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The Knockout Putable Advance: “Set it and forget it!” The Capped Floater Advance: Is the time right? Returnable Advances Revisited

“Back to the Basics”
August 2008

Credit market turmoil leading to record write-downs and possible trillion-dollar capital-raising efforts has dominated the headlines for the past 11 months. News of significant provisioning for loan losses and growing reserves for ALLL and OREO line items are included in nearly every earnings release and quarterly earnings statement. In this time of extreme volatility, when clever acronyms mask complex financial terms (e.g., CDO, CLO, SIV, QSPE), wouldn’t it be nice to go “Back to the Basics”?

Over the past several months, we have discussed numerous structured advance offerings that cater to specific funding needs for specific balance sheets. Taking a step back from the more complex structured advance offerings, this “Back to the Basics” article discusses common advance funding structures that fill a number of critical needs, specifically funding flexibility, cash flow customization, and same day availability. Our Amortizing and Floating Rate Advances are ideal solutions for managing and mitigating a number of concerns—from hedging unwanted interest rate risk and match funding particular borrower requests to structuring payment cash flows and pricing prepayment risk—issues that all financial institutions face. These funding vehicles offer a litany of financial benefits, but before we examine them more closely, let’s first discuss the everyday risks found in every loan portfolio:

• Basis Risk
• Interest Rate Risk
• Cash-Flow Risk

Basis Risk: “Apples to Apples, Not Oranges to Apples”
Astute finance officers ensure that the basis risk of their loan portfolio is both known and accommodated in their pricing decisions. Basis risk speaks to the baseline, or basis, index that underlies both the asset and liability. It refers to both the index utilized and the re-pricing characteristics of that index. Having no basis risk implies that the rates on the asset and the liability are not only the same, but that the rates re-price on the same schedule. Common loan pricing benchmarks include the LIBOR indices, the Prime rate, Seattle Bank advance rates, and cost-of-fund indices, such as the 12th District Cost of Funds. Funding assets with liabilities that have the same basis ensures that any variance between the asset yield and liability cost, usually referred to margin or spread, is known at inception and can be mitigated through pricing controls. Originating assets using one index and securing funding with another index exposes the balance sheet to basis risk. Basis risk may lead to unwanted and unforeseen net interest margin gains and losses. If your goal is to lock-in a known spread at time of origination, make sure you are comparing “apples to apples” and not “oranges to apples.”

In addition to understanding the underlying index basis of a loan portfolio, it’s also imperative to consider the re-pricing characteristics. All else being equal, if eliminating basis risk is part of your modus operandi, you wouldn’t originate loans that re-price every day or every month, with wholesale funding that re-prices every three-months. Again, the re-pricing differences may be detrimental to financial objectives if they are unknown and considered in pricing decisions. Consider, for example, that the recent volatility in the three-month LIBOR index alone would have eliminated nearly 100 basis points of margin in January 2008.

Figure 1. 3-Month LIBOR since 8/1/2007 and Monthly Change

Option risk, or cap and floor risk, must also to be evaluated. Cap risk is the risk that your asset yields will “cap-out” or stop increasing as rates rise, while the funding cost allocated to the asset continues to climb, resulting in net interest margin compression. Floor risk is just the opposite. If rates fall precipitously and the interest rate floor on your funding is higher than the floor on your asset, loan portfolios may quickly find themselves underwater. Although the technical aspects of caps and floors are beyond the scope of this article, you can find more detailed information regarding the Capped Floater Advance and Floored Floater Advance in articles that have appeared in the Seattle Bank’s online financial strategies newsletter What Counts².

Interest Rate Risk and Cash-Flow Risk: “Know thyself and price accordingly.”
Interest rate risk represents the variable value of an interest-earning asset due to the variability of interest rates. It can also be described as the risk of originating assets for terms that don’t match the expected terms of the deposits/wholesale funding supporting the assets; lending long, borrowing short, or vice-versa. As finance officers, you take some degree of interest rate risk every day. As with basis risk, knowing the risk you are taking is more than half the battle; pricing and mitigating this risk is a good portion of the remainder.

Interest rate risk, assuming a positively sloped yield/funding curve, is a key contributor to spread income. From a macro perspective, without interest rate risk, bank balance sheets are interest rate risk-free and earnings neutral, suggesting that money is being “left on the table,” regardless of interest rate variability. Conversely, assuming too much interest rate risk may create undesired income and market-value-of-equity consequences.

Meeting market and shareholder expectations—and keeping a watchful eye on risk management—is a daily struggle, but profitably funding a loan portfolio and doing so prudently are not mutually exclusive objectives. From a funding and interest rate risk perspective, the Seattle Bank can help you manage interest rate variability and cash flow fluctuations through our amortizing advance solutions.

Seattle Bank Solutions: Floating Rate Advances
The Seattle Bank offers a number of floating rate solutions that can help you fund your loan portfolio, including floating rate funding tied to one-month and three-month LIBOR, as well as funding tied to the Prime Rate. In addition, we offer floating rate advances tied to our 28-, 63-, 91-, and 183-day auction funding. Floating Rate Advances offer the ability to structure re-pricing terms to fit your funding needs—and with same-day availability, it is readily accessible. Advance details are summarized in Figure 2 below:

Figure 2. Seattle Bank Floating Rate Advance Details

By way of an example, let’s assume we have host of floating rate advances to choose from per the pricing grid in Figure 3:

Figure 3. Seattle Bank Floating Rate Advance Indications

Furthermore, let’s assume we have a loan portfolio that consists of a consumer loan and two commercial loans, each representing 33% of the portfolio. The pricing on this theoretical loan portfolio is as follows:

Consumer Loan (CONS): Prime +200bps, 1-year final maturity
Commercial Loan #1 (CMCL#1): 1M LIBOR +225bps, 3-year final maturity
Commercial Loan #2 (CMCL#2): 3M LIBOR +250bps, 5-year final maturity

Assume that Commercial Loan #1 has a three-year term, Commercial Loan #2 has a five-year term, and Consumer Loan has a one-year term. Not including fees, interest rate adjustments, or prepayment events, the initial spread and projected pay-offs on this portfolio demonstrate the elimination of both basis risk and re-pricing risk, as the spread is fixed at inception. Note the space between the two parallel lines in Figures 4a and 4c.

Figure 4a. Commercial Loan #1 Pay-offs


Figure 4b. Commercial Loan #2 Pay-offs

Figure 4c. Consumer Loan Pay-off

As a complement to the graphs, the Figure 5 shows the same relationship: the funding eliminates the basis and re-pricing risk, and the spread is fixed given variability in interest rates.

Figure 5. Summary Loan Pay-off Table

Seattle Bank Solutions: Straight-Line and Customized Amortizing Advance Solutions
Have you ever wondered how you could hedge and fund specific loans that have odd payment schedules? Better yet, what would the indicative pricing be on such a structure? Let’s take a look at our amortizing advance solutions to answer these questions.

The Seattle Bank offers both straight-line and customized amortizing advance solutions. Straight-line amortizing advances are quoted daily on our Rates Page, and customized advance quotes are readily available by calling the Funding Desk.

• Amortizing advance structures can be used to hedge both interest rate risk and cash flow risk, patterning payments to best fit your funding needs. Additionally, amortizing structures can be instrumental in retaining your best customers by catering loan products that match their project requirements.
• Unlike a standard mortgage amortization schedule, where the principal payment amount grows each month as the payment stays constant, straight-line amortizing advances pay the same amount of principal each month for the life of the advance, thus resulting in a sliding payment amount, due to the lower interest portion paid each month as the balance amortizes downward.

Let’s work through two examples of how the straight-line and customized amortizing advance work.

Figure 6. Comparative Example of Straight-Line and Customized Amortizing Advances

Figure 7, shows the outstanding principal and the sliding payment schedule for a straight-line, 15-year amortizing advance. The principal payment each month results in a zero balance at the end of the 15-year advance term.

Figure 8, shows the outstanding principal and payment schedule for a customized amortizing advance, with a 30-year amortization schedule and a 15-year final maturity. The balloon payment at the end of the 15-year term is approximately $500,000.

Figure 7. Straight-Line Amortizing Schedule Advance

Figure 8. Customized Amortizing Schedule Advance

Give us a Call!

Call the Seattle Bank’s Funding Desk for help in pricing up specific amortizing terms to see what fits your needs. And don’t forget: if you are funding CIP/EDF-eligible projects with maturities of three years or longer, the pricing on both the floating and amortizing advances could be significantly cheaper—currently 30 basis points cheaper than our posted rates!

“Back to Basics” may be an opportunity to revisit advance strategies that have provided opportunity and success in the past. Give us a call to discuss these ideas and put your financial cooperative to work for you!

The Seattle Bank offers a number of prepayable advance structures, designed to meet our members’ current funding needs. Visit the Rates page for currently available structures.

By Brett L.A. Manning, CFA, Financial Strategist at the Federal Home Loan Bank of Seattle.