Article
September 1996: Derivatives Strategy
The Long March: Developing an Analytics Base
The Home Loan Banks quickly realized a need to upgrade their analytics
when their derivatives activities began to rapidly expand in the early
1990s. However, the road to a solution was a long one. Developing a system
to meet the needs of the Banks was a tall order. The structured note market
gave rise to an incredible variety of financial gadgets: notes linked
to various rate, currency and equity indexes; notes with all sorts of
embedded options; mortgage-linked principal paydowns; and other variations
too numerous to mention. The very difficulty of valuing these structures
played a significant role in the profitability of the market for dealer
firms. In this respect, the more opaque the structure, the better. While
the Home Loan Banks issued all their structured notes on a perfectly hedged
basis, they recognized the need to better monitor the credit risk of a
growing book of exotic hedges and were anxious to better understand what
was a growing part of their business.
The basic philosophy of a good valuation system, according to Trevor Colvin of Pinehurst Analytics, involves "taking the known value of liquid instruments and using them to calculate the value of illiquid ones." With complicated structures, this is easier said than done. Even swaptions – usually the most liquid instrument available to specify term structure volatility – can show wide variations in quoted prices. Colvin emphasizes complete transparency of methods in his system. "It's not a black box," he says. Although this kind of sophistication would seem to play to a limited audience, Colvin observed a keen interest by the Home Loan Banks in understanding the fundamentals.
The 12 banks, true to their separate business identities, took different paths to boosting their analytics capabilities. The Federal Home Loan Bank of Chicago was one of the first to commit to a major trading quality system, commissioned Colvin's firm to develop a system around their needs. Pinehurst Analytics' system went online in late 1994, and since then has been adopted by two additional regional Home Loan Banks.
Another group of banks took a collective approach, joining together with the Office of Finance in Virginia to look for a common solution. The search for the best provider took about 18 months from start to the signing of an agreement. It was an excruciating process, but according to Marshal Anton at the Home Loan Bank of Pittsburgh, one that was worth the effort. The group, which now includes seven district banks, selected Principia Partners to deliver a dealer-developed system based on one that they had originally built for Republic National Bank of New York. Auron says that, despite the formidable complexity of the system, the software implementation was the smoothest he's ever seen. Anton attributes this to the group's insistence on carefully defining its requirements and seeing the system in operation before committing.
The results of the Bank's effort and expense has been gratifying. Says Auron: "The system has made us a lot smarter in entering into transactions-both with pricing and modeling behavior. It's also made a difference in product development and delivery – rather than pester dealers we can model things ourselves." A dealer concurs: "I think they're going about [the application of derivatives technology] in an intelligent way. They're measuring their exposures more objectively, and can price deals themselves."
Colvin is particularly gratified by the use of his system by FHLB System traders to negotiate better deals. Both Principia and Colvin's system can be used to readily evaluate most structured transactions. Although being able to calculate a value does not necessarily strengthen the Home Loan's bargaining position, it sometimes can serve as a basis for negotiating – or simply refusing – a mispriced deal.
The regional Home Loan Banks have differed in the way they use their systems – though an important aspect for all is keeping close track of counterparty credit exposures. Theresa Adams, director of sales and marketing at Principia Systems, says: "Our system provides integrated front, middle and back office functions, but each bank has a different emphasis, such as credit risk, accounting or transactions."
Successful application of valuation systems depends on a lot more than good software code. Both Pinehurst Analytics and Principia emphasize ongoing user training and ongoing development. The systems also rely on daily data inputs from a wide range of markets, a feature that is typically packaged into the service contract. "Our product's scope is constantly broadening, as clients use the systems for more than trading," notes Adams. "In the future, I see more emphasis on the portfolio management capabilities of systems such as ours."
After years of playing catch-up, the Home Loan Banks now seem satisfied with the results of their efforts. The costs in time, money, and effort have been daunting, but unavoidable given the depth of the System's involvement in the markets. Each organization's challenges are different, and the Home Loan Banks' experience seems to offer no clear road map. Asked what else he's learned from the process, Auron says simply, "a lot of patience."