Climbing the Funding Ladder: Growing and Hedging Your Balance Sheet Using Symmetrical Advances

February 2012

Like many others, your financial institution is likely craving loan growth. In recent weeks, you may have seen a modest pickup in C&I loans, or even multifamily activity. In certain markets, Seattle Bank members have begun to “dial-in” a portfolio of residential mortgages—some of which might be slightly out of Fannie Mae or Freddie Mac underwriting parameters. Some institutions are marketing 10-year mortgages to those in their 40s and 50s who have been in their homes for some time and want to accelerate their “forced savings.” Others are focusing on mortgages with balances that exceed conforming amounts.

Regardless of the types of loans you may be considering, extension risk is all too frequently a part of the discussion. In a rising rate environment, extension risk poses a significant obstacle on your road to financial success. Extension risk represents the downside you face when the expected redemption dates or cash flows of your assets extend, or when the expected cash flows of your liabilities shorten. It is present in all assets (like mortgages) and liabilities with optionality (e.g., puts, calls, and prepayments). If extension risk sets in, the value of your mortgage portfolio drops.

But, how does extension risk impact your core deposit portfolio? Core deposits may be the least of your problems today, but what about their duration? If rates rise, will your depositors move their funds to higher-yielding deposit or money market investment accounts—or will they demand higher coupons to meet the market? Because all three scenarios are possible in a rate environment where the Fed moves quickly to stamp-out inflation fears, it is prudent to offset the possible erosion of the value of these assets with upward valuation on the liability side.

The Seattle Bank has the tool that can not only fund your new mortgage originations, but also hedge your risk of deposit erosion or migration when interest rates rise. This funding tool is the Symmetrical Prepayment Advance. The Symmetrical Prepayment Advance provides stable, non-rate sensitive funding and the ability to monetize any value associated with rising rates via termination prior to contractual maturity. A prepayment credit on this advance would be associated with an interest rate environment that is materially higher than the environment that existed when the advance was originated.

A Laddered Symmetrical Prepayment Advance Structure

Assume that you will be funding a $15-million, 3.50%, 15-year mortgage portfolio with a laddering of Symmetrical Prepayment Advances of $5.24 million each (assuming market value of a 3.50% coupon). Maturities would be in equal parts of three, four, and five years. Based on the current market, we’ll also assume that the mortgage portfolio carries an approximate duration of 2.81 years and a weighted average life of 2.97 years.

Currently, a 15-year agency pass-through at 3.50% trades at $104.875, resulting in a total portfolio size of $15.73 million. Stated another way, the cost to purchase $15 million of 15-year pass-through securities would be $15.73. Thus, your ladder of three Symmetrical Prepayment Advances would total $15.73 million.

Table 1. Ladder of Three Symmetrical Prepayment Advances

Advance Term Rate Allocation Allocation $ Total Interest
3 years .95% 33.33% 5,243,750 149,447
4 years 1.18% 33.33% 5,243,750 247,505
5 years 1.53% 33.33% 5,243,750 401,147
Total 1.27% 100.00% 15,731,250 798,099

The value derived from the Symmetrical Prepayment Advance will depend on rate levels. Generally, if interest rates were to decline, the borrower would have a higher-than-market rate liability with no positive gain from the movement in rates. Conversely, if rates were to rise, the liability would be lower-than-market and the gain could be monetized. Table 2 illustrates the relative value of the Symmetrical Prepayment Advance funding mix in various interest rate environments. Rate shocks are assumed to be instantaneous and parallel.

Table 2. Rate Sensitivity of Symmetrical Advance Ladder

Interest Rate Shocks
Advance Term -300 bps -200 bps -100 bps 0 bps 100 bps 200 bps 300 bps
3 years 101.66 101.66 101.66 100.00 97.10 94.30 91.60
4 years 102.97 102.97 102.62 100.00 96.20 92.56 89.08
5 years 104.91 104.84 103.57 100.00 95.34 90.92 86.73
Liability Total 103.18 103.16 102.62 100.00 96.21 92.59 89.14
Sensitizing the Market Value of a Hypothetical 15-year MBS with a 3.50% Coupon

Table 3 illustrates the rate sensitivity characteristics of a 15-year mortgage-backed security (MBS), which, for the purpose of this discussion, we will use as a proxy for the mortgage portfolio.

Table 3. Rate Sensitivity of 15-year MBS

Interest Rate Shocks
15-year MBS Holding -300 bps -200 bps -100 bps 0 bps 100 bps 200 bps 300 bps
Prepay Speeds (PSA) 15,731,250 1021 1019 890 517 233 150 117
Weighted Average Life 15,731,250 1.77 1.77 1.97 2.97 4.72 5.60 6.02
Modified Duration 15,731,250 1.70 1.71 1.90 2.81 4.34 5.08 5.44
Price 15,731,250 108.48 106.59 105.30 104.88 102.51 97.70 92.59

Using the projected average prepayment speed (PSA), Figure 1 illustrates the ending mortgage principal balance juxtaposed with scheduled advances outstanding. The aggregate portfolio is initially over-funded due to the convex nature of mortgages funded by non-convex bullet liabilities. The equal three-, four-, and five-year funding mix highlights the hedging benefits of term funding, while maintaining an acceptable income requirement.

Figure 1. MBS and Advance Balances: Base Case

Figure 2. MBS and Advance Net Interest: Base Case

Figures 1 and 2 illustrate the monthly principal pay-down and related monthly mortgage and monthly advance interest. As designed, this strategy provides both hedging and income benefits. But, what if interest rates rise? If prepayment speeds decrease due to a rise in mortgage rates, this initially over-funded portfolio may yield dividends for the patient financial professional. Consider Figures 3 and 4 provided below, which highlight the performance of the 15-year MBS/Symmetrical Prepayment Advance portfolio under a scenario where rates are 200 basis points higher than current levels. By the end of the third year, the MBS principal stands at $10.2 million, instead of $5.9 million in the base case, and the monthly interest earned extends to match the slower prepayment speeds.

Figure 3. MBS and Advance Balances: 200 BPS Rate Increase

Figure 4. MBS and Advance Net Interest: 200 BPS Rate Increase

A material rise in interest rates may introduce extension risk as liability funding will be much shorter than projected asset balances. The Symmetrical Prepayment Advance helps resolve this issue by allowing borrowers to prepay the advance and monetize the value. After prepayment, borrowers can choose to re-fund into a new Symmetrical Prepayment Advance or a funding alternative, to both hedge the positive net economic value (NEV) and maintain acceptable income requirements. Let’s next examine the concept of NEV and apply it to today’s market.

Table 4. Value of 15-year MBS and Symmetrical Funding Mix under Varying Rate Scenarios

Interest Rate Shocks
Value ($ millions)Holding -300 bps -200 bps -100 bps 0 bps 100 bps 200 bps 300 bps
15-year MBS 15.73 16.27 15.99 15.79 15.73 15.38 14.65 13.89
Symmetrical Prepayment
Advance Funding Mix
15.73 16.23 16.23 16.14 15.73 15.14 14.57 14.02
Net Economic Value- .04 -.24 -.35 - .24 .09 -.13

When rates are upwardly shocked by 200 basis points and the MBS portfolio extends, the value of the MBS portfolio ($14.65 million) is insulated by the funding mix of Symmetrical Prepayment Advances ($14.57 million). Although the value of the MBS portfolio declines by 6.84%, the value of the funding liability increases by 7.41%. In this sense, declining liability values are accretive to equity, which results in both highly positive spread income and significant economic value for the total portfolio.

Figure 5. Net Economic Value of MBS and Funding Mix Under Varying Rate Scenarios

NEV considers the impact of extension risk and the ability to hedge this risk via Symmetrical Prepayment Advances. As rates rise, the value of the MBS portfolio declines, but the value of the Symmetrical Prepayment Advance funding increases. The equal 3-, 4-, and 5-year funding mix both hedges extension risk and provides positive economic and income benefits. Symmetrical Prepayment Advances help manage the dual mandate of providing positive spread income while protecting the economic value of equity as rates rise.

Due to the negative convexity of mortgage assets, the value increase in a falling rate environment is truncated and the upside potential is limited. This effect is exacerbated by the increasing prepayment fee for fixed-rate liabilities. But, given the absolute low-level of interest rates, the aggregate net economic value is less impacted. Why? The positive rate of change of the increase in MBS value is greater than the negative rate of change of the funding mix. In other words, today’s low rates not only provide inexpensive funding, but more amenable liability marks!

The moral of the story: Extension risk can harm your portfolio’s value! In spite of a tepid lending environment, ultimately, you need to grow your assets. Constructing a laddered portfolio of Symmetrical Prepayment Advances to hedge this growth can be a sensible strategy. If the left side of your balance sheet were to erode in value in a rising rate environment, it may be useful to fund your assets with a portion of the right hand side of the balance sheet that can conversely rise in value. A funding strategy incorporating Symmetrical Prepayment Advances can assist in keeping valuation in balance.

Fine Print

The Symmetrical Prepayment Advance is available for same-day funding or forward settling up to five business days. Available tenors range from one to 30 years, with a minimum requirement of $5 million per order. During specified promotion periods, per institution orders may be less than $5 million, provided aggregate orders from all institutions are at least $5 million. The Symmetrical Prepayment Advance can be prepaid prior to scheduled maturity with the contractual ability to realize a gain from the market movement of interest rates. Any prepayment fee or prepayment credit calculation is determined at the sole and absolute discretion of the Seattle Bank.

Check the Seattle Bank’s Rates page for Symmetrical Prepayment Advance offering levels and call the Funding Desk or your Relationship Manager to discuss the details of the Symmetrical Prepayment Advance.

Brett L.A. Manning, CFA, is the National Sales & Funding Desk Manager at the Federal Home Loan Bank of Seattle.

John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.

Mike Terry is Business Development and Funding Desk Analyst at the Federal Home Loan Bank of Seattle.

More Strategies

Contact a member of the Seattle Bank’s Business Development Team to find out how we can help to address your funding needs.