Back to the Basics 2017 Edition

Transcription

1 Back to the Basics 2017 Edition Brett L.A. Manning, CFA, Vice President/Director Member Strategies Brandon Casey, Business Development Analyst The Federal Home Loan Bank of Des Moines (FHLB Des Moines) offers a wide range of structured advances that can be customized to meet your individual needs. Many members find that our floating rate and amortizing advances are great tools for managing and mitigating the risks found in every loan portfolio: basis risk, interest rate risk, and cash-flow risk. In this paper, we ll take a look at the indexed floating-rate and amortizing advance structures in detail and offer some asset strategies to consider funding. Let s first discuss a few risks we hope to hedge. Basis Risk: Apples to Apples, Not Apples to Oranges Astute finance officers ensure that the basis risk of their loan portfolio is both known and accommodated in their pricing decisions. Basis risk speaks to the baseline, or basis, index that underlies both the asset and liability. It also refers to both the index being utilized and the repricing characteristics of that index. Having no basis risk implies that the underlying indice and/or repricing frequency are the same or close to it. Common loan pricing benchmarks include the LIBOR indices, the Prime Rate and FHLB advance rates. Funding assets with liabilities that have the same basis ensures that any variance between the asset yield and liability cost, usually referred to as margin or spread, is known at inception and can be mitigated through pricing controls. Originating assets using one index and securing funding with another index exposes the balance sheet to basis risk. Basis risk may lead to unwanted and unforeseen net interest margin gains and losses. If your goal is to lock in a known spread at time of origination, make sure you are comparing apples to apples and not apples to oranges. Understanding Repricing Risk In addition to understanding the underlying index basis of a loan portfolio, it s also imperative to consider the repricing characteristics. All else being equal, if eliminating basis risk is part of your modus operandi, you wouldn t originate loans that reprice every day or every month with wholesale funding that reprices every three months. Understanding Option Risk Option risk, or cap and floor risk, must also be evaluated. Cap risk is the risk that your asset yields will cap-out or stop increasing as rates rise, while the funding cost allocated to the asset continues to climb, resulting in net interest margin compression. Floor risk is just the opposite. If rates fall precipitously and the interest rate floor on your funding is higher than the floor on your asset, loan portfolios may quickly find themselves underwater.

2 Interest Rate Risk and Cash-Flow Risk: Know thyself and price accordingly. Interest rate risk represents the changing value of an interest-earning asset due to the variability of interest rates. It can also be described as the risk of originating assets for terms that don t match the expected life of the deposits or maturity term of wholesale funding used to support the assets; lending long, borrowing short, or vice-versa. As finance officers, you take some degree of interest rate risk every day. As with basis risk, knowing the risk you re taking is more than half the battle pricing and mitigating this risk is a good portion of the remainder. Interest rate risk, assuming a positively sloped yield/funding curve, is a key contributor to spread income. From a macro perspective, without interest rate risk, financial institution balance sheets are interest rate risk-free and earnings neutral, suggesting that money is being left on the table, regardless of interest rate variability. Conversely, assuming too much interest rate risk may create undesired income and market-value-of-equity consequences. Meeting market and shareholder expectations and keeping a watchful eye on risk management is a daily struggle, but profitably funding a loan portfolio and doing so prudently are not mutually exclusive objectives. From a funding and interest rate risk perspective, FHLB Des Moines can help you manage interest rate variability and cash flow fluctuations through our floating rate and amortizing advance solutions. Funding Solutions: Floating-Rate Advances FHLB Des Moines offers a number of floating-rate solutions that can help you fund your loan portfolio, including floating-rate funding tied to one-, three-, and six-month LIBOR, as well as funding tied to the Prime Rate. Additionally, we offer a Member Option LIBOR Advance (MOLA) that allows you to prepay your advance at the reset date with no prepayment fee. Advances offer you the ability to structure repricing terms to fit your funding needs and with same-day availability, are readily accessible. Advance details are summarized in Figure 1 below: Figure 1. Des Moines Bank Floating-Rate Advance Details Floating Rate Advance Index Natural Hedge Vehicle Prime Floater Prime Consumer and Commercial Loans LIBOR Floater LIBOR Consumer and Commercial Loans MOLA LIBOR Consumer and Commercial Loans Primary Benefit Reduce basis and re-pricing risk Reduce basis and re-pricing risk, exposure to LIBOR funding markets Reduce basis and re-pricing risk, exposure to LIBOR funding markets, and prepayment risk By way of an example, let s assume we have a variety of floating rate advances to choose from per the pricing grid in Figure 2.

3 Asset Yield & Liability Cost Figure 2. Des Moines Bank Floating Rate Advance Indications Term 1M LIBOR 3M LIBOR 6M LIBOR Prime 1 year + 19 bps - 02 bps + 23 bps bps 3 year + 35 bps + 17 bps + 37 bps - 5 year + 53 bps + 37 bps + 55 bps - Note: MOLA advances have a 2 basis point premium in addition to LIBOR spread in the above table. Advance indications as of 1/17/2017. Furthermore, let s assume we have a loan portfolio that consists of two commercial loans and a consumer loan, each representing 33% of the portfolio and that Commercial Loan One has a threeyear term, Commercial Loan Two has a five-year term, and Consumer Loan has a one-year term. The pricing on this theoretical loan portfolio is as follows: Commercial Loan One (CMCL#1): 1M LIBOR +225bps, 3-year final maturity Commercial Loan Two (CMCL#2): 3M LIBOR +250bps, 5-year final maturity Consumer Loan (CONS): Prime +150bps, 1-year final maturity As illustrated in Figures 3a., 3b., and 3c., excluding fees, interest rate adjustments, or prepayment events, the initial spread and projected payoffs on this portfolio demonstrate the elimination of both basis risk and repricing risk, as the spread is fixed at inception. Figure 3a. Commercial Loan One Profile 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% Advance Rate Commericial Loan #1 1.00% 0.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 1-Month LIBOR

4 Asset Yield & Liability Cost Asset Yield & Liability Cost Figure 3b. Commercial Loan Two Profile 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% Advance Rate Commericial Loan #2 2.00% 1.00% 0.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 3-Month LIBOR Figure 3c. Consumer Loan Profile 12.00% 10.00% 8.00% 6.00% 4.00% Advance Rate Consumer Loan 2.00% 0.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% Prime

5 As a complement to the graphs, Figure 4 shows the same relationship: the funding eliminates the basis and repricing risk, and the spread is fixed given variability in interest rates. Figure 4. Summary Loan Payoff 1M LIBOR 3M LIBOR PRIME CMCL #1 SPREAD CMCL #2 SPREAD CONS SPREAD 0.75% 1.00% 3.75% 1.90% 2.13% 4.25% 1.75% 2.00% 4.75% 1.90% 2.13% 4.25% 2.75% 3.00% 5.75% 1.90% 2.13% 4.25% 3.75% 4.00% 6.75% 1.90% 2.13% 4.25% 4.75% 5.00% 7.75% 1.90% 2.13% 4.25% Bank Solutions: Straight-Line and Customized Amortizing Advances Now let s work through a couple of fixed rate asset examples, using amortizing advances. Have you ever wondered how you could hedge and fund specific loans that have odd payment schedules? Better yet, what would the indicative pricing be on such a structure? Let s take a look at our amortizing advance solutions to answer these questions. We offer both straight-line and customized amortizing advance solutions. Straight-line amortizing advances are quoted daily on our Rates Page, and customized advance quotes are readily available by calling the Money Desk. Amortizing advance structures can be used to hedge both interest rate risk and cash-flow risk, patterning payments to best fit your funding needs. Additionally, amortizing structures can be instrumental in retaining your best customers by catering loan products that match their project requirements. Better yet, our amortizing advances can be used to create new loan products for your most complex borrowers. Unlike a standard mortgage amortization schedule where the principal payment amount grows each month as the payment stays constant, straight-line amortizing advances pay the same amount of principal each month for the life of the advance, thus resulting in a sliding payment amount, due to the lower interest portion paid each month as the balance amortizes downward. Let s work through two examples of how the straight-line and customized amortizing advance work.

6 Principal Outstanding (in thousands) Payment Amount (in thousands) Figure 5. Comparative Example of Straight-Line and Customized Amortizing Advances 15-Year Straight-Line 30/15 Customized Principal 1,000, Principal 1,000, Rate 2.89% Rate 3.22% Principal Payment 5, Principal Payment 2, Term 180 months Term 180 months Amortization 180 months Amortization 360 months Figure 6 shows the outstanding principal and the sliding payment schedule for a straight-line, 15- year amortizing advance. The principal payment each month results in a zero balance at the end of the 15-year advance term. Figure 6. Straight-Line Amortizing Schedule Advance $1, $1, Outstanding Principal Total Payment 9 $ $ $ $ $

7 Principal Outstanding (in thousands) Payment Amount (in thousands) Figure 7 shows the outstanding principal and payment schedule for a customized amortizing advance, with a 30-year amortization schedule and a 15-year final maturity. The balloon payment at the end of the 15-year term is approximately $500,000. Figure 7. Customized Amortizing Schedule Advance $1, $1, Outstanding Principal Total Payment 6 5 $ $ $ $ $ Payments 0 These are just two examples of the many different type of amortizing advances FHLB Des Moines offers. You have the ability to pick the term and amortization schedule ranging from two to thirty years, straight-line or mortgage style principal payments, delayed principal payments, or a variety of customized payment schedules. Whether you are trying to match cash flows, minimize interest paid, or whatever your directive may be, FHLB Des Moines has an amortizing advance that can fit your needs. FHLB Des Moines can help you avoid taking on unnecessary risk. The bank offers a variety of products that can mitigate interest rate and cash flow risks tied to your unique assets. Don t hesitate to call your Relationship Manager, the Strategies Team or the Money Desk to discuss your floating rate and amortizing advance needs.