An Analysis of their Hedging Strategy
Mark Glitto, Gajendra Tulsian, Robert Young
University of Florida
In 1993 the stock price of Banc One Corporation had dropped from about $45 at the beginning of the year to approximately $35 at the end of the year: roughly a 20% fall. This sharp decline in stock price greatly bothered John B. McCoy, chairman and CEO of Banc One Corporation. A high stock price was essential for Bank One’s strategic goal of continued acquisition by tendering its own stocks in each acquisition. The fall in stock prices put a damper on this drive for acquiring banks with potential for earnings and growth (it had 10 pending acquisitions worth $9 billion in November 1993). In this study we analyze the possible reasons for the fall in stock price and suggest ways to stop the hemoraging. In December 1993 Banc One held presentations in New York, Boston, and San Francisco to clarify its position on the use of financial instruments known as derivatives. Banc One used Interest Rate Swaps, the most common type of derivative instrument, to manage interest rate sensitivity. At these presentations, Richard Lodge, the chief investment officer, made clear that Banc One was not a dealer but an end-user of swaps. Lodge emphasized that the bank’s position was one of hedging and not of speculating. They first started using swaps in 1983, and subsequently, when the tax reform act of 1986 eliminated the advantages of municipal bonds as a tool for managing interest rate exposure, their dependence on swaps further increased. By 1993 the notional value of Banc One’s derivative portfolio had grown to $38 billion, a sum almost equal to half its assets! The amounts of Banc One’s swaps contracts depended on various factors such as: the loan demand, the slope of the yield curve, the amount of capital held by the bank, and the cost of cash market versus the derivative market. Interest rate swaps have several inherent advantages over bonds and other instruments: capital is preserved, liquidity is increased, swaps contracts enabled faster response to changes in market conditions, and swaps can be customized for duration and other variables. In the light of these overwhelmingly positive features of swaps and other similar instruments, Banc One was in the derivative market to stay. Hence, their task was to ease investors fears of these relatively new instruments and reassure them of the prudence of the continued use of these instruments. Banc One intended to be as transparent as possible in reporting its derivative dealings. In the rest of this study we examine the various issues involved in this complex case.
USE OF SWAPS
Like most regional banks, Banc one's natural balance sheet position is asset sensitive, hence interest rates on their assets reset more quickly than on their liabilities. On one hand 73% of Banc One’s assets are indexed to the prime rate, and thus vary with the market, while on the other hand, 50 to 60% of bank liabilities, mostly non-commercial loans (Certificates of Deposit) are fixed rate. This situation is exacerbated by the fact that commercial customers are more responsive to interest rate movements and will exercise their options to refinance quicker, unlike non-commercial customers who are mostly CDs holders which are considered "sticky-fixed." The result of this asset sensitive position is that Banc One’s earnings rise and fall with interest rates. To minimize this interest rate exposure banks traditionally invested in short and medium-term U.S. Treasures and high quality municipal bonds as a hedge against their asset sensitive position. They would borrow at a floating rate and use the proceeds to buy U.S. treasuries and municipal bonds and thus increase their fixed rate assets. The result is a reduction in its asset sensitivity. Prior to 1986 municipal bonds had an added attraction in that banks could deduct 80% of the interest expense incurred on...