Dear Oscar - Episode 6

last updated on Tuesday, August 25, 2020 in General

Hello and thank you for joining us for another episode of The Insider, a bi-weekly 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.

Several summers ago, we were cleaning out the family cabin in Northern Minnesota and came upon a letter that was written by a relative who served as a bank executive for a long-since merged community bank to another relative who owned a farm in the Red River Valley. The two regularly enjoyed corresponding and commiserating about their respective occupations. The letter, dated March 28, 1944 (yes 1944) was written on the stationery of the “Norman County State Bank, Hendrum, Minnesota, Capital and Surplus $30,000.” Yes. That was $30,000.

Aside from the date and the capital surplus level, the text of the letter could just as easily have been written in 2020. Here are some excerpts:

“The earning power of money is not what it used to be and most banks find themselves in a position where service charges must be added in order to make ends meet. The income from investments and interest charges alone will not cover expenses and leave much profit. Bank deposits have of course increased considerably but the profit therefrom has not kept pace. So many regulations that one hardly knows what to do at times. I believe at present I am more interest in farming that I am in banking.”

The letter further went on to describe the need to diversify due to the vicissitudes of weather, crop mix and loan quality. Wow! Way back in 1944, bankers were citing elevated cash and deposit levels.

Like today, the Norman County State Bank was undoubtedly examining just how inelastic rates on their deposits might have been, likely due to monetary expansion during World War II. The more things change, the more, it seems, they stay the same. Such is the state of our industry – timeless.

The banker and the farmer will always face risk. We’re taught at an early age the definition of risk, commonly and simply cited as the degree of variability of returns. The best antidote to risk, we’re also taught, is diversification. We know that on the left-hand side of the balance sheet, diversification applies to loan types, credit quality, maturity, geography, etc. Often less emphasized on the subject of diversification is the role of funding diversification when it comes to managing risk.

Current conditions warrant re-naming the yield curve as the “yield line.” Still, it’s wise to plan for anything from negative rates to a steep yield curve. Why? Well, financial markets tend to trade in one direction: where they hurt the most people!

The funding diversification concept has actually been supported and endorsed, historically, by the regulatory community. Here’s some text from another letter, in this case, it was in the form of a regulatory Financial Institutions Letter, dated October 2013 stated:

“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… 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…” In a 2014 Supervisory Insights note in 2014, the FDIC stated: “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.”

OK. We agree. Balance sheet diversification is good and it reduces risk. As we’ve said for many weeks now, the banking system is rife with deposits. So, let’s pose a key hypothetical question: “Even with plentiful, low-cost deposits, will 100% deposit funding adequately protect your net interest income and market or economic value of equity from changing interest rates?” The answer is “no,” because the duration of a deposit is uncertain.

So, in a liability structure, what does constitute diversification? It is a mistake to interpret funding diversification as merely “secured” or “unsecured.” Nor might it be prudent to solely use retail vs. wholesale sourcing as a liability diversification framework.

Why? Particularly in a changing regulatory and rate environment, core deposits can quickly shed some of their “core” characteristics and actually exacerbate rather than mitigate interest rate risk. Other sources of funding, read FHLB Des Moines advances carry defined durations.

How about the well-established dichotomy of “core” vs. “non-core” deposits? Although core deposits may be abundant now, it is hard to know when and how duration and rates might change. The actual duration of core funds can be highly variable, particularly for those that have been derived from “surge” sources, such as temporarily non-rate-sensitive money that will only change its spots once rates increase.

Duration uncertainty could also stem from changes in demographics, market channels, and “stickiness” of fee-based services such as online bill pay. Rates and deposit availability may or may not change soon. Even so, if you are 100% funded by deposits, you’re interest rate risk may lack prudent hedging.

So what are the alternatives for prudent liability hedging and diversification? Blending your funding sources can help you optimize net interest margin and manage balance sheet risk. Let’s focus on putting the theory of liability diversification into practice: the strategy of blending laddered, term funding with deposits.

The concept of blended funding incorporates an aggregate liability approach to funding assets. Asset growth strategies are ideally supported by a diversified portfolio consisting of non-maturity deposits, maturity deposits and duration-certain wholesale funding.

So, consider the risks of an unblended balance sheet that is funded 100% by deposits. Non-maturity deposits have uncertain durations. At a certain tipping point, an assumed five-year duration liability might very well turn an assumed one-year duration liability.

Duration is even uncertain in the case of maturity deposits. How might maturity deposit duration be impacted by a rising rate scenario? What, you ask, are you talking about with rising rates? Well, unless you foresee a protracted period of negative interest rates, you can build a pretty good case that rates have run out of room to decline.

Monetary policy has also changed, with less bias toward containing inflation to putting a floor on inflation. We know that presently there is so much excess liquidity that’s not being spent by consumers. Monetary velocity is currently slow, and what isn’t being spent is likely going into such rising asset prices as the stock market, alternative currencies, gold or even in some parts of the country, rising residential real estate assets.

Warren Buffet is decreasing his position in financial services stocks and building new positions in mining stocks. Who knows? The point is, in spite of fundamental rationale that rates won’t increase any time soon, again, you must hedge your balance sheet considering the possibilities ranging from inflation to yield curve inversion.

Anyway, back to deposit duration: Even in the case of deposits with defined term maturities, is the duration of a three-year CD, three years? What is the time period you have assigned for penalties on early withdrawals? The typical answer might be six months. In a rising rate environment and in the information age, the increasingly savvy consumer could very readily conclude that migrating funds into a higher-yielding asset would cover a six-month penalty on short order.

Don’t laugh. It’s happened before. And, what of non-maturity deposit durations, which these days are a larger share of the industry’s total deposits, thanks to the low rate environment? Well, thanks to what seems to be exponential quantitative ease, surge balances now represent a meaningful share. The duration of your demand deposits, MMDA’s and savings products are certainly less certain!

On our next episode of FHLB Des Moines Insider, we’ll continue to build on the idea of liability diversification by describing some tools and strategies that you can apply to your balance sheet management.

Adverse Market Fees

One of the major financial headlines thus far during the month of August came from Fannie Mae and Freddie Mac who both announced a new 50 basis point “adverse market fee” on substantially all refinancing transactions. While the step was clearly aimed at preserving the agencies’ capital in the event of future COVID-related credit losses, the obvious effect will be on the average mortgagee who will sustain an average hit on origination fees of $1,400.

The incremental impact of the fee upon future originations remains to be seen, but we have seen an increase in members that are funding mortgages destined for sale via short-term advances – effectively funding the warehouse of loans-to-be-sold using their excess collateral. We know that mortgage pipelines right now are quite full, comprising roughly 75% refinancing activity. If indeed, refinance activity continues at the current clip, there’s a risk that yields on premium mortgage-backed securities in portfolio could drop rather quickly.

While we’re on the subject of housing, there seems to be two competing narratives of late. For the bad news, as of the end of June, 4.2 million homeowners had been given mortgage forbearance and almost seven percent of conventional mortgages were delinquent. Those in the 90+-day delinquency camp are now at their highest levels since 2010. On a lighter note, housing starts and permit levels are robust, having grown by almost 23% and 19%, respectively during the month of July.

Some PSA’s

In association with the Abrigo team, we recorded a 75-minute webinar on Managing Liquidity and Profitability in Today’s Environment. There were some interesting discussions on how to maneuver through today’s elevated cash levels and margin pressures. The webinar also presented some timely blended funding strategies aimed at enhancing liability diversification. To get access to the recorded version, simply go to the Educational Resources section of our website.

We’ll see you next time on the FHLB Des Moines Insider Podcast. On our next podcast, again, we’ll outline some strategies and observations on how to diversify your funding. We’ll call the forthcoming Episode Seven, “Make the Blend Your Friend.” Stay well, safe, liquid and remember to use your diversification tools to limit your risk. Don’t forget to save those family letters. They might provide you with sage advice for many years to come! Thanks for tuning in.

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