“I've been a Dolphin for 17 years, and I'll be a Dolphin for the rest of my life. That will never change.”
Unlike the 1960’s television series or the Miami football mascot, the Seattle Bank’s
soon-to-be-released “flipper advance” has nothing to do with the life aquatic. Rather, it will represent the Seattle Bank’s newest structured funding solution. The flipper
affords our members the opportunity to sell an option to “flip” a floating-rate
advance to a fixed-rate advance, after a pre-specified period of time. What does
the member receive from the Seattle Bank in exchange for its sale of the conversion
option? At the outset: a below-market, floating interest rate.
The flipper can best be described as a combination of a floating-rate advance and
a putable advance. With a putable advance, the borrower sells an option (a one-time
option in a “European” structure, or multiple options in a “Bermudan” structure),
in exchange for a fixed interest rate that is lower than that of a standard fixed-rate
advance. For example, consider a five-year putable advance with a one-year lock-out
period. If, after the one-year lock-out period, prevailing market rates for the
remaining four years are below that of the rate on the putable advance, the Seattle
Bank will likely not elect to call the advance. On the other hand, if prevailing
market rates for the remaining four years are above the rate on the advance, the
Seattle Bank would likely exercise the option and re-lend the funds at the higher
By way of comparison, consider the following example of a flipper advance. Let’s
say our flipper structure is a five-year advance with a one-year lock-out (i.e., the Seattle Bank may not convert the advance for one year). Let’s also assume that
the structure includes a “European” conversion option, which means that the Seattle
Bank will have the option to convert the advance only once (one year from now).
During the one-year lock-out period, the advance would be priced at three-month
LIBOR, less 0.50%. The rate would adjust quarterly during the first year, and on
the one-year anniversary of the initial draw, the Seattle Bank would have the option
to call the advance. If the Seattle Bank elected not to call, the advance would
flip to a pre-determined fixed rate (assume 5.00%) and become a four-year bullet,
fixed-rate borrowing. If the Seattle Bank exercised its option to call the advance,
the borrower would have two choices: to obtain an alternative source of funding
or to float the advance at the prevailing interest rate.
In considering this flipper structure, the borrower should ask the following question:
“Do I think that the flip rate of 5.00% will be below the rate for four-year borrowings,
one year from now?”
Why? If the flip rate is below the rate for four-year borrowings, one year forward,
the Seattle Bank will likely call the advance and the borrower would have received
sub-LIBOR funding for one year. As illustrated in Figure 1, in the current market,
the flip rate of 5.00% is 35 basis points below the implied four-year swap rate
one year from now.
Figure One: Representative “European” Flipper Structure
A flipper advance might also be structured with a “Bermudan” conversion feature. For example, a seven-year, non-put one-year advance could float for the first year at LIBOR less 0.50%, with the rate adjusting quarterly during the first year. After the first year, the Seattle Bank, on a quarterly basis (as opposed to the one-time only conversion feature of a European option), would have the right to terminate the borrowing.
The flipper advance offers Seattle Bank members: a tool for macro-balance sheet
management, potentially lower funding costs, and sub-LIBOR pricing. In exchange,
the borrower sells the right to convert the floating rate to a fixed rate on a pre-specified
date(s). In a worst case scenario, if implied forward rates turn out to be lower
than the “flip” rate and the advance remains on your books, you’ve still enjoyed
having the sub-LIBOR funding for a meaningful period of time.
Biestman is director of business development at the Federal Home Loan Bank