Kamchatka on Irkutsk - Episode 15
posted on Tuesday, February 23, 2021 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.
I don’t know how your family’s leisure time activities may have changed during the pandemic, but mine certainly has in the sense that board games have come back into vogue. A few week-ends ago, I introduced younger members of our family to Risk, a board game that incorporates elements of strategy and diplomacy. For those that may not be familiar with Risk, if not properly managed, it’s not unusual for a game to last for days, as players try to control 42 world regions through forming alliances and addressing other forms of mitigating geopolitical risk.
There are several key strategies involved in attaining victory on a Risk board, including the realization that the advantage frequently goes to those that believe in “divide and conquer” as opposed to “united we stand.” To be sure, an ongoing push to grow in terms of margin, asset growth and market share is key to enhancing your enterprise’s value. All the while, however, a seasoned Risk player knows that a desire to grow must be tempered by the realization that risks must be calculated, rather than relying excessively on luck. The game of Risk encourages players to form strong alliances to reduce the risk of losing territory. To take this observation to the world of financial institutions, it’s critical to source the Federal Home Loan Bank of Des Moines to reduce your balance sheet risk and encourage your growth prospects across the board.
FHLB Des Moines just released its Q4 Economic Report. It’s now available on our website, or ask your Relationship Manager for a copy. It’s a useful discussion item for ALCO and board meetings. The recent edition includes a new compilation of state-by-state economic indicators. So, let’s scan the environment for just a bit before we touch on balance sheet risk reduction strategies.
The game board right now might now be described as “Dickensian,” depicting “the best of times and the worst of times, the age of belief and the epoch of incredulity.” The Congressional Budget Office bumped up its GDP growth estimate for 2021 to 4.6%. That’s following the 2020 GDP contraction of 3.5%, the economy’s worst performance since the end of WW2 in 1946.
Low historical interest rates are spurring strong mortgage volumes, strong housing prices, and epic stock and bond valuations. If you remember learning about the capital asset pricing model during your school days, you’ve been taught low interest rates represent a significant theoretical portion of an asset’s valuation. Still, those low rates are here for a reason.
First, the effects of the year-old pandemic have caused long-term unemployment, that being joblessness beyond six months, to be at the weakest level since the Great Recession. According to that metric, currently, 40% of the unemployed are now considered long-term unemployed. The January employment release also indicated very slow new jobs generation of only 49,000, with a revision for the month of December being negative 227,000 jobs.
So, employment wise, we’re at about half-a-tank, or 10 million jobs shy of pre-pandemic levels. In the face of muted economic prospects, it appears increasingly likely that a fiscal stimulus package of close to $2 trillion will soon be distributed. As a benchmark, during 2020, due to government assistance and reduced consumption, Americans saved $1.6 trillion more than they did in 2019. Where have those savings gone? Answer: Into very low yielding deposits, treasury bills, discount notes and a stock market that is perhaps inflated.
The Federal Reserve H-8 reports continue to register abundant levels of cash on bank balance sheets. Bank line utilization rates have dropped over the past year from the mid 50 percent range to the 30’s. With pressure on loan originations and a continued low rate environment, a mere 29% of community banks reported Q4 net interest margins that had improved year-over-year. The environment for deposit growth remains strong and could gather momentum with another round of PPP loans and the massive stimulus that awaits. Although it’s a statistic that seems to be scarcely mentioned these days, we have now just crossed into triple digits in terms of the ratio of federal debt to GDP, up from an already high level of 79% at the end of 2019.
Who has been watching capacity utilization? From the depths of March of last year, 64.8%, we’ve now almost caught back up with Q4 2019 levels, now in the mid-70’s.
Since the onset of the pandemic a year ago, we at FHLB Des Moines have been reviewing the balance sheet hedging strategies that certain members executed when the financial ground shook last March. Some balance sheet trades were put on during March and April of last year, and some have since been taken off. For example, asset-sensitive institutions that were borrowing short-term advances throughout 2019 took off the trade that was aimed at decreasing asset sensitivity when rates bottomed out last year.
Other institutions took advantage of lower rates and accelerated their mortgage originations. Those that elected to take a “gain-on-sale” approach to mortgages, are increasingly using short-term FHLB Des Moines advances to fund their mortgage pipelines at competitive borrowing rates, using generic collateral. In spite of ample liquidity, many other institutions are using FHLB Des Moines for the purpose of hedging the reduced asset sensitivity that they have sustained since March of last year (given their need to extend asset duration for yield and to reduce duration assumptions associated with all of these excess deposits). Should the public health crisis improve, there’s a pretty good case that, coupled with massive government stimulus, these forces could propel economic growth and place some pressure on interest rates in the name of stronger demand.
Over the next few months, FHLB Des Moines will launch a Series of Solutions to help give members an opportunity to optimize their interest rate sensitivity and effectively manage their balance sheets.
As the first part of this series, FHLB Des Moines recently introduced a promotional rate special of a four basis point reduction in fixed, bullet rate advances in the one, three and five year maturities. Coupled with an assumed activity stock cash dividend rate of 5.50%, on a net basis, depending on your assumed cost of capital, if you do the math, that means that you are looking at respective net borrowing rates of: 11, 24 and 56 basis points, as of today.
Remember, that four-basis point promotional discount can only be accessed through calling the Money Desk, rather than through executing the advance online. Here’s another balance sheet hedging option to consider. While industry margins are generally thought to improve in a rising rate environment, think about the impact of higher rates on the paper value of your marketable securities, as an example.
You might want to develop some liability-based hedges to counteract these potential value declines. One way to do that is through symmetrical advance funding. There really is no liability structure in the wholesale market that is similar. Not only does symmetrical funding protect a balance sheet against the risk of surge deposit erosion and unpredictable rate sensitivity, it also allows institutions to monetize the value of the liability with rising rates prior to maturity.
Think about the advantage of having a potential future offsetting income entry should rates rise. Realized symmetrical funding is a great way to offset losses stemming from any losses stemming from any future credit charge-offs or securities sales. Talk you your Relationship Manager who can help you strategize about applying the symmetrical advance to your balance sheet management program. We can help you run some portfolio sensitivity analysis that incorporates this hedging tool.
Another strategic move that more members have recently executed in an effort to increase asset sensitivity has been the so-called “blend-and-extend” move on the game board. If your balance sheet holds term advances, we can help you analyze the alternative of extending their durations and additionally review the impact on your future interest margins. Talk to your Relationship Manager about how to further develop this idea.
So, why choose this time of low interest rate policy to dare mention the possibility of rising rates and talk about related balance sheet strategies? Maybe I’m still traumatized by the first mortgage that I ever took out at 15 7/8% a mere forty years ago, but Bill Dudley, former president of the New York Federal Reserve had some interesting comments on the subject of inflation on various media sources earlier this month. He cited some associated risks to add to the risk game board.
Let’s review his concerns:
- In the wake of business closures that have taken place over the past year, a sudden surge in demand could cause some capacity constraints post-vaccination
- Capital misallocations could lead to continued inflation in certain sectors such as residential housing
- The Fed has unabashedly stated that it’s in no rush to remove monetary stimulus in spite of future inflationary prospects
- Estimates for continued fiscal stimulus remain at the high end. Companies have strong levels of cash and consumers continue to post a record savings rate. Companies are increasingly raising low cost debt and equity capital to deploy for rapid expansion once demand returns
- Finally, the current slowdown has been precipitated by a health crisis, rather than a financial crises. There is pent-up demand with liquidity and capital to fuel it
While rates are low and liquidity is in excess, there are some interesting developments in the equity capital markets, including increased bank activity in the subordinated and depository shares markets. Some of these capital strategies, as you’ll see, work hand-in-hand with advance funding. On that note, in association with Performance Trust, next month, we will be producing a webinar on “Optimizing Bank Capital in the Current Environment". Mark your calendars for 3:00 PM on Tuesday afternoon, March 9. Register on our website.
Well, in the words of Commander William Riker of Star Trek: The Next Generation, “The game isn’t big enough unless it scares you.” Remember the level of the game you are playing. Stay well, liquid and hedged. Think chess, not checkers! We’ll see you next time on the FHLB Des Moines Insider Podcast. Thanks for tuning in.
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