Extracting Monetary Value from the Right Hand Side of the Balance Sheet: Introducing the Symmetrical Advance

You’ve been in this situation before. You’ve borrowed from the Seattle Bank at a fixed rate. During that time, interest rates have increased, and that’s great. Your cost of funding is below market. But, while it’s nice to be able to gloat and invest in assets that are higher in yield, there may be times when you would like to monetize that “in-the-money” position of your borrowing. Wouldn’t it be useful to have the option to prepay an advance and reap the monetary rewards of having a funding source that has increased in value?

With the introduction of the Symmetrical Prepayment Advance, you can! The Symmetrical Prepayment Advance allows Seattle Bank members to execute a variety of advance structures, and contractually receive the ability to monetize the value of an underlying interest-rate swap. For the sake of example, we’ll be talking about adding a symmetrical prepayment feature to a fixed-rate advance. On request the symmetrical feature may also be applied to adjustable-rate, capped, floored, putable, and floating-to-fixed convertible advances.

The Mechanics of a Symmetrical Prepayment Advance
The key difference between a standard advance and a Symmetrical Prepayment Advance is the addition of a contractual feature that allows the advance to be repaid—and the borrower to realize a gain—if interest rates and/or volatility rise to levels greater than those that existed when the advance was drawn. Put simply, in the event interest rates and/or volatility rises, the Symmetrical Prepayment Advance gains value, and when rates decline, they lose value. It’s the opposite effect of the behavior of a fixed-income security investment, which tends to lose value when rates increase, and gain value when rates decline.

The value of the Symmetrical Prepayment Advance is also determined by the remaining term to maturity: the longer the time-to-maturity, the greater the value of the option to prepay, and the greater the probability of monetizing the advance.

In return for the right to monetize a gain in a prepaid advance, there is a cost in the form of a slightly higher initial advance rate or rate over the life of the advance, compared with advances that lack this feature. In effect, this premium gives the borrower the right to treat a non-liquid liability (the advance) as a tradable source of funding.

The Symmetrical Prepayment Advance will be offered on a frequent basis, and specific offerings will be posted on the Seattle Bank’s Rates page. Initial offerings will be in the form of fixed-rate loans, ranging in maturities of one year to 10 years. The minimum order for each participating member will be $2 million; the minimum cumulative order for each offering will be $5 million.. Symmetrical Prepayment Advances may be partially prepaid in increments of $2 million or more. On a customized order basis, the symmetrical prepayment feature may be structurally added to formats other than standard fixed-rate advances, including those with adjustable rates and contractual option features.

The maximum amount of monetized gain that a member will be permitted to accrue is 9.99% of the notional principal value of the advance.

A Symmetrical Prepayment Advance Example
Consider the case of a Symmetrical Prepayment Advance, using an underlying five-year, fixed-rate bullet advance. Assume that the seasoned advance with the symmetrical prepayment feature is priced at 5.15%, or, in this example, two basis points above the prevailing standard fixed-rate advance with the same maturity.

Remember that the Seattle Bank typically funds an advance via the interest-rate swap market. That is, in order to fund the five-year advance, the Seattle Bank would have raised funds in the LIBOR-based market and simultaneously converted that borrowing into a five-year obligation through an interest-rate swap. As such, that interest-rate swap would likely be worth more in a rising rate environment.

For a standard swapped advance, where the Seattle Bank matches funds using a LIBOR funding base and then swaps the advance into a fixed rate, there are two key factors that determine the prepayment fee that is typically incurred:

  • The cost to the Seattle Bank of terminating the advance prematurely. This cost is determined by a yield maintenance agreement, which includes a provision for any foregone interest margin.
  • The cost of unwinding the underlying interest-rate swap. This cost is determined by the swap’s market value. As a result, when a member has elected to prepay a swapped advance, it has been typically subject to the sum of: (1) an advance termination fee equal to the present value of foregone interest benefit and (2) a fee relating to the unwinding of the underlying swap.

From the perspective of the Seattle Bank, here is what happens to the value of the advance and the underlying swap when rates change:

Figure 1. Monetary Value of an Advance from the Perspective of the Seattle Bank

Monetary Value to the Seattle Bank/Interest Rate Direction Interest Rates Increase Interest Rates Decreases
Advance Value Decreases Value Increases
Underlying Interest Rate Swap Value Increases Value Decreases

If a member is engaged in a fixed-rate advance during a time of rising interest rates, from the perspective of Seattle Bank, the value of the advance decreases. Why? The Seattle Bank is forced to deploy its funding to an asset that would yield a lower return than would be offered by prevailing higher rates. The Seattle Bank would not mind if the advance were paid down, as the borrowing member has the ability to fund at rates that are lower than the prevailing market rates.

Conversely, in the event rates decline, from the Seattle Bank’s perspective, the advance value is “in-the-money” because the bank is obtaining an above-market yield. As a result, a “yield maintenance” prepayment fee is typically assessed, in the event the borrower desires to terminate the advance before maturity.

Figure 2. Monetary Value of an Advance From the Perspective of the Member

Monetary Value to the Seattle Bank/Interest Rate Direction Interest Rates Increase Interest Rates Decreases
Advance Value Increases Value Decreases
Underlying Interest Rate Swap Value Increases Value Decreases

Under a declining interest-rate scenario, a member institution would be faced with a higher-than-market rate liability that would not hold any degree of intrinsic value. On the other hand, should interest rates increase, the member institution would hold theoretical value in having the right to obtain funding at below-market rates. The question that remains is “how much value?”

Back to our example of a 5.15%, fixed-rate Symmetrical Prepayment Advance, the respective example valuations for this seasoned borrowing are presented in Figure 3.

Figure 3. Example Valuations (from a Member’s Perspective) of a Seasoned Five-Year Fixed-Rate Advance Under Varying Interest Rate Shocks

  Notional Principal Amount -300 bps -200 bps -100 bps Unchanged +100 bps +200 bps +300 bps
Advance Value $5 million ($255,640) ($168,548) ($83,352) ($26,107) $81,556 $161,362 $239,466
Interest Rate Swap Value $5 million ($254,290) ($167,655) ($82,909) $62,220 $81,120 $160,498 $238,180
Value to Member *   ($509,930) ($336,204) ($166,261) $36,113 $81,120 $160,498 $238,180

* Member value attribution is capped at either: (1) 9.99% of the notional amount of the advance, or approximately $500,000, or (2) the value of the interest-rate swap (should the advance value exceed the swap value).

In this example, if interest rates increase by 100 basis points and the member elects to prepay the advance, they would be able to monetize the positive value of the underlying interest-rate swap in the amount of $81,120. If rates remain the same, the member could still monetize value because even though the yield maintenance agreement for the advance carries a negative value, the market value of the underlying interest-rate swap is positive. The positive value of the interest-rate swap could have derived from such sources as favorable volatility characteristics since original execution of the advance. Note that if rates decline, the borrowing member would be assessed both a fee to unwind the interest-rate swap, as well as a fee to terminate the advance.

The Symmetrical Prepayment Advance as a Source of Balance Sheet Management and Liquidity
The Symmetrical Prepayment Advance offers an effective way to hedge a portfolio of fixed-rate investments and/or loans. During a time of increasing rates, it’s typical for fixed-income assets to sustain price depreciation. Having the ability to terminate an advance and monetize the positive intrinsic value of an underlying interest-rate swap could offset the decline in portfolio value.

Furthermore, the Symmetrical Prepayment Advance allows a borrower to liquefy a funding source that would have otherwise been illiquid. Moreover, the symmetrical prepayment characteristics can enable a borrower to simultaneously terminate funding that may not be needed and potentially cash in on the value of a liability. Effectively, this enables a financial institution to reposition its balance sheet using the Symmetrical Prepayment Advance, in much the same manner as they might use a liquid investment.

Think about the unique interest rate risk and liquidity profile of your institution, and consider if any of the benefits offered by the Symmetrical Prepayment Advance are right for you:

  • Ability to liquefy a funding portfolio and monetize a one-time gain.
  • Ability to reposition both sides of the balance sheet, with minimal cost.
  • Flexibility to hedge mortgage portfolios and other fixed-rate assets.
  • Ability to maintain a source of funding that can be prepaid if it is not longer required and to obtain “cash-out” value under certain market conditions.
  • Balance sheet protection for liability-sensitive institutions.

Look for the first of our Symmetrical Prepayment Advance offerings in the coming weeks. Now there’s a way to extract value from the right hand side of the balance sheet.

John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.

Brett Manning, CFA, is Manager of Financial Strategy at the Federal Home Loan Bank of Seattle.