Asset-Liability Management & Funding Strategies for the Current Environment

Well, good morning, everyone.

I thank you for joining us today for our latest webinar here, as we sit on the last day of the First quarter, and I am happy to have you with us.

We have a pretty full agenda, and we have great attendance numbers. So I don’t know if it’s the combination of the topic, the presenters, or just the general climate that we’re existing in right now. So, to give you a little preview of what we have to discuss today.

Caroline is going to take us through some of the pretty exceptional volatility that we’ve seen in interest rates over the last few weeks and some ideas in terms of the exposures and what we can be thinking about to navigate that volatility.

Tyler is going to talk about loan and deposit pricing, and the prospect of prepayment risk, and how we properly account for that.

And then I’ll come back and talk about floating-rate advances and puttable advances, and as the opportunity ebbs and flows there, what looks good right now and what might look good as we advance through into the future.

So Caroline’s going to kick that off, but I will point out that if we have any questions along the way, please use the chat box, and we’ll be happy to address them.

So I usually forget to invite questions. So I think we’re off to a good start.

Just ignore the fact that Stacey, behind the scenes, reminded me.

Otherwise, I 100% would have forgotten.

So no one can say that I’m not transparent with how we approach this.

So without any further ado, I’m going to hand it off to Caroline, and she’s going to take us through our first topic.

All right, thanks, Andrew.

Yeah, so I’m going to start with just what’s happened in interest rates over the last couple of weeks and what that might mean for your balance sheet.

So I’m not going to spend too much time today talking about recent macro data or other macro developments because we’ve now got FOMC updates for you.

And we’re going to cover it more in a macroeconomic webinar focused on New England topics in a couple of weeks.

Though we’re always available to help with questions about that, I more just want to focus on really what’s happening in markets for today.

So, as I’m sure you’re all really well aware, interest rates have moved up a lot since the beginning of Operation Epic Fury, the war in Iran. This has occurred across the curve.

So you’re looking here at the two-year, five-year, and 10-year treasury, but the move has been most pronounced at the front end of the curve.

So you’ve also seen flattening across the curve. We started before March.

We were pricing several rate cuts this year, at least two. Those have now completely been priced out of the curve.

So we have the markets effectively pricing in no change in the federal funds rate for about a year and a half here.

So when we look at decomposing the move in treasuries, what we’ve seen is a lot of the move upward in treasury yields has been a product of a move upward in inflation expectations.

So TIPS, which are Treasury Inflation Protected Securities, have moved up more than nominal treasury yields, which basically means that what we’ve seen is something called TIPS implied breakevens, the difference between the nominals and the inflation-protected securities widening-

That typically happens when you see energy prices move, which obviously has been one of the largest effects of the war in Iran.

It also means that it’s harder for the Fed to cut rates because, as inflation expectations move higher, even if they’re for supply-side shocks like an energy shock, it becomes much harder for rates to come down.

And you saw Powell acknowledge that yesterday when he was talking about the fact that the FOMC is kind of looking through this move in inflation expectations and tips for the shock, the duration of which is pretty unknown.

But at some point, if you get higher run inflation expectations and move higher treasury yields, it becomes really difficult for the Fed to ignore that.

So what I want to talk to you about today is not just the level of interest rates, but also interest rates and volatility.

So, interest rate volatility is not where interest rates are; it’s just how much interest rates are changing. There are a lot of different ways to look at it.

So one is, you can look at implied interest rate volatility, which takes options pricing to suggest what we’re going to see in treasury yields in the future.

Another way is to look at realized volatility, which is just to look at where interest rates have been, and the two are quite correlated.

The chart that I’m showing you here is basically just a rolling monthly standard deviation at the 10-year, so it’s showing you realized volatility, and you can see there my circle got a little moved, but interest rate volatility has picked up a lot.

I want to be transparent and level set with you guys that we’re still at levels well below what we saw in both implied and realized volatility when interest rates were higher.

So if you think about 2022, where we had eight, 9% inflation and treasury yields were at a much higher level, we saw higher interest rate volatility than what we’ve seen now.

Nonetheless, it has moved up a lot in recent weeks and certainly could move up further depending on how many market disruptions you see and changes in energy prices and inflation expectations. Okay, so why should you care, right?

I think the important thing that I want to communicate is that, you know, interest rate volatility is not just an economic curiosity.

It’s something that’s really important for managing your balance sheet.

And there’s a couple of reasons. The first thing is expected liability repricing.

So if you started the year thinking that the Fed’s going to cut twice this year, that’s what’s priced into the curve.

And I can pass that on through my cost of deposits, you’re, based on market pricing, somewhat less likely to be able to do that now.

You could potentially have repricing of liabilities faster than assets, depending on your business structure.

So, depending on how many loans you’re issuing or what you’re buying on the asset side, it may be the case that you’re seeing your liabilities or your deposit costs repriced more quickly than the assets.

So you’re only picking up the benefit of the move upwards in yields on one side, or if you’re really incurring the cost.

And this is going to be particularly true given the flattening that you’ve seen in the curve, right?

So you’re not seeing a proportional move up where longer dated things in the steepening curve is going to be supporting your balance sheet.

There are changes to expected cash flows.

This is really due to options repricing, particularly for mortgages.

So mortgages are negatively convex, which means that when volatility picks up, repayments also on average pick up, which can affect your cash flows and your ROA.

And it also becomes more expensive to hedge option embedded instruments given the wider distribution of outcomes for rates.

Lastly, if you’re holding on to more liquidity, given more uncertainty, that can also be a drag on ROA.

So there’s lots of ways that an increase in interest rate volatility is going to negatively impact your business, or could negatively impact your business.

So the first thing you should do, I think as a depository, is take a look at your own balance sheet in your business model and try to figure out, am I in a position where I’m going to benefit from this uptick in interest rate volatility or am I in a position where I’m going to underperform?

So there are institutions that typically do better when interest rate volatility picks up relative to their peers.

So the first thing is think about your floating rate loan exposure.

If you have floating rate loan exposure in material quantities, you’re typically compared to a peer group going to be less impacted by an increase in interest rate volatility, because obviously floating rate loans are going to be adjusting with the changes in interest rates.

If you have minimal fixed rate mortgage exposure, you’re probably less exposed to a pickup in interest rate volatility than peer group.

If you have short repricing lags, meaning that you’re able to take advantage of the asset side of the equation, you’re able to buy assets or to issue loans at higher rates was as treasury yields move up, you’re less going to be less susceptible to underperforming.

And of course, I mean, this group’s always a winner.

But if you have inelastic core deposits, like transactional operating accounts, you’re going to do a little bit better because you might see less repricing on the deposit side of the equation.

Institutions that have shorter duration, higher turnover lenders tend to do better for the same reason that the depositories with shorter repricing lags do.

They’re able to pass things on more quickly and gain the advantage of higher interest rates in addition to the higher deposit costs.

And then the last thing, which is something you can do, is thinking about depositories that hedge cash flows, rather than just duration alone, are going to have less risk.

So if you’re hedging your duration alone, that duration is not taking into account interest rate volatility, right?

Duration on individual instruments will change as interest rate volatility changes.

But if you’re thinking about being specific and hedging your cash flows, you’re probably better positioned to weather an increase in interest rate volatility than if you’ve just managed your top-line duration risk.

And let’s talk about the flip side.

Who’s vulnerable?

So it’s basically the opposite of the things that I just said.

But if you are a longer-duration lender, you’re typically, on average, more vulnerable to an increase in interest rate volatility.

If you’re a mortgage-heavy lender, particularly somebody with fixed-rate residential mortgages or long-dated CRE, you’re probably more vulnerable.

If you have elastic liabilities where you depend on money market like structured or broker deposits, you’re a little bit more vulnerable here.

And lastly, if you hedge only your duration rather than cash flows, you’re probably pretty vulnerable.

So take a look at your own business structure and try to figure out where you fall in that distribution to try to understand how you might perform if interest rate volatility continues to trend upwards.

Okay, so what can you do?

A couple of things.

The first thing you can do is think about increasing your floating-rate exposure.

So there’s a couple of ways to do this.

On the liability side, FHL Bank Boston offers floating rate advances.

So you can increase your exposure to floating rate advances and increasingly fund yourself through floating rate exposure rather than fixed rate exposure.

On the asset side, you can consider issuance of floating-rate loans or buying assets that are floating rate.

And similarly, you can reduce your issuance of fixed-rate loans or price them higher to account for the fact that you’re going to need to incorporate these higher hedging costs.

Hedge your cash flows, not just your duration.

So consider modeling around cash flows, which are less volatile than duration alone.

You can match them with FHL bank advances if that’s of interest to you.

And you can also use option embedded liabilities and assets to curtail your duration risks.

So when interest rate volatility picks up, tail risks increase for interest rates.

Something you could think about is an option embedded advance, like an FHL bank advance or a Member-Option Advance, to tailor your exposure to duration risk and make sure that it’s strategic, and it’s what you as an institution feel comfortable taking in this environment.

And then the last thing I wanted to flag is that, you know, I’ve something I’ve pointed to a lot here is that if you’re an institution that has a lot of fixed-rate mortgage exposure, there is a risk of underperforming in an environment where interest rate volatility picks up.

This is going to particularly hit home for institutions that still have mortgages that are already underwater because they were issued before the most recent pickup and rates.

And we’ve been talking a lot about the MPF program, and I wanted to give just like a very quick overview of what I think is really compelling about the program.

So through the MPF program, you are able to sell your mortgages to the Federal Home Loan Bank of Boston, but you retain some of the risk in the mortgages.

So what I’m showing on this diagram is the credit risk sharing program.

It’s basically structured where there’s a loss absorption profile, starts with buyer equity, private mortgage, insurance.

And then there’s a first-loss account of 35 basis points that is held by the Federal Home Loan Bank.

And then you retain risk after that tranche, which means that, and you’re compensated for holding that risk.

So it’s essentially a way for an institution to sell mortgages to the Federal Home Loan Bank.

And so doing, you are passing on some or a very large portion of your mortgage risk, and tailoring your convexity risk in an environment where interest rate volatility is changing, but you continue to be compensated because you hold some risk in that mortgage.

So I think it’s a pretty compelling option for institutions that want to revisit their overall exposure to mortgages and think about tailoring that in this environment.

And that was great, Caroline.

And it’s the credit risk that is the shared portion, right?

It’s the interest rate risk, and the liquidity risk is absorbed by us via the selling of the loan.

Thank you.

Yeah.

Thank you, Caroline.

So in this section, I’d like to talk about optionality on both sides of the balance sheet and the situations where customers can react to rates faster than you’re able to, and how to manage that.

So if optionality is not priced in and funded appropriately, you can distort outcomes on both sides of the balance sheet.

So here we go.

So, what is the hidden option on your balance sheet?

This is when customers can move faster than you can.

And they can capture value through that option that they have to displace funding prior to the end of the term or to displace their assets, the loans they have for you prior to the end of the term as well.

And when this happens, it can distort your asset mix, funding mix, and your net interest margin as well.

And really, the thing to keep in mind here is that all options have value.

So walking through this chart, you know, when rates fall, and your borrower is able to refinance, that higher-yielding asset leaves, it’s obviously a negative outcome; rates rise, you lose lower-costing funding, it’s a negative outcome.

And then same thing with rates and falling, you have more expensive funding staying on the books and lower-yielding assets that can stay when rates rise.

And all this can happen if you don’t have that option priced inappropriately, as far as the option that you’re affording to your borrower or to your depositor when you make that initial deal with them.

So what I’d like to look at is what happened a couple of years or the last few years on the liability side when rates rose.

So what we really saw when rates came up is that low-rate CDs became very vulnerable.

Weak penalties really incentivize your depositor to cut that CD early to go into a higher-yielding CD for the end of the term.

And then what happens when this takes place?

Well, you have a lot of pressure on retention.

It becomes harder to hold those deposits.

You have a lot of pressure on your funding because that replacement funding is more expensive than it was when you initially put it on.

And then you have a kind of distortion that happens as far as the verticals that you’re growing.

So you might’ve had a plan in ALCO to be 25% CD, 25% money market, and 25% DDA, but when rates rose and all those CDs are able to prepay and go into those higher-yielding CDs, and you lose control over that funding mix, and you can have adverse outcomes due to that.

So what I’d like to take a look at is some ways that we can address that and there really there are two different ways to place a penalty on a term deposit so there’s a static penalty this would be say six months of interest maybe on a shorter CD or for longer CDs maybe 12 months of interest, easy to understand for the customer but they can undercharge when rates rise as we saw over the last few years.

Another option is a more dynamic penalty so this would be something like maybe the greater of six months of interest or at that current rate that the CED is at or the replacement rate on a the same term federal home loan bank advance so the customer cuts the CED with five months left on the term you would calculate the interest that it would cost you to replace that funding with a five month advance through us and then that would be the penalty if that were greater than six months of interest for example.

As we see on the slide, you know put the numbers to it on the bottom part of the slide, you can have a lot of power as far as giving your customer the incentive to stay in that lower rate CED.

You know thinking about if you had a two percent CD broken after six months and the customer wants to go into a five percent CD and the current Federal Home Loan Bank advanced to replace that 6.1 CDU is at 4.75, the static penalty only offers $1,000 of, it’s only $1,000 versus a dynamic penalty would be 23, almost $2,400 and that $1,400 difference is really powerful because the customer is only gaining $1,500 by breaking it early.

So by having that $2,300 penalty, it locks that funding in, which is really powerful as far as retaining funding mix and just retaining funding more generally, having a stickier liability side.

And this optionality is something that not only applies to your depositors, but some that you can benefit from as well.

So as growth on both sides of your balance sheet becomes more uncertain, whether it be through paydowns or the rate path or you’re not sure what’s happening, you know, whether the dispersion between loan growth and deposit growth, the more that’s true, the greater optionality has value on the liability side.

So whether it be issuing callable CDs on the brokered market or using callable SOFR-Index Advance through us, Member-Option Advance.

This gives you the power, say in six months from now, if you don’t need the funding that you took on or things aren’t as expected on the rate side, this optionality has a lot of value to you to be able to wipe your hands clean, get rid of funding that you don’t need, and something to keep in mind is even being maybe willing to pay up a little bit for that optionality and doing so, paying up more, the more that you have uncertainty on either side of the balance sheet.

And so the main takeaway here is we’re trying to move away from really purely rate-driven liability behavior.

So this is where CDs leave or are able to leave and are incentivized to leave whenever rates rise.

And this causes funding mix to change with rate shocks.

And your margin really ends up being beholden to the customer and timing that they have and the value of that option that they have is really what’s going to drive things as opposed to having a more strategic liability management strategy where the penalties reflect replacement costs that no matter what happens, you’re compensated for that option that you forwarded to the customer and you’re able to keep much more solid funding.

Those callable structures can preserve flexibility with funding as needs become uncertain and allow you to have more intent and make outcomes on the liability side, really reflect your ALCO plan as opposed to being more reflective of the path of rates.

And so the same thing is true on the asset side.

Anytime that the borrower has an ability to get rid of the asset without an appropriate penalty, this is creating an option for them you may not be fully compensated for.

And we want to think about, on the asset side, there’s a few different ways to kind of limit the value of that option and have some kind of control over your loans and the asset side.

So there’s a few different ways to assess a penalty on the loan side.

So that’d be a step down, which would be a much more simple penalty, something like 33221 penalty.

That’d be 3% on the first two years, a 2% of principal penalty for the third and fourth year and a 1% in the final year.

And something to keep in mind with a step-down penalty is that anytime a customer is really negotiating for a certain spot, maybe they’re asking for, hey, what would the penalty be at three years?

Really, keep in mind that’s a signal that the borrower is likely going to want to prepay at that point.

So keep in mind, maybe funding that with that option kept in mind on the liability side.

There’s also a yield maintenance.

This would be if the borrower prepays; they have to make up that yield that they would otherwise be paid.

So it’s similar to the deposit to having that dynamic penalty.

And then the feasible, it’s very similar but just different mechanics as far as how it happens.

Instead of having a replacement rate like a Federal Home Loan Bank and setting it to that, you’re putting a replacement asset on the books.

And so, in light of which of these penalties that you have on your assets, it can dictate how you want to fund on the liability side. So we have a sample five-year balloon CRE or C&I loan.

If you have a step down, it might make sense to, a step-down penalty on that loan, it might make sense to have a shorter, shorter classic ladder or member option or classic ladder so that you don’t get stuck with the funding further down and as I mentioned if the borrower is negotiating for a certain point like at three years keep that in mind and maybe take out a member option that has that prepay – free at that three-year mark so that you don’t get stuck with that asset. We’re sorry, stuck with that extra funding for that asset that you no longer have on the books. But if you do have a much stronger penalty like a yield maintenance penalty or a diffusion penalty, match fund the asset because no matter what happens, you’re being compensated for that lost interest income.

And so it doesn’t matter as much to you about getting stuck with extra funding.

And then something to keep in mind, as well, is that when rates rise, and a borrower wants to prepay, it can make sense to let them share in the difference in interest income.

So you don’t mind if a borrower wants to prepay when they have a 2% loan and the rates are at 5%.

So thinking about maybe allowing them share in that difference in income so that you can get some of those lower-yielding assets off the books a little bit earlier. If I can add, Tyler, one thing about the step-down penalties.

Fairly frequently, we have conversations with members, and we have a calculator that we can share that shows the hypothetical prepayment cost of advances if rates were to go down.

And members use that in a way to make sure that their prepayment fees on the loans are aligned with what the actual value of that option would be.

Tyler talked about how valuable some of those options can be.

So in a case where you may be collecting a 2% fee if the borrower prepays because rates fell down, well, looking at what an advance initiated at the time of the loan would be yielding, maybe that prepayment fee is 5% or 6%.

So a 2% fee in a bubble sounds great, but if you’re giving up something that’s worth 5% or 6%, then that begs the question, are we pricing, do we have the flexibility to absorb that, or are there other levers that we can pull?

Absolutely, and the same thing applies on the investment side as well.

If you’re buying callable investments, keep that in mind that while the extra yield may be very attractive, the issuer is very likely to call that when that benefits them.

So, keep in mind, funding those assets with liabilities that mirror the optionality so that you don’t get stuck with funding that you don’t need if and when those investments do prepay.

And so, to land the claim, what we’re suggesting here is really to, on both sides of the balance sheet, be mindful of the option that you’re granting to both your depositor or to the borrower.

Maybe strengthening those penalties, but either way, whether you do or not, just being mindful of the value of the option.

And if you do have a weaker penalty, keeping in mind maybe using liabilities or options on the other side to make up for that so you don’t get stuck with funding.

And then retain optionality on your own side by, say, issuing callable CDs or taking down callable advances.

And always weighing the value of the option so that you’re not getting surprised when say like a few years ago when rates rise, you’re not having all this funding get cannibalized and your marginal cost of funds going through the roof.

If you have stronger penalties or at least a mindful of the penalties that you do have, you won’t get caught off guard by that.

And by doing this, it really allows you to be more focused on your unique value proposition.

And, you know, when you’re not having to be so reflexive on liability side or on the asset side, you’re able to kind of stick more closely within your guidelines, within your ALCO and then just focus on whatever makes your bank unique as far as a certain lending strength or the way that you interact with your customers as opposed to being worried about the path of rates.

Well, thank you, Tyler.

That was great.

Before we move on, you know, we were talking around the office yesterday about deposit pricing strategy and tying in some of the recent interest rate moves and the volatility there.

Anything about the shape of the curve or the level of curve in terms of where there may be some attractiveness in your opinion on where to go out with a targeted special?

Yeah, I mean, you know, over the last few years, there’s been a lot of emphasis on that short end of the curve, maybe three, four, five-month specials.

But if you think about right now, where the spread is relative to advances, so you might be pretty tight on the three-to-six-month range, as far as the rate that you can get on a CD might be three and a half, and the advance is going to be relatively similar.

But as you look a little bit further down the curve, there’s a little bit more of a spread there where, say maybe an 18-month CD, might be able to be a little bit more above market but without really paying up relative to where the front end of the curve is, and you’re also getting more duration by doing so.

So that makes it a little bit easier to fund on the asset side when you’re funding with 18-month CDs versus short CDs.

And just one final point, say if you are going to do that 18-month special, think about making that special actually special.

By that I mean, you know, if your 18-month special is $3.75, maybe don’t have the rest of your rates at $3.60, maybe bring them all down to $3.40 or in the 3s so that CD actually stands out.

That gives you maybe a little bit more control over tenor, especially if you’re trying to target a certain part of the curve.

No, that’s great.

And yeah, no, the moves in interest rates and the change in the slope, which we’ll get to a little bit more, certainly changes the backdrop of how we have to operate.

So let’s try and tie it all together.

And as we think about the tools at balance sheet manager’s disposal, not just on the wholesale funding side, but also the core loan and deposit side.

I think if anything of the last 5, 10, 25 years has taught us is that there’s no evergreen solution.

At least in our markets here in New England, the competitive pressures on both sides of the balance sheet are really ruthless, right?

I’m sure everybody on this call can attest, and we see it in the conversations that we have, that deposit gathering is not particularly fun.

And those folks who are having real success, it’s at the cost of cost, right?

To bring in the top-line deposit growth, you have to pay up.

And one of the things that we’ve been tracking for a number of years here is that as liquidity has tightened, and as loan growth has been exceptional, and as we may or may not be heading into a different part of the economic cycle, loan pricing remains competitive.

We’re not seeing really material widening of spreads on any type of loan, whether it’s commercial, auto lending continues to be very aggressive, and obviously, resi loans with little supply, there is still very competitive.

So there’s the core dynamics of what’s driving activity, but then there’s also the market-driven activity, and that’s where the wholesale funding comes in.

So we wanted to highlight two different lanes here, some of the floating-rate advances as well as the puttable advances.

We’re going to focus on one in each category.

And we’re going to talk about why they have relative appeal, and what types of environments do they have appeal, and does it align with where we are right now?

And how does the shape of the curve and the level of the curve drive how much or not we think that there’s opportunity there?

And we’ll also look back some historical examples, and we’ll cherry pick to look at sometimes when things were at the extreme, and we’ll tie it back to what things look like today.

So let’s ask the question: when does floating rate funding have appeal?

Well, the first, not a bullet, but the first item here is when the market is not expecting lower short-term rates.

And I think many of us know that the yield curve is a pricing mechanism and that when there’s opportunity, it’s because it’s counterintuitive and it’s opposite to what folks or market participants are pricing into the yield curve. And we’ll come back to that.

Floaters definitely have appeal when there’s the benefit in extending your maturities as it relates to your liquidity management.

So just think of an environment, maybe less so now than call it two or three years ago, where you have a super robust loan pipeline, right?

So when we look at what’s going to happen over the next three months, we have cash going out the door.

Pre-payments on loans or investments are very muted.

So we don’t have a lot of organic cash flow.

And on the funding side, well, maybe as Tyler mentioned, because of the path of rates, there’s been more emphasis from the depositor side flowing into term maturities where we have big chunky blocks coming off at any given time that are possible flight risk.

And even on the non-maturity side, the last five years have really tested our ability to model what would be prudent outflows and assumptions, or how at-risk non-maturity deposits may be for going out or being rate sensitive.

So in that type of an environment where liquidity and cash is at a premium, there’s some value in having wholesale funding to the extent that you need to fill that gap between loan growth and deposit growth and not having another maturity that is going to negatively impact you in a sources and uses report where you want to have the wholesale funding maturity far out the curve.

Well, that’s all well and good from a liquidity perspective, but what about the juggling of interest rate risk?

Now, your institution or your rate view may not necessarily align with wanting to take a fixed rate wholesale funding.

So, how do we bifurcate?

How do we get term liquidity, but overnight or short duration, a short repricing schedule? That’s where the floaters come into play.

And I make mention of the core loan and deposit growth assumptions in the down rate scenarios. And I think that’s important.

And that’s why the Callable Floating Rate Advances have particular value, because we may have a situation where we have a liquidity profile today that calls for supporting liquidity and adding cash and adding wholesale funding.

But that may change materially looking into the future, especially in a down-rate environment, and we want to be nimble in those cases to appropriately manage the balance sheet.

So let’s take a walk down memory lane here and look at what the yield curve has done as it relates to how we might want to analyze floating-rate advances.

So here we are looking at three-month treasury bills and one-year treasury bills and the this, the spread between the two of them, going back from January of 2021.

And I’ve annotated the two extremes here where the slope was at the highest magnitude in opposite directions.

Back in 2022, there was an awful lot of slope in the yield curve.

And you can see I put in quotation, so it’s people were saying it at the time. Rates are going higher.

And we’ll see in the slide how it actually played out.

In the fall of 2024, it was the opposite that one-year bills were significantly below three-month bills because the market was expecting short-term interest rates to go down over the near term. Okay, great.

We talked a little bit about this first item; the market is not expecting substantially lower short-term rates.

That’s when floaters may have appeal. Let’s see how that actually plays out.

So here we are comparing the path of short-term rates and it’s a fixed versus floating analysis with the benefit of hindsight where we have been better to look at fixed-rate funding or floating rate funding.

And in 2022 when the expectation was for higher rates, most of us know, we are all there, we lived it that it caught everyone off guard, that even as the market started to adapt to the prospect, the Fed came right out of the gate with a 50 basis point hike, they followed it up with another 50 basis point hike, and then they were off to the races until they got north of 5%.

So in this instance, going back to June of 2022, the one-year advance rate was at 231, and SOFR was still at a percent handle soon to be north of one percent.

So there was some slope in the yield curve, more slope than we had seen in a long, long time.

But even still, as rates continued to rise and transitory inflation was not transitory, then the net cost rolling across the entire one-year period for a SOFR-based advance wound up being 384.

So obviously with the benefit of hindsight, fixing at a 231 rate would have been advantageous. Let’s flip to September 2024.

Again, that opposite scenario where long-term rates were below short-term rates and the expectation was rates are going to go down.

We were banging the table at the time and saying, rate cuts are priced into the market.

Whether you stay short or tiptoe out the curve, the economics of the way yield curve math works is that you’re capturing or locking in those prices.

And so ultimately what we saw, yes, the Fed did lower interest rates by about 1%, you know, slowly and then held flat for a period of time, but the savings by fixing were in excess of if you had rolled short or gone floating.

So you’re probably thinking, Andrew, you’re trying to make the case for why floating rate advances are attractive, and you showed two examples of where fixed rate won.

So it’s all a function of what is in the market, right?

So Caroline talked about how intermediate rates have come up.

So now we are in this environment where the day one cost of a short-term rate exposure, right, whether that’s overnight or a floating rate advance, is below that of a one-year fixed rate advance.

So if we go back to scenario B, for example, you were paying more on day one to make that bet that rates were going to go down versus locking in the fix.

We are in that opposite scenario now. So you get the day one savings.

And also, we can debate for another day about what will actually happen with short-term rates.

But there’s more downside, or there’s more room to the downside for short-term rates to go down. And, you know, it provides that opportunity.

And so let’s talk about what are the benefits of the floating rate events. 100% beta.

So in the banking world, 100% beta is a bad word, right?

Because we associate it with deposit pricing or responsiveness in as interest rates move higher but as we may or may not be in a scenario where short-term rates go down then you want 100 beta and as we talk with members and we do analysis that deposits lag on the way up we all know that story that works to our benefit but deposits can also lag on the way down so we may not be able to fully pass through all those market movements at least initially especially as the term funding that the CD books have grown over the past number of years.

Term liquidity with overnight duration, right?

We talked about you’re constantly juggling interest rate risk and liquidity risk and how far out on the curve that you need to go for both of those aren’t necessarily going to be the same thing.

And then this last point is really the biggest benefit to why we think not just the floating rate structures, but the callable floating rate structures.

So I didn’t mention the pricing here on the left-hand side.

So you can see, as many of our advances do, you can customize and go to any point on the curve.

And highlighted in blue are the callable structures, where not only are you getting a six-month maturity or a 12-month maturity, but you have the ability to prepay the advance without a prepayment penalty at either the three-month mark or the six-month mark, depending on the examples that you’re looking at.

And the reason why that is important is that it provides you with the flexibility to pay down your wholesale funding if it makes sense.

And why would that make sense?

Like we said earlier, you may have term liquidity needs now, but in a down rate scenario where prepayments are going to accelerate most likely, loan growth in an economic slowdown brought upon by lower rates, the loan pipeline may slow down a little bit.

Hopefully, maybe deposit growth is going to accelerate.

Even if we don’t go down to the 0%, the Fed coming up with new acronym program type of environment, we may see a little bit of an uptick as rates compress.

So in that environment, it’s been a complete 180 where we may not need wholesale funding to the extent that we did when the advance was initiated.

And so while you get the benefit of the responsiveness of rates going down, right?

We do an advance today in the high 3s.

Rates go down to the 2s.

Our floating-rate advance moves right along with us.

We’re doing great.

But you know what’s better than a 2% floating rate advance?

A 1% or 0% deposit.

So here’s your way to enhance margin in that declining rate environment.

So let’s pivot to talking about the puttable advances.

And for those who may not be familiar, puttable just means that where you’re selling the optionality embedded into the advance.

And for that sold option, you get a lower rate.

It’s the same way on the asset side of the balance sheet.

When you portfolio a mortgage or you’re buying mortgage-backed security, you’re taking that prepayment risk and you’re getting more spread than you would by buying a bulleted investment.

When the yield curve’s flat or inverted, it allows the rate on the advance to get inside the marginal short-term funding rate, which is advantageous.

When interest rate volatility is high, Caroline talked about the pickup in volatility.

Again, that’s a contributor just like it’s red apples to green apples with credit spreads on loans, right?

If credit risk gets higher, then the spread that you’re going to demand on loans is going to get higher or wider.

The same way, when volatility gets higher, then that works in your favor in terms of the pricing of puttables.

And from a balance sheet perspective, it’s when margins are under pressure, and we’re turning over every rock to support our margin.

So again, we can look back historically and see what the yield curve presented to us at various intervals.

So, here we’re looking at the difference in the slope between the one-year and the three-year in green, the one-year and the five-year in gray.

And so, I’ve highlighted along the left-hand side, in May of 2023, that was when the curve was most inverted, at least at the one-year and three-year mark.

And rates were very high at that point as well.

And we’ll show in the next chart some of the break-even math that we did at that time, and we can do now.

And just if you’re curious, where are we today on this map?

You can see here we’re slightly positive on the yield curve slope, but rates are a little bit lower.

So rewind to May of 2023.

The one-year classic was at 534, goodness gracious, and at that time, a three-year, one-year puttable was about 4%.

So, in order for that advance across an entire three-year maturity for the puttable to not be the favorable funding option, the last 24 months would have had to be in the low threes.

Now we know with the benefit of hindsight rates have come not come down by as much and at the same velocity as was expected at in 2023, 24, and 2025. So that funding differential creates a significant cushion, right?

So it’s not just that rates have to get to the rate equal to your coupon for things not to go well, but they have to go significantly lower than that.

Caroline talked about interest rate volatility, and here’s a great example that we shared with our team over the last few weeks as rates were changing.

So you can see the five-year treasury went up by about 50 basis points in a three-week span.

Well, because volatility was rising at a five-year puttable advance, it only moved by three basis points.

So that is an opportunity to increase spread and margin that’s independent of taking a bet on interest rates, right?

Caroline mentioned that earlier that as best we can, we want to avoid decisions that are based on or reliant on a certain rate path materializing.

Here’s an opportunity where at the end of the day, we’re all spread managers, right?

want to bring in safe, solid loans at wide spreads and deposits at advantageous rates.

The same thing applies to how we supplement in the wholesale portfolios. So where do we sit today?

Well, we’re not at the high level of rates that we saw in 2023, and we’re not at the same level of inversion, but we have seen volatility pick up.

So one of the areas where we have seen value in these types of structures is paired with investment leverage.

And we’ve been talking about that for a while with the prospect of potentially lower rates and building up liquidity and some potential for unrealized gains if rates were to move down.

And certainly this rise in rates has created some opportunities to nudge the asset side out the curve a little bit.

And so there’s ways to structure funding to get some spreads on the transaction well north of 100 basis points.

There’s still some incremental savings on the front end.

So if you look at some of the three-year maturities, they’re in light blue, you can see that they’re 50 to 75 basis points below what a Classic Advance would produce for you.

So, tying it together with a deposit pricing strategy, right?

If you’re debating a special in the mid to high threes, well, I would look at, you know, could you incorporate some of the puttable funding into the end, you’re getting close to 3% there.

And at least for everything we’ve been seeing and hearing, it’d be awfully difficult to raise deposits to a material level at that level in this environment.

And then the last thing I’ll mention is to be opportunistic on the long end, that if we do see a sharper move down in interest rates, then rather than some of the shorter structures, both in terms of the maturity and the lockout period, then there’s going to be value, certainly as we breached at 3% level and think of it as a way with some of those legacy mortgages and investments that we may have on the books going back to 2020 and 2021, that it could be a way to mitigate some of the long duration pain there by getting cheaper, cheaper funding.

So that brings us to the end.

Caroline mentioned in the beginning, we’re excited that you should all see the invites coming out over the coming weeks that Tyler and Caroline will be doing an economic webinar towards the end of April.

And we’re excited because it’ll be a combination of looking at what’s happening at the highest level in terms of some of the national metrics and unemployment and inflation, but also getting into a granular level and looking at local and regional trends that are impacting members across our six states.

So keep an eye out for that.

Hopefully, you all will find that to be of value.

So that brings us to the end today.

We always appreciate your time and attendance.

And as always, if there’s anything that we can be of assistance of, share a chart, walk through some of the calculators that we have at our disposal.

We’re always happy to do what we can to assist you in the day-to-day.

So with that, we will wrap things up, and we’ll talk soon.