Bank Analysis School eBook

INVESTMENTS GUIDE

ALLOWABLE INVESTMENTS • Bank investments consist of debt securities (bonds). Debt securities are essentially loans from the bondholder to the issuer of the bond. In exchange for the investment, the issuer pays interest and repays the bond by a set date. Bond issuers include corporations, municipalities, the federal government, and federal agencies. • Banks are generally not allowed to invest in equity securities (stocks). However, there are exceptions for certain membership stocks required or allowed by regulation (e.g., Federal Home Loan Bank stock, Federal Reserve Bank stock, and stock in Bankers' Banks). INVESTMENT TYPES U.S. Treasuries • Direct obligations of the U.S. government; considered “risk-free.” U.S. Agencies • Issued by U.S. government agencies (e.g., FHLB, Freddie Mac, Fannie Mae). • Not a direct obligation of the U.S. government but considered to have minimal credit risk. Mortgage-backed securities (MBS) Minimal

• Most are backed by residential home mortgages, although some are backed by commercial mortgages (CMBS). • Mostly issued by government agencies (e.g., Fannie Mae or Freddie Mac); some are issued by private companies (private-label MBS). • Two main structures: ° Pass-through MBS: Investors receive portions of principal and interest as the underlying mortgage loans are paid. ° Collateralized Mortgage Obligation (CMO): Payments are split into “tranches” and distributed based on priority. Municipal bonds • General Obligation (GO) bonds are backed by the full taxing authority of the municipality. • Revenue bonds are supported by revenue from specific projects or services (e.g., sewer, water.) • Industrial development bonds (relatively uncommon) are used to support private companies’ projects within a municipality, with repayment tied to company revenues. Considered riskier than GO and revenue bonds. Corporate bonds • Issued by U.S. corporations.

CREDIT RISK

Moderate

PRIMARY INVESTMENT PORTFOLIO RISKS • Market risk (interest rate risk): The risk that rising interest rates will cause the market value of existing bonds to fall. • Credit risk: The risk that a bond issuer may default on its obligation. Bonds from lower-rated issuers or those facing financial difficulties pose a higher credit risk. Typically, there is less credit risk in a bank’s investment portfolio compared to the loan portfolio. • Liquidity risk: The risk that an investment cannot be easily sold and converted to cash. Certain municipal bonds (e.g., small non-rated issues) or complex mortgage-backed securities may be difficult to sell. • Operational risk: Risk resulting from inadequate internal processes and systems. This can include accounting errors, fraud, or system failures.