Peer Analysis and Balance Sheet Strategies Update February 2023

Peer Analysis and Balance Sheet Strategies Update

0:05 
Good morning everyone. And thank you for joining us today. My name is Andrew Paolillo, and with me, as always, is Sean Carraher.
0:13 
And we're happy to have you with our with us for our latest webinar. So I've been with us before you now that we have a packed agenda here today. Certainly, plenty of things going on in these three main areas that will begin to cover.
0:29 
So we'll start off talking a little bit about what's happening in markets and the economy.
0:35 
Then, we'll take a deep dive into the call reports of banks and credit unions here in New England, looking at the fourth quarter of 2022, And then lastly, we'll wrap up with some asset liability management strategies that we think in this current environment, have some particular interest and relevance.
0:56 
So, you know, we'll get started with, you know, in the past, we have done poll questions, and they, as the current environment, would tell us, would normally be, when do you think the Fed is going to start raising rates?
1:08 
How much longer do you think the Fed is going to raise rates? When will the Fed begin to cut rates?
1:13 
So, I decided to switch it up a little bit today, you know, with something with the lighter tone here.
1:20 
And, you know, frankly, as we observe things happening in all corners of the world and the economy. A lot of charts are going up into the right pretty aggressively here.
1:30 
So, you know, this unlabeled chart here is either the price of eggs, cumulative wins by the Bruins and Celtics, as they both had very successful seasons thus, far. Deposit beta, something near and dear to all of our hearts, has begun to creep up, but then also UFO sighting in just the first month and a half of 2023.
1:52 
So, as you ponder over this question, I will throw in one fact about, or not even the fact, that, an opinion, really, about D. I think, you know, it's been a little casual and cavalier about how people have been talking about oh, yeah, by the way, we saw four UFOs in the last week or two.
2:10 
You know, not even, you know, leading the nightly news. But, you know, to end this suspense here, this chart here is the price of a dozen eggs over the last year.
2:23 
In very short order, it went from about $2 a dozen to over $4.50, pushing for $5/dozen. So a pretty incredible move there.
2:36 
With that, let's jump into the meat of the presentation here.
2:40 
So let's talk a little bit about what's happening in markets and in the economy.
2:44 
So, we'll bounce around. We'll talk about the yield curve. We'll talk about mortgage markets, and then we'll talk about some economic indicators, specifically inflation and unemployment, which are right on the front burner in terms of Fed policy. So, let's talk about the yield curve.
3:02 
So, there's almost an endless combination of both points on the yield curve that you can look at to tell you something. Or to analyze the slope of the yield curve.
3:14 
So, you know, I like looking at the six-month and three-year Treasury yields and spreads because it gives you a little bit of a short-term perspective, right?
3:24 
So, looking at the six-month rate that tells you what the near-term expectations are for Fed hikes.
3:30 
But then, in a little bit more of the medium-term horizon, by looking at the three year without some of the noise and other factors that you get by looking further out the current five-year and ten-year, maybe and even longer than that.
3:46 
So what we look at, when we see the performance of the six-month and the three-year, over the last five years, an interesting week compared to the previous cycle, in 18, 19, and 20, is that the moves that we've seen thus far had been that much more extreme than the previous cycle, right?
4:03 
So as rate hikes were occurring, we saw the curve get too much steeper and steeper points, right, that the three years sold off and was much, much higher than the six month, and they may not feel like it at the time. You know, let's rewind to six months ago, where we were all pretty much caught off guard by the magnitude and the suddenness of rate hikes.
4:27 
But, you know, the gap between the three-year and the six-month, well, that was the first signal that many, many more rate hikes were coming on the horizon.
4:37 
But you know, the really interesting dynamic here is that we've all heard about the inversion of the yield curve, whichever ones you're looking at.
4:46 
But this iteration is a little bit different than in past cycles.
4:51 
So, you know, the six month has continued to go up, and the three year has gone down. Right? So the here's the market expecting or trying to influence the Fed to pivot and begin to cut rates.
5:07 
Look back in the middle of 2019. The six month started to turn. That was when the Fed paused, and they did with the composite, mid-cycle adjustments where they know that the wordsmithing is beautiful there where they said this wasn't a transition to an easing cycle, right? Where rates were going to go back to zero, they were just going to cut, then wait and watch. Now COVID happened in the beginning of 2020. So, we'll never really know if it was truly, in fact, a mid-cycle adjustment.
5:38 
But we haven't yet seen that at the very front end of the curve, right? You see, all the way in the top, right? That green line, the six-month rate, has continued to move higher and higher.
5:49 
So moving to mortgage spreads, and this is my favorite way to look at mortgage rates. Ironic that mortgage rates themselves aren't anywhere on this graph here.
6:00 
But we do have, is the two components of what produced that fixed rate mortgage rate.
6:08 
So you have the interest rate risk component, right, so that's the seven-year treasury on the X axis, and then you have the spread component on the Y axis.
6:17 
So that is how much you are getting compensated for prepayment risk and credit risk.
6:22 
And we've really seen a variety of different environments over the last couple of years.
6:29 So just from a return perspective, the top right is where you want to be.
6:34 
Where you have relatively higher rates and relatively wider spreads, if you look for the dark green circles, that's where we are right now in 2023.
6:44 
Now, rates have come down over the last few months. Treasuries rates in the intermediate part of the curve, but also spreads appetite.
6:54 
But from this relative perspective, we can see that we still are in, from a nominal yield and spread perspective, in a better position than we have been in recent history.
7:06 
We have more to come here in terms of the implications, and the asset decisions, and how you might want to weigh, some of the risks that are inherent when putting mortgages onto the balance sheet.
7:19 
But this can serve as a good proxy. This is looking at mortgage loans.
7:24 
This can serve also as a good proxy for opportunities in the mortgage-backed securities market, again, which we'll get to in a moment.
7:32 
So I'm going to pass it to Sean here, and he's going to go through a couple of other metrics. But, you know, as I always do, I always forget to mention that if you do have any questions anywhere along the way, we're happy to answer them.
7:45 
You should see it on the control panel, And you can input into the Q&A section there. Thanks Andrew. Andrew talked about inflation about the price of eggs on the first chart and also talked a bit about sort of the shape of the curve and the suddenness and pace of rate hikes that have happened.
8:03 
We think if we turn our attention to sort of the other side of the Fed's dual mandate with unemployment. You know, there's a macroeconomic, sort of major, secular trend that I think is often overlooked in a lot of analysis.
8:16
 And that's basically the nature of sort of the population of the U.S., the distribution of that population.
8:22 
And the fact that we're going through a time now where the labor market isn't growing very, very significantly. This chart is year by year, births by year within the U.S.
8:31 
So just U.S. domestic births, and you can see, obviously, at the beginning of this chart, is the big baby boom. Followed by the baby bust of the 1970s. I have it labeled here as the Gen X Valley. There just aren't a whole lot of Gen x-ers compared to Baby Boomers. And then that's followed up by Millennials, Gen Zers, and those other sorts of peaks.
8:49 
But the fact that there were so few births in the U.S. in the seventies is kind of creating some dynamics, I think, in the overall labor market.
8:57 
If we look at that overall labor market distribution and composition, you know, 20 years ago, there were 140 million people who were between the ages of 25 and 65 basically within that, that working age population.
9:12 
And those 140 million people were very middle-heavy.
9:15 
There were not very many people at the top, and there weren't a whole lot of people at the bottom, but the middle, which was really the baby boomer generation was really the meat of the labor market. Wind back ten years, And it was very top-heavy.
9:27 
It's all those folks who were still working, but there weren't a whole lot of people following it up.
9:30 
Today, we're very middle-heavy.
9:32 
We have a lot of folks at the top, and we have a lot of, we have a growing population of folks sort of in the entry-level of the labor market.
9:39 
But if we wind forward ten years from now, it's going to be this sort of natural sort of pyramid of fewer people at the top.
9:46 
And then, then, subsequently, a little bit more people, and different tiers, And the overall pool of labor isn't coming up a whole lot.
9:54 
And so what I would offer is the idea that maybe the fact that unemployment has been stubbornly low is actually a consequence of this demography, as a consequence of the fact that the overall population isn't growing and that the distribution is changing.
10:08 
Which is probably putting pressure on wages because they're just more need for people at the top, and the overall pool isn't growing very significantly.
10:17 
You know, we've heard from a lot of folks, in conversations just about, about their bank and about their credit union, saying that they don't have necessarily the next generation of people to take the reins. And what I'd highlight is maybe it's because they don't exist. It's not necessarily a bench strength problem. It's the fact that there just aren’t a whole lot of folks in their late forties out there.
10:40 
Right. So sticking with that idea of the headline number doesn't tell the entire story.
10:47 
You know, so forgive me for getting on my soapbox here for a second.
10:49 
But you know, we all see the news report that CPI has come down, right?
10:56 
You know, mission accomplished on killing inflation.
11:00 
But, you know, I would caution with that approach.
11:05 
So, you know, the chart on the left-hand side shows the actual consumer price index overtime going back up over the last ten years.
11:15 
And you can see real, you know, look at the magnitude of two things, the magnitude of the spike in the index that we have seen over the last, call it, a year and a half or so, right?
11:25 
But then also look at the lack of move in the COVID drop, right? In March 2020.
11:34 
So, you know, we looked at what the trend line would be if that 2% target that the Fed uses would have held true from December '13 and '18. So, I've extended it out through the end of 2023.
11:49 
So in order to get back to that trend line, we would need pretty significant deflation, which we didn't see in March 2020.
11:56 
And frankly, you know, if we did see that level of deflation, you know, I shudder to think what, know, the world and the economy and the markets would actually look like if that actually came to bear. So, you know, this goes back to the eggs example, Right? They went from 2 to 5 in short order. Well, now, if they only got 5, 10, right, there's 2% inflation. Know, well, what happened to the three and the 4% that normally would've taken years or even decades to get to? So I think the takeaway here is that even if headline inflation does come down, you know, it's come down from 9, 8, 7, 6, most recently, it gets back to 2%. There's still going to be significant pressure on consumers and businesses alike. Just because the magic of compounding is working against folks here as opposed to normally, it's working for you when you think about interests.
12:51 
Yeah, My favorite topic is industry deposit trends. You know, it's no secret out there that deposits are kind of a struggle, and we're going to have some more information later on as well.
13:01 
But this is just trying to take a look at what's going on in the industry generally.
13:04 
So this is all commercial bank deposits, which is what's publicly available. And this is a four-week rolling average because when you look at this week to week, it's kinda noisy.
13:13 
Bottom line is, you know, we really started to fall off in Q4. The pace of deposit outflow has gotten a lot faster.
13:20 
There was a rebound in December, but that deposit outflow has resumed in January.
13:24 
So we have some numbers later on here, but most folks are still experiencing deposit outflows, not inflows.
​13:33 So if you're seeing that, and you're struggling with sort of 2023 budget numbers, you're not alone. That's, that's most people at this point.
13:40 
And I got, it got much more acute in Q4.
13:44 
So, let's move on to some pure analytics and look at what's happening, specifically on the balance sheets of our members here in our six-state footprint.
13:53 
So, you know, we're going to bounce around and talk about a couple different areas.
13:59 
So, let's jump right in and talk about liquidity. So, I've often joked that there was a stretch in 2020 and 2021 that we started by looking at cash levels because they were so historically high. Well, not listed here, but cash levels are back to normal. But you know, what about loans to deposit ratios, loans to shares?
14:19 
So here what we're looking at is the parallel lines are the 25th and 75th percentiles from the March 31, 2020 call records, which was the last call it normal, pre-COVID balance sheet, period. And then, the dashed lines are the median and the 75th percentile. So the middle road and the high-performer bank and credit union, and as you might expect, those loan-to-deposit ratios came down pretty significantly over the course of the two years.
14:55 
But we have started to see some significant recovery, and we'll get to that a little bit when we talk about how great loan growth has been. But, you know, if we try to answer that question, liquidity levels back to normal, it's still uncertain because, as we all know, you know, there's no one magic metric when thinking about liquidity. There are many moving parts, but if we're just thinking about loans, deposits or loans to shares as a proxy for that, we can see that credit unions have done better than banks in getting back to, quote, unquote, normal levels. We can see that loans to shares for credit unions for the 75th percentile are right back where it was, and same thing for the median. Where banks have not quite come back. They're still about, let's see, call it, you know, seven percentage points or so, to get loans, back up to where they were.
15:49 
Now, the caveat here is that the bottom portfolios, and we'll have more a little bit later, is that they're still significantly underwater, right?
16:03 
So, there are less opportunities for remixing the balance sheet and having cash flow come off and contribute to growing the loan portfolio because the saleability really isn't there.
16:18 
So, the other part of the equation that is impacting liquidity, is that it's been a very challenging period, as Sean alluded to before, in terms of not just bringing in the deposits but frankly, even retaining deposits.
16:31 
So the trend for top-line deposit growth has been downward such that in the last quarter, the median bank and credit union both sought negative deposit growth, half a percent for banks and 0.9 for credit unions. Now, these are not annualized.
16:50 
So, if you look back a few quarters on the top two charts here, you can see that it was pretty attainable for folks to hit high single-digit or even low double-digit deposit growth numbers. Now, for the reasons Sean outlined before, and we'll get into a little bit more that has become a very challenging proposition.
17:13 
And not just the top-line growth numbers are not really where most we'd like them to be. It's the composition of what is coming in.
17:24 
So we look at the bottom two charts here. This is simply the percentage of our member banks and member credit unions who have grown to three different types of buckets in terms of deposits that we've outlined here. So transaction accounts or share drafts, time deposits or CDs, and then money market accounts.
17:42 
You can see for the nonmaturity deposits, there's been a pretty consistent decline down that has coincided with the top level, and then in the last couple of quarters, we have seen a pretty big growth in the amount of members who have been able to grow in certificates.
18:02 
So if you think about the low-cost nonmaturity deposits is what we wake up and we all want to bring in, you know for many reasons, whether it's cost or the contribution to duration in your asset liability profile. So growth is limited, and the composition is probably less than ideal.
18:27 
So, this challenging deposit market is coming at a time when loans continue to be on fire.
18:33 
So, for the third consecutive quarter, we have seen loan growth outpace total asset growth.
18:41 
Now, this explains why many members, and we certainly have a view into this, have increased wholesale funding over the past couple of quarters because loans are coming in at double-digit clips, double-digit annualized growth clips.
18:55 
Deposits have been tough to combine and have been outflowing in many cases. And as we said, the bond portfolio is not throwing off the amount of cash that you would like to have to be able to meet this extraordinary loan growth.
19:07 
So if you look at the bottom, it's been pretty robust in terms of the categories that have been contributing.
19:14 
We mentioned this last quarter, if you were with us, initially surprising the amount of mortgage growth that we've seen, right, given the volume challenges.
19:24 
Right, certainly, the re-fi market not really being in play, and given the path of rates. But that just shows you that there's no prepay.
19:32 
So, you know, to get to net growth, it doesn't take an extraordinary amount of originations.
19:39 
But even if we look at, you know, the commercial activity for banks, or auto loan activity, for credit unions, the vast majority, at least upper third, or for upper quartile, have been able to grow those portfolios.
19:56 
NIM changes. So I guess the good news was in Q4. With all these balance sheet changes, NIM was still increasing for most folks out there. Though we're starting to see a kind of a dispersion of different results for different members.
20:09 
Both banks' and credit unions' NIM were up about 4 to 5 basis points—banks, a little bit higher than credit unions. These are on the same scale.
20:16 
And I think that we've seen now and three straight quarters, as NIMs have expanded throughout the membership and throughout the industry, that banks are more asset-sensitive structurally than credit unions. It's allowing them to pay up more in deposits.
20:29
And so, even though they're more asset-sensitive, they're giving more of that back in the form of higher deposit rates.
20:34 
You can see that, you know, for banks, asset rates improved almost 42 basis points. But, liability rates declined or increased also 37 basis points, resulting in a NIM of about 4.8.
20:47 And then, for credit unions, it is 26 and 23, respectively, on the same measures. So, very similar net results quarter by quarter between banks and credit unions, but it's actually from a couple of different dynamics that are happening.
21:00 
And if I just click…the dispersion here, the look at what's happening across all the different members.
21:10 
Because not all these things are created equal, there is a pretty small minority. But a minority of folks who have had very significant NIM declines actually are very liability sensitive.
21:20 
And then there are people who are very asset sensitive, who have had very, very sharp increases, you can see sort of where the center of gravity is. What's happened over these past few quarters is that central tendency, where almost everybody was growing significantly, almost everybody was saying, 10, 15, 20 basis points of NIM expansion. That's not happening anymore. You're still seeing a significant minority of folks who do that.
21:42 
But most folks are sort of in the middle, around zero, these days, and I would suspect that in 2023, we're going to see that continue to evolve. We're more likely to see margin compression than a very significant margin expansion.
22:00 
Again, you can kind of see here that on the bank side, about 55% of members had expansion versus 45, and on the credit union side, 60 versus 40.
22:07 
So different results for different people, depending upon their balance sheet structures.
22:13 
Bank deposits by geography, if we take a look at what's actually driving the changes in deposit costs amongst our different members?
22:25 
So we've taken a look at a few different metrics, a few different variables, to say, what is actually the best predictor of whether a bank is paying up or not on deposits?
22:34 
And on the sort of lower right-hand side, try to say what's the correlation of cost deposits versus size. There's almost no correlation.
22:40 
Big banks and smaller banks. There is almost no correlation to what's happening.
22:45 
How about by loans to deposits though?
22:47 
So that's where you start to see real effects, so the less liquid folks are, the more pressure they're feeling to raise rates on deposits, which makes sense.
22:54 
But then to take it one step further is to say, OK, if we remember from that NIM slide that banks are paying more than credit unions because they're more asset sensitive.
23:02 
What if asset yields go up? What if the loan yield change is more significant for a bank? Does that mean that they're paying more for bank deposits?
23:10
And in fact, that's the best variable I can find for predicting what a bank is going to pay on deposits is how asset sensitive they are.
23:16 
That is if they're feeling if they're seeing margin expansion and our loans are repricing higher, they're feeling more comfortable and pricing up deposits more quickly.
23:25 
So they're managing margin more than they're managing liquidity, Though it's pretty close.
23:30 
And you can also see here a breakdown by our six member states, And as has been the case consistently, Rhode Island has the highest cost of funds. Turning the table over to credit unions, it's a very similar story. It's not as clear on the loan yield side for credit unions.
23:46 
But what is clear is that liquidity and credit unions are driving behavior, and also, there continues to be some small correlation between cost and size amongst credit unions.|
23:55 
Though I think that's an artifact of the fact that the bigger credit unions we have are less liquid, and some of the other credit unions.
24:02 
Correlation is not causation, but the dispersion, which is interesting, is less.
24:07 You know, if you remember that, that bank graph, you'll see a lot more outliers in terms of what folks are willing to pay versus credit unions.
24:16 
You know, Andrew kind of alluded to some of these numbers before.
24:18 
But, you know, banks down on deposits, depends on how you got these numbers, exactly, but credit unions are slightly up on this particular metric. But the composition is what's actually happening here. That's what we're trying to highlight.
24:29 So even if total deposits for banks are slightly up, nominally, just headline deposits, what's actually happening is that brokered and listing deposits are making up the deficit. Core deposits are down.
24:42 
Core deposits are down, but brokered and listing is filling the gap for folks.
24:47 
And it's not the same story in credit unions, but again, you can see that total shares for credit unions are barely up, but nonmember deposits are actually increasing at a much, much faster rate.
24:57 
And this quarter was a quarter where we really saw a very big expansion in that wholesale deposit base from prior histories and prior quarters.
25:09 
All right. So if people are, if the industry is struggling with deposits, how are folks doing who are putting big, gaudy rates in the window? If they're putting big gaudy rates in the window or on their website, or they're highlighting themselves on deposit aggregators, surely, they're doing better than other folks in terms of raising deposits?
25:27 
​So, this was a look at seven $1 billion-plus banks.
25:31 
I think they are all multi-billion dollar banks, in fact, that do consistently advertise much higher rates, both on deposit-aggregating websites that you can go look up and say, you know, where  are different banks paying, and on their own websites.
25:45 
And what you see here is they're arranged by bank one through seven, by how much their cost of funds went up, this quarter. How much more are they paying?
25:54 
And so, the results kind of speak for themselves.
25:57 
I think that core deposits for these banks that are putting in really high rates and had, but some of the higher levels of cost of funds growth, were actually down.
26:07 
And six out of seven, of these, I should say, four out of seven, they outright declined significantly more than other institutions. Only one of them actually saw growth. The strategy of paying up and having that extra product that's at a higher level seems to work for one of these seven, but for the other six, it didn't seem to work very well.
26:27 
And the bottom here shows, you know, what's the unweighted sample average of these seven names because they're all different sizes.
26:32 
They actually had core deposit outflows of -1.6% while paying up 50 basis points. Versus the overall sample of banks out there, having core deposit outflows at -1.3% and paying up only 38. So they had the worst deposit performance by paying up more.
26:50 So, that's not good, right?
26:52 
It's not a great dynamic, and it's just trying to highlight the fact that maybe rates aren't necessarily, aren’t really working very well. And that is the idea of doing rate specials and CD terms, your mileage may vary, but in general, it doesn't seem to be working very well.
27:09 
Last quarter, we took a look on the asset side, and we highlighted the fact that, you know, CRE would seem to be pricing pretty much at the same level as residential. We heard it anecdotally.
27:20 
And we did some work to try to imply that or infer that, I should say, from the data that we had in Q3 and get to these levels where we said, you know, the average mortgage was probably booked around 5.70, and the average CRE at around 5.60.
27:32 
Using that same methodology in Q4, we found that reversed.
27:37 
Pricing on CRE got a lot wider.
27:40 
​And got back to a level that's probably a lot more sustainable in the low sevens, and mortgages went up into the mid-sixes.

27:47 
And so, we do see some, some better loan growth. And in Q4, it rationalizes in a big way and gets to a level that probably starts to make more sense than what we had seen in Q3, where it doesn't feel like the CRE market had really caught up.
28:03 
Something that, you know, we've talked about, or that the industry is thinking about, I think, in a way, It's not only CECL, which is affecting a lot of folks on this call. But is the change in the credit cycle. Now, the curve is so steeply inverted. We all know that it's been that way for a while.
28:18 
The war drums are out for recession everywhere.
28:21 
How is that affecting people's views on credit and their capital levels? Took a look at provisioning, and provisions are hardly changed this quarter for our members.
28:29 
So, that wasn't a whole lot, there wasn't a whole lot there to talk about, but this is a look at excess capital.
28:35 
So, if we think about capital on our balance sheet, you know, depending upon exactly what your elections are, one of the major capital or net worth ratios is going to govern your institution. For banks, you know, there are four regulatory ratios plus the CBLR. And for credit unions, you have the net worth ratio and things like CCULR. One of these ratios is going to be more limiting to you, than one of the other ratios. That is to say, one of them is going to get you below well capitalized before the others, just depending upon your balance sheet and capital stack.
29:06 
And this is a look at where do our members stack up on those things and how much capacity are they giving themselves in this challenging environment that could be heading into a recession? How much rope have they given themselves?
29:21 
And, what we find is that you know, banks have, on average, about 500 basis points of capital versus “well.”
29:27 
And, here's a look at, you know, which, which particular ratio is limiting to them.
29:32 
And it's a pretty even split between tier one leverage and total capital, and CBLR, it's actually really quite evenly split upon which one is going to govern behaviors going forward.
29:44 
And, for credit unions, there's much greater central tendency than banks. You see a wide dispersion there.
29:49 
Much greater central tendency and excess capital for credit unions.
29:53 
And net worth ratio is really the big one for folks. It's the headline 7% net worth ratio, and there's a little bit less rope for credit unions than there is for banks.
30:03 
This is worth contemplating as you think about strategic asset acquisition, simply because if you're really heavy, for instance, if you're a limiting ratio is total capital, and you have a whole lot of commercial loans in the bank.
30:16 
It probably makes sense for you to go to the other side of the boat and have more investments, or Resi and vice versa if you load it up on Resi, and Tier one leverage is really limiting your CBLR, it might make sense to do more higher-yielding things in CRE, or C&I, and the same story in credit union space where depending upon your exact position, you may want to think about a different asset class from what you've traditionally done.
30:42 
Basically, depending upon how much, how much rope you have going into this environment.
30:50 
We've got a poltergeist in this room today, I think. It did not like the position, you know, that lamp there.
30:58 
Sorry, Thinking about the investment portfolio. Certainly, you know, isn't this the third time, I said, uncharted waters? I think or second.
31:09 
But yields have been coming back at a fraction of the magnitude of market rates, as you would expect that given the nature of what folks are doing in an investment portfolio.
31:22 
So, you know, the thing that really jumps out here is that there is a huge gap between the book yields of what is there now versus the replacement yields.
31:34 
So, when you think about the book yields in the 2% range.
31:40 You know, that's a combination of bonds bought at all different yields. So in some regards, there are bonds at 0% and 1% handles rolling off.
31:50 
And without much effort, you are, you know, able to replace them in the threes, fours, and fives.
32:00 
So that's a pretty significant amount of opportunity there. So at the current pace, you're probably looking at credit unions within the next quarter, and banks within about two quarters will be able to put, have yields, book yields exceed that, which they got it at the top of the last cycle, back in 2019, and we'll go into this a little bit more in the next section. But there's an opportunity when you look at those x-es. They're looking at the cost basis, right, or, excuse me, the fair value versus the cost basis. With deep discounts. So, you know, about 88% for banks and closer to 91% par value for credit unions.
32:44 
There's a dynamic that we'll talk about in a little bit that really creates the two different portfolios within the bond portfolio.
32:51 
You know, the chart on the bottom is very interesting because you would think, given you talked about loans on fire, the challenging market for deposits, Not a lot of cash flow coming off investments, you would think that many are saying, every dollar that comes off the bond portfolio, we're going to redirect it to do what we need to do in loans or deposits.
33:10 
But given some of the, you know, the dynamic.Well, hi, everyone, apologies for the delay.
33:18 
So, we'll be back in just a second. We'll pick up, right, where we left off. I mean, the good news is, we got an exorcism performed in record time in order to take care of this.
33:29 
These questions, know, we know a little bit about the balance sheet strategies. Technology is not for, as Sean said, dealing with poltergeists is not our forte.
33:42 
I know, and after the Data Center problem centers, that it's just, you know, hopefully, this exorcism will work. One of those weeks. Yep. So let's get into it. Thank you very much for sticking with our limitations.
33:55 
And we'll wrap things up with a couple of different strategies that are jumping off the page here for us.
34:01 
So the first thing is, so we've talked a little bit about, you know, the challenging environment that the inverted curve has posed, but also the exceptional growth in the pricing that we've seen.
34:15 
So there's one dynamic that we want to talk a little bit about, I don't know if the actual technical term, but we've been referring to it as the Air Pocket. So, Sean, do you want to talk a little bit about that? Yeah. Sure. So I mean when we think, you know, we talked about the rapid rise in rates. And sort of the breadth rapid loan growth that we've seen.
34:34 
You know, there, it does seem that there are an awful lot more low coupon loans out there, and mortgages, especially than higher coupon.
34:42 
And so that dynamic basically means that as margins are likely to start compresses rates rise, probably folks are going to be more liability sensitive then than they might appreciate. Because there's going to be less asset repricing, simply because there's such a disproportionate amount at the bottom end of the curve there, and so it's also something to think about from a modeling perspective. I mean, I have a modeling background, and so I think about that in terms of if you're just using a single factor and doing prepayment speeds. That's probably not a great assumption right now simply because there are so many so low and so few at a higher level.
35:22 
So, something to think about, you may have more liability sensitive in the future than when you think about.
35:27 
And then, Andrew, when I, when I think about, you know, we talked about spreads, you have that really nice chart around, mortgage spreads being really good compared to what we've seen in recent years. How do you think about MBS? What do you think about investment opportunities?35:41 
I hope that's your background and you always have some interesting observations on that.
35:46 
Yeah, so, on that side, it's similar to what we're seeing in mortgage rates right now. I mean mortgage loans - where the rates are high, and the spreads are high.
35:57 
You know, with securities, you have a little bit more flexibility and customization to get the part of the curve that you want to be on, the type of collateral that you're exposed to, as opposed to you're lending origination, you're just getting 30-year fixed or, in this recent environment, ARMs and it's your local markets and economies. So there is the opportunity for a little bit more diversification.
36:22 
But, you know, I think the thing that jumps off right now is the possibility of investment leverage.
36:27 
And Sean talked about the Capital ratios and, frankly, you know, our bank securities are very well capitalized in aggregate.
36:37 
So, when you think about the prospect of margin compression, given forces on both sides of the balance sheet, then this is one way to grow through that and also, you know, prepare. If you're a proponent of it is going to be a pivot to shorter, to lower rates relatively soon.
36:57 
And when you look at your net interest income simulations, and that's an exposure that you fare not great in then, you know extending out, and looking at adding funding against it is something that it might be worth considering.
37:16 
So, you know, I think this is the biggest thing on the funding side right now that many folks are grappling with.
37:22 
So, no, I'm sure everyone is familiar with the concept of marginal cost of funds, where, you know, you may have a deposit offering out there.
37:31 
We're seeing a lot of, you know, one of the first pages in the playbook of Rising Rate Environment is to lag rates and then come out with the odd month CD specials. Right, so, you know, we drive around, you see, the seven month at 4.25, 13 month in 4.5.
37:46 
But, you know, to figure out what is the true cost of that money, new money that comes in the door, and we talk about how challenging it is to bring that money in the door, that if you're a weakening lower cost deposits.
38:00 
And some of that money is moving from 0%, 1%, or 2% into 4% and above.
38:06 
Then really, you need to apply that added interest cost on those existing deposits.
38:11 
Do the new deposits, and that's the marginal cost of funds.
38:13 
And what you'll see is oftentimes, I mean, just a purely economic basis.
38:18 
It can be advantageous to be disciplined with the deposit rates, you know, lead more towards exception pricing, as opposed to the CD special offerings.
38:28
 So, you know, we have, you know, the calculators and the analytics to support this.
38:34 
But here's just a very simple example if you're debating a 4.5% deposit offer versus a 5% advance and depending on what the cannibalization rate is, right, so how much of that going into specials is coming from, existing lower-cost deposits, you can find out exactly how much you can withstand before the interest costs put you in favor of borrowing instead of raising trying to raise those deposits. You can see down on the bottom it doesn't take an awful lot of cannibalization to get to where those deposit specials aren't favorable. You know, we can tell you that we cut off this graph at 70% because you might be able to tell the graph begins to go parabolic once you get higher.
39:21 
And if we were to go, say, 80, 90%, then it would have totally screwed up our scaling.
39:26 
And, you know, we've had many conversations with folks who said, gosh, 80, 90% cannibalization.
39:36 
Know, some were cheering, getting 50 or 60% cannibalization, and when we ran the numbers on one of the higher cannibalization scenarios, the marginal cost, and the funds came back at 60%. Not six, not four, five, six. That’s six zero percent. That's because money was coming out of very, very low rates and going into high rates. So, it's just something that you have to weigh in thinking about, you know, protecting the deposit franchise and also meeting your current funding needs.
40:09 
Yeah. So if we kind of, again, kind of take a step back and zoom out from an ALM strategy sort of standpoint, what we see is deposits aren't growing.
40:17 
​Margins are increasingly under pressure, and probably more folks are going to see margin pressure in 2023 than 2022.
40:24 
And the asset cash flows are pretty slow. So from a liquidity perspective, we've probably been as tight as we've gotten in a very, very long time.
40:31 
On the other hand, capital is strong.
40:33 
There are no signs of credit distress so far, even though the yield curve is so deeply inverted.
40:38 
And so what does that sort of lead to?
40:41 
The margin is shrinking. What can offset it?
40:44 
You know, Andrew talked about it earlier, growth can help offset that whether it's inorganic growth in terms of a leverage strategy, or it's more organic, or there are more loans, but probably going to have to be funded through wholesale means because the deposits just aren't there.
40:58 
And then, when we think about wholesale funding from the Home Loan, what structures could exist to help reduce some of those margin pressures?
41:05 
Especially in the face of the fact that there's probably more liability-sensitive liability sensitivity, I should say, going forward, than you might initially appreciate because of that Air Pocket on the asset side.
41:17 
Two things come to mind, the HLB-Option and forward starting advances.
41:22 
HLB-Option. I'm not going to spend a ton of time on this slide with the gory detail on the HLB-Option Advance. Especially given that we've got delayed there.
41:29 
But the bottom line is you're selling an option to the Federal Home Loan Bank.
41:34 
And, as a consequence, getting a lower all-in rates than you would on a bullet.
41:39 
of course, the downside to it is, it's just, it's kind of. It's just like the inverse of a mortgage.
41:45 
If rates go down very suddenly, then the advance will stick around with you for an extended period of time when you probably don't want it to.
41:52
Because rates will have gone down significantly, and vice versa, if rates go up very significantly, The advance will be called back from you, will be put back by the FHLB, and you'll have to refinance at a higher level.
42:03 
So basically, you pick a maturity.
42:05 
And then you pick out a lockout. You say, I want this advance for no more than five years, but I want the advances to not be callable for at least six months or a year, or pick a number.
42:18 
What does that look like in terms of pricing?
42:20 
You know, if we talk about something like a five-year final maturity and a six-month lockout, that's 150 basis points or so cheaper than the bullet.
42:30 
And so you can get pricing in the threes versus the fives or high fours on a lot of different advanced structures for that, and what's sort of the, what's again with that risks dynamic for folks. What that means is you get the higher margin in 2023 when you might need it and when you're going to feel that pressure.
42:45
And then if you, the worst-case scenario, happens, or the potential worst-case scenario where the advanced sticks around for the full five years, you're probably able to cut other liabilities. And that probably would lead to higher margins. So it's sort of ballast for the rest of the balance sheet.
43:00 
Which, I think, is why it's been very popular and why I think it's if you haven't considered the structure or you're not crystal clear on how the advanced structure works.
43:10 
It's something really worth kicking the tires on it and asking questions. Of course, we can reach out to us.
43:14 
But this is a real opportunity for folks who are feeling that margin pressure and are probably more liability sensitive than they think going forward in order to kind of meet all the different masters that they have on their balance sheet.
43:29 
So, another advance that jumps off the page, and certainly, it seems to be tailor-made for this environment, is our Discount Note Auction Floter-Advamce or DNA floater.
43:39 
And when you look at the dark, the three dark blue sections there, it really encapsulates the value proposition, right? It provides long-term liquidity. So, you get the benefit of longer maturities.
43:52 
Where short-term wholesale funding, you know, from sources and uses perspective aren’t as supportive from a liquidity management perspective.
44:03 
But maybe you don't want the classic fixed rate alternative, where, yes, you get the long-term liquidity, but I don't need or want a long-term fixed rate.
44:13 
So, it's a floating rate, advance, and adjust every four weeks. And, then, the third piece of the puzzle is interesting because, you know, certainly, we're in this uncertain time for, as you alluded to, how we budget for deposit growth when we don't know if it's coming or going and loan demand is great. Is it going to fall off a cliff? Or are we going into recession, so?
44:35 
Assessing how much wholesale funding we'll need, and for how long is a big question mark right now. So, to be able to have flexibility on prepayments which is what the advance affords you, is huge.
44:49 
So, when you think about those three key characteristics and the fact that, you know, as you can see in the table below, the pricing is on par with the one-month classic. So you're getting those three benefits, in this case, as it ebbs and flows, a negative spread to the bullet can be pretty, pretty significant.
45:12 
Another idea, again, the same type of dynamic, of being able to get relatively cheaper pricing versus the bullet, is Forward Starting Advances. We've seen it needs to be popular for the first time in a long time.
45:22 
Again, if you know that, so, a Forward Starting Advance works that you basically lock in the rate predicated on today's yield curve for the future. It can go out to two years on the forward curve.
45:35 
So an idea might be, you take a two-year bullet, but six months forward from now.
45:41 
What does that actually translate into?
45:43 
End up getting a rate that's about 40 basis points, 30 odd basis points, cheaper than the two-year bullet today, and why. Basically, because you're trading the rates, that is, the short end of the curve, that's implied to be in the fives.
45:53 
For things longer on the curve, which are implied to be in the sort of high threes or low fours.
45:58 
And so that results in getting a lower all-in rate.
46:02 
The value to that, of course, is as though it's a lower rate, And the risk is that you don't necessarily need that funding.
46:10 
But I think that's a risk that a lot of folks are willing to take right now because the need for funding is so significant liquidity pressure is so significant.
46:17 
It's not likely to abate in the immediate future.
46:20 
So if you know you're going to need liquidity, if you know you need funding, Forward Starting Advance could be an opportunity to try to, again keep, keep a lid on those costs and limit sort of the risk of a PPI print.
46:32 
Like today being worse than expected and hedging your risk that way.
46:44 
Final slide on the value of dividends, if I was talking about the value of Dividends, You know, as rates have risen, the relative value of Dividends versus advances has also increased.
46:57 
So, this is Q1, Q2, and Q3 of 2022. Q4 is not yet announced.
47:03 
You know, the overall dividend rates that members have received has increased significantly and have been tied to SOFR.
47:11 
And so, as rates have risen, you've gotten higher dividend rates.
47:15 
And with that higher dividend rate, you're effectively able to buy down more of the advance rate because the dividend is worth more than the relative change in advances. I actually have an article on our website talking about this exact dynamic.
47:29 But, as you evaluate the cost of different wholesale options, and as you evaluate the cost and advances, don't forget that evidence because the dividend has real value, especially in this environment, and the rates are up, and it has been increasing.
47:45 
There we go.
47:46 
All right. So that brings us to the end. You know, as always, I mentioned that this is one of our favorite things to do.
47:56 
Because it gives us an opportunity to really dive deep into what's happening with our members, and look at some actionable ideas in the current environment, so, you know, we'll wrap things up, and, again, just say thank you. We appreciate your time and your partnership, and your membership. As Sean mentioned if there's anything we can do on the analytical side or even just share some of the things that we're seeing and hearing.
48:21 
​We're always willing and able to help out where we can. So with that, we'll wrap things up. And thank you very much, and have a great day. Thank you.