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Federal Home Loan Bank: Seattle

Running your financial institution on the basis of forecasting interest rates is a road fraught with peril. True, the yield curve has inverted and the implied forward yield curve is pointing in the downward direction. Still, the fact remains that you have no control over the direction of interest rates. What you do have is access to ALM models that can help you understand how a given interest-rate condition might affect your earnings and market value of equity. If you are an asset-sensitive institution (i.e., re-pricing your assets faster than your liabilities), your ALM models may be showing that your equity duration has shortened, and that you are vulnerable to a potential downturn in rates.

The Floored Advance: Purchase an Interest-Rate Floor and Retain the Contractual Features of a Floating-Rate Advance
As an asset-sensitive institution, you may wish to purchase insurance that would offer protection should interest rates decline and you find that your assets yields are declining faster than your funding rates. That insurance can be found in the form of a floored advance.

A floored advance allows a financial institution to simultaneously: (a) purchase an interest-rate floor on a benchmark index such as three-month LIBOR; and (b) borrow on a floating-rate basis. In the case of a floating-rate floored advance, a decline in rates would magnify the pay-out by allowing the borrower to benefit from lower interest rates and an interest-rate floor that moves further into an “in-the-money” position. By having the interest-rate floor negotiated as a contractual feature within an advance, an institution would not hold an interest-rate floor on a stand-alone basis, thereby avoiding (subject to the institution’s independent accounting advisor’s opinion) potential adverse accounting consequences.

The Mechanics of an Interest-Rate Floor
An interest-rate floor simply represents an option that has intrinsic value below a pre-specified strike rate. The strike rate could be based on such indices as three-month LIBOR or Prime. To the extent that interest rates decline, the interest-rate floor continues to increase in value. At the expiration of the floor (i.e., the maturity date of the advance), should prevailing interest rates be above the strike rate, or “out-the-money,” the option would expire with no value. However, prior to advance maturity, the interest-rate floor would still have value, even if prevailing rates were above the strike rate. The value would be determined by such factors as assumed rate volatility, time-to-maturity, and distance from the strike rate.

As is the case with the purchase of all options, there is a cost. Rather than purchasing the interest-rate floor with an upfront premium, the cost is reflected in an advance rate that is higher than the rate on an advance that does not contain an option.

Floored, Floating-Rate Advance
Consider the case of a floating-rate advance that contains a contractual feature specifying that if three-month LIBOR declines to less than 4.75%, the interest rate on the advance would be reduced to equal the difference between the strike rate and the prevailing three-month LIBOR rate, adjusted quarterly. This means that once LIBOR is less than the strike rate, the interest rate of the advance will decline at twice the rate of LIBOR. Why? Because, in addition to deriving the benefits of a declining adjustable borrowing index, you also accrue the benefits of an in-the-money, interest-rate floor. Further assume that this particular advance is priced at a premium of 35 basis points per annum relative to a standard adjustable-rate advance and that LIBOR reaches 4.00% (1.35% below the current 5.35% level).

Formulaically, the rate on this floored, floating-rate advance could be described as:

[(3-Month LIBOR –- Max. (-0-, Floor Strike Rate – 3-Month LIBOR)) + Effective Annualized Interest-rate Floor/Advance Premium]

In this specific example, the all-in advance rate would be:

[(4.00% – (4.75% – 4.00%)) + 0.35%] = 3.60%

Figure 1. Yield on Floored Floating-Rate and Standard Floating-Rate Advances vs. 3-Month LIBOR Scenarios

* Floored floating-rate advance is "at-the-money," relative to standard LIBOR Advance.

In the case described in Figure 1, the floored advance, relative to the standard floating-rate advance, would be “in-the-money” when the 3-month LIBOR rate is less than 4.48%. [4.75% - (0.35% - 0.08%)] = 4.48%.

Table 1. Yield on Floored Floating-Rate and Standard Floating-Rate Advances vs. 3-Month LIBOR Scenarios

This example shows that the floored, floating-rate advance contains an accelerated benefit when LIBOR drops below the designated strike rate. There is effectively a “two-for-one” source of the rate reduction: one generated from the declining LIBOR index, and the other from monetization of the interest-rate floor.

Impact in a Rate Shock Scenario
To summarize the effect of significant rate changes, coupled with usage of a floored, floating-rate advance, let’s assume two scenarios in which LIBOR (presently 5.35%) increases and decreases by 200 basis points above and below the strike rate, respectively.

Table 2. Scenario Analysis of Floored, Floating-Rate Advance Impact on Interest Expense

In the case of LIBOR dropping to 200 basis points below the strike rate, the borrower would enjoy a net benefit of the rate decline of 365 basis points. Conversely, if rates were to rise by 200 basis points, the only downside would be the assumed 35 basis points of premium associated with the contractual floor feature. In the case of an asset-sensitive institution, the natural hedge of profiting in a rising rate environment would assist in offsetting the embedded floor premium. For those institutions whose interest-rate-risk settings are closer to neutral, it may make sense to consider complementing the floored, floating-rate advance with term fixed-rate advances. This additional feature would assist in neutralizing the negative effect of rising rates.

A Balance Sheet Management Solution for Cushioning the Negative Impact of Falling Rates
For many institutions (i.e., those whose assets have been re-pricing faster than their liabilities), the past three years of rising rates have been favorable. Today’s inverted yield curve and softer economic indicators may cause a concern on the part of those asset-sensitive institutions: that declining interest rates will impact interest margins.

Depending upon your specific interest-rate risk position, your institution might derive the following benefits from executing a floored, floating-rate advance:

• Balance sheet protection for asset-sensitive balance sheets.
• Assuming that rates decline below the pre-set strike rate, monetization of an “in-the-money” interest-rate floor via an interest rate that is lower than a standard floating advance rate (as opposed to a one-time gain).
• Subject to independent accounting opinions, avoiding the need to mark-to-market an interest-rate floor because it is contained within the advance.
• No up-front, out-of-pocket payments. The cost of the floor is blended into the rate of the advance.
• In a declining rate environment, application of a “two-for-one” rate reduction that is derived from both a declining rate index and monetization of the interest-rate floor.

Look for the introduction of the floored, floating-rate advance to be offered by the Seattle Bank soon. The structure could make your transition to a changing interest-rate environment just a little more tolerable!

Want to learn more? Register today for our upcoming Web seminar: New Funding Strategies and Solutions: Introducing the Floored Advance

John P. Biestman, CFA, is director of business development at the Federal Home Loan Bank of Seattle, and Brett Manning, CFA, is a financial institutions strategist at the Seattle Bank.

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