The Invisible Gorilla - Episode 4

last updated on Tuesday, July 28, 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 from the Bank. This is your host, John Biestman, Senior Relationship Manager.

A wise-cracking relative texted me last week with a riddle: “What do Alexander the Great, Charlie the Tuna and Chance the Rapper have in common?” Exerting the mind for possible parallels between ancient history, piscatorial cartoon characters and contemporary musicians was futile. Dumbfounded, I reluctantly read the snarky answer: “All three share the same middle name.”

The same conundrum can actually be applied to the way we sometimes monitor our strategic dashboards where the answers are deceptively as plain as the nose on our faces, which I’ll get to in a minute. A famous human behavior study was conducted more than a decade ago by Daniel Simons, a University of Illinois cognitive scientist. That video study, a selective attention test, depicts six students that for a minute or so, are passing a basketball around. Viewers are asked to count the amount of times the students passed the basketball.

In the middle of the video, a gorilla promptly walks across the screen. After the video concludes, viewers are asked two questions: “How many times was the ball passed?” Did you see the gorilla prominently featured in the video?” After seeing the clip, the vast majority of viewers correctly counted the basketball passes. No one at all recalled seeing the gorilla.

For those of you interested in the short video, search for “The Invisible Gorilla Experiment.” Try it on your friends.

So, what’s the point of an invisible gorilla? Especially these days with the issues our industry faces such as margin compression and credit pressures, our ability to solve complex problems may cause us to overthink simple problems. Naturally, we’re predisposed to searching for a complicated answer in favor of a simple one. I’m sure that many of you would agree that the best way to solve a complex problem is to solve an underlying and related group of simpler problems, one-by-one.

We’re in the thick of Q2 reporting season. Not unexpectedly, loan loss reserves are on the rise and may need to increase into the third quarter. It’s possible that the level of loss reserving has yet to reach some of the more severe credit stress tests; that is those that go beyond the “V-shaped” recovery scenario. We’re all looking at developments associated with the potential expiration of government pandemic aid and prospects for additional funding legislation.

We do know that many of the larger banks are seeing the ratio of their reserves to projected losses from stress tests beginning to increase. So, we’ll soon see if current conditions will result in financial institutions sustaining balance sheet issues a la 2008, or if they would more significantly impact earnings or returns. Indeed, in addition to credit concerns; headwinds posed by the flat yield curve, excess liquidity and waning loan growth don’t seem to be dying down.

The Sum of the Parts (by Dupont)

So, lets go back to the theme of solving a complex problem by collectively solving a series of simpler problems. Your top-line indicators of performance, be they return on equity or return on assets, are driven by a sum of multiple metrics. The modern theory of corporate finance postulates that a firm should continue to invest in itself to the extent that its risk-adjusted return on equity exceeds it weighted average cost of capital. If we were to decompose a return on equity, round one would could be represented by the simple formula of ROE = ROA*Leverage.

The “leverage” component is of course a function of regulatory constraints as well as levels of acceptable cushion for potentially adverse business conditions. ROA, now that can be a bit more complex. It consists of multiple parts, including: deposit costs, deposit mix, securities yields, loan pricing, non-interest income…the list goes on. As these multiple determinants change, so too does the top line, ROE. This sum-of-the-parts or decomposition methodology is called DuPont analysis.

If you are going to target an ROE that exceeds your cost of capital, you will need to deconstruct your financial metrics and figure out what it takes to get there. Can you change your loan mix, adjust your pricing, change the mix of your securities? A decomposed DuPont analysis can be useful from different perspectives. Let’s say you would like to raise your ROE objective by 50 basis points. You might focus on deposit costs, which might be 43 basis points, slightly above your peer group’s cost of 39 basis points. This variance might prompt you to examine your deposit pricing elasticity and your segmentation strategies.

What a great item of focus for your next ALCO meeting. You could also run a marginal cost of funds analysis to compare the true cost of deposit funding versus advances or wholesale borrowings. Historical experience shows that it’s best to de-segment your deposit categories when rates are declining and re-segment when rates are rising.

You might also look at the mix between securities and loans. Are you carrying too many lower-yielding securities on your balance sheet? Some of your securities may unnecessarily be encumbered by your public funds depositors. You might want to run an analysis of how you could redeploy capital toward higher-yielding loans by eliminating securities pledges and alternatively having an FHLB Des Moines letter of credit being issued in favor of the public depositor.

Your Relationship Manager and our Member Strategies team can help you construct a customized DuPont analysis. Together, we can discuss the composition of a peer group analysis and a “what-if” impact and strategic analysis for any of your key ROE-drivers. The process has generated quite a few “ah ha” moments in our discussions with members. Also, I mentioned the exercise of de-pledging public funds-related securities. We have some analytical tools available that can help you assume the opportunity ROE impact of reducing securities as part of your asset mix. Again, our strategies tools and consultative approach are a key benefit of your membership. Let’s roll up the sleeves together.

Funding Forward

In Episode 2 of The Insider, we discussed the funding alternative of fixed-rate, fixed-term advances whose funding could be delayed up to two years forward on a mandatory settlement basis. Just a quick note: In recent trading sessions, some forward-settlement maturity and settlement combinations, particularly in two-year maturities, have actually supported yields that were a few basis points less than corresponding maturities without the settlement feature.

So, if you’re looking to fund an asset commitment that doesn’t settle immediately, give us a call and we can explore the forward settlement solution with you.

Hybrid HELOC’s – Looking Under the Collateral Hood

Some of our members have expanded their HELOC marketing efforts to include so-called convertible or hybrid HELOC’s. These loans contain a provision that permits conversion, during the floating rate period, of one or more draws to be funded as closed-end, fixed rate, amortizing loans. Many of you know that banks in the Federal Home Loan System are bound to accept only collateral that has a readily ascertainable market value that can be liquidated, if ever necessary, on short order. So, we conducted a lengthy legal, regulatory and operational review of this emerging collateral category and will be issuing updated guidance on HELOC eligibility, effective October 1.

As a result, we’ll continue to accept all standard open-end and closed-end HELOC’s. For those HELOC’s with convertible or hybrid features, those with no closed-end funding are eligible. Also eligible would be hybrids that have closed-end funded portions that are documented by notes that are separate and distinct from the original HELOC note upon which that funding was based. What would be ineligible are funded closed-end, fixed portions of hybrid HELOC’s that remain documented against the original HELOC note. Clear as mud? If so, and if you have pledged or plan to pledge hybrid HELOC’s, contact your Relationship Manager for further clarification.

Relative Performance

Don’t forget that our Member Strategies team can help you customize peer group performance trend analysis for multiple variables, including: deposit and loan growth, credit metrics, funding usage, capital complexion and many others. For illustration purposes, we recently completed an analysis that scanned the performance of community banks with assets ranging between $500 million and $1 billion in the states of Washington, Oregon, Montana, compared with the overall FHLB Des Moines membership. We could just as easily juxtapose your desired performance metrics against a specific institution-by-institution peer group that you can provide.

Let your Relationship Manager know if we can ever help you with any such customized analysis. Simply tell us the parameters you’d like us to run and we’ll get to work. Customized peer performance and Dupont analyses, as I mentioned earlier, are a nice benefit of being a member of your cooperative.

With the imminent release of second quarter results, an increasing amount of our members’ ALCO’s and boards are using output from our quarterly economic analyses. Look for that analysis to be released early in the second week in August. We’ll cover the highlights in the next broadcast.

Strong Communities Award

Every year the Federal Home Loan Bank of Des Moines highlights the leadership and work of our member financial institutions and their community partners by awarding the Strong Communities Award. In light of the far-reaching effects of COVID-19 on our communities, we are proud to offer the Strong Communities Award this year. The award recognizes collaboration and leadership in communities by measuring the results of these projects and their impact on creating stronger communities.

Two first place winners - one in the Rural category and one in the Urban category - will win $15,000. All runner-up finalists will receive $3,000.

Applications are now being accepted through August 28, 2020. Visit to learn more and apply.

We’ll see you next time on the FHLB Des Moines Insider Podcast. Stay well, safe, liquid and methodical. Sometimes those answers to your complex issues are right in front of you. Thanks for tuning in.


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