Peer Analysis and Balance Sheet Strategies Update May 2023

Well, hello, everyone, and thank you for joining us today. I’m Andrew. This is Sean, and we’re excited to have you with us here as we have a jam-packed agenda and have a nice discussion about what’s happening in the world of banks and credit unions right now.

So, if you haven’t joined us before, the plan here is to go over three main areas. We’ll dig deep into some trends that we’re both seeing in the numbers and also, hearing from our membership base.

So, before we jump right in, if you’re not a fan of charts, and graphs, and numbers, and all that you want something to share with, you know, folks, within your organization back home about, you, know how challenging it is right now to be managing a depository balance sheet, you can send this to them. And, no, I don’t remember exactly the result of this play. You know but I can go out on a limb and say that James Harden probably complained, as expected for a foul to be called. So that’s, I can say I can say that with high confidence and conviction, but I know our banks and credit unions are faring a little bit better than that.

So let’s jump right into our first section, markets and the economy. So, we’ll talk about the yield curve a little bit, some key economic indicators, and then some things related to market sentiment.

So first and foremost, let’s talk about short-term interest rates. And there is the $31.4 trillion, elephant in the room. And that is the debt ceiling discussion, which is soaking up a lot of the conversation now that we’re seeing and hearing right now. So, when we look at one-month T bill rates, as well as the rate that one can earn, with doing reverse repo with the Fed, what we see is that typically one-month rates are at slightly higher yields than overnight rates. And that makes sense because investors need and want to be compensated for extending out incrementally one month versus overnight, especially when there’s an expectation of rising rates. So you can see those big jumps in the RRP rate, which move alongside Fed Funds and SOFR and short-term rates. But an interesting thing started to happen over the last month or so, and we see the dashed green line dip pretty sharply.

And that was because there was a shift in where investors of non-depositories would look to park their money, and they were handicapping when the debt ceiling would be breached. And they were trying to avoid that mid-summer range and where, at the time, it was about three-month Bills or so and wanted to have maturities be on the shorter or longer than that. So that’s why we saw the rates move sharply lower than where the overnight alternative was. But then recently, Janet Yellen came out and said that the timeline, maybe sooner than what many thought was going to be the case — potentially being the beginning of June. So, we saw a complete 180 pivot, and we saw the rates on Bills spike, approaching 6%.

Now, you know, that creates a very challenging dynamic. And so, you know, we’ll see ultimately what happens.

But I think the debt ceiling has been reached 78 times in history, and the U.S. has not defaulted once.

So, while this makes good for good headlines on financial news and Washington, D.C. debates, I think everyone is in agreement on both sides of the aisle that U.S. default is not good for business. Ultimately, you know, while we may be a temporary blip, you know, this will get sorted out.

So, moving further up, the yield curve. You know, we really are in uncharted waters when we look at what is happening with the intermediate points of the curve. So, as many are well familiar with, the yield curve has been inverted lower, longer rates have been lower than short-term rates for a good period of time.

When we look at 20 years’ worth of data, we can see that we really are in an area in terms of the depth of the inversion that we haven’t been. So, down on the bottom of the chart, you can see the light blue triangles. That is where we are currently here in the second quarter of 2023 in terms of the level of inversion.

So measured by both the one-year Treasury minus Fed Funds as well as the five-year Treasury minus Fed Funds. So, I’ll just talk about, and we will talk a little bit more about where the Fed going, when will they go? And we keep coming back to the three parts. And it’s not just about the direction of where rates are going to be. It’s also the timing and magnitude of any changes in what is happening in rates.

And that certainly has implications for how we think about it and position things on the balance sheet.

So, when we talk about that, you know, will the Fed hike will they cut? Will they pause?

Remember that the two things that are front and center on the Fed’s mind are inflation and employment. And last week, we had a 4.9% print, which was promising in directionally where everyone would like to see inflation go.

And you know, but I came at it with a little bit of a skeptical eye, saying I think it’s a little too early for the victory parades in terms of mission accomplished on inflation because, you know, certainly 4.9% is better than the 7% and 8% numbers that we have been seeing previously. But two things: one, 4.9% is not yet back to that 2% to 3% range where the Fed would like to be. But that 4.9% was also on a year-over-year basis, based off of a very inflated level that we saw back in 2022. So, if you were with us in previous webinars, you know, we’ve put together a chart where not just looking at the change, the headline number that we see in articles and on TV, but also looking at the index itself. That the spike itself was so dramatic in 2021 and 2022 – remember “transitory”? – that, in order to normalize back — so, when we think about consumers and businesses dealing with you know with actual cost, and not just year-over-year measures, that, you know, the pain is still being felt.

So, here, what we’re looking at is, you know, the Federal Reserve of Atlanta puts a good dashboard together looking at some underlying components of inflation.

And we can see relative to where the target that would be implied by a 2% core reading that, you know, the various versions of inflation are still, at least as of the April 2023 print, are much, much higher than where they would ultimately like to be.

Yeah, and related to all of that is, you know higher rates, accompanying that is tighter liquidity.

And so, something that I don’t think we’ve examined previously before in our webinars here is turning the mirror on ourselves about what, what has happened with our particular balance sheet here at FHLB Boston, given all these changes, and the tighter liquidity conditions that we see in the markets.

And so this goes back 30 years. We’re taking a look here at our headline total advances at FHLB Boston going back to the early nineties. A couple of reasons for picking that timeframe. One, is when we have data, but, two, it’s also because membership changed in that timeframe where commercial banks, most notably, were allowed to be members and to be borrowers for the first time. And you can see that into the great financial crisis, there was slow and steady growth. Actually, pretty, pretty, aggressive growth in the mid to late nineties there. Followed by a big, comedown after all the money printing and lower rates that happened in the wake of the great financial crisis.

In the 2010s, we started to go back with FHLB advances before really falling off a cliff in the past couple of years.

I’d like to note that, you know, as Andrew highlighted, since I started about a year ago, purely coincidentally, I’m sure, advances actually have really gone up very significantly. And you can see that at the year end of 2021, advances here were down to $12 billion. And at our most recent print, they were just shy of $50 billion. Last year they finished at about $42. So, it’s a good kind of proxy for how our folks are feeling out there about liquidity.

We’re approaching levels that we haven’t seen in a good long time around here, and it speaks to how tight money is.

And so, as a consequence of having sort of tighter liquidity conditions, something that is also on a lot of people’s radar is tighter lending standards.

Recently, we had the senior lender survey that’s produced on a quarterly basis come out. What that survey does is basically just ask a bunch of senior lenders at several dozen banks, about 60 different banks, are you, on various measures, “Are you tightening your standards? Tightening a little bit? Kind of where you were? Loosening to a little bit or really loosening?” And the center of gravity on that response has really been, “we’re tightening a little bit,” and this chart kind of quantifies all of that in the C&I space for across all the lenders that were surveyed. And again, you’re seeing that we’re starting to approach levels that we’ve only really seen in recessionary periods going back, 2008, 2011, early nineties, auguring that there might be some tighter credit conditions coming up in the near future.

So, if you were with us for our webinar at the end of March, you remember we talked a little bit. We’re just in the wake of the Silicon Valley Bank failure. So here we’re looking at, you know, what bank stocks have done so far here in 2023, and we’re looking at the S&P 500, but also two measures of banks – an ETF for regional banks, KRE, as well as a community bank ETF.

So right or wrong, there was some contagion effect when Silicon Valley, and then more recently, First Republic bank went under. So, it really brought into light the potential issues and challenges that many of us are facing right now in terms of interest rate risk and liquidity risk, but also earnings. So this is a price measure, but the price/equity multiple, is something that many investors look at.

So, with the recalibration of both the outlook for earnings, but also the multiple that investors are willing to apply to the earnings—both of those moved in a negative way. So accordingly, the price on bank stocks had to go down. So, you can see here the S&P 500 is up approximately 8% year to date. So, this is, everything is indexed back to 100 at the beginning of the year, whereas the two bank stock indices are down between 30% and 40%. So, some pretty aggressive drops.

Now, you know, I’ve said this many times before, but even if you’re a credit union, or even if you’re a mutual or even a privately held bank, you know, the stock price isn’t necessarily something that you’re thinking about all the time, but I think it is a good measure for an outlook on the industry and what investors are thinking about that the go-forward situation for depositories.

And it certainly does have impact on things like merger and acquisition activity in the footprint as multiples change and an appetite for consolidation contracts or expands.

So, that’s, that’s Section One. So we’re now going to jump into the next area, where we’re going to take a deep dive into some of the trends that we’re seeing from the first quarter Call Reports. So, you know, there’s a lot to talk about. We’re going to talk about margin and earnings and we’re going to talk deposits, as you might expect, is a big theme and we’re going to come at it from a number of different angles. So Sean, take us away on, you know, we really know how to kick it off with the positive news, I guess — declining NIM. I get to talk about tight liquidity and declining NIM.

But this was the quarter where we really saw NIM decline. In the prior three quarters, we had seen really significant NIM expansion. But a lot of that was given back this quarter. You can take a look here – these are histograms.

So every one of these bars represents the number of member institutions here at FHLB Boston, that experienced certain levels of NIM change, and it’s organized by ten basis points of NIM change.

So on the left-hand side, member banks, there were 51 member banks that had NIM drops between 20 and 30 basis points. Everybody, to the left of that sort of green line at the center, had NIM declines.

Everybody to the right had NIM expansion.

​So for banks, about 90% of banks actually had NIMs decline this time, and the average decline was 27 basis points.

And you can see that it’s very few institutions that had any meaningful improvement in NIM this time around, a big reversal from what we’ve seen. And then, on credit unions, credit unions actually fared better. Only about 64%-65% of credit unions saw declines versus 31% with expansions, but again, you can see the center of gravity was for NIM declines, only seven basis points on average for credit unions versus banks.

And no surprise, I’m sure, to the folks on this call that the culprit for it is deposit pricing, overwhelmingly. Folks really lag very significantly in 2022 on deposit pricing, but in Q1, we really started to see that bite back for the first time.

Both banks and credit unions had a little over 20 basis points of expansion in NIM, all else equal that was induced from higher rates because we did see a rate raise in December and February and at the end of March.

But gave up more than that in terms of liability rates, overwhelmingly on deposits.

In bank space, it was about 47 basis points and in credit unions on shares of 30 basis points. So, banks are now paying, actually, fairly significantly more than credit unions for their funding costs. And again, that adds up to the 27 and 7 basis points that we saw on the prior slide.

​And unfortunately, growth isn’t a strategy that’s really working to offset that level of NIM compression.

You can see here on the left again, banks on the right, credit unions that higher asset volumes aren’t compensating for the worsening liability rates.

Again, this is just putting this in terms of what’s really resulting in the lower NIMs that we’re seeing. Is it rate? Is it volume? Is it mix?

Overwhelmingly, you can see that its liability rates that are more than offsetting asset volumes and asset re-pricing.

So, if folks are growing, and we saw previously from my prior slide there that, you know, liquidity is much tighter, and people are borrowing more, what’s actually happening to fuel asset expansion if liabilities are so tight?

The answer is people are turning to wholesale sources and in the deposit space, deposit, or shares, they’re being replaced with wholesale deposits.

So, amongst both banks and credit union shares and deposits, we had, for all institutions, below $100 billion in assets, $400 billion of client deposits at the end of the prior year, core deposits were down $2.2 billion and 2.7 billion dollars wholesale, additional wholesale funding was identified, wholesale deposits were taken to offset that. So, folks are losing deposits on average, and then replacing it with brokered CDs, pretty much.

And so, is it the case then that just paying more in rate, will be able to result in getting better deposits. So what this scatterplot is trying to identify is if you pay more, do you experience higher deposit performance? So this is all of our member banks and the X axis of this is the relative core deposit performance going from left to right. It’s higher numbers to the right. Obviously, at zero there, it’s higher growth than average.

Then, on the Y axis, we’re taking a look at relative rate performance. So if you’re in the lower left-hand quadrant of this, that means that there’s underperformance on balance, but you’re not paying up.

These are basically folks that are inferring that they’re not willing to pay up as much in order to continue to grow deposits.

And on the upper right-hand side, it’s just the opposite. It’s outperformance on both rate — or outperformance on balance, but underperformance on rate. That is, to say, they’re paying. They’re paying more to get more deposits. So if garnering more deposits, were really about rate and product, we would expect to see most of these dots sort of lineup on a 45-degree angle line going from the lower left to the top right. And so this green line, that’s just above the X-axis there, it’s actually the trend line for this data. So it’s actually the total reverse of that. It’s actually that folks on the upper left-hand quadrant are overpaying for underperforming deposits.

So it’s not necessarily the case that paying more in deposits actually results in higher deposit performance. In fact, I think a way to interpret this data is to say that folks who are experiencing deposit outflows are raising rates more aggressively, and they’re not getting new deposits to replace them.

So having new products or increasing rates hasn’t been a panacea for people.

And in fact, I would suggest perhaps what’s actually happening is that client verticals, that is to say, your clientele type is more determinative of what your deposit performance is than what your products or rate offerings are.

So, sticking with that theme of putting everything into quadrants and searching for a correlation that we think is true, but ultimately, it’s moving in a different direction. Is here, we’re looking at the advances to asset ratio for all our members. As well as the cost of deposits.

And you know, going into this, our theory was that if anything, it would be flat or work going from the north-west to the to the south-east with the thinking that, you know, as Sean just alluded to, allowing deposits to leave, back-filling with advances and not willing to pay up for deposits that aren’t necessarily going to lead to deposit growth. But if anything, there’s no trend line noted here, but you can kind of infer that there is a gradual southwest-to-northeast trend there. So when we look at what’s happening in each of the quadrants — number two, the thing that jumps out the driver of folks with higher advances to assets but also a higher cost of deposits is something that, you know, we’ll get to in a slide or two. That is because loan growth has been phenomenal, and you simply need to fund the loans.

And also, you know, calling back to about four or five slides ago, with NIM decomposition that the ability to remix the Balance Sheet hasn’t been there. Because cash flows off of investments, have been so modest. There isn’t really that option to say, “Loan growth is great. We’re going to fund it by investments at 3% lower yields. Just cashflow P&I come off. Turnaround, put it to the loans. And we don’t even have to worry about the right side of the balance sheet.” But we know that hasn’t been the case.

So folks are trying to accomplish funding their loan growth by adding wholesale adding advances, but also by being aggressive on rates. Now the folks in Quadrant Three, those are the ones who have been able to maintain some of that pricing discipline backfill with advances and moderate that marginal cost of funds. The folks in Quadrant One, top left — so with high cost of deposits, but very low usage of advances — that’s where, even in this tighter liquidity environment, you have, you might have more capacity than most to test that elasticity of the deposits, right? You don’t have to get into the food fight for one-upping the bank or credit union down the street to maintain or grow those deposits purely on rate.

And for the folks in Quadrant Four, nothing really more to say than good job by you. And, you know, whatever the secret sauce you have in order to keep your costs deposits low, to keep the deposits there, you know, whatever you’re doing, it’s working.

So, you know, moving on to deposit pricing. So, we track the posted deposit rates for all our depositories where we have reported data for.

So when we go back over the last year or so, when, on the left-hand side, we’re looking at the rate paid on high balance money market funds and the 75th percentile ratings. So not the tip-top payers, not even the middle of the pack folks, or the keep rates low at all cost folks. So that they can get that sweet spot of “we’re OK with being a little bit on the aggressive side,” and we’re showing it versus the effective Fed Funds rate. And what we can see is that the most folks have that pretty common knowledge at this point — we’ve lagged most of the hikes in short-term rates, and that gap has been growing.

So, what this tells us, what jumps out to us here, is that, in terms of using rate as a tool to retain and grow deposits, that folks are not necessarily leading with high rates. They are, you know, being more defensive and reactive in saying when a large depositor may be looking to leave. Well, they’ll match that, or they’ll do exception pricing.

So, the worrisome thing here is that lag works in both ways. Right? The last couple of quarters, we got the benefit of higher rates, assets repricing, but our liability costs lag.

Well, if we get to a period, and we’ll talk about this a little bit more, where, even if rates don’t continue to go up, but they go sideways, or even dip a little bit, we will probably still see those deposit rates continue to rise, which is going to put that much more pressure on NIM. So when we look on the right-hand side, at CD rates, we see a similar thing, and then CDs. The idea of the odd term CD special certainly has been possible and has been leveraged a lot. So certainly, when we look at posted rates, but we will also peruse websites, we see a lot of seven-month, 13-month CD specials, things of the sort.

And notable here is that credit unions, you look at the distribution of the rates paid or the range of rates paid on CD rates here, in May. The credit unions are much more aggressive on the top line benchmark tenor rates then banks are.

So I mentioned previously that loan growth has been phenomenal. And this past quarter, it wasn’t up to the standard that we have seen in the previous quarters where it was mid-double digits, you know. Loan growth that, you know, we were all usually normal times, we’d be doing backflips over as long as we can fund it in and manage risks accordingly.

​So here we’re just simply looking at, you know, breaking up into segments the amount of loan growth, annualized loan growth, that our members had going over the past few quarters. So whether it is negative zero to five, five to ten, or greater than ten, so with greater than ten being the dark blue, all the way up on top.

So you can see the prior three quarters before the first quarter. The majority, two-thirds to three-quarters of members, had over 10% loan growth, which is, which is really amazing. Because usually, 10% loan growth, which was only the area where those folks who had, they were loan-driven, lending-driven organizations. And that was the focus. And they had the ability and the infrastructure to do that, but really, everybody was out there producing considerably attractive levels of loan growth.

So, it makes sense that, at some point, it can’t go on in perpetuity. Right?

Now, whether it’s a slowdown in customer demand for loans, or even as we talked about with the lending standard survey, that maybe it’s institutions themselves pulling back the reins a little bit on the lending growth because we’re trying to recalibrate where we are, in terms of our liquidity, where our interest rate risk or even spreads. You know, one thing that we have good insight into, with many of the conversations we have, is that, despite this pullback on lending and tighter liquidity, we haven’t really, and we’ll get to credit risk in a little bit, but we haven’t really seen spreads start to widen out. Now, certainly, you know, on one-off cases, we do hear anecdotally, that’s the case.

But, you know, in contrast to other parts of the capital markets, where risk is growing, and spreads are winding, that really hasn’t been the case on the depository lending side.

Yeah. So how have folks actually compared or performed compared to their modeling expectations going into a rising rate cycle?

So the OCC actually produces a report, periodically, that shows what their member institutions have basically assumed in their key NII models and what the results of those models are.

So here on the left-hand side is NII parallel shocks over year one. And on the right-hand side, EVE results, and what we can see here is that the average or the median, I should say, OCC-regulated bank, was expecting in an environment like this to see mid-single digit improvement in NII all else equal. I think that was actually a pretty good assumption because we saw NIM expansion in the first three-quarters of this to a very significant degree. A little bit difficult to tease-out growth versus rate when you’re talking about all the banks everywhere across the country.

But margins expanded by 30, 40 basis points for a lot of folks, which translates into, you know, mid-single digits, about 10% of NII growth, so that was accurate. That turned out to be accurate.

​What’s very interesting here, and especially in the wake of some of the bank failures we’ve seen, is that, whether rates go up or down, the median bank that is regulated by the OCC expects EVE to decline, which really identifies the fact that there’s a lot of negative convexity on people’s balance sheets.

Obviously, you know, probably most famously, that’s what started to hurt the likes of First Republic, with their mortgage book. And so, that the fact that there is so much negative convexity does give pause about what will happen when rates come down. Will we see a lot of loans or assets booked in the past year start to reprice unfavorably? The key assumptions that are shown by OCC banks show you might see them.

Then how folks have done with deposit rates relative to what their assumptions were?

So we can see here this is great data here to kind of compare what are the baseline modeling assumptions that other institutions are using, and here it is by product again. This is the OCC, so it’s all bank.

For now accounts and savings accounts, the beta’s are about 20% on the median institution.

You can see that they actually the OCC actually gives you some different data on different types of institutions and a couple of different levels.

In the interest of time and energy here, I’ll just show the median, but about 20% on NOW and savings.

And MMDA is 35% the median institution, then the life assumptions, which are controversial within the credit union space and the NEV test, but, for banks for OCC banks, the life on most of these accounts is about five years and a little less than four years for MMDAs.

If we translate that into what’s happened with 500 basis points of Fed Funds increases in the past year, that argues for the fact that there will be NOW and savings rates around the low ones, and we’re kind of there.

The current rate highlighted in the green is the estimate that we get from call report data for our New England number institutions, little bit harder to precisely do it because there’s different ways to reclass deposits, and the assumptions that are underlying this might be a little bit different than what the classifications are.

But we’re probably close to where those assumptions were going into for most institutions, but there’s still probably a long way to go on MMDAs.

And then, if we think about, sort of, the economic modeling that I’ve talked about in other presentations around these parts, we think about what’s the actual profitability of these deposits, given that rates are high. They’re probably at levels we haven’t seen in a while. DDAs probably have a 4% value, and some of these non-maturities are in the mid to high twos. Think about that in comparison to a loan spread.

That’s a pretty decent way. Probably not a lot of loans out there getting 400 basis points of loan spread right now versus, say, an FHLB advance.

And so that highlights just how valuable DDA accounts are in this environment and how valuable even higher-priced non-maturity accounts can be when rates are this elevated. And then at the bottom here, it’s just an estimate on what if you had a very high cost, money market special, which some folks do.

Here the assumption that it’s at a 4.75% current rate. What’s the profitability of that? It’s probably only in the mid-zeros.

And so that’s where you see that sort of dynamic that we had talked about earlier, that people are paying up, but they’re not really seeing performance for that. That’s reflected in sort of this much lower profitability versus sticking to their knitting and sticking to the core assumptions on other traditional, more traditional types of accounts.

​So when we think about what’s been happening in the bond portfolio. So it’s been the bane of the existence of many of our members, going over the last year or so, with the unrealized losses, which moderated a little bit in the last quarter, thanks to the rally in Treasury yields. But still, a ways to go to get back to something approximating a neutral position.

So on the top, here’s one way that we look at the sentiment in terms of the percentage of members who are increasing the dollar amount of investments quarter over quarter. So, with 50% usually the baseline. So, you can see even going back to 2021, folks were more aggressively deploying and growing investment portfolios. And then that cratered in 2022 and has been starting to come back more for banks than credit unions. And, and the dynamic there is that we have a large number of credit unions who don’t have traditional investment portfolios, so they neither grow nor shrink in times of excess or tightening.

So they’re going to be, naturally, much lower than where we are with banks, so but it’s interesting to see 52% of banks increasing investments quarter over quarter in this period where liquidity is tightening and loan growth is accelerating as well. And we’ll talk about a little bit more later in the presentation about why that is and why it might be timely to have that flexibility to be opportunistic.

On the bottom panel, just going back to investment yield for a second.

You know, the ability to reprice the investments, you know, no matter what you’re doing, whether you’re growing or contracting, changing your philosophy, this is the benefit of having a 1% or 2% investment yield and being in a 4% to 5% world like we are right now.

So we can see we break it out by those who have decreased and increased in terms of dollars. But also year over year and quarter over quarter. Interesting, that year over year, as you might expect, those who were increasing investments saw greater increases in their investment yields. So, close to 200 basis points for those banks, 60 basis points for credit unions.

Excuse me. It’s the other way around: credit unions have almost 200 basis points. But quarter over quarter, interesting that it’s, it’s flipped. It’s counter-intuitive in terms of who was able to increase investment yields the most.

And my theory here is that the folks who are more inclined to increase are the ones who are willing to trade current yield to move further out the curve because it’s going to have benefits if we do pivot and move to a lower rate environment, because right now, with the inverted curve, more yield is to be had on the front end of the curve, so all else equal doing nothing, given the shape of the curve that, moving further up the curve is not going to increase your investment yield as aggressively as staying put.

So thinking about credit. So interest rate risk and liquidity risk have gotten a lot of headlines over the last two months.

But as many people on this call may attest, you know credit risk is usually the one that keeps most folks up at night.

So here, just looking at some data related to credit performance. And here we’re not looking at the median or the 75th percentile. We’re looking at the 90th percentile because we are looking for the outliers.

We’re looking for the big spikes that may, that may tell us that there are some credit issues bubbling up, and we really don’t see anything just yet.

And, you know, there’s an argument that credit risk doesn’t really creep up on you. It just kind of explodes out of nowhere. But nonetheless, you know, let’s look at the numbers. Non-performing assets have been trending down for a number of years now.

Net charge-offs ticking up slightly in the last few quarters but still comfortably below where they’d been recently. Provisioning remains low, but that’s because loan loss reserves are still at pretty healthy levels. Now one thing that didn’t make its way into this presentation is something that we saw the other day. This interesting alternative data that looked at cell phone usage, device usage in major metropolitan areas in North America, and as a proxy for activity and recovery in downtown areas. So, Boston was right, middle of the pack, about 50% indexed to 2019, a pre-COVID baseline. Middle of the pack for North American cities. By contrast, San Francisco was the lowest at 29% of 2019 levels, and Salt Lake City at 130%. So, you know, I don’t know what’s happening there, but, you know, everyone’s really excited to get back into Salt Lake City, but, you know, as we all know, credit risk and commercial real estate come in all different shapes, sizes, and flavors.

But there, you know, this is a segue to you know, Sean’s going to talk about credit risk here in just a second, but, you know, it is something to consider the prospect of what’s going to happen with CRE as remote work and hybrid work becomes that much more prevalent and ingrained.

​Yeah. So just to take a look at that, and to follow up on Andrew’s point there. This scatter plot — we’re all about scatter plots today — on the X-axis takes a look at what percentage of balance sheets of member bank balance sheets are in CRE. And then, the Y-axis is a look at how much excess capital is there versus the well-capitalized minimum with respect to whichever capital ratio is governing your institution. So there are five different capital ratios, Tier-one Leverage, Tier-one Risk, CET1, Total and CBLR – Community Bank Leverage Ratio. One of those is governing your institution because it’s closer to the well-capitalized limit. Take whatever that level is minus the well-capitalized limit. That’s what shows up on the Y axis.

And so down and towards the right is where there’s just a lower margin for error.

If you have more CRE on the balance sheet, especially if you had office exposure, probably there’s more risk out there.

And then where does that line up with how much cushion is there relative to the well-capitalized minimum?

And you can see there are probably about 20 names out there that have not a ton of extra cushion compared to the size of the balance sheet.

And then as we think about how that, what that might look like, you know, Andrew talked about the fact that capital sneaks up on you and then credit doesn’t really necessarily sneak up on you, it happens all at once. Well, here’s one way it could sneak up on you a quarter or two ahead of time. It’s just to say on the left-hand side, how much would you see in expected losses — that’s the result of the probability of default times the loss given default — so, what are the odds something might go wrong versus how much I might lose from it?

You can see if you had, you know, sort of these mid, if you had risk migration where you start having to mark down loans on your risk rating matrix, you might start to see expected losses creep up in the high zeroes into the low single digits.

And then, what does that translate into capital, which is what’s happening on the right-hand side.

The point of this is simply to say, sort of like OCI, we saw last week, where OCI snuck up on a lot of folks and impacted capital ratios to the tune of 100 basis points or more, credit could sneak up, and it could be, you know, 30, 40, 50, 100-something basis points depending upon the mix and the severity that happens in it.

And it doesn’t have to be experienced losses, and it doesn’t even have to be nonperformers. It just has to be a rating migration that happens organically.

So, let’s talk a little bit about, you know, where do we go from here? And, you know, ways that we can position the balance sheet to make our way through this, this unique and challenging time.

So, you know, first and foremost, you know, if we go to the next slide, we can think about the path of short-term rates. And you know, it’s often said that the Fed can only control the short end they have. As you go further up the curve, there’s less direct impact that they can have on the long end.

But I think we are in such a unique position right now in terms of the possible paths that short-term rates may take that, that the intermediate and long and have no choice, but really to take their cues from what’s happening on the short end. So here, we’ve mapped out three potential paths. And obviously, there are more than three exact ways that short-term rates can go for the balance of the year.

But in terms of a fast pivot scenario, or rates may go down pretty abruptly, and this is what the yield curve is pricing in right now. Higher for longer. Where rates may tick up higher, through the end of the year or long pause scenario, and that’s closer to what the Fed is saying publicly and even in their dot plot.

So, you know, let’s break down a little bit further what is happening in these different paths. And what types of things on the asset and liability side, you know, may perform better than others. So, we think about the fast pivot.

I think it’s worth pointing out in terms of the Fed’s insistence on taming inflation and recalibrating unemployment. That in the last two months, the Fed has raised rates twice by 25 basis points within days of a $200 billion banking institution failing.

So, you know, this idea that, the Fed is going to pivot so quickly, right? We talked about direction, timing, and magnitude earlier. That rates are going to come down so sharply with the yield curve is saying that it wants.

It’s something that has to break.

Well, we just saw things kind of sort of start to break, and the Fed continues to be march higher. So, you know, to be determined.

Obviously, shorter funding tied to short-term interest rates would be favorable in that in that scenario, but when we think about the inverted yield curve, overnight rates, looking at our Daily Cash manager, is already 75, 25 to 100 basis points behind rates where you go further up the curve. So, again, it’s that magnitude rates may pause and pivot.

But if they don’t go down super aggressively, then, you know, maybe tiptoeing up the curve is still going to have benefits. Higher for longer. Again, what if the banking industry is fine, but inflation is not. The economy continues to roll along. And the Fed sees it justified to continue to raise rates higher to 6%.

You know, the thing I would be worried about there is that the, the intermediate part of the curve, the one that the folks who are trying to fight the Fed right now, that there would be the potential for those rates to snap back and that wouldn’t treat asset valuations kindly. So, that’s a scenario where extending the funding would be advantageous. And I will say, anecdotally, well also, the numbers bear it out, that we have seen a lot of extension from depository members moving their wholesale funding out the curve. And one refrain that we have heard a lot is we are not as asset-sensitive as we used to be. Or even asset-sensitive at all and given the dynamics on deposit growth or lack thereof, that wholesale funding is going to stick around, we want to mitigate interest rate risk, and we’re going to tip-toe out the curve, and maybe that one, three year part of the curve. Long pause? We’ll get to that a little bit more when we talk about the HLB Option, and you know, I’ll pass it to Sean to talk about some mortgage strategies that are highlighted here, but then he’ll go a level deeper.

Yeah. Thanks, Andrew.

​So, you know, obviously, there are different strategies with advances that can be done, but if you’re just looking to manage liquidity and think about it from a different perspective. Selling mortgages outright to us through the MPF Program is another strategy. And we think the MPF Program is more attractive than it’s been in a long time, frankly. For a combination of factors, both internal and external to us.

So, first off, we have very highly competitive pricing compared to what has happened. You know, there were some changes to the advance structure a year ago as a sort of a similar sort of change where MPF pricing has been made more attractive than it has been in a lot of ways.

MPF is a little different than selling outright to other GSEs in that you’ll ultimately earn fee income for continuing to perform, for loans that continue to perform.

That gives you greater flexibility with your clientele because you can kind of change, are different offerings here. Again, because MPF doesn’t feature the loan level price adjustments. It’s a different sort of structure. I’ll talk about one second.

And there are no required minimums, and you enjoy access to DU without those required minimums. We’ve heard from several members — to Andrew’s point about some changes going on — we’ve heard from several members that they recently have been cut off or been notified that they are likely to be cut off from other GSEs.

And so, again, there’s an alternative here that if you haven’t looked at in a while, it’s probably gotten more attractive in that time.

Quick overview of it, PFI stands for Participating Financial Institution, that’s the member bank, or credit union, that’s at the center of the transaction.

You extend your loan to your borrower as you normally would, and then payments that come in from your borrower are netted to us and net of servicing.

We pay you an initial price, and we pay you a continuing or a credit enhancement fee as a trailer.

And there’s this one other piece here around a credit enhancement obligation.

So, instead of having LLPAs, Loan Level Price Adjustments, associated with the loan in the first place, there’s a different method here where there’s a credit enhancement obligation. It’s usually something like 3% to 4% depends entirely on the credit characteristics of the loans being sold, but something like that, that ultimately has to be held as collateral against your FHLB borrowing capacity.

A couple of different flavors of the product that are available, depending upon your view on interest rates.

And to Andrew’s point, there’s a lot of uncertainty right now about when and how rates will change over the coming couple of years

If there’s concern that rates might come down more from here, and the life of the mortgage might be shorter, there’s an upfront solution, within MPF, where you actually get paid more upfront in exchange for having a smaller trailer. And vice versa, you think loans will extend for an extended period of time, you can take the traditional product that has larger trailers, depending upon how long it stays around.

This is just a look at what the cash flows of these would look like, and here’s just assuming a $10 million pool that’s sold to us, and you’re targeting something like par.

You can see that over time, depending upon which of those flavors of product compared to what we see from other providers, we think you’re likely to have higher cash flows over time because of the CE fee and even upfront, depending on the scenario, there’s a good chance that our pricing will be more competitive.

I alluded to upfront the fact that LLPAs versus MPF Credit Enhancement is a little bit of a different structure. The way that the LLPA is, and a lot of folks are familiar with this work, is that, depending upon the credit characteristics and collateral characteristics of the loan, there’s a there’s a grid that identifies exactly how much the upper GSEs will charge, and ours is a little different where it has to be more specifically granularly quantified based on a credit model versus a strict grid.

So and instead of recognizing it, for sure, in an LLPA, it’s a contingent liability that doesn’t necessarily have to be recognized.

So, the fruit of that is that the flexibility you retain with your clients is different. You can have sort of different offerings associated with the MPF Product versus the other products.

Again, our pricing is probably more competitive than it’s been for a long time. This graph is just taking a look at where MPF headline upfront pricing is relative we think, to a lot of other, other pricing that we see out there, and we think, generally speaking, we’re more competitive.

So I mentioned about, you know, flipping back to the funding side, you know, one strategy that has been very popular with members of late because of the inverted curve because of the uncertainty with interest rates and high volatility has been the HLB-Option Advance. So, if you’re familiar or not familiar with it, you sell the option to the Home Loan Bank, then we have the ability to put the advance before maturity.

So, you know, given that you have a lower rate versus Classic rate alternatives, it performs favorably in flat interest rates. It performs well in higher interest rates because you have a lower rate.

​Now, well, what happens if interest rates go down? So, we can look and try and solve for X solve for that breakeven rate, for where the incremental funding rate would have to be. Because we know we’re going to get some savings initially. So, here in this example, we’re looking at a structure with a five-year, one year. So, it’s five-year maturity with a lockout period of one year, and we’re comparing that. And so, that’s at 3.08% versus the Classic into the one-year Classic Advance at 4.82%.

So, we have some 170 basis points or so of savings in year one.

Well, what happens if rates move down and the advance extends? So, let’s stress test this and say, what if it goes fully out to maturity? So, you can see the dotted line blue line. That takes into account that breakeven right here is at 2.64%.

So, rates would have the incremental funding rate for the next four years, would have to be 2.64% for the strategy of the HLB Option, versus Classic and replace, to be equivalent.

Now, I think we’ve been so conditioned over these last 15 years that when rates go down, they have to go down all the way to zero because it’s almost the end of the world. So, whether it’s the great financial crisis or COVID. So, we think about scenarios where maybe that’s not the case. And here looking at 2.64% is over 250 basis points below where short-term interest rates are right now.

So, if we were to consider that maybe rates pause for a little bit and then come down to the 3% range, it’s highly likely that the Advance wouldn’t extend fully out. So, when we shorten that horizon, and this is what the graph on the right-hand side is showing us that, that breakeven rate gets lower and lower.

So if we were to look at a 24-month horizon, that breakeven rate would have to be 1.33%. So the moral of the story here is that this savings at 3.08% versus 4.82% are such that it creates a cushion, that not only will the advance do OK in flat or rising rates, but even there is some room for rates to go down and for interest expense to still be favorable in the former strategy.

So, we mentioned earlier about investments and members replacing the investments even though liquidity is tightening. And I think that is wise and timely, and it’s great to have that flexibility in terms of capital and liquidity to be able to do so.

​So when we look at where spreads are on mortgage-backed securities – the core asset that makes up most of bank credit union investment portfolios — we are at spreads 125, 120 basis points over five-year Treasuries.

Higher than double the 10-year average that we’ve seen and really higher than any individual time we have seen save for a day or two in March of 2020 when, again, going back to, everyone was thinking that the world and the markets were going to cease to exist.

So, you know, those wider spreads certainly in this period where prepayment risk is muted, given that the path of interest rates, that creates some attractiveness. Now, we look on the right-hand side and say, “OK, that’s great, spreads are wide, but how do I fund it if you’re funding in cash or with short-term rates?”

​Well, the inverted curve doesn’t make that math look particularly attractive, but that may be what the balance sheet needs in terms of positioning for a fast pivot or down rate NII scenarios.

But one way to isolate those attractive spreads and remove the interest rate risk component would be to extend the funding. So, we can see that the spread increases materially when we extend the funding by either using a three-year Classic, or a particular HLB-Option structure, that the advance, the overall package spread, you know, gets too much more favorable and attractive levels. So, it’s ultimately a function of if your balance sheet has the flexibility to be opportunistic in this environment where opportunities are to be had.

So, that brings us to the end. I want to thank everybody for joining us. This is always a blast for us to do. So hope, hopefully, you gain some nice insights, And we’ll be following up with a copy of the presentation and a copy of the recording of the presentation. So there’s, as always, if there’s anything that we can do or be in assistance with, please feel free to reach out to us or your relationship manager. And hopefully, we’ll be back. We’ll be back at the end of June with another webinar. And hopefully, that’ll kick off with a slide of comparing Jerome Powell beating inflation and Jason Tatum raising a championship trophy, so a TBD on that. From your lips to God’s ears on that. Thank you again and have a great day.