Fly Like an Eagle - Episode 10

last updated on Monday, October 19, 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.

In these days of limited travel, I’m reminded of the golden eagle who was checking in for a flight. When asked those once familiar questions at the airport, “Would you like to check your luggage or purchase an in-flight meal?” he politely replied, “No thanks. I’ll just bring my carrion.”

Ask your resident ornithologist. Bald eagles use their feathers to balance. When they lose a feather on one wing, they will also lose a matching feather on the other side. That same symmetrical principal can apply to your balance sheet. In this episode, we’ll explain why’s and wherefores.

On our last episode, we built on the concept of asymmetrical returns. We also described a recent history of negative interest rates globally. Assuming that the Federal Reserve prefers to stay clear of negative interest rates as a monetary policy solution, the law of physics would dictate that there’s nowhere to go but up.

While emerging third quarter results show continued pressure on net interest margins, one source of comfort has been the increased paper gains that many institutions have accumulated in their investment portfolios.

It would be entirely logical for these institutions to sell them at some point and record the resulting gain against any credit-related write-offs. Perhaps that’s easier said than done.

As interest rates hover just above zero, asymmetrical risks surface. In order to generate positive inflation-adjusted real returns, it’s become a Hobson’s choice: invest in longer durations with higher price risk propensities and/or seek higher returns on assets that carry higher default risks.

During our recent Mortgage Conference, Dr. Ernest Goss of Creighton University, when asked about the consequences of monetary outpourings from the Federal Reserve and future fiscal stimulus resulting in either inflation or so-called “Japanization” of the American economy, meaning a multi-year deflationary struggle; he replied, “both.”

In fact, the risks are currently compounded by the fact that our inflation-adjusted yields are now negative, whereas throughout Japan’s “lost decade” yields remained positive because there was persistent deflation rather than inflation.

In the meantime, friendly monetary and fiscal policies are already running the risk of misallocating capital, perhaps diverting excess liquidity to the stock market, or perhaps to houses with remote home office capacity.

So let’s summarize the current environment facing financial institutions: waning loan demand, pocket-burning deposit flows at inelastic rates, credit issues that are being kicked down the road with the possibility of metamorphosing from forbearance-to-modifications-to-TDR’s-to-NPA’s, asset rates re-setting downward at a faster speed than funding costs, and a dearth of assets to book at risk-worthy rates.

To address the headwinds, we are seeing financial institutions and our members doing some interesting things. Here are some snippets:

• Although municipal bonds no longer support the wide spreads that they did at the start of the pandemic, some members are looking at their incremental attractiveness in the event there are enhanced tax-exempt consequences resulting from election-driven tax policy changes. In recent weeks, Lipper Analytical Services has noted large declining balances in municipal bond funds, in spite. Perhaps some of these balances have been detoured to the stock market.
• We are having many discussions with members lately about their term funding structures. Many are evaluating how to deploy impending maturities of term CD’s. It’s strategic planning time and many are assessing the role of CD’s or indeed their necessity in the current excess deposit market and are asking the following questions: Should rates rise, can we predict durations in which we can continue to tap into low rates, or will these deposits on the books pre-pay in spite of pre-payment penalties? On the basis of the lowest marginal cost relative to other forms of term funding, is the strategy of rolling term CD’s appropriate in the current environment? Finally, do we have more flexibility in pre-paying other forms of term funding than we do with CD’s? Now is a great time to roll-up the sleeves and address these strategic funding questions. One tool that can help is the FHLB Des Moines Member Strategies approach to analyzing your local deposit market. It works in various steps: 1) Tell us which MSA, or specific location and deposit category you’d like us to review. We can perform a current rate and special rate comparison. 2) While we don’t advocate making rate-setting decisions solely on the basis of what your competitors are doing, that’s dangerous, competitive benchmarking does help you develop rate scenarios that can help evaluate different marginal cost scenarios. We can work with you in developing scenarios involving different cannibalization of existing depositors and other assumptions. Even if you’ve done marginal cost analysis in the past, you’ll be amazed at how today’s current environment has created completely different outcomes compared to a few short months ago. Engage with your Relationship Manager to help you with this analytical framework. Remember that this is not last year’s CD market. Today’s market demand is heavily rate inelastic. Scrutinize your deposit rates. The surplus of liquidity and market dynamics demand it.
• Some members are thinking ahead about potential credit losses that may be realized some quarters down the road. While there may be some good gains to realize from the securities portfolio at current rate levels, will the same magnitude of potential gains be there should rates rise? Maybe. Maybe not. As such, are there other ways that you could build potential gains down the road in your balance sheet that can offset any future realized credit losses? One possibility that members are acting on is the Symmetrical Prepayment Advance, an advance type that allows a financial institution to hedge and potentially monetize the prepayment value of an advance in rising rate environments. Think of the earlier ornithological analogy of the eagle and think about how it might apply to your balance sheet. As a feather falls in the event of a rate rise, another, on the alternating side automatically falls to maintain balance, in this case the ability to prepay a symmetrical advance and record a gain in a rising rate scenario.

A word or two about the mechanics of the symmetrical prepayment advance. It’s a term advance that includes a contractual feature that allows a borrower to monetize its value associated with rising rates, creating a realizable value to the liability. To realize this value, a borrower would need to prepay the advance prior to contractual maturity, which would allow for a prepayment credit to be paid should rates rise beyond a certain threshold.

Symmetrical advances are typically used as a funding and hedging tool for longer-term assets such as mortgage loans or a securities portfolio. It’s a great way to hedge not only against the risk of higher interest rates, but it represents a possible source of a gain that can offset future credit and/or rate-related losses. At present, the price of the symmetrical’s contractual feature is only in the range of five basis points above a standard (asymmetrical) advance in rate in the one-to-seven year maturity sectors.

Again, deployment of a symmetrical funding strategy may come in handy if rising rates created paper losses or AOCI in your investment portfolio. Who knows? Maybe a higher rate environment would hurt your loan portfolio’s ability to cover debt service. Monetization of a symmetrical position might be useful at that stage of a credit cycle.

For more information or help in modeling the impact of symmetrical funding under various interest rate and yield curve scenarios upon on your investment or loan portfolio, contact your Relationship Manager. As an example, the Member Strategies Group at FHLB Des Moines can custom-analyze your investment portfolio under multiple funding sources. We use tools such as ZM Analytics and can help you optimize and analyze the trade-offs between NII and Market Value under multiple and customized rate scenarios.

Again, there’s a reason why it’s called a balance sheet. If the value of your mortgages, investments or for that matter, other fixed income assets deteriorate as a result of rising rates, there’s no reason why you should be denied the ability to monetize what could be an offsetting gain derived from symmetrical funding.

Some PSA’s

By the time you’ve tuned into this podcast, you might have missed our October 21 2020 Virtual Leadership Summit. If not, register on our website, soon. On our next podcast, I’ll review some of the key highlights. Our special guests, including Mohamed El-Erien, Chief Economic Advisor at Allianz and PIMCO along with James Bullard, President of the St. Louis Federal Reserve Bank will be addressing issues at the top of many minds, including: the credit environment, prospects for continued zero interest rate policy and which letter of the alphabet best applies to a prospective economic recovery.

Finally, early next month, well launch another episode of The Insider’s new companion podcast, “On the Record.” We’ll be interviewing Bill Bemis, our Chief Capital Markets Officer. Bill oversees our balance sheet and is charged with product pricing and other financial strategies for the bank. Drop me a line if you’d like any subject that we can inject into the discussion.

We’ll see you next time on the FHLB Des Moines Insider Podcast. Stay well, safe, liquid and may your balance sheet remain profitably balanced! Should its right side lose a feather, count on the left side to support staying in balance. Thanks for tuning in.

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