Duration Mismatch in a Rising-Rate Book
A treasury desk at a community bank holds a $500M available-for-sale securities portfolio. $300M sits in 10-year agency MBS with an effective duration of 6.5 and a current yield of 4.2%. $200M sits in 2-year Treasuries with a duration of 1.9 and a yield of 4.6%. The bank funds the portfolio with deposits and short-term borrowings repricing monthly. The ALCO chair projects a parallel +100bp shock and asks for the impact. A trader notes that MBS convexity means duration will extend if rates rise, and that the portfolio is marked to market through AOCI, which feeds the tangible capital ratio. The bank's tangible common equity is $180M and its regulatory minimum plus buffer leaves $40M of headroom.
1. Estimate the first-order mark-to-market impact of a +100bp parallel shift and assess capital headroom.
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Approximate price change = -duration x change in yield x market value. For the MBS: -6.5 x 0.01 x $300M = -$19.5M. For the Treasuries: -1.9 x 0.01 x $200M = -$3.8M. Total first-order loss = -$23.3M, or about 4.7% of the $500M portfolio.
Against $40M of capital headroom, a $23.3M AOCI hit consumes roughly 58% of the buffer. That is survivable but leaves little room for a second shock or for credit deterioration. The judgement point is that the first-order estimate understates the loss: MBS with rates rising will experience negative convexity, meaning duration extends as prepayments slow, so the realized loss could be materially larger than $19.5M. A second-order estimate using an extended duration (say 7.5) would put the MBS loss near $22.5M and the total near $26.3M, consuming two-thirds of headroom. The desk should not treat the linear estimate as a ceiling.
2. What structural action would you recommend, and what risk does it introduce?
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The core problem is a duration mismatch: assets with duration of roughly (6.5 x 0.6) + (1.9 x 0.4) = 4.66 years funded by liabilities repricing monthly. In a rising-rate environment this compresses net interest margin and hits AOCI simultaneously. Reasonable actions include shortening asset duration by adding floating-rate or shorter bullet securities, extending liability duration with term funding, or hedging with receive-fixed/pay-floating swaps or Treasury futures.
Each introduces risk. Buying shorter assets reduces the AOCI hit but sacrifices yield and may lock in a lower spread. Hedging with swaps adds basis risk and counterparty credit exposure, and hedge accounting complexity that can create earnings volatility if the hedge fails effectiveness testing. Selling MBS realizes losses and may be capital-accretive only if reinvestment yield exceeds the realized loss amortization. A balanced recommendation: layer a partial hedge (e.g., pay-fixed swaps covering $150M) to cap the AOCI hit, extend some deposit funding, and set a hard AOCI tolerance limit reported to ALCO monthly. The key exam judgement is that 'reduce duration' is not free - it trades yield and adds basis or hedge-accounting risk.