Federal Home Loan Bank of Des Moines A Case for Diversifying the Right-Hand Side of the Balance Sheet 1
Agenda 1. YIELD CURVE FUNDING STRATEGIES 2. BUILDING A CASE FOR FUNDING DIVERSIFICATION 3. BLENDED FUNDING AND EXTENSION STRATEGIES 2
A CASE FOR DIVERSIFYING THE RIGHT-HAND SIDE OF THE BALANCE SHEET 3
YIELD CURVE FUNDING STRATEGIES 4
YIELD CURVE FUNDING STRATEGIES Fixed Rate Advance Types 5
YIELD CURVE FUNDING STRATEGIES Adjustable Rate Advance Types 6
YIELD CURVE FUNDING STRATEGIES Representative Fixed-Rate Advance Graph 7
YIELD CURVE FUNDING STRATEGIES Yield Curve Strategies History of Inversion 8
YIELD CURVE FUNDING STRATEGIES Normal or Steepening Confident Investors, Frequently Precedes an Economic Upturn Rates Rise Due to Increased Inflationary Expectations Investors Anticipate a tighter FOMC Monetary Policy Stance Longer-Term Rates Increase as Investors Demand Greater Yield to Extend Maturities Long-Term Fixed-Rate Advances Extend Funding Durations Consider Option and Structured Advances Capped Libor Forward Start Symmetrical Prepayment Convertibles with Longer Maturities and Longer Lockout Periods 9
YIELD CURVE FUNDING STRATEGIES Flat Often Signals an Economic Slowdown or During a Time of Mixed Economic Messages FOMC Typically Raises Rates to Restrain Growing Economy Suboptimal Lending Activity: Less Return for the Risks of Lending out Funds Longer- Term More Likely to Deploy Funds to Investments Short-Term Advances Generally Outperform and Allow Members to Lower Borrowing Costs Libor and Prime Indexed Advances Often Outperform Consider MOVR Structures 10
YIELD CURVE FUNDING STRATEGIES Inverted Frequent Harbinger of a Recession Historically, Inversion Starts 12-18 Months Before a Recession Declining Rates Due to Lower Inflationary and Economic Growth Expectations Markets Expect FOMC to Begin to Lower Rates and Stimulate Economy Short-Term Advances Generally Outperform and Allow Members to Lower Borrowing Costs Libor and Prime Indexed Advances Often Outperform. Choose Shortest Repricing Interval Consider Convertibles with Shorter Lock-Outs and Medium-Term Final Maturities 11
Size Discount worth 4bps to 8bps YIELD CURVE FUNDING STRATEGIES All-in Cost Reduces the Rate on Advances $15mm to $25mm, 4bps discount >$25mm, another 4bps discount, totaling 8bps from posted rates Dividend worth approximatel y 12bps annually 12
BUILDING A CASE FOR FUNDING DIVERSIFICATION 13
BUILDING A CASE FOR FUNDING DIVERSIFICATION Multiple Funding Purposes of Wholesale Funding Interest Rate Risk Management Liquidity Management Just-in-time funding Re-allocate lower yielding assets Control asset/liability mismatches Balance sheet (macro) funding Transaction (match) funding Maintain Profitability and Safety Capital Management Increase capital efficiency Allow capital to determine assets size, not deposits Increase net income/return to ownership (dividends) 14
BUILDING A CASE FOR FUNDING DIVERSIFICATION Wholesale Funding Relationship with Deposits Deposits are a Key Component of Funding Strategy Deposits represent the primary source of low-cost funding and franchise value. Deposits are inherently duration-uncertain. Can deposits be run-off and transferred into durationcertain, long-term funding in the form of advances? Advances are Complementary to Deposit Funding Advances add duration certainty to the right-hand side of the balance sheet. Diversification of funding sources can help reduce overall volatility of balance sheet. Advances are capital-efficient, customizable, simple and backed by a strong counterparty. 15
BUILDING A CASE FOR FUNDING DIVERSIFICATION Embrace Uncertainty Uncertainty is an uncomfortable position. But certainty is an absurd one. - Voltaire 16
BUILDING A CASE FOR FUNDING DIVERSIFICATION Typical Funding Classifications Correct Approach? (Objective Bases for Diversification) Incorrect Approach? (Subjective Bases for Diversification) Duration Defined vs. Duration Uncertain Core vs. Non-Core Secured vs. Unsecured Funding Source: FHLB, Correspondents, Broker Retail vs. Wholesale Volatile vs. Non-Volatile 17
BUILDING A CASE FOR FUNDING DIVERSIFICATION Managing Risk: The FDIC on IRR Traditionally stable deposit categories may have higher rate sensitivity than historical behavior may indicate In general, mitigation strategies could include shifting the asset and funding mix; diversifying income sources; ensuring capital is adequate to absorb losses should depreciated securities have to be sold. - FDIC Supervisory Insights, 12/13 The agencies believe that a diversification of funding sources strengthens an institution s ability to withstand idiosyncratic and market-wide liquidity shocks The most common way to control IRR is through the balance sheet mix of assets and liabilities Financial institutions have a number of approaches that can be used to mitigate risks associated with outsized exposure to interest rate risk. These approaches can include rebalancing asset and liability durations - FIL Managing Sensitivity to Market Risk in a Challenging Interest Rate Environment, 10/13 18
BUILDING A CASE FOR FUNDING DIVERSIFICATION Managing Risk: The FDIC on IRR The most common risk mitigation strategy is slowly repositioning the balance sheet over time to more consistently align an institution s overall re-pricing, maturity and duration profile. For example, an institution exposed to rising interest rates may need to shorten the duration of assets or extend the duration of liabilities. Generally, the rapid sale of illiquid, long-duration securities could result in significant losses and may not be an optimal method to reduce risk. The FDIC strongly supports banks efforts to control outsized exposure to interest rate volatility and will not criticize an institution for temporary adverse consequences to earnings resulting from a prudent rebalancing strategy. - FDIC Supervisory Insights, 12/14 19
BUILDING A CASE FOR FUNDING DIVERSIFICATION Asset Diversification Widely Accepted. Why not Liability? Fact: Interest rate outcomes are uncertain. The best means of mitigating interest rate risk is via diversification. Diversification has been a proven means of addressing return variability traditionally, more so on the asset side of the balance sheet, than on the liabilities side. 7% 5% 4% First Mortgage Auto Loans Industry/ Geography Market Cap/Style/ Sector Manager 12% 30% 42% Other Real Estate Unsecured Credit Card Other (non-re MBL, etc.) Other Unsecured Maturity Asset Allocation Stock/Bon d Credit Quality 20
BUILDING A CASE FOR ASSET DIVERSIFICATION Liability Diversification: Eggs are Frequently in One Basket 21
BUILDING A CASE FOR FUNDING DIVERSIFICATION Blending Laddered Term Funding with Deposits Blended Funding Strategies Laddered Term Advances 22
BUILDING A CASE FOR FUNDING DIVERSIFICATION Term Funding Restructuring Considerations Members must determine if the restructuring would be accounted for as a debt modification or extinguishment which includes, but is not limited to: Determining if there is a substantial difference between the two instruments and Comparing the present value of the two instruments by using the coupon rate on the old advance as the discount rate Extinguishment - present values differ by 10 percent or more, then prepayment fee booked as a one time expense Modification - present values differ by less than 10 percent, then prepayment fee accreted over the term of the new advance Note: FHLB Des Moines does not offer nor provide any accounting guidance with regard to advance restructuring, the appropriate accounting treatment or possible accounting implications. Members should consult with their own internal and/or external accountants and/or auditors prior to entering into an advance restructuring transaction. 23
BUILDING A CASE FOR FUNDING DIVERSIFICATION Term Funding Restructuring Strategies Advance Restructuring Program Since the introduction of the Advance Restructuring Program, a number of members, with the approval and certification of their external auditing firms, have used the program and seen the following benefits: Extended liability base duration without increasing the overall size of their balance sheet Decreased cost on advances Added duration to funding mix to mitigate interest rate risk on longer-term loans Example: In this transaction, a member was able to restructure $77.5 million in advances. Original Advance Amount Original Interest Rate Maturity Date of Original Advance Years to Maturity $15,000,000 2.32% 9/15/2015 1.88 $32,500,000 5.01% 1/27/2016 2.24 $15,000,000 3.03% 6/9/2015 1.61 $15,000,000 2.98% 9/11/2014 0.87 $77,500,000 3.71% 1.78 Restructured Advances New (Blended) Interest Rate Maturity Date of New (Restructured) Advance Years to Maturity $15,000,000 2.27% 2/8/2018 4.28 $16,250,000 3.80% 2/7/2020 6.27 $16,250,000 3.86% 2/8/2021 7.28 $15,000,000 2.65% 2/8/2019 5.28 $15,000,000 2.04% 2/8/2017 3.28 $77,500,000 2.95% 5.32 Result: This member was able to accomplish their well-defined goals by restructuring several existing advances. The member lowered their cost on advances by 76 basis points and extended their liability maturities by over 3.5 years. As the chart shows, this decrease in the cost on advances should result in a yearly interest savings of $589,000. Ultimately, this restructuring strategy allowed the member to hold some of their 15-year mortgage production on balance sheet without increasing advance balances. 24
BLENDED FUNDING AND EXTENSION STRATEGIES 25
BLENDING AND EXTENSION STRATEGIES The Blended Funding Approach Concept: Use term funding to provide structural support with bullet or amortizing fixed-rate loans Partially matched cash flows Prepayment protection Supplement term funding with non-maturity deposits to plug funding gap taking advantage of: Low cost Pricing betas affected by segmentation Decay rates Inherent extension risk hedge 26
BLENDED FUNDING AND EXTENSION STRATEGIES Static and Dynamic Modeling Use fixed-rate funding to provide structural support with bullet or amortizing fixed-rate loans: Partially matched cash flows Prepayment protection Complement fixed-rate funding with non-maturity deposits to plug funding gap, taking advantage of: Low cost Pricing betas affected by segmentation Decay rates Inherent extension-risk hedge Assess relative attractiveness of each strategy with and without the blended funding approach: Assumption is that strategy with highest Net Interest Income is superior. 27
BLENDED FUNDING AND EXTENSION STRATEGIES Risks of Failing to Diversify Funding The potential impacts of rising rates are numerous and are potentially different for every institution. Higher Core Funding Costs The Dilemma: Sacrifice margin for hedging against unacceptable financial outcomes. Rising Rates Earnings Uncertainty Slower Prepayment Activity We will illustrate how a blended funding approach can help manage the risks of a rising rate scenario on a portfolio of loans. Reduced Market Value of Fixed-Rate Instruments 28
BLENDED FUNDING AND EXTENSION STRATEGIES Example: Setting a Blended, Laddered Advance Strategy - CRE $5.00m $3.30m $1.15m Deposits $1.15m 5-Year Advance $1.15m 6-Year Advance Strategy: Non-amortizing bullet advance designed to partially match asset cash flows. No attempt to match fund the tail due to the small amount of cash flows during the last four years. Deposits 0 1 2 3 4 5 6 7 8 9 10 29
BLENDED FUNDING AND EXTENSION STRATEGIES Example: Setting a Blended, Laddered Advance Strategy $10m Strategy: Ten-year/15 amortizing advance to match asset cash flows. No attempt to match fund the tail due to the small amount of cash flow during the last five years of the loan. $5m Deposits $5.0m 10/15-Year Amortizing Advance 0 1 2 3 4 5 6 7 8 9 10 15 30
BLENDED FUNDING AND EXTENSION STRATEGIES What is Your Funding Proportionality? 120 Deposit Composition - U.S. Banks $500m - $1b 100 80 60 40 20 0 12/31/2013 12/31/2014 12/31/2015 12/31/2016 Transaction Account MMDA & Savings Retail Time Jumbo Time Other 31
BLENDED FUNDING AND EXTENSION STRATEGIES What is Your Funding Proportionality? 4 Deposit Category Yields U.S. Banks $500 - $ 1 billion 3.5 3 2.5 2 1.5 1 0.5 0 12/31/2009 12/31/2010 12/31/2011 12/31/2012 12/31/2013 12/31/2014 12/31/2015 12/31/2016 Interest Transaction Savings MMDA CD >$100,000 CD<$100,000 FFP/Repo Borrowings 32
BLENDED FUNDING AND EXTENSION STRATEGIES Deposit Price Sensitivity (Beta) Beta measures deposit rate changes compared with market rate changes Beta = Change in Product Rate/Change in Market Rate e.g. 35 bps/100 bps = 35% May vary according to: Current rate levels Magnitude of projected rate changes Changing demographics, technology, market competition Non-deposit investment alternatives Consumer behavior (e.g. surge deposits, parked funds) 33
Balance ($) Rate/Yield (%) Millions BLENDED FUNDING AND EXTENSION STRATEGIES What are your funding beta s? 6,000 5,000 MMDA Balance MMDA 24-month CD 2-yr Treasury Total CDs - mat./reprice 1-3 yrs. 12-month CD 36-month CD 1.20 1.00 4,000 3,000 2,000 1,000 0 0.80 0.60 0.40 0.20 - Core share Model: Correlation MMS Rate & Index = 43% CD Rate & Index = 18% MMS Rate & MMS Balance = 76% CD Rate & CD Balance = 34% MMS Balance & Index = 80% CD Balance & Index = 48% 34
BLENDED FUNDING AND EXTENSION STRATEGIES Duration-Certain Funding Reduces Risk of Rising Rates $5.00m Strategy: Non-amortizing bullet advance designed to partially match asset cash flows. No attempt to match fund the asset tail due to the small amount of cash flows during the last four years. $3.30m Deposits $1.15m 2.20%, 5-year advance $1.15m $1.15m 2.20%, 5-year advance Deposits 0 1 2 3 4 5 6 7 8 9 10 35
BLENDED FUNDING AND EXTENSION STRATEGIES Asset/Liability Assumption Set 36
BLENDED FUNDING AND EXTENSION STRATEGIES Inputs of Funding Mix Allocation for Deposits and Assets Current Weighted Average Cost 0.40% REPRICING BETAS AND CHANGES IN MIX Est. Weighted Average Beta 57.5% CORE DEPOSITS Appx. 65% Non-Maturing Deposits Gradual Return to Normal Deposit Mix Interest Rate Scenario CPR Average Life (Years) -300 bps 9% 4.04-200 bps 8% 4.18-100 bps 7% 4.31 Base Case 6% 4.46 +100 bps 5% 4.61 PROJECTED DEPOSIT COSTS +100 bps 0.97% +100 bps 2.12% +200 bps 4% 4.76 +300 bps 3% 4.93 37
BLENDED FUNDING AND EXTENSION STRATEGIES Inputs for Advance Ladder Detail INTIAL FUNDING ALLOCATION 50% Deposits 50% Wholesale Funding Wholesale Amount Term Rate $.25m 1-year 1.51 $.25m 2-year 1.67 ADVANCE ALLOCATION $.375m 3-year 1.86 Laddered Bullets 1 to 7 Year Final Maturities $.375m 4-year 2.03 $.50m 5-year 2.20 WEIGHTED AVERAGE COSTS Deposits = 0.40% Advance Funding = 2.07% $.50m 6-year 2.37 $.25m 7-year 2.56 38
Thousands BLENDED FUNDING AND EXTENSION STRATEGIES Net Interest Income In Varying Rate Scenarios Resulting From100% Deposit Funded and 50/50 Blended Funded Mortgages 1,000 900 800 700 600 500 400 300 200 100 Deposits Only Blended Funding - -300-200 -100 Base 100 200 300 39
BLENDED FUNDING AND EXTENSION STRATEGIES Market Value of Equity In Varying Rate Scenarios Resulting From 100% Deposit Funded and 50/50 Blended Funded Mortgages 40
A CASE FOR DIVERSIFYING THE RIGHT-HAND SIDE OF THE BALANCE SHEET 41
A CASE FOR DIVERSIFYING THE RIGHT-HAND SIDE OF THE BALANCE SHEET 42
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