Coin of the Realm - Episode 16

last updated on Tuesday, March 23, 2021 in Letters of Credit

Hello and thank you for joining us for another episode of The Insider, a monthly podcast production of the Federal Home Loan Bank of Des Moines and your source for industry news, strategies and key information about the bank. This is your host, John Biestman, Senior Relationship Manager.

On the occasion of his 100th birthday last year and just before his passing last month, former Secretary of State, Treasury and Labor, George Schultz, published an essay entitled “Life and Learning Over 100 Years: Trust is the Coin of the Realm.” After a century of experiences, Secretary Schultz remarked, “When trust was in the room, whatever room that was – the family room, the schoolroom, the coach’s room, the office room, the government room or the military room – good things happened. When trust was not in the room, good things did not happen. Everything else is details.”

When it comes to managing an organization’s risk, be it reputation, counterparty or settlement risk; the common goal is to deal with a trusted party. There are occasions where a business counterparty may not know your organization or your customers and may require additional layers of trust in a transaction.

On the subject of transactional trust (sorry, that sounds like an oxymoron), enter the letter of credit. While there is debate about the origins of this vital financial instrument which was used as a trade guarantee instrument perhaps as far back as Ancient Babylonia and Egypt; the 2017 BBC series ”50 Things That Made the Modern Economy” featured a segment on “The Warrior Monks Who Invented Banking.”

The story starts in 1185 at the site of the Temple Church, London’s first bank, established by the Knights Templar. This was the time of the Crusades. The Crusaders naturally need to fund the long trip to Jerusalem and its requirements for many months of food, accommodation and transportation.

The late-1100’s was a time when trust hardly abounded and it was generally a bad idea to carry around large sums of cash. As such, letters of credit could be drawn upon along the journey via correspondents of the Temple Church. While there were turbulent accounts of settlement missteps and identity fraud with this payment and credit system, it was indeed a precursor to the modern-day letter of credit.

The modern day letter of credit now supports a variety of applications. Members of FHLB Des Moines frequently access letters of credit for three general purposes:

• First, to support performance obligation guarantees. More on that in a minute.
• Second, to address collateralization requirements associated with uninsured portions of public unit deposits.
• Third, to provide credit and/or liquidity enhancement for bonds and private placements that are issued to fund taxable and tax-exempt housing projects, along with taxable issuances for community economic development projects.

With any of these three applications, the benefits of employing a “Aaa/AA+” rated FHLB Des Moines Letter of Credit feature:

• Prompt payments in the event of draw events
• A fee income opportunity for members, balance sheet ratio and ROE enhancement and enhancement of customer relationships.

So, let’s think about some of the performance obligation situations that many of our listeners run into that could very well apply to a letter of credit. Here are some “for instances:”

Do you or your customers have self-insurance programs of any kind in place? Think of self-insurance programs for workers compensation, unemployment or liability. Generally speaking, self-insurance programs require payment guarantees in the form of either pledged securities or letters of credit by an acceptable counterparty.

FHLB Des Moines Letters of Credit can readily be applied on a confirming basis in support of a member’s customer; for example a trucking fleet that is being self-insured for liability. Letters of credit are a superior alternative compared with pledging securities which can unnecessarily divert capital and require frequent monitoring.

Here are some more applications.

Do you ever run into instances of your institution or your customers needing a lease guarantee or support of a construction bid or project completion? It’s very typical for a FHLB Des Moines member to issue a letter of credit on behalf of a customer that is paying leases, and in favor of a beneficiary, or lessor. In turn, the member’s letter of credit is confirmed or “wrapped” by a FHLB Des Moines Letter of Credit. Payment under the letter of credit may be exercised in the event the underlying contract is in default or subject to a draw event, and if the member institution is not capable of satisfying the draw request.

One final example: We’re finding that more FHLB Des Moines members and their customers are using over-the-counter swaps or futures obligations to help hedge their business risks. Interest rate swaps, for instance, frequently entail contractual provisions that require third-party backing or collateral support to address counterparty risks associated with credit or underlying price variability.

Contracts often specify threshold levels of market value variability beyond which some level of additional support is needed. Rather than negotiating the delivery of cash or securities should a threshold break, the margin requirement may be satisfied by a letter of credit in favor of the swap counterparty.

Depending on the specific swap situation, the backing of a “Aaa/AA+” letter of credit could even altogether eliminate the need for a contractual margin requirement, enhance execution and/or enhance the all-in swap rate. This type of performance obligation LOC could be issued on behalf of a member directly, or as a confirming LOC on behalf of a member’s customer.

Contact your Relationship Manager for additional information and to qualify any specific performance obligation situations that you or your customers are in touch with.

And don’t forget to ask about our ability to design a custom analysis of how your use of FHLB Des Moines Standby Letters of Credit to back uninsured portions of public deposits can improve your balance sheet liquidity ratios and help you direct capital away from the unnecessary requirement to pledge low-yielding securities to your public unit depositors.

Let’s check in now with economic and fixed income capital markets developments. As measured by mortgages and the 10-year treasury note trading closer to 2% than 1%, longer-term rates are trending higher due to increased signs of economic recovery and inflationary expectations.

Although rates are low on a relative historical basis, it’s hard to believe that the yield curve is, proportionately, at its steepest level in four years. The five-year so-called break-even inflation rate that we mentioned in last month’s podcast has increased by roughly 15 basis points since then.

Another index, the Producer Price Index for the month of February rose by half-a-percent and is up by 2.8% over the past year. That’s the largest increase since October of 2018. If you’re collecting economic recovery metrics, the most recent University of Michigan Consumer Sentiment Index was a greater-than-expected 83.0.

It’s likely that confidence is being boosted by the fact that household net worth, now at $130 trillion, grew by 10% during 2020, thanks to rising home and stock prices along with government stimulus. All this, notwithstanding the pandemic and the associated economic drag.

To some degree, household net worth has been improving due to government transfer payments being used to pay down debt. Also, the U.S. savings rate has exceeded 12% for every month over the past 12 months. For the banking sector, the number one strategic issue has indeed become how to put excess liquidity to work.

The most recent Federal Reserve Senior Loan Officer Survey describes weak demand for CRE, C&I and construction loans in the wake of more price competition and tightening underwriting standards.

Mortgage rates have risen now for five consecutive weeks, something that hasn’t happened in over two years. That’s caused the share of re-financings as a percentage of mortgage originations to decrease to 64.5%. That figure was 71.4% in late January, so there’s been a bit less re-financing activity in recent weeks.

Time to get the calendars out. Mark down May 26 and 1:00 pm CDT for our Member Value Meeting. We’ll feature a nationally-known economist, balance sheet strategists and thought and action-oriented business leaders.

In a world of multiple counterparties, as the late Secretary Schultz averred, “trust is fundamental, reciprocal and, ideally, pervasive. If it is present, anything is possible. If it is absent, nothing is possible.”

Here at FHLB Des Moines we’re here to help build bridges to financial trust be they through letters of credit, reliability of funding or being mindful of the capital that you have invested in your cooperative.

We’ll trust you will stay well, and liquid with pockets full of coins of the realm. We’ll see you next time on the FHLB Des Moines Insider Podcast. Thanks for tuning in.

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1. Confirming Letter of Credit
2. Insider
3. Letters of Credit
4. Podcast Series
5. Standby Letter of Credit