Q4 2023: Asset Rotation Strategies in Balance Sheet Management

by JB Long, President, Incenter Capital Advisors

Managing the balance sheet is like trying to steer a car by looking in the rearview mirror. No matter how long you’ve been in the industry, and no matter how strong your market data and analytics are, it’s tricky. Just when you think you’ve got the hang of it, the road takes an unexpected turn.

Such turns include the recent failures of Silicon Valley Bank and First Republic. Although the remnants of both banks were quickly acquired by First-Citizens and JP Morgan respectively, the rescues did not prevent masses of anxious depositors from getting the jitters. Institutions large and small saw significant drops in deposits as customers rushed to protect assets in case more banks crashed and burned. In a matter of days, balance sheets became decidedly out of balance. Even though several months later the other shoe has not dropped, those deposits aren’t coming back any time soon.

As if that weren’t enough, institutions holding their own mortgage portfolios are seeing lower prepayment rates. The result is asset extension keeping these loans on the books beyond originally calculated payoff timelines.

The impact of both curve balls is that capital ratios are tighter and some may even be red lining. Now there is growing pressure to raise capital or sell assets to reduce risk and improve those capital ratios. This is always where asset rotation strategies go from important to critical. Catch 22s abound as portfolio managers are caught between the need to generate income and grow their AUM (their bonuses depend on it) and the liquidity required to bring the balance sheet back into balance. That liquidity, previously supplied by depositors, has shrunk and the only strategy left for expanding NIM (net interest margin) is asset rotation.

This is where the real fun begins. Optimizing asset rotation requires deep understanding of hedging and liquidity strategies for each asset class, the ability to look at all assets wholistically and orthogonally, and the transactional firepower to execute the rotation strategy. Moreover, banks are often a house divided with, for example, MSR portfolio managers and whole loan portfolio managers more interested in protecting their own AUM than the overall financial health of the balance sheet.

CEOs often call in reinforcement in the form of third party loan brokerages and advisory services. But the same conflicts often apply as different providers have their own theories and agendas about which assets to rotate out and which to keep.

It takes a strong, practiced and determined hand on the wheel to devise, manage and execute an asset rotation strategy that will achieve short term balance sheet needs without hamstringing longer term growth. And then be prepared to do it all over again just a few short months down the road when yet another unexpected curve comes up.