The Capped Floater Advance: Is the time right?
June 2008

With declining asset yields and stubborn retail deposit costs continuing to compress margins, most financial institutions have been left with little choice but to roll maturing funding into the shortest of duration buckets to take advantage of any available margin relief.

Most asset-sensitive institutions have found themselves to be far more asset sensitive than they expected, due in large part to accelerated mortgage prepayments and the recasting of commercial loan terms, which eliminated interest-rate-floor covenants and, thus, exacerbated the fall in rates. The result is an aggregate balance sheet that is liability sensitive—at a time when the Fed may be looking to hike rates to stem inflation concerns due to spiraling commodity costs. ¹

How can you enhance net interest margin in such an environment, while maintaining balance sheet flexibility? And how much will it cost you? What tools are at your disposal to fight margin compression in a rising rate environment? Enter the Capped Floater Advance.

Simply put, the Capped Floater is a blend of a floating rate advance and a long position in an interest rate cap. ² The structure is ideal for institutions looking to mitigate rising rates by effectively capping the interest expense on a piece of their funding book. Let’s work through a quick example:

The periodic Capped Floater Advance interest rate is determined by the following formula: 3-month LIBOR + Advance Spread + Option Price – (max [0, 3-month LIBOR – Strike Rate])

Every three months, the advance will reset to the then-current 3-month LIBOR level. If the option is “in the money,” the borrower is paid. A theoretical pricing matrix over various 3-month LIBOR levels for these two structures is as follows in Table 2.

Table 2: Theoretical Pricing of Non-Capped vs. Capped Floaters Based on 3M LIBOR

Per Table 1, the current Capped Floater Advance is priced at +64 basis points to a standard non-capped LIBOR floater, and it is “in the money” once 3-month LIBOR reaches 4.55%. Please reference Chart 1 below:

Figure 1: Capped Floater Advance Pay-off

To determine if the Capped Floater Advance is right for your institution, ask yourself: Is this an opportunity to hedge unwanted interest rate risk? Is this an opportunity to use competitive capped funding to leverage into discounted asset classes? If these motivations hold true, is the time right to execute on this funding?

Forward Expectations: Rates to rise.
After 325 basis points of easing over the past 10 months, the Fed has suggested that future rate cuts are highly unlikely. In his speech regarding the outlook for the U.S. economy on June 3, Fed Chairman Ben Bernanke stated, “For now, policy seems well positioned to promote moderate growth and price stability over time.” While not directly stating that there will be no more future rate cuts, Bernanke’s message is as clear as any scripted by a Fed Chairman in the past 21 years. And, it’s probably fair to say that “Bernanspeak” is slightly less cryptic than “Greenspeak”!

Currently, forward rates are implying approximately +200 basis points of steepening by September 2011, with the biggest hikes occurring between 2010 and 2011.

In concert, volatility on interest-rate cap pricing has increased from a six-year low on May 31, 2007. Interest-rate cap pricing is a function of the strike rate on the cap, the term of the cap contract, and the volatility associated with forward rates. Three-year cap volatility, which spiked upwards with the negative news associated with the subprime debacle, numerous bank write-downs, and capital calls for financial institutions, has fallen from recent highs and is now trading at a six-year average.

Relative to historical levels, interest rate cap premiums are palatable and when blended with Seattle Bank funding levels, the all-in rates on Capped Floater Advances offer attractive macro balance sheet funding options, as well as specific arbitrage applications.

Arbitrage: Credit spreads reappear.
The credit crunch has roiled capital markets, from risky assets such as CDOs, sub-prime paper, and agency-backed securities, to some of the most conservative of asset classes such as agency MBS. Credit spreads have reappeared as term swap and overnight indexed swap (OIS) spreads have widened.

Figure 2: Overnight Indexed Swap (OIS) Spread

Source: Bloomberg

With the recent flight to quality, Treasury debt has rallied, and with the underlying credit concerns, swap rates have moved away, indicating that the cost of lending to an “AA” rated financial institution has increased. This risk premium isn’t isolated to swap rates, as mortgage asset values have also deteriorated.

The spread between 2’s to 10’s has reached 153 basis points, and mortgage spreads are trading in a range that hasn’t been seen since the early 2000’s. Is the time right to purchase discounted agency MBS /CMO and fund with liability sensitive funding, i.e., the Capped Floater?

Consider the example of purchasing a LIBOR-based, floating-rate CMO, funded with capped floating-rate LIBOR-based debt:

• Asset: FHLMC CMO, currently priced at 97.5 , priced to yield 1-month LIBOR + 206 basis points Liability: 3-month LIBOR Capped Floater, strike on LIBOR of 3.75%, initial price of 3.58%
• As shown in Table 3, based on LIBOR levels, the pay-off for this security would vary between 43 and 800 basis points:

Table 3. Pay-off for Mortgage Leverage Strategy

Although the mortgage asset becomes more valuable as rates fall, the value of the capped liability comes into play when rates rise. This feature allows maximum balance sheet flexibility in both falling and rising rate environments. In addition, if you blend the discounted funding available for CIP/EDF-qualifying assets, you can increase the pay-off on this strategy by up to 30 basis points!

As with any structured advance, the application and applicability of the Capped Floater should be determined on a case-by-case basis. Effective portfolio management considers not just the trade, but the entire funding book. Purchasing interest rate protection, in the form of a Capped Floater Advance, enables Seattle Bank members to retain maximum balance sheet flexibility at a time when liquidity and margin concerns are at the forefront of funding officer’s strategic issues.

We can price and structure Capped Floater offerings tied to one-month and three-month LIBOR, across a number of maturity terms and strike rates. Please feel free to call on us to discuss these funding options.

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.