Navigating Through the Financial Doldrums - Episode 2
last updated on Tuesday, June 30, 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 and key information from the Bank. This is your host, John Biestman, Senior Relationship Manager.
Let’s talk weather for a minute, specifically the wind. From where we are now broadcasting it’s partly cloudy with calm summer winds; but it was William Arthur Ward who coined the appropriate phrase: “The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.”
The doldrums, also known as the intertropical convergence zone, are located in a narrow latitudinal band near the Equator. The bane of many a mariner, the weather phenomenon is caused by the intersection of two opposing trade winds that in turn creates protracted periods of listless wind conditions. Some might think that recent financial conditions bear some meteorological similarities. A typical sailing day has lately consisted of inconsistent loan growth amid abundant liquidity. Some are wondering if that liquidity will indeed be consistently available, yet alone sustainable.
The June 12 Federal Reserve H.8 Report showed that the banking industry’s cash position from May through March increased at an annual average rate of 295%. During that same period, deposits increased at a rate of 55%. As I mentioned, loan activity appears sporadic, although lower mortgage rates may have bolstered residential mortgage activity in certain markets. May housing starts came close to an annual rate of one million units with a growth rate of 4.3% alongside a nice increase on permits of 14.4%. The Mortgage Banking Association’s Purchasing Index has actually risen for nine consecutive weeks.
Other than activity in some of these housing indicators, however, at least for now, there’s not much wind on the horizon other than palpable anticipation of the our second quarter numbers. We sense that evidence of the direction of the credit breezes will soon shift, in line with pending call report filings, sometime within the next six weeks.
Although the industry has played the role of the good corporate citizen with widespread forbearance opportunities, it sometimes feels as if we are somewhat adrift, knowing that it may soon be time to batten down the NPA hatches. It’s therefore incumbent on us to make certain that we have as much access as possible to financial liquidity as we sail out of today’s doldrums. More on that observation in a minute.
Balance Sheet Management – Playing it Forward
Let’s talk now about managing your balance sheet and your interest rate risk position. We wouldn’t be creating a dust-up if we were to say that fiscal and monetary has been massive. At the beginning of this month, the Federal Reserve’s balance sheet exceeded $7.1 trillion after having maintained a cruising altitude of a little bit above $4 trillion for the better part of five years, with the exception of a reduction of over a few hundred billion dollars during a few intervals in the months leading into the pandemic.
Although just as age doesn’t necessarily guarantee maturity, it’s pretty likely that the scale of the balance sheet of the Fed and for that matter other central banks, will continue to climb as municipal purchase, main street lending and corporate bond purchase programs take shape. Chairman Powell in congressional testimony earlier this month underscored his belief that balance sheet scale would likely not shrink until well after the crisis.
On the monetary side, on the surface at least, conditions also appear exponential. From March through May, M1 grew at an annualized, seasonally adjusted rate of 105.1%. However, money supply’s velocity (that is money supply relative to GDP) continues the accelerated secular downtrend that it’s been in since 2008. In fact, monetary velocity levels have not been this low since the early 1970’s.
Understandably, some in the fixed income markets are assessing the possible longer-term cross-currents. Will it be inflation once demand and monetary velocity return? How about a dash of currency depreciation?
All of us on the call know that we run our financial institutions with the objective of risk management. We are in the business of positioning our balance sheets with well-monitored and measured execution of interest rate and credit risk. We are paid to take a view and to prudently adjust the risk management dials accordingly.
Some may have the view that for at least the next couple of years, funding rates will remain low, yet could increase in the future. Such an institution might have also taken a look at output from their IRR model that projected asset-sensitivity in several years’ time. A favorable outcome, in this instance, would be the ability to keep accessing low funding costs and be able to lock-in a fixed term rate several years hence.
As a funding and hedging tool, under these circumstances, you might want to take a look, for example, at advances with forward settlement characteristics. You might want to model the impact of funding a portion of your balance sheet with a fixed-rate, fixed term advance whose funding could be delayed two years on a mandatory settlement basis.
From an interest rate risk angle, you could protect against rising rates and for now, use internal deposits to maximize spread; or you could take advantage of the current rate environment to fund short-term. All at the same time, duration risk could be hedged and no collateral and no activity stock would be required until funding actually took place two-years down the line.
So, think about the appropriateness of a forward settlement strategy for your institution in the current environment. I’d be glad to touch on other balanc sheet strategies during subsequent podcasts.
For forward settlement funding and other strategies, engage with us. Our Member Strategies and Relationship Management team can help you gauge whether they may be right for you.
Effective July 13, 2020, we will be implementing scheduled revisions to our loan-to-value assignments for each category of loan and security collateral. We last updated our LTV grid in June of 2019. Single-family residential, HELOC and agricultural real estate categories supported a decrease of several percentage points. Many commercial loan categories were static.
On the securities collateral side, increased price volatility had a small impact on the assigned LTV’s of some categories. We also collapsed RMBS and other securities types that were formerly classified according to their specific investment grade rating, into one LTV.
We have a link to the revised LTV schedule and respective changes that we’ve posted on our web page.
Remember that LTV’s that we post should not be construed as a valuation surrogate that you might apply to your loan or investment underwriting. These periodically updated ratios are put in place with the central premise that for FHLB Des Moines sole purposes, we assume that we can liquidate an asset class within a very short period of time. To a large degree, therefore, the LTV’s that we generate are “pre-stressed.”
Once again, the preeminent determinants of your advance equivalent availability are i) your credit line and ii) the degree to which your collateral (i.e. non-performing assets) remains eligible for pledging. LTV’s are not the “be all, end all” determinant of advance equivalent collateral value.
A loan category’s advance equivalent calculation includes three key components:
- The pledged unpaid principal balance,
- An adjusted Eligibility Factor, which is a product of loan sample results from the most recent Member Collateral Verification review, and
- The assigned categorical loan-to-value ratio.
Eligibility Factor results are determined through our scoring of loan file consistency and loan underwriting. Examples of variables that are reviewed include:
- Documented repayment ability,
- Income and asset verification,
- Evidence of appraisal and other valuation, lien verification and credit underwriting documentation.
Some examples of Eligibility Factor/Underwriting items that we look for are derived from the Member Collateral Valuation Review process:
- Repayment Ability Performed and Documented
- Income and Asset Verification (1-4 family residential loans/lines only)
- Collateral Valuation (Certified/Licensed Appraisal)
- Lien Verification (Title Insurance or Attorney Opinion)
- Residential Loan-to-Value
- Credit Assessment (all loans must have evidence of review)
Again, any ineligible collateral would not be included in this advance equivalent availability calculation.
We’d like to help members understand their current advance equivalent availability and perhaps more importantly, their potential future availability. Let me or your Relationship Manager know if we can help with any of the following discussions:
- A collateral optimization analysis that involves screening your call report against categories that are eligible for pledging
- Scenario analysis involving the impact of different credit and economic conditions against: credit line amount, maximum allowable advance maturities and collateral arrangement
- Reviewing suggestions on how to best prepare for a Member Collateral Review and maximize your Eligibility Factors
Avoid surprises. Don’t be in the position of thinking about why a baseball keeps getting larger…and then it hits you!
Save The Date
You won’t want to miss this one. We have our 2020 Virtual Leadership Summit set for the afternoon of October 21, from 1:00 pm Central Time on. We can’t yet release the names of our speakers, but you’ll have every reason to believe that they are world-class, well known to you already and on-point for the times we are in. We also have in store some additional ways to keep you in your seats. We hope that you and your team can get it on the calendar!
Stay well, with the wind at your back.
What do Alexander the Great, Winnie the Pooh, and Chance the Rapper have in common?
Same middle name.
- Podcast Series