Does the extra net interest income generated from lengthening maturities when the yield curve is sloping upward create shareholder value?

Unfortunately, the answer is almost always "no." In some banks, the extra net interest income isn't enough to offset the extra risk, and shareholder value is actually destroyed.

How can this be? The logic is a simple application of the "no free lunch" rule of the financial markets.

Flaw in the Logic

Let's assume that all investment portfolio securities are Treasury securities. Bank A decides to "stretch for yield" by selling $100 of three-month Treasury bills from its portfolio and buys $100 in 10-year Treasury bonds.

On a mark-to-market basis, the value of the bank's assets has not changed. It sold something worth $100 and bought something worth $100. Nothing has changed from a shareholder value point of view (if we ignore the risk of bankruptcy).

If, instead, Bank A had held onto the three-month bills, shareholder X could have created the "new Bank A" by holding the stock of "old Bank A" and replacing $100 of three-month Treasury bills in her fixed income portfolio with 10-year Treasury bonds.

Since X can duplicate "new Bank A" by herself, there is no reason to pay more for the stock of "new Bank A" than she would for the stock of "old Bank A."

But, some bankers will argue, new Bank A's net income will be higher, its price-earnings ratio will be unchanged, and therefore new Bank A's stock price must be higher than old Bank A's stock price.

The flaw in this argument is the statement that the price-earnings ratio stays the same -- unless all shareholders are stupid, the price-earnings ratio has to drop.

A Riskless Arbitrage

The risk of the organization has gone up, so the price-earnings ratio must decline. If this were not the case, there would be a riskless arbitrage that shareholder X and even retail investors could pursue.

How? It's easy. Let's assume Bank B takes the same strategy as old Bank A: it is identical in all respects and holds $100 in three-month bills. New Bank A holds the $100 in 10-year Treasury bonds.

Let's assume that the yield on three-month bills is 4% and the yield on 10-year bonds is 8%. How does X make money if the (pretax) price-earnings ratio on both banks is 10? If that is true, then the market value of new Bank A is $40 higher than Bank B (10 times the extra $4 per year in income -- we ignore taxes).

X does the following:

1. She buys all of Bank B stock for $Y.

2. She shorts $100 in three-month bills and receives $100.

3. She takes the $100 and buys 10-year Treasury bonds.

4. She sells Bank A shares short and receives $Y plus $40.

On a net basis, X has a perfect riskless hedge and keeps the $40. Therefore, either the price-earnings ratio of new Bank A must be lower than the price-earnings ratio of Bank B or Ms. X and others like her can easily become billionaires.

Cases of Value Creation

When does lengthening the bank's assets relative to liabilities create shareholder value? It creates shareholder value in only three circumstances. First, it creates value if the longer-term maturity asset can be purchased at less than its fair-market value. Shareholder value goes up by the amount of this discount to fair-market value.

Needless to say, there aren't any legal discounts in the Treasury market.

The second circumstance when lengthening assets makes sense is when a longer-maturity asset portfolio reduces the interest rate risk borne by the bank. The shareholder value goes up by the amount that the expected cost of bankruptcy goes down.

The third circumstance where lengthening the bond portfolio makes sense is if the bank is better at predicting interest rates than the marginal shareholders, like X. Some bankers believe their bank is smarter than shareholders.

As Dave Barry would say, I am not making this up.

The burden of proof on this issue rests with the bank. Where is the bank that has the courage to do the following: take a $500 million interest rate bet and then publish a press release announcing that the bet has been taken because of the bank's superior forecasting ability?

The resulting change in the bank's stock price will tell the bank whether or not the market thinks its belief is correct.

How does a CEO tell whether his strong-willed asset-liability manager or Treasury manager can predict rates as well as he says he can? As a practical matter, during the CEO's tenure in office, he won't have enough information to ever answer that question.

In my career at two of the 10 largest banks in the United States and one of the largest American securities firms, I've met 32 traders who thought they could predict interest rates.

The first year, 16 were wrong and lost their jobs. In the second year, eight of the 16 remaining were fired for the same reason.

During the third year, four of the eight bet wrong and left. In the fourth year, two more disappeared, and only one was left after five years. But that trader had been right five years in a row. Was he smart or was he lucky? No one can say for sure.

If the trader himself were positive that he was smarter than the market, he should have been trading for his own account.

The Risk Factor

Every senior banker has a lot of self-confidence in his understanding of interest rates and money markets. Nonetheless the only way banks create shareholder value by taking more interest rate risk is when they're buying assets at a price lower than their true value.

If the bank believes it can predict interest rates, it should create a fixed-income investment management department. That way, only those who believe in the bank's forecasting ability will gain or lose, and shareholders won't be harmed in the process.

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