ROE DECOMPOSITION

Sterne Agees Strategies group recently introduced a detailed ROE decomposition model coined IDEAS. The report allows the analyst and bank management to gain a strong understanding of what is driving net income and the return on shareholders equity. It also allows the managers to compare their institution to a group of up to 18 peers, along with its size based peer group. A detailed understanding of this report highlights Sterne Agees holistic approach to helping our clients maximize income for a given level of risk that is considered prudent for the institutions size. The Strategies Team uses the report extensively in developing client specific recommendations. The report and its components will be discussed in detail below. A sample of the information that can be extracted from this report includes: What is driving the institutions profitability? How much leverage is being utilized across the balance sheet? What is the mix of liabilities? How confidence sensitive is this funding mix? And how competitive is the local deposit market? What is the mix of assets? Is the institution earning an adequate return on this risk? How diversified is the institutions revenue base? And how rate sensitive is the revenue mix? How efficiently is the institution managing expenses? Is the mix of assets in the securities portfolio generating an adequate return and is the risk in this portfolio balanced with the risk taken elsewhere on the balance sheet?

These are just a few of the questions that a thorough understanding of the ROE Decomposition report can address. Banking more so than most industries is a numbers driven business. Balance sheets are highly leveraged and small changes in interest rates and spreads can have a magnified impact on performance. It is also a highly fragmented and homogenous business - which means that there are always competitors in the marketplace that will exhibit irrational pricing both on the deposit and asset gathering side of the balance sheet. If management strays from the numbers and begins to chase an irrational competitor the results can be terminal. This is evident from the increased number of bank failures that inevitably follow the bursting of an asset bubble, such as the real estate crisis that we are currently experiencing. A clear understanding of the numbers and how an institution is managing its balance sheet will lead to better investment

decisions and will allow management teams to avoid chasing business that is not generating an adequate risk adjusted return on capital.

How is the report structured? There are 9 sections to the report which cover the main earning asset and interest bearing liability categories, including Loans, Investments, Deposits, Wholesale Funding, Net Interest Spread Drivers, Earning Asset and Liability mix, Drivers of ROAA, and the Derivation of ROE. The following illustration is the main page of the report. This is where everything comes together. At first glance, it looks a little busy but once you understand the flow you will see that this page provides a wealth of information.

This page flows from the bottom up and revolves around the 4 main asset and liability categories which we call the foundation. On the asset side, the allocation to loans and investments and the yields on these assets is displayed. On the liability side, (right side) we start with the deposit and

wholesale funding allocations and the corresponding costs. The model includes a balance/counterbalance type of mechanism whereby several levers can be pulled to improve the resulting ROE, however; one should be cognizant of the potential ripple effect of a lever to other parts of the model (balance sheet). For example, the Net Interest Spread on Earning Assets is impacted by several variables, i.e. the allocation or yield on any or all of the foundation categories. The remainder of the report drives off of this flow chart by taking each section and exploring it in more detail.

What is the information contained in each of the individual boxes on this page?

Each of the boxes on this page contains the same category of information. For example, the Return on Equity box includes the actual ratio and it allows the viewer to see how this ratio compares to the peer average in blue. On the left side of the box, highlighted in yellow, is the

ranking of the institution within the peer group and the number in red, is the page number that provides details of the calculated ratio. In this example, the subject institution is outperforming its peer group with a 19.87% ROE versus a 5.47% average for the peers. This institution ranks 2 out of 20 for this metric. Wait a minute - I thought you mentioned earlier that there were only 18 peers? Thats correct, however the size based peer average is included in this calculation as well so the comparison is to the 18 chosen peer institutions and to the average for the size based peer group. It is important to point out that the rankings are simply ordered from highest to lowest for each metric. Therefore for measures where a lower number implies better performance such as the Cost of Interest Bearing Liabilities, a higher number ranking would be preferred, i.e. 20 out of 20 would be consider best in class.

Following the arrows from the bottom of the pyramid up, one sees that the information flows very logically. The product of each foundation categorys asset allocation times its yield results in the weighted average yield for each category. These numbers roll up to the next level which shows the Yield on Earning Assets and the Cost of Interest Bearing Liabilities. The difference between these two numbers is the Net Interest Spread on Earning Assets, which is found in the middle of the page. In the example above, this number is 3.65% for the subject institution. From this information one can see that the subject institutions Net Interest Spread is slightly above average relative to its peer group. They are generating modest yields on the loan portfolio and the allocation to loans is relatively low. However, the weighted average yield on the investment portfolio is slightly above the peer average and the allocation to this asset class is also above average at 38.95% relative to the peer average of 25.17%. Questions management and/or analysts may ask at this point might include; Why is the allocation to loans so low and the investment allocation so high? Is loan demand weak in their core market? Or could this be an underwriting or competitive pricing decision? What types of loans are being put on the books? And is this risk reflective of the average loan yields being generated? For those outside the bank, the report will not provide answers to all of these questions, but it can lead to some interesting discussions among management that will enhance the knowledge about bank, the markets in which they are operating, and the performance relative to their strategic plans. This also allows Sterne Agees Strategies Team to gain a better understanding of how the institution is managed and the areas in which to focus to help maximize the return on equity. Thus begins the collaboration between Sterne Agee and its clients to develop strategy and implement necessary actions to move the bank closer to reaching their goals.

Moving further up the page, the net interest margin on earning assets is shown at 3.86%, which is calculated as the (yield on earning assets cost of interest bearing liabilities) + gain on net interest position. The net interest position is the difference between total earning assets and total interest bearing liabilities as a percentage of average earning assets. The net interest margin on

earning assets is multiplied by the percentage of earning assets/total assets to derive the net interest margin. In the example, the net interest margin is calculated as (3.86% * 96.26%) = 3.72%. The net interest margin plus the non-operating margin (fee income) equals total revenue. Subtracting taxes and non-interest expenses from this number leads you to the ROAA (1.85%). Finally, the ROAA multiplied by the leverage ratio equals the Return on Equity at the top of the pyramid.

Exploring the numbers in more detail The picture on the following page illustrates the layout for presenting the quarterly loan yield data for the subject institution and the corresponding peer group. From the loan yield box on the main page we know that this information is found on page 12 of the report. The first line item on this page shows the average quarterly loan yields for the size based peer group. This is followed by the quarterly loan yields for the chosen peer group and the subject institutions information. Below the loan yield for the subject institution, is the rank within the peer group, including the size based peer average along with some basic statistics around the numbers. The bottom of the page shows this same information graphically. The numbers in the bar chart highlight the difference between the peer group mean and the subject institutions loan yield for the corresponding period. This breakout information is presented consistently for all of the foundation categories and is provided quarterly for 10 periods and annually for 5 periods.

As noted earlier, the loan yield for the subject institution is modest at 6.12% ranking 13 among the 20 peers. However, the risk adjusted loan yield (loan yield adjusted for provision charges and the allocation to loans) is 6.07% ranking 13 out of 20. This information is helpful as it suggests that the bank is pricing the product appropriately to capture the risk and that the expected loss in the loan portfolio is relatively low. To confirm these conclusions, a deeper analysis is required, but the numbers suggest that the bank is probably making relatively low risk residential real estate loans with modest LTVs and decent borrower credit profiles. This would further suggest that the bank is exposed to a high degree of option risk due to the borrowers prepayment option. The prepayment risk should be taken into consideration when making strategic or investment recommendations for this institution. For example, one would most likely want to minimize the exposure to MBS in the investment portfolio and instead focus on nonamortizing product or CMO type structures with tight payment windows and limited extension risk.

What if analysis The model is a static, point-in-time snapshot of the institutions performance relative to the chosen peer group, however there are a few pages that allows for some simple What If Analysis. Page 9 of the report, shown below, highlights several of the key drivers of ROE. Each metric is isolated and set equal to the peer average, while all other metrics are held constant to gauge the impact that reversion to the mean would have on the institutions ROE. This analysis is best shown versus a high performing peer group so that the reversion to the mean is reflective of the best in class performance. This is a key area for management to focus on as one of the main goals is to maximize shareholder value and this page provides a good roadmap of the areas to address that will have the biggest impact on this metric. The ROE Mean Reversion analysis is also a key focus of the Sterne Agee Strategies team as we analyze an institutions performance and offer strategies that may improve risk adjusted returns.

The column labeled Variance From Actual, suggests the biggest improvement to ROE would come from an increase in the allocation to loans that is closer to the peer group average allocation. If this metric was set to the peer group average, with everything else held constant, the institutions ROE would improve by 424 bps to 24.11% from 19.87%.

On the far right of this page, the chart that shows the improvement in ROE that would be generated from a 100bp increase in each ratio, holding all other variables constant. The number at the top of the box is the adjusted ROE and the number below is basis point change from the base case ROE. From this information, it is apparent that an increase in the yield on the loan portfolio would have the biggest impact on ROE.

Conclusion ROE Decomposition is not a new concept. Equity analysts have been using this analysis for years to review a companys performance and identify the key drivers of return on equity and shareholder value. However, the concept is not as broadly used by fixed income investors and is also not as broadly used internally by a companys management team. We believe this is a

cornerstone report to understand how an institution is being managed, the challenges that it is facing, and the key financial metrics to focus on in order to improve profitability.

As a broker/dealer, Sterne Agee is in the business of buying and selling securities on behalf of our customers. However, knowing what to buy or sell should really be viewed in the context of an institutions entire balance sheet and its particular risk profile. Banking is a homogenous business, but there are clearly some broad differences in each institutions willingness to accept risk and its ability to manage risk. These factors need to be taken into consideration in designing a strategic plan.

We take this responsibility seriously and would welcome the opportunity to work with your institution to develop a customized plan to improve return on equity and maximize shareholder value. Contact your Sterne Agee Representative to request an ROE Decomposition Analysis for your institution. A specific list of peers to be included in the report would be useful to customize the analysis.

Larry Meding, CFA Managing Director Fixed Income Strategies lmeding@sterneagee.com 901-761-6990