“A picture is worth a thousand words.” 
- Napoleon Bonaparte

We’re all waging war on the root causes of margin compression: a challenging deposit environment, exposure to asset extension risk, and loan demand that seems to vary from sector to sector—not to mention a persistently flat yield curve. Here are four steps you can take to skirt the shoals of today’s turbulent financial waters.

1. Measure and manage your liquidity.
Over the past year, investment balances have declined—throughout the banking industry. The reason, no doubt, is the effort to fight narrowing margins via the substitution of investments for loans. Not only are marketable securities balances shrinking, but also their maturities are becoming shorter.

The phenomenon of declining investment balances highlights the need to develop an effective means of managing liquidity. Mitigating liquidity risk (i.e., the risk of not having sufficient liquid assets to meet short-term funding needs) necessitates: (a) close monitoring of short-term asset and funds flows; and (b) developing the capability to raise funds quickly—and at a sensible cost. Remember to take a forward look at your liquidity position and consider such variables as loan, investment, and deposit originations, prepayments, and maturities. As we have discussed in previous issues of What Counts, make certain that you are using a liquidity risk management model and have implemented a comprehensive liquidity policy. (See the November 2004 issue of What Counts.)

Obtaining sufficient liquid assets to meet short-term funding needs is not restricted to launching new, competitively priced deposit promotions or tapping into your marketable securities portfolio. Rather, consider your additional sources of just-in-time liquidity, such as the Seattle Bank. As inferred in Figures 1 and 2, wholesale funding is becoming a readily acceptable part of the liquidity management landscape.

2. If you must grow via investments, consider the relative shape of different yield curves.
If you must grow via investments, rather than via loans to “A” credits, consider the following. On a relative basis, the municipal yield curve is steeper than the Treasury and agency curves. As shown in Figures 3 and 4, the Treasury and municipal yield curves are relatively the same as they were during the second quarter of 2000: a flat Treasury curve, and a modestly positive municipal yield curve (due to the credit component within the term rate of interest). In today’s market, the spread between one-year and 10-year municipal yields is 52 basis points, versus a virtually non-existent spread in the case of the Treasury curve.

3. Consider opportunities for fixed-rate, junior-lien mortgages in your market.
Compared with growing the balance sheet via investments, growing via “A” credit loans is undoubtedly the preferred approach. Still, some of the higher-growth sectors of recent years, namely home equity loans, have shown signs of slowing. Sometimes maturing business lines prompt institutions to enter such new business lines as small business or professional lending, or leasing. Another option is to reconfigure the maturing product.

As Figures 5 and 6 demonstrate, the growth rate in HELOC commitments is waning. During 2003 and 2004, at the height of HELOC originations, few institutions were offering products such as a five-year, 15- to 30-year second-mortgage with an amortizing balloon. With a steady stream of Fed tightening and a persistently flat yield curve, you might want to consider demand for fixed-rate junior-lien product in your market.

4. Know your options and the relative price of premiums over time.
Even if you have never purchased or sold a derivative, chances are your balance sheet is replete with options, which are often hidden and embedded within many of your deposit and loan products. For example, if your loan portfolio includes pre-payable mortgages or caps and floors, or if your deposits include “bump” or add-on features, you’ve got to know what those options are and make certain that they are represented in your ALM modeling.

Per Figure 7, interest-rate-cap volatility has dropped to its lowest level since 2000. All other things considered, if volatility is low, the price of an interest-rate cap would be in a similar position. Now, the question remains: What could drive volatility higher? There are factors aplenty: new leadership at the Fed; Japan’s emergence from disinflation prompting less stability within the U.S. Treasury market; shrinking labor and manufacturing capacity; questions about consumer spending in the wake of softening residential real estate price growth. Had enough?

If you’re looking for some insurance against rising rates, consider the Seattle Bank’s capped floater—an adjustable-rate advance with an embedded cap. Speak with your commercial lending team and see if a variable, capped rate product would sell in your market.  You’ll want to do so while premiums appear to be on their cyclical lows, however. Insurance premiums are seldom cheap when it’s time to file the claim! 

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

IMPORTANT DISCLAIMER, PLEASE READ: The Federal Home Loan Bank of Seattle ("Seattle Bank") publishes What Counts for educational and promotional purposes only. The data and analysis presented are based upon information obtained from sources that we consider reliable. The opinions expressed represent the current opinions of our staff and are subject to change without notice. We make no warranties, express or implied, regarding the accuracy or completeness of any information, analysis, or opinions presented. No part of this newsletter may be reproduced in any manner without the written permission of the Seattle Bank. The Seattle Bank, its employees, agents, and contractors are not registered investment advisors, financial advisors, or broker dealers, and they are not acting in a fiduciary capacity. The information contained in this newsletter does not constitute a recommendation, offer to sell, or solicitation of an offer to purchase any particular investments or products, including without limitation securities of any companies discussed, and it should not be construed as such. It is the reader’s responsibility to evaluate the suitability, risks, and merits of any investment, funding strategy, or business proposal presented in this newsletter. Newsletter content is for our readers' informational purposes only. Please refer to our Terms of Use for details.