Managing Through Excess Liquidity

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Andrew  Paolillo

Opportunities exist on both sides of the balance sheet to efficiently normalize liquidity levels.

Asset and Liability Challenges

FHLBank Boston depository members continue to grapple with a liquidity conundrum wholly different than what has been the case historically — having too much liquidity as opposed to not having enough. 

The pressure is being felt on both sides of the balance sheet as shifts in the composition and amount of both assets and liabilities keep adding to the challenge, even as members take actions to counteract it. 

In 2020, many members were able to balance this adverse impact with above average fee income from Paycheck Protection Program (PPP) loans and higher secondary mortgage sale activity. But as PPP activity declines and the refinance wave slows, the core balance sheet’s ability to generate spread comes back into focus. 

After conversations with members and analyzing call report trends and market conditions, there are several strategies we can examine that can be deployed to navigate this unique operating environment. We’ll explore some approaches that can be used with loans, deposits, and investments, as well as ways that advances can complement the efforts across the rest of the balance sheet.

Residential Mortgages: Keep or Sell?

The precipitous drop in long-term rates in 2020 led to record volumes in mortgage originations. Selling production into the secondary market led to high fee income that helped offset margin contraction. 

As liquidity began to increase in the latter half of 2020, we noted the potential value of holding a greater proportion of fixed-rate mortgage production, driven not just by the need to sop up cash, but also because spreads were much wider than historical levels. Fast forward to the present and liquidity has remained high or even grown for most, and we have heard from members that they are keeping more mortgages on the balance sheet despite narrowing spreads.

The above graph shows the relationship between the 30-year mortgage rate and the 10-year Treasury rate from 2010 to the present. Historically, the spread between these two rates has been around 175 basis points. But in 2020, sharply wider mortgage spreads offset record low Treasury rates — 0.75% to 1.00% more than normal. 

This meant that the return profile was more attractive for depository institutions that were able and willing to either hedge or absorb the interest-rate risk of holding these longer duration assets. Now, as Treasury rates have drifted off the lows, the spread in mortgages has contracted toward and below the historical average. 

Depending on the magnitude of your asset sensitivity and excess liquidity, retaining fixed-rate mortgages may not have the same risk/return trade-off as the strategy had previously, thus making secondary market sales relatively more appealing.

Putting Cash to Work in Investments

Both call report data and commentary from members have confirmed that many are more recently focusing more efforts in their bond portfolios.

“With uncertainty surrounding the timing and magnitude of normalized lending activity as the economy recovers, investments offer the ability to support income while being able to tailor the level of liquidity, credit, and interest-rate risks.”

Despite high levels of gross purchase activity, there has been mixed impact on reducing cash levels, as prepay activity (from both loans and investments) continues to be high, new loan growth is muted, and deposits continue to flow in. 

As noted above, Treasury yields bottomed in mid-2020 and, at present, there is a fair amount of slope in the intermediate parts of the curve where most center their activity, which provides compensation for moving out of cash.

With uncertainty surrounding the timing and magnitude of normalized lending activity as the economy recovers, investments offer the ability to support income while being able to tailor the level of liquidity, credit, and interest-rate risks. 

As discussed in Using Advances for Just-in-Time Liquidity, being able to access funding immediately through FHLBank Boston advances allows members to put cash to work now while still being prepared for any intermittent liquidity needs along the way. 

Amortization from mortgage backed securities (MBS) can provide liquidity to fund a pick-up in future loan growth —for example, taking principal run-off from a 1% bond and redeploying it into a loan at 4%. 

The table below shows a variety of generic MBS structures and how much principal is returned from amortization and prepays to different horizons. Depending on rate outlook and the need for earnings, MBS can offer highly customizable alternatives to help normalize liquidity levels.


10-year MBS15-year MBS20-year MBS30-year MBS
After 1 year15 %13 %12 %8 %
After 2 years34 %30 %28 %20 %
After 3 years51%47 %42 %33 %
After 5 years75 %71 %63 %54 %

Testing Deposit Elasticity

While members can take steps to deploy cash on the asset side of the balance sheet, another approach members have taken is to use the historic surge in core deposits to reduce reliance on non-core liabilities. 

The chart below shows the ratio of Core Deposits to Total Liabilities for FHLBank Boston depository members at March 31, 2020 and at March 31, 2021. 

As to be expected given the huge growth in deposits, core deposits now comprise a greater percentage of the funding mix. In fact, the member at the 25th percentile at March 31, 2021 has a similar ratio as the median member had a year ago in 2020 (87% vs. 88%).

Forecasts from members are mixed on whether these deposits will be sticky long term. Many believe deposits will hang around to some extent but given the unique circumstances that led to this situation, many are hesitant and cautious to position the balance sheet accordingly. 

While deposit pricing is often more art than science, especially as it relates to the qualitative aspect of maintaining customer relationships, the combination of deposit inflows and choppy asset deployment opportunities affords the ability to test the elasticity of deposits by lowering rates. 

If deposits stay, then there is some cost of funds relief. If some deposits leave, then excess liquidity is reduced. Many members have utilized this approach, and results have been more skewed towards margin relief versus liquidity reduction. A common refrain we have been hearing is: “we have lowered rates, but the money still stays.”

As shown in the chart below, with each passing quarter, cost of funds keeps coming down but by smaller amounts as they approach 0%. 

As noted earlier, where having advances at the ready can allow for cash to be deployed into investments, let the advance curve be a benchmark for deposit pricing. When there is a general lack of need for incremental funding, deposit pricing should reflect that by being (comfortably) inside of where you can take down an advance.

Advance Solutions

Strategies within the loan, investment, and deposit portfolios tend to move the needle the most in normalizing liquidity levels, but some advances can help you take advantage of current market conditions without adding incremental funding.

  • Advance Restructures: For certain advance types, and depending on the coupon and time to maturity, members may be able to “blend and extend” an existing advance to lower the rate being paid and lengthen the duration, with no prepay fee in the current period and no new funding taken down.

    As outlined in a recent case study, a useful strategy can be to restructure and invest, which would involve adding income by moving from cash to securities while at the same time mitigating the interest-rate risk and improving margin by restructuring the advance. This approach can also be beneficial, as mentioned above, for those retaining more longer duration fixed-rate mortgages than is typical.

  • Forward Starting Advance: This advance allows you to lock in funding that is priced off of the shape and level of today’s yield curve, but delay the disbursement of the funds to a point in the future when the funding may be needed more. In a recent article as well a case study, we examined how the Forward Starting Advance can be a useful way to hedge against uncertain deposit and loan flows, as well as the potential of a steepening yield curve.

Flexible Funding

Recent market conditions have created challenges and opportunities for FHLBank Boston members. Our Financial Strategies group has developed a suite of analytical tools designed to help you identify the funding solutions that best fit the unique needs of your balance sheet. Please contact me at 617-292-9644 or, 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. 

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