Fighting Fire With Fire: Using "Returnable" Advances
by Roy Hingston
Most financial institutions like mortgage loans as high-quality assets and would love to put them on the books, but struggle with the associated interest-rate-risk exposure, which can last as long as 30 years or pay off in just a few years.
Common industry analysis would suggest that mortgage loans have a long “average life” or duration. In an attempt to properly fund mortgage loans, most institutions try to manage interest rate risk by controlling the “duration” mismatch between the asset and the liability. That usually means extending liabilities to reduce the mismatch.
Many institutions, however, remember a time when they had 30-year fixed-rate mortgages on the books at 8.00%, and the cost of funds went up to almost 20%. That was an expensive lesson on the subject of being “underfunded.”
Most also remember the spring of 2001 when they were worried about rising rates and went out and “locked-in” fixed-rate FHLBank advances for up to 10 years at 6.00% or even higher. When the Fed lowered short-term rates towards 1.00% in reaction to the events surrounding 9/11, the mortgage assets prepaid rapidly to take advantage of lower rates, and the institutions were left with expensive funding and few mortgage assets. This was an expensive lesson on the subject of being “overfunded.”
What should/could we have done differently? We could have examined the nature of the mortgage asset a little closer to discover that the problem is not “duration.” The problem is “convexity.” The problem is the prepayment option. The borrower can pay the regular monthly payments for up to 30 years, or the borrower can prepay without penalty at any time. The fact that the competition forces us to “give-away” this prepayment option does not mean that the option has no value. In fact, it is quite valuable—as we can easily see when we try to duplicate it.
Getting Flexible Funding
In theory, the correct offset to making a loan with a prepayment option is to acquire funding with a similar prepayment option. If the borrower exercises his option to prepay the mortgage, we exercise our option to prepay the funding. See, that wasn’t very hard at all, was it?
As usual, the theory is simple but the “devil is in the details.” We have known for years that the theoretical solution to the flexible mortgage loans product is the acquisition of flexible financing. The problem has been the cost. In order to obtain funding that was as flexible as the loan we were making required us to pay the same rate we were receiving on the loan! No risk, no reward! This was not an acceptable solution.
Getting the "Right" Options
We cannot afford to be “overfunded” or “underfunded.” In the same way, we cannot afford to be “over-optioned” (another new word?).
We understand that if we want options on our side, we have to pay extra to get them. Therefore, we only want to pay for options that we will really need. We do not want to pay good money for options that we are unlikely to use.
That being said, how can we know which is which? A picture is worth a thousand words. Consider Figure 1.
Figure 1. Estimated Paydown Schedule for a Mortgage Asset With 60 percent Fixed Rate Funding
We begin by estimating the paydown schedule for the mortgage asset we are buying/originating in the “Base Case” of unchanged interest rates. We have determined in the past that the most efficient funding strategy uses a combination of 60% fixed-rate funding and 40% short-term funding. This combination is able to handle most variations in the actual paydown experience.
We then “layer-in” a series of FHLBank advances to provide the 60% fixed-rate funding. The result is shown below in Figure 2.
Figure 2. Estimated Paydown Schedule for a Mortgage Asset with 60 percent Fixed Rate Funding Portion from a Series of FHLB Advances
However, in today’s rapidly moving interest-rate environment, prepayment speeds can be dramatically different if rates decline. As a result, even with 60/40 funding, we could end up being “overfunded,” as demonstrated in Figure 3.
Figure 3. Estimated Paydown Schedule for the Advance-Funded Mortgage Asset, Including a Rate Shift of -100 basis points
The problem could be addressed if we had the right to prepay some of the advances without a penalty. A “returnable” advance—often called a “putable” advance—offers the right to do just that.
As shown in Figure 4, with a returnable advance, if prepayments ended up following the "down 100" path, we would simply “return” the unneeded fixed-rate advances to the FHLBank without penalty.
Figure 4. Estimated Effect on Funding if Returnable Feature is Added to the Advance Structure
“Returnable” advances cost a little extra, however, in today’s flat yield curve environment, the small extra payment is well worth the flexibility. In our example, this flexibility was acquired at a blended average cost of just 6 basis points! Notice that we did not need to take out “returnable” advances for year 1 or year 2 or year 3 or even year 4. We only needed to protect ourselves from prepayments that occur after the "down 100" line crossed the "60/40 funding" line—at about four years. We did obtain “returnable” advances for the 5-year, the 7-year, and the 10-year funding.
The key points in this analysis are that mortgages come with prepayment options. Therefore it makes sense to structure the funding with some prepayable advances. The Seattle Bank offers these types of advances—and their cost is very reasonable in today’s market.
I hope that you will find this idea to be worth a discussion with your Seattle Bank representative. Ask about the costs and the benefits. But don’t wait too long! When the yield curve shifts back to a more “normal” shape, these “returnable” advances may cost quite a bit more.
Roy Hingston is Chief Balance Sheet Strategist at Shay Financial Services.
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