Make the Blend Your Friend - Episode 7

posted on Tuesday, September 8, 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.

When you ask anyone that has ever served in a choir, you frequently hear them explain that the biggest challenge, yet the penultimate reward is blending in. The old self-deprecating radio comedian, Fred Allen, begged to disagree, once saying, “The first time I sang in the church choir, two hundred people changed their religion.” More about the subject of blending-in, in just a minute.

The FDIC’s Second Quarter 2020 Quarterly Banking Profile was recently released and had some interesting insights. Industry Return on Assets, thanks to a 40% increase in provision expense, was 36 basis points, versus 138 basis point during the same quarter a year ago. Community banks, which comprise 91% of insured banks, fared a bit better thanks to gains on loan sales and non-recurring loan volumes associated with PPP activity. The industry’s net interest margin also declined by 58 basis points, to 2.81%, a record low. Clearly, asset yields have been declining at a much faster rate than have funding cost. Now, that’s interest rate risk, alive and well. Net charge-offs increased by 22.2% over a year ago, the largest percentage increase since 2010.

On our last podcast, we introduced the concept of funding diversification beyond deposits, even in times of excess liquidity, and how it mitigates interest rate risk. Objectively, the funding world is divided in two: duration-certain and non-duration-certain (even in the case of so-called maturity deposits).

All other funding dichotomies in and of themselves, including “core” or “volatile”, are subjective definitions of funding. That’s not to say that certain types of volatile liabilities are not worth examination. In such times of excess liquidity, it’s still helpful to recognize how much of your deposits are composed of the “surge” variety and for how long they might stick around.

I recall one of our Montana members once telling me that a famous Hollywood actor habitually deposited large surge deposit balances at the completion of his movies. The duration of these sorts of surge deposits is perhaps easier to project than those that stem from macro-sources such as pandemic-induced excess liquidity.

While we’ve hopefully established the need to diversify funding sources, let’s summarize how we view success or what our objectives are. Our goals are to:

  1. establish and protect spreads,
  2. coordinate funding flows with asset cash flows and
  3. complement your deposit with duration-certain wholesale funding. 

At the end of the day, examining various blended funding scenarios can help you make loans your customers want, create funding solutions that meet your risk and return parameters, match fund a single loan or a portfolio of loans.  We see many members regularly review blended funding output with their loan, credit and ALCO committees.

Simply put, a blended funding concept involves using term advances that can be either bullet or amortizing structures and supplementing them with low cost, admittedly duration-uncertain deposits. 

Again, why duration uncertainty? Deposit lives may vary according to interest rate environment, geography, type, access, pandemics, technology, etc. The idea is to create some partially matched funding flows with advances in order to build in some prepayment protection against asset prepayments. 

Deposits serve as funding complements due to their low cost and because of their value in the event funded assets are on the books for longer than expected. 

There are few steps involved in developing a blended funding strategy: 

Step 1

You will need to understand your deposit base.  Why? Especially these days, it’s the largest funding component of your balance sheet.  You’ll need to have some idea of how sensitive your non-maturity deposits, in particular, are to changes in interest rates. If you tuned into the August 25 balance sheet webinar with Dave Koch of Abrigo, we learned about how often we fail to appreciate how the composition of our deposit types can shift as rates rise and fall. Dave also discussed three of the major issues which many of our members are talking about of late:

  1. how to put all of this excess liquidity to work,
  2. changes that must be made in approaches to stress testing and “what-if” analysis, and
  3. the importance of re-setting prepayment and deposit beta assumptions in the wake of COVID-related distortions.

If you missed that webinar, we’ve recorded it on the FHLB Des Moines Educational Resources link on our website.

Step 2

You’ll need to understand the character of your asset cash flows.  Remember you’re in the business of funding cash flows and not maturities.  A 15-year loan is NOT a 15-year asset.  We know that the average life of a 15-year loan can be substantially less, especially in this day and age. 

Step 3

Now that we better understand the characteristics of our funding and asset cash flow projections, we would first, explore fixed-rate funding to provide structural support with bullet or amortizing fixed-rate loans in order partially match cash flows and provide some prepayment protection. Again, think about your asset cash flow projections in today’s environment. As an example, are you adjusting your loan-related cash flows in the wake of forbearances, deferrals and the like?

Step 4

We would complement the fixed-rate funding with non-maturity deposits to plug the funding gap, and take advantage of low-cost and inherent extension-risk hedge qualities.

Step 5

Finally, we would compare the relative impact of each strategy with and without a blended funding approach. 

Our Member Strategies team uses a blended funding model and protocol that can help you assess different funding scenarios against interest rate outcomes, asset prepayment and deposit assumptions. With the goal of mapping various scenarios and assessing their impact on you net interest income and economic or market value of equity, give us a call.

While we’re on the subject of balance sheet blending, here’s another strategy that may be worth a reminder: “blending and extending.” With interest rates having dropped to levels approaching sea level, it’s worthwhile for financial institutions to monitor their soon-to-be-maturing advances.

For example, some may have conducted term funding when rates were higher, say during the latter half of 2018. A number of factors may influence your decision to refinance advances before maturity, including: liquidity projections associated with loan and deposit growth, interest rate sensitivity or your view on future interest rates.

Essentially, subject to satisfactory accounting treatment, the strategy calls for the prepayment fee of an existing advance to be blended into the rate of a new, lower coupon advance; while the duration of the existing advance is extended.

As such, there is no need to wait for the existing advance to mature in order to renew your funding requirements. There would be no cash settlement of the prepayment fee since it would be blended into the rate of the new advance.

Why might it make sense for an institution to consider whether a “Blend and Extend” strategy is a good fit? There are a number of possible benefits, including:

  1. improving future interest margins,
  2. filling funding gaps with new maturities ranging from two to 20- years,
  3. gaining an ability to pre-fund against the possibility of rising rates, and
  4. for liability-sensitive institutions or those that desire additional asset-sensitivity there may be benefit in extending liability duration without increasing funding balances.

Your Relationship Manager is well-versed in the blend-and-extend strategy. Typical users of this strategy of late have been liability-sensitive members or others holding longer-duration assets such as mortgages which could use some extension in liability duration without adding funding to the balance sheet.

Let’s turn now to the corner of NW Connecticut Avenue and 20th Street in Washington, DC. All eyes have been focused on the possibility of moving the threshold of inflation tolerance. It’s now been almost ten years since the Fed promulgated its inflation target of 2% a level that, at least measured by the PCE deflator, has fallen short. It seems that sentiment is shifting to a growing willingness to increase inflation tolerances in order to invigorate economic growth.

For right now, it seems that there’s a lot of money chasing too few good investable situations, rather than too few goods and services. How long this condition persists depends on vaccine development, business spending and consumer confidence.

So, the Federal Reserve with its dual mandate of containing inflation and the unemployment rates, plans to accentuate the latter goal. Just remember the wise words of Herbert Stein, who served as Chairman of the Council of Economic Advisors during the inflationary era of the Nixon and Ford administrations and father of Ben Stein, known as Stein’s Law:

“If something cannot go on forever, it will stop.”

This law should resonate as you focus on your balance sheet’s interest rate risk. We’ll see if the change in the Fed’s approach to the dual mandate will have any impact on the shape of the yield curve. There’s no doubt that the Fed is bending over backwards to provide liquidity into the system. I’ll give you a benchmark. 

In the second quarter, the combined $5 trillion injections of monetary and fiscal aid actually exceeded the quarter’s GDP! We’ll talk about what we’ll dub the reverse liquidity crisis means for you and steps you can take to address it in our next podcast.

FHLB Des Moines Reminders

Don’t forget about our headliner event, the Virtual Leadership Summit scheduled for October 21. Featured speakers will be world-known Mohamed el-Erian, Chief Economic Advisor at Allianz, the coprporate parent of PIMCO, where he served as CEO and Co-Chief Investment Officer. Also, James Bullard, President and CEO of the Federal Reserve Bank of St. Louis, and noted author Shawn Achor. Online registration is now available or contact your RM for more information.

For another worthwhile event, online registration is now available for our October 8 Virtual Mortgage Conference. Discussions will encompass Economics, Mortgage Operations Best Practices and Motivating Your Mortgage Teams.

We’ll see you next time on the FHLB Des Moines Insider podcast. Whether it’s during times of excess liquidity or sparse liquidity, we can work with you to find the right, customized blended funding strategies that can diversify your funding sources, and that can address your margin and duration challenges. We’ll talk in the fall! Thanks for tuning in.