It's Still Not Too Late for a Flu Shot, But Don't Wait Too Long!

In most years, flu season doesn't peak until February, and higher-than-usual flu rates may even persist well into May. It is always a good strategy to get your vaccination as early as possible, but what’s really important is getting your shot before flu season hits and your window of opportunity closes.

The same idea can apply to your balance sheet. When the credit markets seized-up and implied volatility spiked in late summer, you might have instantly regretted that you had not purchased interest rate protection when it was a relatively cheap commodity. Well, don’t berate yourself too harshly because the good news is that, although volatility has risen off its historical lows of the last few years, it has stabilized (and even receded) as of late, and there are still ample opportunities to give your balance sheet a “flu shot” to protect against excessive interest rate risk as the capital markets shift into a new season.

Throughout the last few years, large banks have transformed their role as the traditional storekeepers of risk to packagers and deliverers of it, round-tripping credit risk back to Wall Street in the form of credit default swaps (CDS) and shifting risky assets off balance sheet through the proliferation of new securitization innovations such as collateralized debt and loan obligations (CDOs and CLOs, respectively). What happened this summer was a “perfect storm” caused by the collision of: (1) a bull housing market, (2) the proliferation of easy credit and lax mortgage underwriting standards, (3) investors’ increasing tolerance for risk, and (4) the financial engineering that allowed for the wide dispersion of risk to suit a variety of tastes. It was a delicate game of economic “hot potato;” banks were willing to take risk, but only for as long as they could quickly and easily find investors who were willing to be the ultimate owners of it. When investor demand abruptly subsided last summer, banks instantly shut off the cash spigot to borrowers both big and small, and the rest became history.

To put the credit market meltdown into a useful visual context, we can examine the T-bill – Eurodollar spread, known simply as the “TED” spread, which is classically defined as the spread between three-month T-bill futures and three-month Eurodollar futures. The TED spread is used as a barometer of credit risk since T-bills are considered risk-free while the LIBOR market reflects the perceived credit risk of corporate borrowers. A widening TED spread usually foretells a downturn across the markets as lenders tighten credit, withdraw liquidity, and flock to risk-free assets.

Figure 1: TED Spread

What was initially a credit problem (subprime) triggered a liquidity problem (symbolized by LIBOR spiking), which caused equities to tank, Treasuries to rally, swap spreads to widen, commodity prices to surge, and the dollar to plummet. After the Fed shocked the market with a 50 basis point easing on September 18 and shifted the primary risk assessment away from inflation to growth, things have since calmed, stocks recovered, Treasuries remain in somewhat of a directionless and range-bound drift, implied volatility has fallen, and TED spreads are beginning to retighten.

As an aggregate measure of implied volatility, we like to look at the Lehman Brothers Implied Swaption Volatility Index (LBPX), which spiked in late summer, but has been trending down lately.

Figure 2: LBPX Index

The downward trajectory of both the TED spread and the LBPX suggests we are experiencing at least a temporary reprieve from escalating volatility as the markets stabilize and investors take a breather to pre-price risk and adjust to the new reality. That makes now an ideal entry point for anyone who might have missed the opportunity to pick up protection before the nightmarish “summer of subprime.”

We at the Seattle Bank have long advocated the purchase of options as insurance against interest rate volatility, and offer a variety of choices, ranging from our Capped Floater Advance, which works great with liability-sensitive balance sheets, to our Floored Floater Advance, which complements asset-sensitive institutions, to our Returnable “Prepayable” Advance, which is a great way to hedge against the prepayment risk of adjustable rate mortgages held in portfolio. Since you are buying the option (or “going long” in market parlance) and the contractual feature is blended into the advance rate rather than purchased up front for a premium, the interest rate on the advance is slightly higher than on prevailing bullet or non-structured advance products. But as bankers, we have all learned to differentiate between value and price, and the lowest price almost never has the most value in the long run.

Additionally, a great way to defray the cost of the option is to earmark your assets for the Seattle Bank’s Community Investment Program (CIP) or Economic Development Fund (EDF). To the extent you are able to identify eligible assets and can match them against Seattle Bank advances that are three years or more in maturity, you can save 20 basis points on a Capped Floater, Floored Floater, or Returnable Advance!

There aren’t a lot of second chances in life or business, so consider seizing this market reprieve as a chance to double back through your balance sheet to search for any pockets of risk that could be neutralized through the purchase of a long option, structured advance from the Seattle Bank—as an investment in your institution’s future.

Negative earnings news from large banks and more concerns over structured investment vehicles (SIVs) permeated back into the market this week, driving implied volatilities higher and raising the likelihood of another Fed easing this month. If you want to capture the recent drop in volatility, you’ll want to get your flu shot fast.

By Jonathan Hartley, Institutional Sales and Trading Manager at the Federal Home Loan Bank of Seattle.