Case Study: Aligning Prepayment Risk Across the Balance Sheet

Hi, I’m Tyler Buckridge with the Federal Home Loan Bank of Boston.

In this case study, I want to focus on a simple idea.

Pre-payment risk is as much a pricing issue as it is anything else.

If customers can react to rates faster than you can, they capture option value.

And if that optionality is not priced and funded thoughtfully, it can distort balance sheet mix, margin, and growth over time.

So this is not just about prepayment in theory.

It’s about how better structure, better pricing, and more flexible funding can help institutions make better decisions on both sides of the balance sheet.

I’ll cover three things.

First, why prepayment exposure matters on both sides of the balance sheet.

Second, how stronger prepay design and more flexible funding can improve pricing discipline.

And third, how advances can help create more certainty, which makes it easier to price aggressively where it makes sense and more cautiously where it does not.

The starting point is that optionality affects pricing, whether we always frame it that way or not.

When customers can react to rates faster than you can, they capture value.

When rates fall, borrowers refinance and higher-yielding assets leave. When rates rise, depositors reprice or leave and you lose lower-cost funding.

But it also matters when customers stay.

If rates fall, customers may keep high-rate CDs in place and expensive funding stays on your books.

If rates rise, borrowers may stay in lower-rate loans and lower-yielding assets stay on your books.

So this is not just about runoff, it is about who benefits when rates move and whether that value transfer was reflected in the price that you set in the first place.

We saw this play out very clearly on the deposit side when rates moved higher.

A low-rate CD that looked fine when it was booked looked very different once market rates moved up sharply.

At that point, the customer had a reason to break it, reprice it, or leave it maturity, and that created retention pressure, higher replacement funding costs, and more rate-driven changes in the funding minutes. So the pricing lesson is straightforward.

If you’re going to pay up for deposits, make sure you either really need them or have enough protection, the pricing decision still makes sense.

And this issue has become salient again, because the market is now pricing in a higher chance of than cuts over the next 12 months. This is where penalty design matters.

A static penalty is simple and easy to explain, but simple does not always mean economically accurate.

If the market has moved a lot, a static penalty can materially undercharge relative to actual replacement cost.

A dynamic penalty is conceptually stronger because it ties the economics more closely to what it really costs to replace the funding.

And you can see that in the example on this Here, we start with a one-year CD for $100 ,000, booked at 2%.

The customer decides to break it after six months to move to a new CD at 5%.

Under a static penalty, the bank charges six months of interest at the original contract rate, so that is 100 ,000 times 2%, times 6 over 12, and that gives you a $1,000 per hand penalty.

Under the dynamic approach, you look at replacement costs instead.

In this example, the current 6-month FHL Bank Advanced cost is 4.75%.

So now the penalty becomes 100 ,000 x 4.75% x 6 over 12, and that gives you a penalty of $2 ,375, compared with the static penalty that is $1 ,375 of additional protection.

And on the customer side, if they move the remaining 6 months from 2 to 5%, their gain is about $1 ,500.

So the static penalty does not even fully offset the customer’s economic incentive to move.

And that’s the point.

The dynamic approach is much closer to the institution’s real economics.

Now an important caveat here is that a dynamic CD penalty can be operationally difficult to implement. And that’s real.

So the point here is not that every institution should implement this tomorrow.

The point is the pricing mindset.

If you’re going to be aggressive on deposit pricing, make sure you are protected enough that the funding is actually worth paying for.

Otherwise, you may be paying up for deposits that can leave before they really support the balance sheet.

And that is especially important for longer CDs.

The longer the tenor, the more option value you are potentially giving away, and the more damaging it can be if the penalty does not reflect real replacement cost. And that also connects to tenor targeting.

If the spread between 18-month CDs in advances or wholesale is more attractive than what you see in the three-to-six-month area, then extending out may make sense.

You can create more stable funding, more lending capacity, and more certainty around the pricing decision.

And while this slide focuses on CDs, the same optionality idea exists in non-maturity deposits too.

In some cases, if you do have to pay up, it may make more sense to do that in money markets rather than CDs.

With a money market, you still retain the option to lower the rate as fast as, or faster than, the effective federal funds rate.

And that can create positive data in a declining rate environment.

Who doesn’t love that?

And that can be attractive if you need to compete for balances, but still want to retain flexibility.

The key of course here is to not guarantee the rate or the spread on the money market.

So repricing and migration risk may not look like prepayment, but the economic issue is similar.

The next step is not just protecting yourself from customer optionality.

It is also about retaining some optionality for yourself.

If growth is uncertain, if paydowns are uncertain, or if the path of rates is uncertain, issuer side optionality becomes more valuable.

That is where callable CDs, callable SOFR index advances, and member option advances can fit.

Callable CDs can be useful when you want term funding, but also want the ability to take that funding out if your needs change.

A callable SOFR index advance can help you when you want floating rate funding with some built-in flexibility, rather than locking into a more rigid structure.

And a member option advance can make sense when the outlook is less certain and you want the ability to manage funding differently, say if runoff, paydowns, or the rate path change.

So each of these is really a way to retain more control over funding behavior when the balance sheet is harder to forecast. And this matters from a pricing perspective.

The more certainty you have around funding flexibility, the more confidently you can price assets and liabilities.

If advances give you a better ability to manage runoff, unexpected pay downs, or changing funding needs, then you are not pricing in the dark.

You have more confidence around the funding side and that can support better decisions on the rates you offer or the rates you charge. This is the liability side summary.

The basic point is simple. If structure is weak, rates and customer timing drive more of the outcome.

If structure is stronger, management has more control, penalties can better reflect replacement costs, callable structures can preserve flexibility, and advances can help align funding to how the balance sheet is actually likely to behave. And that leads to the broader takeaway.

On the liability side, pricing and structure should work together.

If you are paying for funding, you want clarity around why you need it, how long you are likely to need it, and how much flexibility you want to retain.

The goal is not just to raise deposits or add term, it is to build a funding mix that behaves more intentionally and is less driven by the path of rates alone. And that also means only paying up when you have need, certainty, or ideally both.

If you do need to pay up, be thoughtful about where.

In some cases, it may make more sense to pay up in a money market or other administered rate structure where you still retain the option rather than locking yourself into above-market term funding.

And if you want a CD special to actually work, make it actually special.

If you want 18-month money, make the 18-month point stand out clearly relative to the rest of the rate rack.

And if the whole rack is clustered together, the special is not really special and behavior may not move the way you want.

That is really the liability side message.

Better structure, better flexibility, and better alignment can help make funding outcomes more reflective of management intent.

The same problem exists on the asset side.

And again, this is very much a pricing issue.

When rates fall, borrowers refinance or prepay and better yielding assets leave.

When rates rise, borrowers stay in lower rate loans and lower yielding assets remain on the books.

So weak prepay design can distort earning asset mix the same way weak deposit design can distort funding mix.

And in many ways, the asset side is harder.

You usually have more control over tenor on the liability side than the asset side.

On the asset side, you can target a vertical or a product type, but actual duration is much harder to lock down.

And that’s largely because borrowed behavior is what’s driving that.

And that’s exactly why stronger prepay protection and better funding alignment matter so much.

because they give you more certainty, and more certainty supports better pricing.

For most depositories, the practical discussion here is usually step-down versus yield maintenance, with the fees in more as a reference point.

A step-down penalty is exactly what it sounds like.

The penalty declines over time, so borrower flexibility increases as the loan seasons.

That makes it simple and easier to negotiate, but protection weakens later in the loan.

Yield maintenance is meant to be closer to a true replacement cost concept.

The idea is to compensate the lender for the difference between the loan yield and what prepaid funds can be reinvested at.

So it generally provides stronger spread protection, but it can be harder to explain or negotiate.

Defeasance doesn’t work quite like a simple payoff fee.

Instead, the loan is actually effectively replaced with substitute collateral, typically securities.

so the cash flow protection to both the investor or lender are preserved, and that is why it is the most structured and operationally complex of the three.

But the real question is not just what the structure is called, the real question is how much protection it actually gives you, and then what that implies for pricing and funding competence.

Stronger loan side protection can support more confident asset pricing because expected life is clearer and the funding match can be more That is where the asset side connects directly back to advances.

The same five-year balloon loan may need a very different funding strategy depending on how protected the asset really is.

If the loan has step-down protection, expected life may be shorter than stated maturity.

In that case, shorter classics, latter classics, or a member option advance may make more sense.

Those structures help because they reduce the risk of being stuck in full-term funding if the pre-pays once the penalty burns down.

If the loan has yield maintenance, you may have more confidence that expected life is closer to full term and that can support a longer classic advance or an amortizing advance because the loan side protection gives you more confidence in the funding match.

And if the structure is very strong or expected life is especially stable, that’s where more fully matched funding can make the most sense.

If replacement economics improve enough that runoff is actually beneficial, flexible funding can matter there too.

That’s where a member option advance or a callable SOFR index advance can be helpful, because they give you flexibility if the runoff becomes desirable instead of harmful.

And one point worth mentioning here is that we do have a calculator that can show the penalty under all three structures, step down, yield maintenance and defusement with adjustable assumptions.

So if you want to model a specific loan, we can run the prepay economics and compare them against different advance structures too.

So the point is not just that advances can fund loans, the point is that advances can help increase certainty around funding behavior, and we can model that in a way that is specific to the loan structure and prepay terms.

The same logic applies in the investment portfolio too.

Callable investments may offer extra spread, but the issuer owns the option, not you.

If the asset runs off and the funding stays in place, the option can end up costing more than the spread pickup was worth. So again, this comes back to pricing and certainty.

A few extra basis points may or may not be worth it, depending on the balance sheet context and how the funding is set up. If you do buy callable assets, fund them accordingly.

Shorter funding, laddered funding, member option advances, callable SOFR index funding, those can all help reduce the risk of being left with excess funding if the asset prepays.

So the question is not just whether spread is attractive.

The question is whether the funding and the balance sheet are set up to absorb the optionality intelligently.

All right, let’s pull it all together now and land the plane. At the highest level, this is about pricing with more intention.

Price optionality more intentionally on both sides of the balance sheet and only pay up when you have need, certainty or ideally both.

And use advances in flexible funding structures to create more certainty around behavior because more certainty supports more accurate pricing and that means you can be more aggressive where it makes sense like where demand is real where structure is stronger and where expected behavior is clear it also means you can be less aggressive where you’re not properly protected and that’s the real value here better prepay design better funding alignment and more flexible advanced structures can all help reduce the extent to which mix growth and margin are driven by the path of rates and that lets performance reflect the things that should reflect.

Pricing discipline, balance sheet strategy, and your actual value proposition.

So if you want to work through the trade-offs on a real structure, we do have a calculator, like I mentioned, that could compare step-down, yield maintenance, and defeasement assumptions.

And we can model those results against different advanced options as well.

So if any of these ideas would be useful to model out, deposit side, loan side, funding side, or all three together, please reach out to or any of your relationship managers, and we’d be happy to talk it out and put something together for you.

Thank you for taking the time to go through this case study with me.

I hope it was useful as a framework for thinking about pricing, prepayment risk, and funding strategy more holistically across loans, deposits, investments, and advances.

And most importantly, thank you for considering the Federal Home Loan Bank of Boston as a part of that conversation.