The Seattle Bank’s adjustable-rate funding products offer several key benefits: protection against increasing asset sensitivity; lower borrowing costs if interest rates decline; and the ability to use different indices to mitigate basis mismatch. No wonder Seattle Bank members are using these products to address more and more of their funding needs.

Adjustable-Rate Advance Products
Over the last few months, increasing numbers of Seattle Bank members have been taking advantage of our adjustable-rate advance products. The recent interest in these products seems to be the result of several factors. One, of course, is the current state of the market. The flat yield curve makes short-duration funding a particularly attractive tool for balance sheet management. Short-duration funding allows members to benefit from falling short-term interest rates, therefore providing value in the current market. The fact that the market seems to be placing a higher probability on interest rates falling, rather than rising, over the next year adds to the appeal. (And, the Fed’s recent pause in its monetary policy tightening has certainly strengthened this view.)

Another market-related issue is the building consensus that the U.S. economy will be slowing down dramatically over the next several quarters. History shows that credit spreads throughout the market typically widen when the economy enters a significant slowdown. The behavior makes sense since periods of economic slowdowns generally correlate with lower corporate earnings, resulting in lower debt service coverage. Adjustable-rate advances can help our members take advantage of today’s credit spreads for term funding.

Another factor contributing to the use of adjustable-rate funding is the changing nature of the asset mix our members are funding. Many have been adding adjustable-rate loans and/or construction loans to their portfolios, thereby increasing their asset sensitivity. Falling interest rates will exacerbate asset sensitivity as prepayments of other asset classes will likely increase. Short-duration wholesale funding also allows our members to address these issues. Further, the array of adjustable-rate products available can allow our members to resolve some of the issues created when adding assets with a different basis than the majority of their funding.

Finally, there’s no better way to match fund your adjustable-rate loan production than with an adjustable-rate advance. Adjustable-rate advances can also be utilized by members who may wish to match-fund, or hedge, loans being produced in their adjustable-rate commercial and commercial real estate loan portfolios. The ability to choose from many different maturities and index the funding to several different indices provides member banks great flexibility in looking at match-funding options, as well as general funding needs for a specific basis (e.g., Prime, LIBOR).

Adjustable-Rate Advance Products and Their Mechanics
By their nature, adjustable-rate advances exhibit short duration, so they are highly appropriate instruments to fill the need for that specific type of term funding. Take, for example, a bank that is currently asset-sensitive and would like to address the issue by taking down short-duration funding that resets every month. Just as the institution benefits from falling rates with short-duration funding, however, it is also exposed to a potential increase in interest rates. Members who wish to reduce their exposure to rising interest rates may address this risk by utilizing a capped floating-rate advance. A “capped floater” is composed of an adjustable-rate advance with an interest rate cap set at a specified rate. (For more information on the capped floating-rate advance, refer to the article, “Timely Wholesale Funding Strategies: Using Capped, Floating-Rate Advances in a Flat Yield Curve Environment,” in the February 2006 issue of What Counts.)

The Seattle Bank offers an array of adjustable-rate advances linked to several popular and widely used indices. There are a variety of structures with terms tailored to meet members' specific needs. The most commonly requested maturities range from one to five years, although it is possible for the term to be longer than five years. The most common indices used by our members are one-month LIBOR, three-month LIBOR, and Prime, as these indices are the most commonly used in their loan portfolios.

The reset dates and interest payment dates for adjustable-rate advances will depend upon the related index. Advances indexed to one-month LIBOR will reset and pay interest monthly on the appropriate re-price date. Advances indexed to three-month LIBOR will reset and pay interest quarterly on the appropriate re-price date. Advances indexed to Prime technically reset every day. But, since Prime is a function of the federal funds target rate, the index resets only when the target for the overnight lending rate changes. Interest payments on advances indexed to Prime occur monthly on the first business day of the month.

Adjustable-rate advances are quoted as a spread over the underlying index. Table 1 illustrates how the prices on these advances are quoted.

Table 1: Adjustable-Rate Advance Spreads as of 08/09/06

For example, if the rate on a four-year advance taken on August 10, 2006 is three-month LIBOR plus seven basis points (bps), the advance will reset every three months beginning on November 10, 2006. Keep in mind that advances indexed to LIBOR will follow the standard market convention of a two London business-day look-back. In this case, the advance will reset to the three-month LIBOR rate on November 8, 2006 (two London business days prior to 11/10/06) plus seven bps. The advance will continue to reset quarterly based on the underlying index.

Diversifying the Basis of Your Funding
Many of our members offer their customers adjustable-rate, commercial and industrial, and commercial real-estate loans. These loans may be similar to their residential counterparts in that they have an initial fixed period followed by a floating-rate period, or they may be strictly floating-rate. The adjustable-rate loans offer several advantages to borrowers by allowing them to access a term loan without long-term interest rate. At the same time, the loan may have a higher likelihood of staying on the members’ balance sheet due to the lower incentive to refinance.

There are also some disadvantages associated with adjustable-rate loans. For example, embedded interest caps in the loans may prevent increases in the loan rates, and the index used to re-price the loan may not match the equivalent cost of funding the loan, thus affecting the margin made on the loan. That said, adjustable-rate loans are a suitable and integral part of most banking operations.

Financial institutions have numerous indices to choose from for the underlying index. They range from short-term indices such as three-month LIBOR and Prime, to indices such as the two-year or five-year swap rate and even Federal Home Loan Bank rates. (Choosing the right index remains a challenge, but that is a topic for a whole other discussion.)

Although many see the Prime index as an antiquated phenomenon, many in the lending business still use Prime as the index for adjustable-rate loans. The main reason for this seems to be the borrowing community’s familiarity with the index and the fact that the Prime rate is easily accessible. For this reason, let‘s consider how the Seattle Bank’s adjustable-rate advances indexed to Prime could help mitigate some of the basis mismatch between Prime-based assets and their funding. Figure 1 offers a quick analysis of how Prime and three-month LIBOR have fluctuated over the last five-and-a-half years.

Figure 1. Relationship between Prime and 3-Month LIBOR, 01/01/01 – 07/01/06

If your institution generates loans indexed to Prime, you have an inherent basis mismatch between the asset and the funding on the portfolio. As shown in Table 2, the difference between Prime and other short-term interest rates (i.e., three-month LIBOR) has been relatively stable, but there are still some substantial movements in the relationship that may produce some pricing and funding discrepancies. Although this risk is small compared to other interest-rate risk that a financial institution faces, it is one that can be easily addressed. Using the Seattle Bank’s Prime-based adjustable-rate advance as a source of term funding can help to reduce this risk. An institution doesn’t have to match every Prime loan with Prime funding, but adding some funding that is indexed to Prime is a good way to diversify your cost of funds and, at the same time, reduce some of the basis risk in your portfolio.

Table 2. Key Statistics on Prime Rate and 3-Month Spreads, 01/01/01 – 07/01/06

There will always be some variability in how two indices behave. By offering a suite of adjustable-rate funding products, the Seattle Bank provides members with the necessary options to address these issues. When combined with the Seattle Bank’s wide array of structured and fixed-rate advances, our adjustable-rate advances provide our members with a plethora of wholesale funding products to choose from to address their individual needs. All are designed to support the Seattle Bank’s goal of providing value to our members through ease of use, competitive prices, and customized solutions.

Erick Rendon, CFA, is the institutional sales and trading manager at the Federal Home Loan Bank of Seattle.

This article is the fourth in a series of wholesale funding strategies:

• “Timely Wholesale Funding Strategies 3: Using Returnable Advances to Mitigate Prepayment Risk,” July 2006
• “Timely Wholesale Funding Strategies 2: Using Flipper Advances to Obtain Sub-LIBOR Funding,” May 2006
• "Timely Wholesale Funding Strategies: Using Capped, Floating-Rate Advances in a Flat Yield Curve Environment,” February 2006

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.