Strategies

    Returnable Advances Revisited

    June 2008

    What if you could purchase call options on fixed-rate funding to mitigate loan prepayments, enhance balance sheet flexibility, and match-fund loan products on your balance sheet? And what if you could structure advances with these provisions at historically low levels, and priced at reasonable spreads to other callable funding avenues?

    Given recent market volatility, which saw 325 basis points of easing in eight month’s time, the collapse of Bear Stearns, and the introduction of the Fed’s various lending programs, the value of funding with a high degree of certainty cannot be understated. In a time when liquidity is king and balance sheet flexibility is being put to the test, the value associated with terminating wholesale funding has never been more important.

    Funding via the Returnable Advance enables Seattle Bank members to receive low-cost funding, tied to the significant decline in Seattle Bank’s cost of funds—and the right to terminate the advance prior to maturity without a prepayment fee. The prepayment option is most applicable to asset-sensitive balance sheets in falling rate environments, as the prepayment option is a natural hedge for the negative convexity found in most loan products. Fixed-rate commercial loans and consumer mortgage products are subject to increased prepayment behavior as rates fall and borrowers exercise their right to prepay their loans to take advantage of lower interest rates.

    But the value of Returnable Advances is not limited to asset-sensitive balance sheets, and the value of the prepayment option is not limited to falling rate environments. In a time when balance-sheet flexibility and liquidity policies are being stress-tested, the ability to match-fund specific loans, hedge interest-rate risk, and lock-in net interest spreads is worth a premium. How much is this premium worth—and how is it derived?

    During mid-2007, it wasn’t uncommon for Returnable Advances to price out at +50 basis points to callable brokered CDs of the same maturity1. But as shown in Figure 1, they have recently come into the money, and at one point in March, Returnable Advances were cheaper than their brokered counterparts.

    Figure 1. Callable Funding Yield Comparison: Brokered CDs vs. Seattle Bank Advances

    6/1/07 – 5/1/082.

    Figure 1. Callable Funding Yield Comparison: Brokered CDs vs. Seattle Bank Advances – 6/1/07 – 5/1/082.

    There are two primary drivers of this spread difference: (i) the cost of funds base and (ii) the premium associated with the call option. Brokered CDs are funded by retail depositors, who are looking for a rate premium over non-callable CDs. These retail investors may or may not properly value the call option they are selling, and to the benefit of borrowers in the callable brokered CD market, current levels suggest that they may not be valuing these options efficiently.

    Returnable Advances are funded by Seattle Bank debt issuance, and the returnable structure is created by blending this debt with a callable swap. The debt and swap are priced in the capital markets, which value the callable options more efficiently and pass along the Seattle Bank’s funding advantage, which has benefited from the flight to quality associated with the deterioration of the credit markets. Figure 2 shows that the cost of these options in a 5-year, non-callable 1 year Bermudan (B), is currently cheaper than it has been in the recent past.3

    Figure 2. Yield Premium for Returnable Advance relative to Bullet Advance

    Figure 2. Yield Premium for Returnable Advance relative to Bullet Advance

    By contrast, the callable brokered CD is originated in the retail market, with individual investors determining the value of the options. Figure 3 shows that, currently, the capital and retail markets value the same call option quite differently.

    Figure 3. Relative Valuation of Wholesale vs. Retail Call Options

    Structure Rate
    5-year Bullet Advance 4.48
    5-year Non-call 1Year Advance 5.00
    Wholesale Call Option 0.52
    5-year Brokered CD 4.70
    5-year Non-callable 1 Year CD 4.75
    Retail Call Option 0.05
    *Indications as of 5/27/08

    In the case of the 5-year, non-callable 1 year (B) advance, the capital markets assigned a value of 52 basis points to the call option, based on the spread difference between the 5-year bullet, non-callable advance, and the 5-year, non-callable 1 year (B) advance. In the case of the 5-year, non-callable 1 year (B) brokered CD, the retail market has assigned a value to the call option of 5 basis points, again based on the spread difference between the non-callable and callable structure. Why are the option valuations so different? Some of the variation is attributable to the fees the broker charges to aggregate orders and execute trades; but the bulk of the difference is the means by which retail investors determine the value of the option and how the capital markets value the same option.4

    The moral of this story isn’t to point out the differences between retail and wholesale funding channels. These are well documented and vary for established reasons. The point is to demonstrate the significant value found in callable funding, whether it is through a brokered counterparty or the Seattle Bank.

    As shown in Figure 3, Returnable Advance rates are currently at historical lows, driven in large part by the Seattle Bank’s low cost debt and affordable option costs. The price to protect net interest margin, hedge unwanted interest-rate and prepayment risk, and manage balance sheet liquidity can be quite valuable.

    Figure 4. Seattle Bank Returnable Advance Structure: Offering Expires June 6, 2008

    Returnable Advance Structure
    Structure Feature Rate Indication* Deadline
    Returnable Advance 5 - year/non-call 1 - year (Bermudan) Terms (pdf) 5.00% 10:00 a.m. PT 6/6/08

    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.

    1 This spread differential was upwards of +100bps at points in 2006.
    2 Aggregate of five brokered CD quotes
    3 Option cost determined by, Callable Advance-Non Callable Advance, of the same maturity term.
    4 A more direct analysis is to compare the coupon levels between non-callable and callable brokered CDs of the same maturity tenor. In the case of the 5-year structures above, this difference is closer to 15 basis points, not 5 basis points.

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