion in assets). Banc One's stock price was approaching the point where the Liberty National deal could be dilutive. Equity analysts commented that the sizeable use of interest rate swaps had distorted earnings, earning assets, margins, and return on assets. All of this data is used to value the firm. In an effort to make investors feel more comfortable and to become more transparent to the market, Banc One should reduce the amount of risk it assumes, which at the same time will require less reliance on interest rate swaps.

Like many regional banks, Banc One's balance sheet was asset sensitive. As a result, earnings were directly correlated with the rise and fall in interest rates. If Banc One wanted to manage its interest rate exposure without using swaps it could invest in short and medium term U.S. Treasuries and higher quality municipal bonds. Specifically, Banc One could borrow at a floating rate, buy Treasuries and/or municipal bonds to increase its fixed rate assets and therefore lower asset sensitivity. However, the tax reform act of 1986 removed the 80% interest tax deduction on municipal bonds reducing the benefits that this option provides.

Another option is for Banc One to invest in Collateralized Mortgage Obligations (CMOs), which are pooled mortgage securities. The pools are divided into different tranches with differing prepayment priorities which would allow Banc One to better predict the prepayment speed. Still, some prepayment risk remains, therefore limiting a shift in asset sensitivity. In addition, CMOs are less liquid than Treasuries and municipal bonds. More importantly, the capital guidelines for CMOs require that Banc One hold 50% of the principal value of the asset whereas Treasuries require no risk adjustment and general municipal bonds require only 20%. In 1993, Banc One had $4.5 billion invested in CMOs.

However, interest rate swaps have advantages over the above two options. First, interest rate swaps improve liquidity. This is important for Banc One because it has the freedom to invest in short term projects and has cash available when a liability (e.g. certificate of deposit) comes to maturity. Next, as mentioned previously, interest

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