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

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Federal Home Loan Bank

• f Des Moines

A Case for Diversifying the Right-Hand Side of the Balance Sheet

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Agenda

• 1. YIELD CURVE FUNDING STRATEGIES
• 2. BUILDING A CASE FOR FUNDING DIVERSIFICATION
• 3. BLENDED FUNDING AND EXTENSION STRATEGIES

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A CASE FOR DIVERSIFYING THE RIGHT-HAND SIDE OF THE BALANCE SHEET

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YIELD CURVE FUNDING STRATEGIES

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YIELD CURVE FUNDING STRATEGIES

Fixed Rate Advance Types

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YIELD CURVE FUNDING STRATEGIES

Adjustable Rate Advance Types

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YIELD CURVE FUNDING STRATEGIES

Representative Fixed-Rate Advance Graph

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YIELD CURVE FUNDING STRATEGIES

Yield Curve Strategies – History of Inversion

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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

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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

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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

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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

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BUILDING A CASE FOR FUNDING DIVERSIFICATION

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BUILDING A CASE FOR FUNDING DIVERSIFICATION

Multiple Funding Purposes of Wholesale Funding

Maintain Profitability and Safety

Liquidity Management

• Just-in-time funding
• Re-allocate lower yielding

assets Interest Rate Risk Management

• Control asset/liability

mismatches

• Balance sheet (macro) funding
• Transaction (match) funding

Capital Management

• Increase capital efficiency
• Allow capital to determine

assets size, not deposits

• Increase net income/return

to ownership (dividends)

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BUILDING A CASE FOR FUNDING DIVERSIFICATION

Wholesale Funding Relationship with Deposits

Deposits are a Key Component of Funding Strategy Advances are Complementary to Deposit Funding

• 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 duration-

certain, long-term funding in the form of advances?

• Advances add duration certainty to the right-hand side of

the balance sheet.

• Diversification of funding sources can help reduce
• verall volatility of balance sheet.
• Advances are capital-efficient, customizable, simple and

backed by a strong counterparty.

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BUILDING A CASE FOR FUNDING DIVERSIFICATION

“Uncertainty is an uncomfortable

• position. But certainty is an

absurd one.”

• Voltaire

Embrace Uncertainty

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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 “Retail” vs. “Wholesale” Funding Source: FHLB, Correspondents, Broker “Volatile” vs. “Non-Volatile”

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BUILDING A CASE FOR FUNDING DIVERSIFICATION

“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

Managing Risk: The FDIC on IRR

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BUILDING A CASE FOR FUNDING DIVERSIFICATION

“The most common risk mitigation strategy is slowly repositioning the balance sheet

• ver 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

Managing Risk: The FDIC on IRR

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BUILDING A CASE FOR FUNDING DIVERSIFICATION

• 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.

Asset Diversification Widely Accepted. Why not Liability?

42% 30% 12% 7% 5% 4%

First Mortgage Auto Loans Other Real Estate Unsecured Credit Card Other (non-RE MBL, etc.) Other Unsecured Asset Allocation

Market Cap/Style/ Sector

Manager

Credit Quality Stock/Bon d

Maturity

Industry/ Geography

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BUILDING A CASE FOR ASSET DIVERSIFICATION

Liability Diversification: Eggs are Frequently in One Basket

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BUILDING A CASE FOR FUNDING DIVERSIFICATION

Blending Laddered Term Funding with Deposits

Laddered Term Advances Blended Funding Strategies

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BUILDING A CASE FOR FUNDING DIVERSIFICATION

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.

Term Funding Restructuring Considerations

24 Advance Restructuring Program

Since the introduction of the Advance Restructuring Program, a number of members, with the approval and certification

• f 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.

BUILDING A CASE FOR FUNDING DIVERSIFICATION

Term Funding Restructuring Strategies

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BLENDED FUNDING AND EXTENSION STRATEGIES

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BLENDING AND EXTENSION STRATEGIES

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

The Blended Funding Approach

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BLENDED FUNDING AND EXTENSION STRATEGIES

• 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.

Static and Dynamic Modeling

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BLENDED FUNDING AND EXTENSION STRATEGIES

• The potential impacts of

rising rates are numerous and are potentially different for every institution.

• The Dilemma: Sacrifice

margin for hedging against unacceptable financial outcomes.

• We will illustrate how a

blended funding approach can help manage the risks of a rising rate scenario on a portfolio of loans.

Risks of Failing to Diversify Funding

Earnings Uncertainty

Higher Core Funding Costs Slower Prepayment Activity

Reduced Market Value of Fixed-Rate Instruments

Rising Rates

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BLENDED FUNDING AND EXTENSION STRATEGIES

Example: Setting a Blended, Laddered Advance Strategy - CRE 0 1 2 3 4 5 6 7 8 9 10

$1.15m 6-Year Advance $1.15m 5-Year Advance Deposits

Deposits

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.

$5.00m $3.30m $1.15m

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BLENDED FUNDING AND EXTENSION STRATEGIES

Example: Setting a Blended, Laddered Advance Strategy 0 1 2 3 4 5 6 7 8 9 10 15

Deposits

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.

$5.0m 10/15-Year Amortizing Advance

$10m $5m

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BLENDED FUNDING AND EXTENSION STRATEGIES

What is Your Funding Proportionality?

20 40 60 80 100 120 12/31/2013 12/31/2014 12/31/2015 12/31/2016

Deposit Composition - U.S. Banks $500m - $1b

Transaction Account MMDA & Savings Retail Time Jumbo Time Other

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BLENDED FUNDING AND EXTENSION STRATEGIES

What is Your Funding Proportionality?

0.5 1 1.5 2 2.5 3 3.5 4 12/31/2009 12/31/2010 12/31/2011 12/31/2012 12/31/2013 12/31/2014 12/31/2015 12/31/2016

Deposit Category Yields U.S. Banks $500 - $ 1 billion

Interest Transaction Savings MMDA CD >$100,000 CD<$100,000 FFP/Repo Borrowings

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BLENDED FUNDING AND EXTENSION STRATEGIES

• 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)

Deposit Price Sensitivity (Beta)

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BLENDED FUNDING AND EXTENSION STRATEGIES

What are your funding beta’s?

• 0.20

0.40 0.60 0.80 1.00 1.20 1,000 2,000 3,000 4,000 5,000 6,000

Rate/Yield (%) Balance ($)

Millions

MMDA Balance Total CDs - mat./reprice 1-3 yrs. MMDA 12-month CD 24-month CD 36-month CD 2-yr Treasury

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%

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BLENDED FUNDING AND EXTENSION STRATEGIES

Duration-Certain Funding Reduces Risk of Rising Rates

0 1 2 3 4 5 6 7 8 9 10

$5.00m $3.30m $1.15m

$1.15m 2.20%, 5-year advance $1.15m 2.20%, 5-year advance

Deposits Deposits

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.

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BLENDED FUNDING AND EXTENSION STRATEGIES

Asset/Liability Assumption Set

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BLENDED FUNDING AND EXTENSION STRATEGIES

Inputs of Funding Mix Allocation for Deposits and Assets

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 +200 bps 4% 4.76 +300 bps 3% 4.93

PROJECTED DEPOSIT COSTS

+100 bps 0.97% +100 bps 2.12%

REPRICING BETAS AND CHANGES IN MIX

• Est. Weighted Average Beta

57.5% Gradual Return to Normal Deposit Mix

CORE DEPOSITS

Current Weighted Average Cost 0.40%

• Appx. 65% Non-Maturing

Deposits

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BLENDED FUNDING AND EXTENSION STRATEGIES

Inputs for Advance Ladder Detail

Wholesale Amount Term Rate $.25m 1-year 1.51 $.25m 2-year 1.67 $.375m 3-year 1.86 $.375m 4-year 2.03 $.50m 5-year 2.20 $.50m 6-year 2.37 $.25m 7-year 2.56

WEIGHTED AVERAGE COSTS

Deposits = 0.40% Advance Funding = 2.07%

ADVANCE ALLOCATION

Laddered Bullets 1 to 7 Year Final Maturities

INTIAL FUNDING ALLOCATION

50% Deposits 50% Wholesale Funding

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BLENDED FUNDING AND EXTENSION STRATEGIES

Net Interest Income In Varying Rate Scenarios Resulting From100% Deposit Funded and 50/50 Blended Funded Mortgages

• 100

200 300 400 500 600 700 800 900 1,000

• 300
• 200
• 100

Base 100 200 300 Thousands

Deposits Only Blended Funding

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BLENDED FUNDING AND EXTENSION STRATEGIES

Market Value of Equity In Varying Rate Scenarios Resulting From 100% Deposit Funded and 50/50 Blended Funded Mortgages

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A CASE FOR DIVERSIFYING THE RIGHT-HAND SIDE OF THE BALANCE SHEET

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A CASE FOR DIVERSIFYING THE RIGHT-HAND SIDE OF THE BALANCE SHEET

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Headquarters

801 Walnut Street Suite 200 Des Moines, IA 50309

Western Office

901 5th Avenue Suite 3800 Seattle, WA 98164

Our Phone

(800) 544-3452

Website

www.fhlbdm.com www.members.fhlbdm.com www.thememberssource.com

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