A Time to Hedge, and a Time to Fund: Introducing the Forward Settling Advance!
In tribute to The Byrds 1965 hit “Turn! Turn! Turn!” to everything there is a season. Right now, it seems that everyone in the financial services industry is more than ready for a seasonal change—an end to the current period of low loan origination and excess deposit growth, driven in large part by industry deleveraging. Of course, this would require the supposed “green shoots” of economic recovery to take shape and the nascent beginnings of new loan originations.
Looking forward to a season of more robust lending, how can you take advantage of today’s historically low interest rates to satisfy future consumer and commercial loan demand—while earning acceptable spreads and prudently hedging the associated interest-rate risks? Hedging short- to intermediate-term interest-rate risk by locking in current rates has typically been a function of the secondary markets. Using the mortgage TBA market is an efficient way to execute an originate-to-sell mortgage business model. Selling through to Fannie Mae or Freddie Mac’s multi-family platform is another way to hedge the associated risks of fixed-rate loans in volatile markets. But what about commercial real estate (CRE) loans, non-conventional loans, and other illiquid loan types?
The Seattle Bank now has a funding tool to help: the Forward Settling Advance (FSA).
How does it work?
The FSA is similar to a fixed-rate bullet advance, with the added benefit of the forward settlement feature, which allows a borrower to trade an advance on a given day, and take settlement of the funds at a designated future point in time. The forward settlement feature does come at a cost, which approximates the Seattle Bank’s cost of negative carry of pricing, hedging, and funding the advance up front—but not earning interest on the advance until it settles in the future. These costs are blended into the rate of the advance, rather than included in an up-front cash payment. In other words, the FSA allows you to lock in today’s funding levels at no up-front cost.
The cost of an FSA is a function of the current rate environment, the term of the forward settlement period, and the maturity term of the advance. All else being equal, the lower the absolute rate environment, steeper the funding curve, and longer the forward settle term, the higher the cost of the FSA.
From a credit, collateral and stock perspective, the FSA will look and appear as a commitment on your Online Services account and will draw on activity stock, collateral, and available credit line capacity when traded. Upon expiration of the forward settlement period, the FSA funds will appear as an advance on the Online Services system, subject to the same credit, collateral, and stock requirements.
FSA Product Specifications
The FSA is a blend of an interest rate commitment and a standard fixed-rate bullet advance. Additional product specifications are as follows:
|Basis: ||Fixed-rate bullet advances only
|Settlement: ||Mandatory and discrete settlement. FSA has a mandatory requirement to be settled and settlement is discrete, one-time only at end of forward settle period
|Minimum size: ||$1 million
|Maturity Terms: ||1 to 30 years; shorter terms also available
|Forward Settle Terms: ||Six business days to 18 months
|Pricing: ||Available upon request from the Funding Desk
How to Apply the FSA?
FSAs can be an ideal funding tool for commercial loan originators who want to hedge and fund large, competitively priced loans—or for mortgage originators who want to hedge the duration of portfolio loans or pass-through securities. The FSA is also helpful for construction loan originators who have “construction-to-permanent” products and are looking for a competitively priced takeout option. It may be prudent to fund the construction phase with short-term advances and/or retail deposits and then use the FSA to hedge the permanent takeout.
Let’s work with the example of a CRE loan that begins with a construction loan and finishes with a permanent longer-term takeout option. The question is: What is the most efficient way to hedge and fund the permanent longer-term takeout option?
Our commercial real-estate project example is a mixed-use retail/residential building. The borrower is looking for short-term financing during construction and a long-term takeout for permanent financing.
The borrower is worried about rate volatility and, given the size and scope of the project, wants to lock-in five-year permanent financing terms prior to construction.
Let’s take a look at funding the permanent phase.
Standard CRE loan convention, the borrower requests the following:
|Loan Term: ||5-year fixed-rate loan
|Amortization Schedule: ||20-year amortization schedule
|Fixed Rate: ||5-year FHLBank bullet + 300bps, or 4.53%
|Construction Phase Term: ||12 months
|Amount: ||$5 million
The lender has two goals in funding this loan:
- Hedge associated rate volatility (as terms are locked prior to construction and well before the permanent takeout)
- Earn an acceptable spread on the loan
To hedge the associated rate volatility, given the 12-month construction phase and the borrower’s desire to mitigate this volatility, the lender can use an FSA to lock in today’s rate for settlement at some point in the future.
Let’s assume the following pricing. The posted fixed-rate to maturity rate is included for reference.
|Forward Settlement Term ||Maturity Term ||Fixed-rate Bullet to Maturity ||FSA Rate ||Principal
|12 months ||36 months ||.91% ||1.53% ||$1,000,000
|12 months ||60 months ||1.53% ||2.16% ||$4,000,000
The $5 million loan is funded with a blend of a three-year FSA (20%) and a five-year FSA (80%). Both parts of the advance are assumed to trade today for settlement 12 months in the future. This blend is set to closely pattern the cash flows of the advance to the cash flows of the loan amortization. This allows the lender to hedge the rate volatility for the first 12 months and lock in today’s attractive funding rates. Again, the cost reflects the forward settlement term and the Seattle Bank’s cost of funding the transaction up front, but not receiving any corresponding loan interest until the advance settles in 12 months. This cost is the difference between the fixed-rate bullet to maturity rate and the FSA rate.
The principal cash flows track closely to one another, and the loan transaction, from a funding basis, is profitable on both a monthly and cumulative basis.
Chart 1: Principal Outstanding for Combined CRE Loan and Blended FSA Portfolio
Closely reconciling loan repayment cash flows to advances outstanding may be beneficial if the borrower chooses to repay the loan prior to contractual maturity. Any associated loan prepayment fee will help offset any fee due on the outstanding advance, should both sides of the transaction need to be unwound.
Another key aspect of this sample portfolio is profitability. The interest accrual schedule clearly shows the portfolio is profitable from a funding standpoint each and every month and, therefore, profitable on a cumulative basis. The relative profitability increases after month 36, as 20% of the funding matures and results in the portfolio being slightly underfunded by approximately $250,000 for the last two years of the loan.
Chart 2: Interest Accrual History for Combined CRE Loan and Blended FSA Portfolio
Additional Applications and Considerations
The FSA is also a great alternative to using forward-starting interest-rate products, which may require monthly mark-to-market and, typically, the posting of highly liquid investment securities collateral, and the continual monitoring of counter-party risk. With the Seattle Bank, the FSA is not marked-to-market, and it is treated like any other advance borrowing. As you know, Seattle Bank members can pledge investment securities, both conventional and non-conventional single-family mortgage loans, CRE loans, home equity loans, as well as many other loan types as collateral. Taking counter-party risk into consideration, the Seattle Bank is rated “AA,” and its debt is joint and severally liable by all 12 FHLBanks.
There is a season, turn, turn, turn…
With record deposit inflows providing ample funding for most institutions, wouldn’t it be great if loan demand could step up and meet the challenge? If we can believe that the real estate market has reached the nadir and government programs aimed at breaking the log-jam of distressed mortgages provide clear passage, this is a time to hedge and a time to fund.
Brett L.A. Manning, CFA, is the National Sales & Funding Desk Manager at the Federal Home Loan Bank of Seattle.