Federal Home Loan Bank: Seattle

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Federal Home Loan Bank: Seattle

It has now been more than six months since the last change in the Federal Reserve’s target rate for Federal Funds. After raising rates 425 basis points in 17 moves over two years, the Fed has been quiet since. We are all asking ourselves, “What’s next, and how can I profit from (be protected from) those changes?”

The Fed, the economists, the forward yield curve, and the “technical analysts” all agree that, in the short run, we do NOT expect any major changes. The economic data is “mixed” and no clear trend has emerged in either direction. However, history tells us that flat and inverted yield curves are inherently unstable and that they only last, at the longest, about one year. We have already seen more than six months of that one-year period. Therefore, we expect that the curve will change shape within the next six months or so.

The MOST LIKELY scenario is a return to a more “normal” (positively sloped) yield curve, where short-term interest rates are lower than long-term rates. Short-term rates could be forced down by action on the part of the Fed. If the Fed sees the beginnings of a slow-down in the economy, it may decide to initiate such a strategy to ensure a “soft landing.” It does not want to put the economy into a recession.

How many times have we looked back after interest rates made a major move and said to ourselves, “I knew that move was going to happen, why didn’t I …” With perfect 20/20 hindsight, we can determine that we should have borrowed long-term funding in June 2003, when the 10 year Treasury hit the low point of 3.10% yield. We should also have sold all longer-term investments in June 2004 and invested in LIBOR-based, variable rate assets.

If we can see this next move coming, it’s time to ask ourselves, “What strategies would work well in an economic environment where long-term rates remain stable, while short-term rates decline by 100 to 200 basis points?

One answer would be the classic “Lend Long–Borrow Short” strategy. We could originate a 30-year, fixed-rate mortgage loan at about 6.25% in today’s market. If we decided to fund this loan for the short term, we would pay about 5.25% for the funding, leaving us a beginning spread of just 100 basis points (6.25% - 5.25%).

However, if short-term rates were to decline by 100 basis points in the fall of this year, we would be funding that loan at 4.25%, and our spread would widen to 200 basis points. If, by this time next year, the Fed has decided to push short-term rates back to neutral (say, 3.25%?), we would be earning a more “normal” 300-basis-points spread on the loan.

Assuming that rates declined, the loans might begin to prepay. As they do, we would simply reduce the amount of short-term funding at each rollover date of the short-term (30-day) borrowing. That way we would never be “over-borrowed.”

We know that the Federal Reserve might surprise us by raising rates should economic conditions change unexpectedly. This might result in funding costs that exceed the 6.25% rate that we are earning on the loan. The fact that the Fed has already raised rates so dramatically argues against another 100 or 200 basis point increase in rates, but there are no guarantees in life.

Any Other Choice?
If we believe short-term rates are going to fall in the future, is there any way we can take advantage of that today, rather than waiting until it happens? Well, yes, there may be just such a transaction available.

If we believe it is likely that short-term rates will decline, logic suggests that we must also believe that it is unlikely that short-term rates will increase. Therefore, if we are willing to act on that opinion, we can be paid a PREMIUM to write an OPTION as part of a funding contract with the Seattle Bank that will help to dramatically reduce the cost. These options can come in many variations, but let us take a look at one example.

Instead of borrowing short-term (30-day) money from the Seattle Bank, we enter into a longer-term contract (say 10 years), and we grant the Seattle Bank the right to CALL the funding at any time after one year, which they would only do if they can lend it to someone else at a higher rate. How much would we be paid to do this? How much money will this save us?

As I write this, the 10-year Treasury note has a yield of about 4.82%. This is our benchmark rate. If we wanted to take out a “regular” 10-year, fixed-rate Seattle Bank advance, the cost would be about 5.50%. However, if we were to grant the Seattle Bank the right to call after one year, we would only pay 4.375%! (44 basis points below the on-the-run 10 year Treasury note)

Advantages?
The most immediate impact of executing a transaction such as the one above is that your institution will earn a larger spread on the same loan, starting immediately and remaining steady for at least one year.

If short-term rates do not decline until the fall and are only reduced by say 100 basis points, short-term funding will average about 5.00% for the next 12 months. This structured Seattle Bank advance would then offer considerable savings at a time of narrow spreads in our industry. Let’s look at the two choices:

Please keep in mind that this is a very simplified version of a more complex funding strategy. First, the asset is a mortgage loan, which is an amortizing asset, and the advance is not amortizing. If your institution keeps making new mortgage loans each month sufficient to maintain an outstanding balance of at least $10 million, then this would be reasonable. However, if your institution makes only $10 million of loans, as these loans pay down, the excess funding would be available to fund other types of loans. Secondly, if short-term interest rates decline more quickly, or further than our example, the benefits of the advanced funding strategy would not be as pronounced.

What If?
What if interest rates remain unchanged for years? What if interest rates go up instead of down? What if both long-term and short-term interest rates go down? These scenarios need to be examined, especially for the market value, one year from now, of both the asset and the liability.

Unchanged Rates – If both short-term rates and long-term rates stay about where they are, this transaction should last a long time and earn a profitable spread. There would be no reason for the Seattle Bank to exercise its right to call the funding, and the mortgage borrower would have no incentive to refinance.

Rates Rise – If rates rise, the mortgage borrower will be happy with the low interest rate and will not refinance. The Seattle Bank might exercise its option to call the funding, but if that were to happen, your institution would simply replace this advance with another one. The rate on the new advance might be higher and might impinge on the spread. A new “option enhanced” advance could be arranged that might help to reduce the effects of those rising rates.

Declining Rates – If interest rates decline sufficiently, the borrowers will begin to prepay. Then your institution would re-allocate the Seattle Bank advance to the loan department. The loan department has historically had no problem finding a use for long-term funding that costs 4.375%.

Conclusion
This short article is not intended to be an exhaustive study of the various types of advanced funding strategies available and the possible outcomes of such funding strategies under multiple future interest rate environments. It is simply pointing out that if you have a point of view on the probable future direction of interest rates, there are many ways that such a view can be translated into profitable dollars for your financial institution.

Note: This article is not intended to suggest that option-based funding is suitable for every institution. As with any financial strategy, this concept should be reviewed to ensure that it qualifies under your existing ALCO policies. If not previously authorized, management may wish to seek board approval before proceeding.

Roy Hingston is senior vice president and chief balance sheet strategist of Shay Financial Services, Inc. and has been involved in strategic planning, investment analysis and asset/liability consulting with financial institutions at Shay since 1985. Mr. Hingston is the author of "Creating the Perfect Portfolio for Your Financial Institution" written for the Financial Managers Society (F.M.S.), is a frequent speaker at industry functions and regularly authors the "Investment Management" column in Community Banker Magazine.

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