Balancing Prepayment and Interest-Rate Risks

As the financial markets continue to adapt to conditions brought forth by the COVID-19 pandemic, FHLBank Boston members face new challenges in the familiar instruments that populate their balance sheets. The economic shutdown has stunted commercial lending growth, and as first quarter earnings reports are beginning to show, provisions for loan losses are growing. Investment spreads have moved wider and presented some opportunity, but low nominal yields, high premiums, and a cloudy economic picture have led many to defer to a more defensive posture.

Despite these conditions, many members have indicated that residential mortgage pipelines remain robust. Social distancing has created some logistical and operational hurdles, and the mix of activity reflects more refinancings than new home purchases. Advance rates had declined faster than mortgage rates toward the end of 2019, leading to wider spreads. This created opportunity for asset-sensitive members who had the capacity to absorb the interest-rate risk.

In just the last few months, the precipitous drop in interest rates has moved those spreads even wider. As the chart to below shows, funding a fixed-rate residential mortgage loan with a three-month Classic Advance currently produces over 300 basis points of spread. This is comfortably above the 201 basis points as of January 2, 2020 as well as the average of 159 basis points for all of 2019.

Also included is the spread from funding the fixed-rate mortgage with a three-year maturity, one-year lockout Member-Option Advance. Similar to the example using the three-month Classic Advance, spreads have improved considerably when using the Member-Option Advance as a funding tool.

As the name implies, the Member-Option Advance grants the member control over the advance. After a designated lockout period, the member can choose to hold the advance or return it to FHLBankBoston without a fee. The decision at the end of the lockout period is driven by how market conditions have changed. If rates have increased, the member will likely want to retain the advance, as the longer liability will prove favorable as opposed to shorter funding that would have needed to be repriced in a rising-rate environment. If rates have decreased, then the member can elect to return the advance and choose new funding at a lower cost.

This type of structure is ideal for efficiently funding an asset like a fixed-rate mortgage loan, where both prepayment risk (if rates go down) and interest-rate risk (if rates go higher) exist. Let’s look at an example where a Member-Option Advance would have allowed a member to manage those risks and improve their margin in a challenging environment.

At the beginning of 2019, a member could have taken a pool of 30-year fixed-rate residential mortgage loans into portfolio at a yield of 4.40% (dark green line). To fund that asset, the member could have used a three-year/one-year Member-Option Advance at a cost of 3.71% (dark blue line).

As 2019 progressed and interest rates fell, the addition of the fixed-rate asset looked like a smart decision. However, locking in longer-term funding and mitigating the interest-rate risk prevented the ability to reduce funding costs. At the end of the lockout period, with rates lower by 100 basis points, the member would have returned the funding that was costing 3.71% back to FHLBank Boston.

At this point, replacing it with rolling one-month Classic Advances saved nearly 200 basis points in interest expense, as well as allowing the ability to adjust the funding amounts for any prepayments, amortization, or deposit growth that may have occurred. When interest rates dropped again in March 2020, funding costs fell too, pushing the spread on the remaining balance of the mortgage loans to over 400 basis points.

This example shows how the Member-Option Advance can be used to mitigate the prepayment risk of mortgage assets while driving margin enhancement as rates change. Rolling short-term advances would have also produced cost savings that would have occurred faster; however, in hindsight, that was due to taking a risk (interest-rate risk) that was ultimately rewarded. With rates at or near historic allows, the Member-Option Advance can offer a balanced approach to addressing both interest-rate and prepayment risks.

Recent market conditions have created many new challenges for FHLBank Boston members. Our Financial Strategies group can work with you to identify the funding solutions that best fit the unique needs of your balance sheet. Please contact me at 617-292-9644, or andrew.paolillo@fhlbboston.com, or your relationship manager for more details.

FHLBank Boston does not act as a financial advisor, and members should independently evaluate the suitability and risks of all advances.