It Just Doesn't Matter - Episode 25

last updated on Thursday, January 20, 2022 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.

During the Holidays, many of us have the tradition of watching movies whose endings we’ve seen many times before. Over 40 years ago, in 1979, comedian Bill Murray debuted in his first starring film role in an Ivan Reitman-directed film called “Meatballs.”

Other blockbusters such as “Stripes” and “Ghostbusters” soon followed. Murray played the role of a lead camp counselor of the low-budget Camp North Star whose rival was an upscale camp resided just across the lake. With gaps in financial resources and integrity, the annual Olympiad between the two camps was always a lopsided affair.

Just when the score was getting magnanimous, with North Star coming back from behind and one event to go, Murray rallies the dispirited campers with the repetitive cry, “it just doesn’t matter!” In the end, North Star’s multi-year losing streak comes to an end.

Aside from fiscal and monetary ease, the phrase “It just doesn’t matter” are just about the only explanations we’ve had until recently as to why fixed income and equity markets have stayed strong for such a long period of time. That’s often the case during periods of accommodative fiscal and monetary policy, until…well you know the punchbowl analogy takes hold.

The table for interest rates during 2022 appears to have been set. The minutes of the Federal Reserve Open Market Committee’s deliberations clearly changed their heretofore “wait and see” tone, as did Chairman Powell’s testimony during his recent reconfirmation hearing.The Fed’s dual mandate of price stability and full employment has clearly become unbalanced in favor of the growing risk of inflation. The prospect of a sequential serving of monetary tightening has become clearer.

First, the leveling-off of mortgage-backed and Treasury purchases will be accelerated and accomplished by March.

Second, we could expect the first round of targeted rate hikes at that time.

Finally, the Fed has indicated that it would further change course and start to actually reduce its $8.7 trillion balance sheet.

Keep in mind that this level is twice the level that existed at the onset of the pandemic. The “dot plot” is currently forecasting three 25-basis point increases during 2022, three more during 2023 and two more in 2024.

Some outside market watchers are even forecasting four rate hikes to take place in 2022. With the imminent prospect of rising rates, it’s hardly surprising that the stock market has reacted adversely. Modern financial theory has always posited that higher rates represent an increase in cost of capital, hence higher required rates of return.

Here’s to rational behavior! Maybe it just does matter! My prediction for 2022: More eyes could be focused on changes in the size of the Fed’s balance sheet than on well-telegraphed changes in the targeted Fed funds rate.

It’s a new year and financial institutions are now, regulatorily, no longer allowed to execute de novo Libor contracts, aside from very few extenuating circumstances having to do with hedging existing LIBOR exposures.

Going forward, any newly-originated Libor-based assets will not be deemed as eligible collateral at FHLB Des Moines and Libor will cease serving as a reference point on June 30, 2023 by the market. In any event, we can expect to see rapid adoption to the Secured Overnight Financing Rate or “SOFR.”

As in example, over the past three months, open interest in the CME futures market for term one-month and three-month SOFR futures increased by 83%. Most daily trading volumes are trading in three-month maturities.

Early indications thus far in the new year are that new risk interest rate swap activity that is denominated in SOFR is picking up speed, while there is some residual LIBOR-based activity related to hedging existing positions.

In recent weeks, large syndicated loans have also been originated with SOFR benchmarks, including a large food processing plant syndicated facility $750 million loan that was originated by Bank of America.

We’ve also seen some of our regional bank members issuing fixed-to-floating rate subordinated debt using a SOFR index. Recognizing growing SOFR loan and investment activity, FHLB Des Moines has made some recent changes in our SOFR advance structuring capability. We can now offer expanded maturities from two-years to 10-years. Stay tuned for more developments on this advance type as SOFR usage continues to expand.

Times of abundant liquidity often prompt members to reflect on why they fund their balance sheets with FHLB advances. Many have board or ALCO-approved targeted loan-to-deposit ratios.

While LTD targeting is well and good, there are dangers in placing too much focus on this ratio. Here’s how a decreasing LTD ratio could, if fact, serve to the detriment of your institution’s liquidity.

An increase in the ratio’s denominator, deposits, could technically be conducted by placing brokered CD’s on the balance sheet. Placing brokered CD’s on a balance sheet, as opposed to advances, could expose your institution to “pro-cyclical” liquidity risks.

What do I mean by “pro-cyclical?” During pro-cyclical points in the economic cycle, the impact of funding positions can be amplified in either direction, good or bad. When time are good, access to brokered funds, be they CD’s, one-way reciprocal deposits, repo or correspondent funding should be relatively available.

Should the economic tables turn, however, the risk of continued access to brokered wholesale funding sources increases. Losing access to these brokered sources during a negative amplification of an economic or credit cycle can be a parlous consequence of loading up with brokered funds all in the name of decreasing a targeted loan-to-deposit ratio.

Funding reliability is paramount to your balance sheet, especially during pro-cyclical points in the cycle. Think about roll-over risk. If credit issues were to become problematic, regulatory prohibitions on rolling brokered funding could only make matters worse.

A sound liquidity policy should call for diversifying your funding sources, even in times of abundant liquidity. Think about scenarios in which there is a sudden liquidity shock. FHLB Des Moines advances are readily available.

With underlying eligible collateral, funds can be consistently available in a matter of minutes. Still, it’s good to know that deploying FHLB Des Moines advances, especially during pro-cyclical times is a wise means of avoiding concentration risk.

Remember that brokered funds cannot be prepaid or restructured at any point. Nor do they share the duration-certain properties of advances.

Again, beware of LTD ratio conclusions that may be misleading. Best of all, remember that advances generate earnings for your cooperative that are returned to members via cash dividends and awards to Affordable Housing Programs.

A couple of years ago, a friend of mine visited Northern Thailand during the month of March. When I asked her about how the weather, she replied, “I don’t know, I never saw it.”

The perennial burning of the rice fields causes air quality monitors to go off the charts, with negative consequences to the region’s health and economy. She told me of meeting an entrepreneur that had just opened a processing facility that was designed to convert the straw waste into safely-produced rice starch pulp that is used in the production of waterproof coatings for packaging.

It’s good to hear the occasional true story about turning straw into gold. The same would apply to really what is the key benefit of gaining liquidity through an FHLB Des Moines advance.

Literally, members are given the ability to process their less-liquid collateral into off-the shelf funding. That’s why, throughout 2022, we will be engaged in outreach to our members on the subject of how to optimize collateral positions.

There are three general reasons why a member may not have optimized its eligible collateral position:

1. Overlooking the ability to pledge a loan category that you are eligible to pledge or;
2. Not being able to gather sufficient file documentation to warrant eligibility for a loan, or;
3. Not fully understanding requirements for eligibility.

We can help you measure the extent of your collateral optimization by providing you with a customized report that compares your call report information with the actual amount of collateral that you are pledging.

The report highlights gaps between your call report loan categories with how much collateral you are actually pledging. It also highlights any categories that you may have overlooked.

The more “straw” that you can provide, the more readily available funding you have access to. Again, contact your Relationship Manager and ask to prepare a collateral optimization analysis. We’ve already seen these discussions lead to process improvements in the loan servicing areas of many members.

On the road again. In April and May, we will be presenting Regional Member Meetings in six locations around the district. The meetings will include two concomitant core sessions.

One on developing and executing balance sheet strategies during the transition away from zero interest rate policies. This session will be primarily targeted toward C-suite decision-makers, board and ALCO members, and other individuals charged with balance sheet decision-making.

The other separate core session will focus on optimizing your institution’s collateral position with FHLB Des Moines. This session will be targeted to those individuals within your organization that are directly tasked with the collateral management and filing processes.

Throughout the sessions, we will provide you with actionable steps leading to liquidity maximization and optimal interest rate risk mitigation.

Here is a quick rundown on the dates and locations: Salt Lake City, April 26; Seattle April 28; St. Louis, May 3; Sioux Falls, May 5; Minneapolis, May 10; and Des Moines on May 12. We’ll be sending registration and complete details in the next few weeks.

When it comes to balance sheet management, 2022 will take us down a road of changing liquidity conditions, interest rates, yield curve slope, among many variables.

Contingency planning and the ability to measure and monitor the impact of external changes in your operating results and balance sheet have never been more critical. It matters, down to the last detail.

On that note, I’m reminded of the road trip that we took over the Holidays. We drove past a farm that posted a sign that read, “Duck, Eggs.” As I read the sign, I wondered about the unnecessary comma. Then it hit me…It really does matter!

Stay well and we’ll see you next time on the FHLB Des Moines Insider Podcast. Thanks for tuning in.

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