Banc one Case

Banc One started using swaps as a risk management tool since mid-1980s.In 1993, investors' concern surrounding Banc One's increasing swap position had caused continuous stock price decline. Moreover, some analysts openly criticized Banc One's sizable derivative portfolio. The situation called for immediate reaction and management of Banc One had to decide the optimal strategy: to do nothing, to abandon or severely limit its derivative portfolio or to educate investors?

One thing without doubt is that banks have to conduct certain measures to manage their interest risks. Banc One chose to increase its fixed-rate investment to convert its balance sheet from asset sensitive to liability sensitive. To determine whether Banc One should use swaps as its risk-management tool and thus its optimal strategy, we fist examine the alternatives Banc One had for adjusting interest rate sensitivity.

Banc One had made several fixed-rate investments to offset its fixed-rate liabilities. These investments include Municipal Bonds, Mortgage-backed Securities investments, Collateralized Mortgage Obligation investments and Swap investments.

Municipal Bonds

In the early 1980s, Banc One invested in short and medium-term U.S. Treasuries and high-quality municipal bonds to offset its fixed-rate liabilities. Municipal bonds were an especially attractive investment because prior to 1986, banks could deduct 80% of the interest expense on financing them and the income earned on the bonds was free of state and federal taxes. Banks enjoyed a large after-tax spread on their leveraged municipal bond investments.

MBSs

In 1986, Congress passed the Tax Reform Act, eliminating the banks the deduction of interest expense on the financing for municipal bond investment. Correspondingly, Banc One replaced many of its municipal investment with Mortgage-backed Securities (MBSs). MBSs had a payment stream that was backed by pools of mortgage loans and were typically guaranteed by the federal government. However MBSs provided a slightly lower promised after-tax yield than municipal bonds and carried an additional risk of prepayment.

CMOs

Collateralized Mortgage Obligations (CMOs) took a pool of mortgage loans and carved the principle and interest outflows into a set of different securities, or tranches. The tranches are different only in their priority for repayment of principle. With a large pool of mortgages, investors could estimate the likely time at which each tranche would be fully paid down and stop paying interest. Each tranche paid a different yield to compensate for the various amount of prepayment risk a buyer faced and the different average life of investments. By investing in CMOs, Banc One could still receive the high yields associated with mortgage securities, assuming it was comfortable with the prepayment risk it would bear.

Swaps

Banc One used swaps as a proxy for some of its conventional fixed-rate investments. The swap has several advantages including improving the bank's liquidity, reducing the amount of capital needed and being off the balance sheet.

Given the advantages of using swaps to synthesize payoff of other investments, there is no surprise that Banc One's position in swaps continuously grew. Banc One