​Deploying Excess Liquidity

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Andrew  Paolillo

Many members are sitting on excess liquidity due to shifts on both sides of the balance sheet, while margins are being pressured and asset sensitivity has been growing. Retaining fixed-rate mortgage production can help balance liquidity and earnings, both now and in the future.

Calibrating Risk with the Need for Earnings

In this current environment, balance sheet managers face an interesting challenge. Trying to assess rapidly shifting interest rate, liquidity and credit risk exposures can be difficult, but determining the appropriate blend of those risks that should be accepted as they seek out adequate levels of return is equally challenging.


For FHLBank Boston depository members, the unsurprising common theme in the June 30, 2020 call reports was that there was a sharp decline in net interest margins and loan-to-deposit ratios. At a time when core spread income is needed most, there have not been enough high-quality loans to add to the balance sheet. This has dampened the impact of the exceptional surge in low-cost deposits, which in normal times is a positive driver of earnings. A bright spot for many was that they saw elevated levels of mortgage sale income as the low-rate environment spurred a refinancing boom in residential mortgages.

                       QUARTER-OVER-QUARTER CHANGE (1Q20 to 2Q20)

METRICBANKSCREDIT UNIONS
Net Interest Margin-0.19 %-0.20 %
Loan/Deposit Ratio-3.25 %-5.39 %
Mortgage Sale Income/Net Income9.20 %n/a


The above table shows the median quarter-over-quarter change for FHLBank Boston depository members in selected balance sheet and income statement categories. While the data above shows that many balance sheets may have the liquidity profile to add more loans as well as the earnings need for it, it doesn’t account for interest-rate risk. Measuring interest-rate risk is a complex exercise that is difficult to distill down to a simple metric. However, banks file their one-year gap as a percentage of total assets on their call reports, which can serve as a proxy for asset sensitivity. The higher the gap, the lower the exposure to rising rates.

“…the bright spot of late for many members has been the increase in earnings attributable to mortgage sales.”

When looking back at this measure for every quarter since 2010, we noticed two interesting points. First, FHLBank Boston member banks have been gradually becoming more asset sensitive over the last decade as the median value (as well as the 25th and 75th percentile) for the one-year gap/total assets has trended higher. Secondly, the second quarter of 2020 saw the largest quarter-over-quarter change in over 10 years. This can be largely attributable to the historic surge in non-maturity deposits, accelerated prepayment speeds on assets, and elevated cash levels.

Opportunities in Residential Mortgages

As noted earlier, the bright spot of late for many members has been the increase in earnings attributable to mortgage sales. There have been two main components to this. First, volume has come at a record-setting pace due to the primary mortgage rate breaking through 3% — giving consumers incentive to refinance. Secondly, in addition to the increased volume, gain on sale margins has gone up as well. Quantitative Easing has led to dislocations between the mortgage loan and mortgage-backed securities (MBS) markets, such that mortgage loan spreads versus Treasurys are much wider than historical levels.


The chart above shows the spread of the Freddie Mac primary mortgage rate versus the 10-year Treasury rate. Even with some recent tightening, levels are much wider than the average and maximum spreads in 2019. By contrast, a comparable chart for MBS spreads would show that despite the record-high premium prices and the prepayment risk that comes with that, MBS spreads are currently tighter than they were for most of 2019. Tight MBS spreads can help boost non-interest income when selling loans, but they work against the member trying to deploy excess liquidity prudently when loan growth is tepid.


Origination: Keep or Sell?

To summarize, right now the average balance sheet has excess liquidity with some capacity to take duration risk, and residential mortgages are offering better relative spreads and/or a larger pipeline than other types of loans or investments. However, by electing to retain fixed-rate mortgage origination, the member is choosing to bypass the immediate earnings from a sale for spread income earned over the life of the loan. Given some assumptions, we can identify the amount of time it takes for earnings to break-even when comparing the two approaches.


Consider an example where a member can originate $50 million of 30-year fixed-rate mortgages at 3.00%, and they can decide to either sell at a 2.75% gain (servicing retained) or keep in portfolio and fund with excess deposits, currently costing 0.10%. The point at which the earnings by holding exceeds the earnings by selling occurs around month 13. Given the opportunity cost of carrying excess liquidity, especially as margins are being squeezed and asset sensitivity has increased, retaining fixed-rate mortgages at wider spreads can be a way to optimize the balance sheet. If some of the deposit surge begins to dissipate, the efficiency of advances can always be used to supplement any funding needs for these assets being booked at wider spreads.


KeepSell
2020 Income$604,556$1,426,606
2021 Income$1,412,560$111,982
Total$2,017,116$1,537,988


A less obvious benefit of the elevated spreads and gain on sale margins is that it affords the member some flexibility to potentially sell the loan in the future as it seasons, even if rates rise or premiums shrink. For example, for a loan originated today at 3.00%, mortgage rates could rise by 44 basis points and the loan would still be priced at par on a 12-month horizon.


Alternatively, if you were to assume that gain on sale margins contracted to 2.00%, the loan could absorb a move higher in mortgage rates of 32 basis points. This approach could be particularly valuable for members who prefer to emphasize other types of loans, and as the economy returns to normal, would expect to resume selling as opposed to holding most of their residential production. Through the Mortgage Partnership Finance®* (MPF®) Program, FHLBank Boston offers standard pricing for loans with up to 24 months of seasoning.


For members where the willingness to portfolio residential loans exceeds the amount of deposits needed to fund it, several advance solutions look particularly attractive right now. In particular, the inversion and flattening of the advance curve from 12- to 24-month range presents an opportunity to mitigate some of the interest-rate risk being taken via the fixed-rate mortgages. And floating-rate advances like the SOFR-Indexed Advance and the Discount Note Auction-Floater Advance ​can offer the repricing frequency of being on the short end of the curve, but with greater liquidity and potentially interest expense benefits.



FHLBank Boston does not act as a financial advisor, and members should independently evaluate the suitability and risks of all advances. *Mortgage Partnership Finance® and MPF® are registered trademarks of Federal Home Loan Bank of Chicago.  

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