​Case Study: Restructure Advances and Invest

Case Study: Restructure Advances and Invest

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Hello, everyone. My name is John Kornacki, and I'm the Financial Strategist here at the Federal Home Loan Bank of Boston.
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Thank you for joining us today for another edition of our case study series, this one titled Restructure Advances and Invest.
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Today we're going to discuss a strategy that looks at both the asset and liability sides of the balance sheet.
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Given today's environment and the challenges that our members face, there are opportunities and considerations worth discussing.
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So when you look at some of these considerations, we first look at the high levels of cash and dampened loan production, which has really become a common talking point for several months now.
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Cash levels reached historic highs during the pandemic
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​and members have found it very challenging to put excess cash to work. And now fresh off new stimulus and talks of additional stimulus money,
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we may see this trend continue on balance sheets. And outside of mortgage production and PPP, 
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loan growth has been a challenge.
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So when you combine increased deposit balances with slower asset growth, you're left with inflated balance sheets with shifting risk profiles.
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Another consideration we'll talk about shortly is the rise of intermediate and long-term rates.
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The Fed has remained clear and consistent in that it intends to keep short rates low for the foreseeable future, but that does not prevent longer-term rates from moving up, as we will discuss shortly.
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And as I mentioned a moment ago, mortgage production was the highlight for 2020.
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Many of our members saw record sales and gains on sale
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so when you look at that business line, there are some things
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to consider, especially when you consider the impact, if there are shifts in that volume.
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Then the last consideration, which again is a theme we've talked about over the last few quarters, is the tightening of margins and how that has impacted earnings today
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as well as over the next few years.
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So, taking a look at the five-year and 10-year Treasury yields, we've seen a gradual rise over the last quarter in both terms and a more significant rise starting in the beginning of January.
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The five years up more than 22 basis points, and 10 years up 45 basis points in that timeframe -- at the time we pulled this data.
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So, while the Fed has said short-term rates will remain low, their bond purchase program does not include longer tenors at this time, and when you consider that, along with, you know, recent political shifts that may bring in more stimulus, the idea of continued rise in rates should not be unexpected.
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When we think about the considerations that intermediate rates may continue to rise, the question that I pose to you is, “How does that impact your balance sheet?”
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And if we do continue to see a bear-steepener where longer rates rise with short rates unchanged, it's important to understand the impact to both sides of the balance sheet: assets and liabilities.
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And the point is especially important today as we've seen shifts in balance sheets over the last several quarters.
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The greatest risk that your ALCO discussed in March is most likely not the greatest risk today due to the current economic environment, but also due to the shifts throughout the pandemic.
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Another important consideration I want to highlight is the growing reliance on secondary market sales.
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When you look at the components of ROA, you have all these different pieces that impact earnings, you know, with your core business, coming from net interest margin, but as we've seen over the last several quarters, margins continue to tighten for many of our members.
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But even with tightening margins, many members saw steady or improved returns and that's largely due to the unbelievable mortgage market in 2020.
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The chart I'm showing on this page is looking at net interest margin, as shown by the blue line, as well as gains on sale from secondary market activity, as shown by the green and blue bars.
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As you can see, when you look at both median and 75th percentile, gains on sale are remarkably high and especially when you compare to the prior year.
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And one of the questions I would ask, “Where would you have ended the year without the mortgage market providing so much income?” And more importantly, “What happens if this slows down considerably?”
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As you know, the mortgage business is highly rate sensitive and if rates continue to rise, which then leads to higher mortgage rates, you know, what does that do to your pipelines?
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I put an example scenario where if rates rise 25 basis points pipelines shrink by 20%.
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Now, if you take that example, you know, with tighter net interest margins, how does that impact year 2021 earnings and future years?
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Then how does that impact your exposure on the balance sheet?
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As we discuss this strategy over the next few slides, please keep in mind these considerations that we discussed and how they will impact your institution.
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The first part of this strategy addresses both margin pressure and exposure to rising rates.
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What we're looking at here is four hypothetical advances. These are advances that were originally taken out when rates were much higher in prior years.
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They're above market rates, and given the current environment, are expensive and pose significant costs to margins.
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So, as an example of what we mean by a restructure, let's look at the first advance.
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This 
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is an advance … that has an original maturity of December 2021
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at a rate of 3.07%.
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If that member were to prepay the advance, they would incur a sizeable fee.
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However, by restructuring the advance to a five-year maturity, the member would avoid taking any prepayment fees and could reduce the rate on the advance to 1.5%, which is a savings of 157 basis points.
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So, if we apply this same restructure approach to each of these advances, we have four advances totaling $40 million and have reduced the overall rate by 125 basis points by extending the average life by 3.72 years.
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When you look at the results, you help improve margin by $500,000 annually through lower-cost advances and you also reduce exposure to rising rates by extending the average life of the advances.
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Restructuring advances on their own adds value as we discussed in the previous slide.
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Another benefit that it allows members is to expand on the universe of assets to consider as you seek to normalize cash levels.
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As a starting point, we're going to take a look at the restructured advances from the last slide.
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If you remember, we had $40 million … that we were able to restructure to a new advance rate of 1.64% with an average life of five years.
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If you look at the table on this page, you can see those figures and the liability side of the table. When you think about how members typically invest, it tends to be concentrated on the front end of the curve, you know, or frankly, there's not much yield right now.
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But by extending your liabilities, which affords you the ability to purchase further out on the curve, we can take a look at a longer life MBS pool, for example.
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So in this case, we're assuming an asset yield of 1% with an average life of four years.
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So when you combine both the asset purchase with the restructures, you see some very noteworthy takeaways.
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Particularly when you look at the two data points circled in green, the first one is showing a margin of improvement of 215 basis points,
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and the second one is showing a change of zero point three years to GAAP exposure.
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With the assumption that, you know, this is a $2 billion institution, we see a four-basis point improvement of net interest margin or $861,000 in annual net interest income.
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So, depending on your institution's balance sheet needs and risk exposure, you know, that the restructures are  flexible to different terms so, we can look at custom strategies that fit your particular needs, but this is just one example of how the impact can resonate with members.
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So, just to recap here, when you combine restructuring advances with asset investments, this can help address the considerations we talked about earlier.
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We can reduce cost of funds when margins are under pressure.
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We can mitigate exposure to rising intermediate rates through advance restructures.
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In a time when most members have more liquidity than they need, we can accomplish this strategy without adding funding to your balance sheet.
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We can improve asset yields and extend asset duration by moving from cash to investment opportunities.
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And then lastly, we can improve margins without changing our interest-rate risk profile.
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That's all for our presentation today. Hopefully, you've found some value in walking through this case study with me and took away something that your team can discuss and work through.
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The recording and PDF version of the slides are available on our website, along with our other case studies, webinars, and articles.
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If you have any questions at all, feel free to reach out to me or your relationship manager, and we'd be happy to help out.
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​Thanks again, and appreciate you listening and tuning in today, and have a great day.