Those Who Stay Cool and Calm... Can Coll$ct! Balance Sheet Management Strategies for Turbulent Times

by Jonathan Hartley

Growing turmoil throughout the credit markets has set off a seemingly endless margin spiral: investors are forced to liquidate assets (frequently including those with “AAA” credit ratings) to meet ever-increasing margin calls, initiated in response to plummeting collateral values. The forced liquidation saturates an already flooded market and further dampen prices, leading to a negative feedback loop of more margin calls.

Forced selling into weakness is a bellwether of a classic financial panic, but, depending upon an institution’s balance sheet, may still offer a great opportunity for carry trade and spread product investors. In fact, many investors are seizing this opportunity to reload their balance sheets with very attractive NIM packages by leveraging low-interest funding to purchase high-quality mortgage and agency securities, which continue to suffer technical pricing dislocation due to the incredible shrinking balance sheet effect from “The Great Unwind” of over-leveraged credit markets.

Understanding the Risks: Taking Advantage of Wide Investment Spreads and Rate Volatility
To an extreme—and with more than a modicum of risk—one way to take advantage of the market volatility is to use putable advances to purchase high-quality mortgages or agency securities to lock in arbitrage opportunities (which, last month, were as attractive as nearly 300 basis points). Since such an institution would be short convexity on both sides of the trade, this could carry a significant amount of risk, which some investors have hedged by purchasing out-of-the-money caps.

Interest rate caps can provide insurance against margin compression from rising interest rates that would trigger a duration extension on the asset side and a truncation of liabilities, which would force investors to refund at prevailing (higher) interest rates. Interest rate caps can be purchased in the open market, or via executing a variable-rate Seattle Bank advance that includes an interest rate cap as a contractual feature. Conversely, an investor could take advantage of historically wide agency and GSE mortgage spreads by simply funding these investments with bullet advances.

Figure 1. Recent Historical Spread Relationship between FNMA 5.5% and Interpolated 7.5-Year U.S. Treasuries

Buying Prepayment Insurance in a Declining Rate Environment
Another idea that is starting to garner more attention is growing the balance sheet to expand NIM, by simultaneously buying prepayment insurance with callable advances. Callable advances are the opposite of putables. In the case of the Seattle Bank’s callable advances, members purchase the right to prepay the advance without penalty on a pre-determined schedule. The future call date may be either a one-time event (i.e., a European option), or may occur periodically (i.e., a Bermudan option) after the initial lockout. Similar to the Seattle Bank's putable advances, the option is conveniently blended into the advance rate as opposed to purchased separately with an upfront premium. In this way, the buyer avoids the accounting complexity of holding a standalone derivative on the balance sheet. This prepayment flexibility, if used properly, can act as an effective hedge against interest rate volatility. Because the mortgage basis is currently cheap by historical standards, it is now more affordable then ever, leaving ample margin in the strategy.

In addition to serving as a cost-effective funding vehicle and as an effective hedge against the negative convexity intrinsic to mortgage-backed securities and callable agencies, callable advances can also be used to more effectively compete with and repel incursions by large competitors into local lending markets. How many times have you seen competitors eschewing the prepayment penalty feature that we all know would be desirable in fixed-rate loan documentation?! By offering callable funding, the Seattle Bank gives its members more alternatives, helping them avoid the dreaded Hobson’s Choice between exposing one’s balance sheet to prepayment risk just to keep a deal, or losing customers to larger competitors. That is especially valuable in today’s tight lending markets in which “A” credits are becoming increasingly rare.
Callable advance pricing, in the form of the “Prepayable Loan Index” is generally posted across standard structures twice weekly (Tuesdays and Thursdays) on the Rates page of the Seattle Bank’s Web site and is always available upon request.

Figure 2. Recent Representative Seattle Bank Structured Advance Indications

Seattle Bank Advance Product

Indicative Rate

5-year US Treasury

2.95%

5-year non-put 1-year (Bermudan)

2.80%

5-year non-put 1-year (European)

2.95%

5-year Bullet

4.34%

5-year non-call 1-year (European)

4.70%

5-year non-call 1-year (Bermudan)

4.60%


Any flavor of structured advance product—whether putable, callable, floating-to-fixed convertible, capped, or floored—makes perfect sense given the efficient execution offered by the Seattle Bank’s customer funding desk and the economic and operational utility of using the blanket lien and whole loan collateral rather than your highest quality marketable securities. In the end it just makes sense to put your membership equity to work by partnering with your local cooperative and reaping the long-term rewards of a strategic partnership, as opposed to getting your funding from the competition!