Timely Wholesale Funding Strategies: The Symmetrical Prepayment Advance
Like many others, your financial institution is likely craving loan growth. In recent weeks, you may have seen a modest pickup in C&I loans, or even multifamily activity. In certain markets, Seattle Bank members have begun to “dial-in” a portfolio of residential mortgages—some of which might be slightly out of Fannie Mae or Freddie Mac underwriting parameters. Some institutions are marketing 10-year mortgages to those in their 40s and 50s who have been in their homes for some time and want to accelerate their “forced savings.” Others are focusing on mortgages with balances that exceed conforming amounts.
Regardless of the types of loans you may be considering, extension risk is all too frequently a part of the discussion. In a rising rate environment, extension risk poses a significant obstacle on your road to financial success. Extension risk represents the downside you face when the expected redemption dates or cash flows of your assets extend, or when the expected cash flows of your liabilities shorten. It is present in all assets (like mortgages) and liabilities with optionality (e.g., puts, calls, and prepayments). If extension risk sets in, the value of your mortgage portfolio drops.
But, how does extension risk impact your core deposit portfolio? Core deposits may be the least of your problems today, but what about their duration? If rates rise, will your depositors move their funds to higher-yielding deposit or money market investment accounts—or will they demand higher coupons to meet the market? Because all three scenarios are possible in a rate environment where the Fed moves quickly to stamp-out inflation fears, it is prudent to offset the possible erosion of the value of these assets with upward valuation on the liability side.
The Seattle Bank has the tool that can not only fund your new mortgage originations, but also hedge your risk of deposit erosion or migration when interest rates rise. This funding tool is the Symmetrical Prepayment Advance. The Symmetrical Prepayment Advance provides stable, non-rate sensitive funding and the ability to monetize any value associated with rising rates via termination prior to contractual maturity. A prepayment credit on this advance would be associated with an interest rate environment that is materially higher than the environment that existed when the advance was originated.
We encourage you to read the Symetrical Prepayment Advance strategy, Climbing the Funding Ladder: Growing and Hedging Your Balance Sheet with Symmetrical Advances, found on the strategies section of our website. To cut to the chase, the moral of the story is: Extension risk can harm your portfolio’s value! In spite of a tepid lending environment, ultimately, you need to grow your assets. Constructing a laddered portfolio of Symmetrical Prepayment Advances to hedge this growth is a sensible strategy to consider. If the left side of your balance sheet were to erode in value in a rising rate environment, it may be useful to fund your assets with a portion of the right hand side of the balance sheet that can conversely rise in value. A funding strategy incorporating Symmetrical Prepayment Advances can assist in keeping valuation in balance.
Brett L.A. Manning, CFA, is the National Sales and Funding Desk Manager at the Federal Home Loan Bank of Seattle.
John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.
Mike Terry is Business Development and Funding Desk Analyst at the Federal Home Loan Bank of Seattle.