Federal Home Loan Bank of Des Moines A Case for Diversifying the - PowerPoint PPT Presentation

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

YIELD CURVE FUNDING STRATEGIES “All - in” Cost Reduces the Rate on Advances  Size Discount worth 4bps to 8bps  $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 • Control asset/liability mismatches Capital Management • Balance sheet (macro) funding Liquidity Management • Increase capital efficiency • Transaction (match) funding • Just-in-time funding • Allow capital to determine • Re-allocate lower yielding assets size, not deposits assets • Increase net income/return to ownership (dividends) Maintain Profitability and Safety 14

BUILDING A CASE FOR FUNDING DIVERSIFICATION Wholesale Funding Relationship with Deposits • Deposits represent the primary source of low-cost funding and franchise value. Deposits are a Key • Deposits are inherently duration-uncertain. Component of Funding Strategy • Can deposits be run-off and transferred into duration- certain, long-term funding in the form of advances? • Advances add duration certainty to the right-hand side of the balance sheet. Advances are Complementary to • Diversification of funding sources can help reduce Deposit Funding 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? Incorrect Approach? (Objective Bases for (Subjective Bases for Diversification) Diversification) “Core” vs. “Non - Core” Duration Defined vs. Duration Uncertain “Retail” vs. “Wholesale” Secured vs. Unsecured “Volatile” vs. “Non - Volatile” Funding Source: FHLB, Correspondents, Broker 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 ris k.”…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. 4% Market 5% Cap/Style/ First Mortgage Sector 7% Industry/ Auto Loans Manager Geography 42% Other Real Estate Asset 12% Allocation Unsecured Credit Card Credit Maturity Quality Other (non-RE MBL, etc.) 30% Stock/Bon Other Unsecured d 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