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Is Now the Time to Extend Funding?

By Loughlin Cleary, Relationship Manager

On August 9, the Federal Open Market Committee announced that it would keep the federal funds rate at its current low level.

"To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent," the FOMC said. "The committee currently anticipates that economic conditions ― including low rates of resource utilization and a subdued outlook for inflation over the medium run ― are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013."

Based on this statement, members may conclude that now is the wrong time to extend liability funding. On the other hand, it could be argued that the current environment presents the perfect opportunity to look at extending. Even though the FOMC says that current conditions "are likely to warrant exceptionally low levels," there is no guarantee that the rate outlook will remain the same in the future.

Although the Fed has promised to keep the fed funds rate between 0 and 1/4 percent, that could change if market conditions warrant. Moreover, a near-zero fed funds rate can't control the long-end of the rate curve, and there is no direct correlation between short and long rates. There is also no guarantee that the Fed's bag of monetary and stimulus tools will control the direction of rates. Factors beyond the Fed's control affect long-term rates, including economic indicators such as inflation, which may cause term rates to increase. Since there are no guarantees, now may be a good time to look at funding extension.

As asset rates continue to grind lower, the use of term funding provides members with more flexibility in the types of loans offered and makes them more competitive in their markets. At the same time, term funding locks in a fixed spread regardless of the direction in which rates are moving and reduces income volatility on the balance sheet. 

The extension of liabilities provides an insurance policy against rising rates, especially for institutions that book long-term, fixed-rate loans. Because of the recent precipitous fall in term rates, the cost of insurance has fallen drastically. As an example, on July 15, 2011, the cost of a five-year advance was 2.22 percent, compared with a current rate of 1.67 percent. The cost of extension insurance at five years has fallen by 55 basis points or $5,500 on a $1 million advance (annualized). The extension premium ― defined as the difference between short rates and the extended term (or the amount given up by extending versus staying short) ― has also fallen.  On July 15, the extension premium was 2.03 percent (five-year advance 2.22 percent less one-month advance 19 basis points), compared with a current premium of 1.48 percent (five-year advance 1.67 percent less one-month advance 19 basis points) ― a decline of 55 basis points.

Similarly, when considering derivatives for interest-rate protection, bankers typically buy caps and floors when insurance is relatively cheap. That same logic can be applied to the purchase of term advances, which currently are both relatively and historically cheap.

On September 8, members took down $75 million in our five-year special.

 
 
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