Timely Wholesale Funding Strategies 3:Using Returnable Advances to Mitigate Prepayment Risk

“I came out of Bataan and I shall return." – Douglas MacArthur

Would your financial institution suffer any ill affects if interest rates were to decline? Are any of your “A”-credit, fixed-rate commercial borrowers starting to question the presence of loan prepayment penalties? How quickly would your fixed-rate mortgage portfolio pay down during a rate decline? Would you be left with expensive funding and no assets to show for it? Things might be different, if you had the right to terminate the funding.

If you don’t want to be over-funded if rates drop, the Seattle Bank’s newest structured funding solution, the returnable advance, may benefit your financial institution. As the name implies, the structure enables the borrower to return or “call” the advance to the Seattle Bank, after a pre-specified period of time, without incurring a prepayment penalty.

Table 1. Application and Advantages of the Returnable Advance

Product Description Application Advantages
Callable or “Returnable” Advance Subject to termination by the borrower on predetermined dates Funding specific assets not subject to prepayment penalty; loan and investment portfolio management; liquidity and balance sheet management Addresses loan pre-payment problem for customers without prepayment penalty; protects mortgage and MBS portfolio from accelerating prepayments

Here’s how it works.

The returnable advance is simply a fixed-rate bullet advance with an option that gives the borrower the right to return the advance to the Seattle Bank. The cost of purchasing this termination right is reflected in a coupon rate of interest that would be higher than that of a standard fixed-rate advance. As an example, consider the case of a five-year returnable advance with a two-year lock-out period and a European structure. (Remember that a European structure gives the borrower the right to exercise the termination option, on a one-time basis, at the end of a pre-defined lock-out period. Other structures could include Bermudan options, which would enable termination exercises on a quarterly basis at the end of a lock-out period.) The borrower would be able to return the advance to the Seattle Bank, two-years from the date it is drawn, without incurring any prepayment penalties. Once the two-year lock-out period has passed, the borrower would have the option to terminate the advance or allow it to go to term behaving like a three-year fixed-rate bullet advance.

The value of the option to return the advance would increase in line with the expectation that rates would decline. Conversely, in the event that rates increased, it is likely that the value of the option would expire worthless and the borrower would, all things considered, hold the advance to maturity. Variables that are incorporated in setting the price of the call option include: maturity, lock-out, assumed volatility, exercise frequency, the absolute level of interest rates, and the shape of the yield curve.

As Roy Hingston, Chief Balance Sheet Strategist of Shay Financial Services, points out in this month’s What Counts feature, “Fighting Fire with Fire,” the historical cost of returnable premiums in a flat yield curve environment is low. He also makes the point that mortgages and other assets frequently do not come with prepayment options. It’s only fair that both sides of the balance sheet fight fire with fire!

Later this month, the Seattle Bank will unveil a new specific offering of the returnable advance. Look for further details regarding the offering in the coming weeks, as well as a Web seminar that will focus on strategies and applications of this structure.

John Biestman is director of business development at the Federal Home Loan Bank of Seattle. This article is the third in a series of wholesale funding strategies he has written for What Counts: