Fast Forward - Episode 18
last updated on Tuesday, June 1, 2021 in General
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.
This year’s brunch table conversation on Mothers Day took on a bit of an existential tinge, with our family members unanimously concluding that “life is long, but it just goes by too darn quickly!”
The same observation can apply to positioning your financial institution for fast forward scenarios, or as world-famous hockey player Wayne Gretzky once averred, “I skate to where the puck is going to be, not to where it has been.” It’s easy to fall into the trap of what behavioral economist call “recency bias.”
When Dr. Richard Thaler, the 2017 winner of the Nobel Prize for Economics for his work on the impact of irrational human biases on decision making was asked what he was going to do with his prize money, he replied that he would spend it as irrationally as possible. Among the many decision-making biases cited by Dr. Thaler, recency bias, simply implies that human decisions err towards extrapolating current trends well into the future. I’ll be the first to admit that when I entered my banking career, the annual rate of inflation was 13.5%.
When the bond market rallied throughout the 1980’s, I must admit that I fought it all the way through, simply because most impressionable reference point was coming of age during a period of high interest rates. Recency bias would have caused me to lock in borrowings at high rates, when in actuality, it would have been wise to not lock in any borrowings during much of the past 40 years!
Another irrational bias that Dr. Thaler cited, availability bias, occurs when decision-makers assign more importance to new and current information, as opposed to looking at longer-term trends. That’s the forest-through-the trees analogy. How many of us are guilty of this infraction?
So let’s, for a minute, take Wayne Gretzky’s advice, refrain from thinking about the present state and develop contingency strategies based on where the puck may be traveling. And, in an effort to recognize our decision-making biases, what’s your view of where rates are heading?
Remember, your institution is being rewarded for safely and responsibly acting on a held view, otherwise, you’d be investing in treasury bills! See if you can isolate your bias to recent events and business conditions. Better yet, think about how you might position your balance sheet for any disruption in the direction of what has been a benign rate environment for quite some time.
On our last podcast episode, “Inflation Conflation,” we discussed the potential disruptive impact of a rising rate environment in which the long-end of the curve reflects growing treasury supply and inflationary pressures. It’s the scenario in which the Fed becomes forced to taper its seemingly limitless securities purchasing appetite of longer-term securities or a scenario in which the Fed realizes that there is already plenty of liquidity that’s been provided to an economy whose growth is accelerating.
As we fast-forward, is this the direction in which the puck might slide through the ice? Although we’re getting into the summer months, do you envision being the driver of the Zamboni machine, cleaning up the ruts and potholes a few years down the road?
Due to the glut of liquidity and record levels of securities on our balance sheets, most institutions purport to be asset-sensitive. But, should the pendulum shift back to normal liquidity conditions, many institutions may no longer price their assets at a faster rate than their liabilities.
There are always future funding risks associated with your duration-uncertain deposits – both the non-maturity as well as the maturity variety. Always appreciate that duration and maturity are two different metrics. Case in point, whenever I’m asked how many children I have, I reply “five, ranging from 36 to 27 in inverse order of maturity!”
One tool that we at the FHLB Des Moines have sharpened provides protection against potential future rising rates, recognizing the excess amounts of present-day liquidity. That would be a mechanism in which financial institutions could lock in funding for a pre-determined future draw, without taking down the funds in the present tense.
It’s known as the “FSA” or Forward Starting Fixed Rate Advance. Starting this week, we will be providing more thorough indications on our Rates Page of multiple maturity and future lock combinations. Future funding lock periods could range anywhere from six days forward to two-years.
So, let’s take a minute on the forward start funding mechanics. Essentially, you’re locking-in funding costs immediately and taking settlement of the advance proceeds at a pre-specified forward date. At the time that the rate is locked, no credit or collateral capacity is taken up. Capacity is only absorbed when settlement of funds takes place.
Pricing depends on two key variables: forward settlement length and maturity of the advance. The commitment to draw is mandatory. Prepayments are permissible once settlement takes place, but not during the undrawn interval.
Let’s think about typical applications of forward funding in today’s environment.
Now to the question at hand, what are some reasons to use an FSA advance? The ability to lock in a rate not only hedges against the chance that rates could rise during the forward start period, but also offers both duration and cost-certain funding. This feature can be useful for a couple of different situations.
For one, think about instances in which your customers require funding in the future, such as construction projects. Forward funding would allow you to lock-in today’s low rates. In many situations, it’s unnecessary to immediately fund a future liability maturity, construction draw or security purchase. Nor is it necessary to cross your fingers and hope that rates don’t negatively impact your targeted net interest spread between now and when you need to fund.
And finally, for those institutions unable to enter in derivatives contracts, a forward start advance is a great alternative to lock in a rate rather than use a forward settling swap. Again, look on our expanded rates page or call the Money Desk for further indications.
Last week, we released our second quarter Collateral Quarterly publication. Several items of interest: First, a new collateral type that we will soon be accepting – Interest-Only Loans. These will include multifamily and commercial real estate loans – only whole loans, no participation loans.
As many of you know, we periodically conduct Member Collateral Verification Reviews that assess collateral eligibility and underwriting quality of a sample loan category. A resulting Eligibility Factor is updated once the review is completed and the factor is used to calculate members’ advance equivalent availability from FHLB Des Moines.
We’re pleased to report that average eligibility factors remain high across the membership, ranging between 90% and 92% for the residential, commercial and agricultural loan types. Let your Relationship Manager know if they can help you identify the most common causes of loan ineligibility.
While we’re on the subject of loan ineligibility, when you are running your liquidity stress tests, always recognize that FHLB Des Moines periodically changes its collateral category loan-to-value ratios. However, when members are stressing liquidity availability, the analysis should devote far more emphasis on whether or not collateral would be eligible in the first place. That is, LTV’s and Eligibility Factors only apply to pledged loans that are creditworthy, and adequately documented.
We posted current collateral loan-to-value ratios and updated them on our website, effective May 10. Many loan collateral types increased their loan-to-value ratios. On June 30, we will also be revising loan collateral eligibility checklists to incorporate some changes we have made to acceptable threshold eligibility levels for maximum property-loan-to-values and minimum debt service coverage ratios for multifamily and commercial real estate loans. Again, check out the Collateral pages of our website or contact your Relationship Manager for clarification.
Finally, we recently published state-by-state profiles that depict the impact that FHLB Des Moines makes throughout its wide geography. These profiles, available on our website, provide statistics on the positive impact that advances, letters of credit, mortgage purchases and affordable housing activities contribute to your communities.
We know that you have a choice in your sources of funding. As your cooperative, our goal is to be a competitive, easy-to-use, responsive and reliable source of financial solutions.
As an example, we’ve raised our activity stock dividend to 6%. That action, in and of itself, lowers your funding costs. It’s a direct incentive to use your cooperative.
Recently, you may have been thinking about such questions as: “How do I continue to sell second home mortgage originations in the wake of Fannie Mae and Freddie Mac’s recently-imposed 7% cap?” “How can I quickly help one of my customers that needs backing for a performance obligation such as a lease or self-insurance requirement?” “How can I enhance my relationship with public units and not burden them with tracking securities collateral or being subject to overnight settlement risk?” “How can I strategically hedge my balance sheet’s projected interest rate risk if rates rise and my asset sensitivity is projected to drop, even if I don’t need to fund today?”
Like you, we’re always in search of answers to balance sheet management’s persistent questions. Talk to us and we’ll help you get there. Use your cooperative!
Remember that in today’s competitive environment, you can’t look back. You have no other choice but to push the fast-forward button and to collaborate with your trusted partners. Stay well and we’ll see you next time on the FHLB Des Moines Insider Podcast. Thanks for tuning in.
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