Vanity, Sanity and Reality - Episode 3

last updated on Tuesday, July 14, 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.

One of my favorite, timeless source-anonymous words of wisdom that I’ve ever heard were: “Revenue is vanity. Profit is sanity, but cash is reality.”

It’s fair to say that our industry has been trying to offset the pressures of a flat yield curve with extraordinary, non-interest income opportunities. Many are looking forward to booking income associated with the sale of Paycheck Protection Program (PPP) loans and/or a spate of refinance-related mortgages. Knowing that financial institutions recognize fees once PPP loans are paid-off or forgiven, we’re hoping that the positive non-interest income effect will carry over into the third quarter. Some of this income will likely be directed to increase loss reserves, or more optimistically, to sustaining dividend programs.

On the funding side, we’re once again becoming accustomed to a ZIRP or “zero interest rate policy” world. Even CD’s which as of the end of March represented 19.1% of total $3-$10 billion-in-assets bank deposits (vs. 22.2% one year earlier) are re-pricing aggressively lower, albeit now at a slower rate than last month. It goes without saying that the industry is welcoming the prospect of imminent term deposit maturities.

Overall, banking industry deposit growth has been leveling off, but has still outpaced loan growth by a significant pace since January 1 and has grown by roughly $3.4 trillion. Industry loan balances which peaked in growth by approximately $800 billion in early May, have since dropped by roughly $300 billion in the wake of reduced PPP originations.

Evaluating Sustainable Earning Power

Now on its sixth edition, the 1934 classic, Graham and Dodd’s “Security Analysis” has served as the foundational treatise for value investing and fundamental financial analysis. Way ahead of its time, the timeless book discusses the importance of what the authors characterized as the “continuity, consistency and stability of earning power.” They used the term in describing the inherent value as well as the creditworthiness of an enterprise.

Even in the days of the book’s first edition, when cash flow statements were not common, Graham and Dodd recognized the importance of regular and optimally predictable core earnings streams. On the subject of forecasting earnings, “next year’s profits are of real importance only if they can be viewed as indicative of the longer-term earnings power…seldom does a single year’s result turn out to be representative of the results over a full business cycle.”

In modern times, your financial institution’s value is increasingly viewed as being related to the consistency and quality of earnings. But, in these unique times, the scenario of flat and low rates may be plausible for quite a while. Many of our members, particularly those with asset-sensitive interest rate positions that are so dependent upon supporting sound net interest margins, could see the quality of their core earnings face unprecedented challenges.

So, on the whole idea of earnings consistency, even during black swan events and unpredictable cycles, are you asking yourself, “How can I position my business to support a more consistent and reliable stream of earnings?” We’re not necessarily talking about earnings from an accounting perspective, where it’s fairly straightforward to isolate extraordinary income and non-recurring events. We’re taking a strategic perspective where we are talking about what parts of our businesses are core and can generate earnings over a sustainable period versus those that are non-core and transitory. That’s the basis upon which we’re valued. Warren Buffet and other investors who are in it for the long haul look at earnings persistence and consistency to estimate both financial stability and the basis for valuation of a company.

Mortgages: To Sell or Not to Sell?

Let’s apply this logic to the current environment. In spite of weak unemployment and economic growth conditions, the housing market appears, for now to be supported by favorable demographic demand relative to limited inventory and perhaps the desire of some to leave the confined environment of multifamily living units to the controllable environment of a single family home.

Coupled with low interest rates, demand for mortgages has been the most robust loan category in an otherwise moribund lending environment. You have probably been thinking about how to best take advantage of the mortgage origination opportunity. It might not be a bad thing to consider should the growth in other lending categories continue to wane.

There’s no doubt that a protracted low-rate environment has and will negatively impact your net interest rate margins. With ample liquidity in the deposit market, for now, you may want to employ the logic of funding and holding mortgages or mortgage-backed securities with your deposit base. Alternatively, you may be looking at the option of taking a gain from originating and selling mortgages.

As relatively attractive as these options may be, you’ve got to some important questions to ask yourself: Are the deposits, or at least a portion of them that you’re looking to use as a source of funding, transitory? Are you uncomfortable with the assumed duration of these deposits? How susceptible are mortgages to prepayment or interest rate risk? Are these two risks asymmetrical given current rate environment?

We’ll save a deep discussion of funding diversification for a separate podcast, but in this situation, whether or not you ultimately sell or hold originated mortgages, you should be thinking about blended funding scenarios where you would evaluate the impact of different proportions of duration-uncertain deposits with laddered advance structures with duration-certain funding characteristics. In doing so, you’d need to do some serious thinking about the prepayment speed assumptions of the mortgage assets as well as characteristics of the deposit side, such as decay rates, rate beta’s and assumed surge levels.

So, back to the original proposition: In the face of margin pressures and limited loan demand from many loan types these days, are you best off to originate, portfolio and service mortgages; or should you take the gain on sale?

If your strategy and infrastructure has been on the side of selling mortgages into the secondary market, you’ve been riding on some gains for quite a while. Congratulations!

Or, lately after having seen your interest margins slip, have you been tapping into this source of non-interest income? If you have been, hopefully you’ve considered the opportunity cost of selling mortgages that you are now originating. That is, there may be an opportunity cost of not holding your originated loans on your balance sheet, as this may come at the expense of diminishing your long-term or sustainable net interest margin.

If you’re not considering potential impacts on your sustainable net interest margin, Messrs. Graham and Dodd might be taken aback!

So, you used to think that you were indecisive, but now you’re not so sure…

OK. We continue to assume that you’ve been thinking rationally about the importance of not having your institution join the industry’s secular NIM downtrend and are originating and selling mortgages.

Your thoughts next turn to the foregone net interest margin that you would have received in 2021 and well beyond. There is a way to help frame the trade-off in the form of a break-even analysis: At what point would the present value of a foregone stream of income from retained mortgages equal the value of an immediate sale?

Our Member Strategies team has developed some analytical tools to help you frame this assessment. I encourage you to engage with your Relationship Manager to analyze the decision options that your specific institution might have on the table.

I’ll run an example for you. We recently reviewed a member that is originating mortgages and wanted to evaluate the trade-offs between holding and selling.

In building our assumptions, we looked at the member’s cost of capital and assumed a variety of rate scenarios, including parallel and instantaneous shocks and situations in which we might return to a positive yield curve slope or even sustain an inverted yield curve. We also evaluated various funding blends, for funding portfolio'd loans with a mix, as an example, of 80% deposits and 20% laddered term advances.

Assuming parallel and instantaneous rate shocks, we saw that net present valued cash flows generated by holding mortgages was substantially in excess of gains from mortgage sales on the order of three times in an unchanged rate scenario. The break-even cross-over took place just above an instantaneous rate move of slightly over 200 basis points. It’s useful to test outputs from multiple blended funding mixes, yield curve and rate movements.

There may be other ways to address the opportunity cost issue. For instance, if you ultimately decided to sell mortgages, you can consider other ways to replenish your balance sheet growth, perhaps through looking at seasoned mortgage-backed securities that may be less susceptible to interest rate changes.

Again, on the issue of holding vs. selling mortgages, engage with us. Your Relationship Manager and the Member Strategies team would be glad to help you visualize the trade-offs under different rate and yield curve scenarios.

eNotes Up and Running

Shifting gears, we’re now up and running and working with members to accept eligibility of residential mortgage electronic promissory notes as collateral. Loan-to-value ratios will be the same as wet-signature notes. We know that you’ve been looking for ways to compete with those non-financial institution originators, reduce origination expenses and expedite the lending process; so we’re encouraging you to get set-up.

Contact us and we’ll help you get started with the process. You’ll start out the enrollment process by executing an addendum to your existing APSA agreement. Then, you’ll select an eVault technology provider and complete the integration and membership process with MERS, our electronic registry. You can access resources, checklists, guidelines and other learning material on

Funding Over Year-End Opportunities

During a protracted lockdown, it’s important to get plenty of exercise. Accordingly, many of us are taking the advice to heart; jumping to conclusions, pushing our luck and dodging deadlines.

Speaking of which, we’ve extended the pandemic response short-term funding program to October 15. Of late, respective rates on the three-month and six-month have priced in the range of 12-13 basis points below regular posted levels. So, on a dividend-adjusted basis, it’s possible now to fund beyond year-end with rates that net out in the mid-teens, based upon your cost of capital assumptions. Again, the program is only accessible by calling trades into the Money Desk. $60 million institutional caps still apply.

Back to School

If you haven’t done so already, get our 2020 Virtual Leadership Summit on the calendar. It’s set for the afternoon of 1:00 pm Central Time on October 21. We’ve scheduled some headliners that are world-known.

Finally, back to the subject of finding that right balance of short-term profit opportunities with sustainable earnings, I’m thinking about the wise man who once discovered how to double his quarterly profits. He declared that going forward, each quarter would last six months!

We’ll see you next time on the FHLB Des Moines Insider Podcast. Thanks for tuning in.


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