June 2023 ALM and Funding Strategies for the Current Environment

Well, hi, everyone, and thank you for joining us today. Happy to have you with us for our latest webinar.

So, you know, as we head into the end of the second quarter here, we have a pretty fun agenda and the plan. Yeah. Fun. TBD on that, I guess.

So the, you know, the plan for today. No market, an economic analysis, or peer analytics, like we do occasionally every quarter.

But we’re really going to take some time and do a deeper dive into some balance sheet, strategy considerations, given the interesting environment that we find ourselves in, and we’ll talk about our bread-and-butter lending and deposit portfolios, but also the wholesale portfolio’s investments in funding that, given everything going on, continue to gain more and more importance as we go on.

So let’s just set the stage here a little bit on before we jump into the individual portfolios.

So, you know, when we think about the last, call it 15 years or so, more or less, there hasn’t been much uncertainty about where the Fed is going to be in the next meeting or over the next three meetings. You know, so we’re in this extreme period of volatility, uncertainty, as everyone is well aware of. Most recently, we just had our first pause, skip, non-hike – however we want to debate that. So when we think about the rate cycle, and also the credit cycle, you know, to use a balance sheet, a balance sheet — a baseball analogy, you know, are we in the first inning or the ninth inning? Well I don’t know. I don’t think we’re in the first inning. I also don’t think we’re probably not in the ninth inning, but we’re probably closer towards the end of the game than we are the beginning. But, you know, one thing that we keep coming back to is the last two cycles, call it ‘08 and 2020, may have conditioned us to think that when things turn and rates go down, it’s this huge, gigantic, hundred-year, storm situation, and rates go to zero.

And, you know, you can look at centuries worth of rate and credit cycles, and it’s not always the case, but it’s the most recent history. So, you know, there’s nuance to what may happen in terms of pause or declines in rates.

So, know, Sean is going to go through some things on the lending side that, as we prepare for a potential turn in both the credit and the rate cycle, some things that you should really be focusing on to make sure that we batten down the hatches there. Talking about deposits, if you’re not having a fun time right now with the deposit portfolio, don’t worry. It’s not you. It’s pretty much everybody.

So, when we think about, you know, the growth in retention and the cost, and it’s very challenging. So, you know, all is not lost.

And there are things that we can do to make sure that we’re getting the types of products at the types of cost in the most efficient manner. And again, Sean is going to go through some things that we can be thinking about on the deposit side. And then, as we mentioned on the wholesale side, you know, given that the size of the investment portfolio and the size of the reliance on advances in wholesale funding, you know, we’re not in this perfect world where we all have a 100% loan-to-deposit ratio, and they grow in lockstep and, you know the rate sensitivity is where we want it to be and we earn above average ROAs and, in all our shock scenarios, that’s not the case. We still have, we have some challenging, existing environments, and we have some potential pain if we do see markets change and pivot.

So, you know, we’ll talk about some of the things that we can do in both of the wholesale portfolios, you know to hopefully strengthen things up at the broader balance sheet level.

So, at that point, you know, I’m going to flip it over to Sean, and he’s going to go through some things that we can think about with lending and deposit. Yeah, thanks, Andrew. Obviously, deposits and funding is on everybody’s mind.

We’ve seen deposits come down for the first time in historic ways in 2022 and early in 2023.

​In Q2, actually, if you look at the Federal Reserve published numbers, deposits might not actually be down a whole lot right now.

I think part of that is happening because borrowings with the Federal Reserve from depositories is up — actual Discount Window borrowings.

It’s published quarterly, so we don’t have Q2 numbers, but I think the last number we saw was about $70 or $80 billion. And then the BTFP, the new program that was introduced after the bank failures, that’s about $100 billion as of last week.

So that extra funding directly from the Fed is actually sort of boosting, I think, deposits throughout the industry right now.

So it’s kind of counterbalancing the other forces working against deposits.

So we might not necessarily see deposits down this quarter, as much as we’ve seen in the past couple of quarters for most of our members.

But I want to take a look at different deposit valuation methods and then think about different deposit strategies – a top-of-mind issue for so many folks.

Here, we take a look at the marginal cost of funds analysis, and, you know, Andrew and I haven’t spent a lot of time talking about this particular type of analysis, but you see it in a lot of places, and it’s, it’s good and valuable.

It’s trying to say, what happens if we raise rates on a particular product that we have or a particular type of client vertical, and they’re at a certain rate, and we raise it to a much higher rate.

What’s the effective marginal cost of those funds once you consider the fact that there’s a level of cannibalization that’s going to occur with our existing deposit base. So, in this example, if we have funding at 1%, and we decided to raise, try to raise funds at a product at 5%.

And we ended up with 33% cannibalization — what would the effective marginal cost of those funds be?

And it turns out to be about 7% a year, and these curves take a look at what would that marginal cost of funds be under different higher rates predicated on that 1% level.

And what you see here. It might be a little bit tough to see just because the lines start to get close together there, and there’s only so much room.

But around 15 to 20% is where that marginal cost of funds is higher than what it would take to just borrow from the Federal Home Loan Bank on a short-term basis.

So if you’d think about this kind of strategy of raising rates, and what the, what’s the value or the value erosion that exists from cannibalization — it’s around 15 to 20% where the math starts to suggest, hey, we should just borrow instead of, instead of pursuing this strategy because we’re eroding too much profitability from it.

But there’s a limitation to this type of methodology, right?

Because if we’re just looking at marginal cost of funds, we’re only contextualizing what’s happening with the deposit book with respect to itself at a certain point in time.

And we’re not really thinking about it holistically with respect to the whole marketplace. We’re only taking a look at sort of a little narrow slice – “If we raise and go from 1% to 5%, what does that really kind of marginally cost?”

But it’s not really saying what’s the value of the deposits in the first place.

And so, this alternative method that I’ve talked about a time or two is trying to create a funds transfer pricing mechanism, basically, to say, what is the actual profitability of our deposits?

And so, in a nutshell, if we think about trying to put a number around the value of our deposits, that makes sense in a way that we might think about loan spreads.

You know, we might think about loans as saying loans plus FHLB plus 250. We think about 250 as the loan spread. Can we do something like that on the deposit side?

I would say, yeah, we can take a swing at doing something like that, and here’s the basic methodology in a nutshell.

We happen, through our traditional ALM modeling, through EVE modeling, through NII modeling, we have a couple of key metrics, one being the decay rate, two the beta, three, a lag term around how long it will take to reset rates.

And if we think about how our deposits behave, I think most folks would realize a lot of deposits are here today, gone tomorrow. Kind of come in and out, aren’t very long-lived, and implicitly, what we’re saying with the decay rate, is that’s the percentage of deposits that are in sort of that bucket. These are the deposits that are likely to leave within a year. By definition, that’s what the decay rate is.

So if we think about our overall bulk, or an overall percentage of our product, that decay rate sort of defines this short-term deposit piece, what I’m calling here a non-core float.

And then on the total other end of the spectrum, there is a portion of deposits that are very sticky, very static, and aren’t very particularly rate sensitive and are likely to stick around almost no matter what we do

And that has sort of a hidden relationship here, where we say, we have this deposit beta in this example, maybe 50% is the deposit beta. How much will the rate of the products go up with respect to Fed Funds?

If we think about this portion, some portions of balances are very insensitive, not particularly concerned with rate, likely to stick around —

100% minus the beta is that portion of the overall book that is likely to have that behavior.

Then how long are they likely to stick around? It’s the life.

We’re assigning some life for the Economic Value of Equity calculation or the Net Economic Value calculation that we’re doing to try to figure out our interest rate metrics. That life helps to find that core fixed piece.

And then the in-between bucket, the everything that’s leftover, I’m calling core float here, these are balances that are likely to stick around, but you have to pay them.

They’re not particularly sensitive, so long as you give them a reasonable deal in a reasonable timeframe. And so what’s the, what’s the actual term that we would assign to that deposit? It’s the lag term.

If we pay them within three months, six months, whatever timeframe that you have in your modeling, that’s how long they’re likely to stick around.

​Enough about the actual validation method. Let’s try to put this into action and show what these values might be on certain types of deposit books and behaviors.

So, here, we have sort of five major breakdowns. A lot of banks use DDAs, NOWs, savings, money markets. And then I added this high cost, which is, sort of, this super-duper product that I’ll talk about in a second too that a lot of folks have introduced as a way to sort of sop up the more rate-sensitive pieces.

You put in what you think that ultimate rate will be, whether you’re there today or you’re going to get there, probably in the near future.

What the deposit beta is, the lag term, the decay, the life. And I’m assuming here that the life is just the inverse of the decay. So if it’s a 20% decay, that’s a five-year life, for instance. Or if it’s a 25% decay, that’s a four-year life.

Do the math that has, as I suggested on the prior slide, that winds up with these profitability numbers you see here.

And so the value of this type of analysis is showing not merely that DDA is more valuable than some of the more rate-sensitive products but by how much.

So on an annualized basis, that DDA is under current rates assumed to be about 4.3% level of profitability versus a money market, or particularly the rate sensitive, or a sort of average sort of rate sensitive money market, around 60%, that has a 1.50%.

And then, if we just multiply that profitability by the life and discount it by, you know, an interest rate over that, over that timeframe, we get to this lifetime value number.

And that’s really giving you a good estimate.

Or some, some baseline to start to do some more rigorous quantitative analysis around what is the real value of the accounts we have and what could you apply that to.

“Hey, if we have this deposit associated with this loan, how much value is that relative to the loan?”

Well, I can start to think about these terms and start to think about this is these are the dollars that are coming in from the deposit through this transfer pricing mechanism.

If you had something like, “Hey, this account had fraud against it, should we, should we honor that and basically continue to maintain this account?”

We’ll start to do the math against what the profitability of that account is to try to figure out what’s worth what, basically.

So, if we had a $1 million DDA in this example, maybe the lifetime value of that DDA is — this is suggesting $239,000.

It’s really, really valuable versus, say, a really high cost, really rate sensitive product, that would suggest it’s much, much less valuable — only about $12,000 in that example.

And then, if we think about what — how sensitive are these assumptions, right? So we showed sort of, all right, we had these seven-year lives on sort of the transaction accounts and five-year lives on the more rate-sensitive non-maturity products.

We see these lifetime values, you know, low twenties into sort of the 6-7% range. What if we sensitize some of those examples?

And so here we’re comparing basically a sort of steady, steady as she goes, sort of book at the top where the lives are assumed to be around 4 to 5 years.

And the deposit betas are on that key MMDA product 50%, and on that key savings product, 30%. Paying sort of lower, but not super, super low, Compared to somebody who’s probably got a more rate sensitive deposit book. In this example, it’s money markets at 4% with a 75% beta, super-duper product at a 5% level with a 90% beta, and shorter lives, and those are probably really highly correlated. You know, a couple of a couple of webinars ago, I was talking about sort of the interrelated risks that are a little bit hidden in the balance sheet between interest rate risk and liquidity risk and other risks.

Probably, life and rate are related, as well. Where if it’s got a higher rate, it’s got a shorter life. So it’s a double whammy on value erosion.

And here we’re just comparing those results on sort of this sort of standard book versus a more rate-sensitive book. How much is that worth?

And the table at the bottom quantifies that value difference on an annualized and then a lifetime value difference.

And it shows just how much that’s worth.

So if we think about, you know, that money market product, it goes from 6% to 3% lifetime value.

It’s a really big difference by paying up more and sort of creating a more rate-sensitive clientele.

And so, training your depositors to be more rate sensitive is probably a short-term solution, but it winds up actually hurting the value creation deposit franchise overall in the long run.

All right, so now, how do we think about applying that in today’s world. Because, you know, rates are up. People are hungry. Depositories are hungry for deposits because it’s relatively scarce.

What are the methods people are using to attract deposits? And then, how do we think about putting all this together? We’ve got a couple of different methods to value them.

What are the ways that we can try to attract deposits?

So I identify here five strategies that I think we’ve seen folks, and especially in our conversations and looking through financial statements and just kind of looking at the broader world.

What are these strategies that different depositories are using to try to attract things? And I’ve got five. One, that super-duper product that we just talked about.

This is introducing a higher-cost product that’s sort of an opt-in product.

So, if you have more rate-sensitive clients, they could go into that product voluntarily.

And what the risks, you know, the value of that, you can put on volume.

You know, sometimes there’s an opportunity there to really put on volume, and it’s lighter administration.

The risk, of course, is cannibalization. You could really get your own clientele in there. And what have we seen folks who seem to be more successful with that do? It’s sourcing through different channels. Particularly something like an online channel, so instead of just having it in the branch level, it’s somewhere else – it’s some other means by which to gather deposits in order to kind of limit the cannibalization.

CD specials, very popular out there, and we’ve heard very mixed stories frankly about the success of those CD specials in different places. Some folks have said that they had great success, some folks less so. The value there, again, you can get volume quickly. But the risk is that you end up with a lot of balances that all come due together. So you end up creating this sort of cycle, this vicious cycle of all the deposits coming up at the same time.

And then there’s this sort of hidden risk too of if you end up with and introduce a 17-month special, and then three months later introduce a 14 month special, well, it turns out you’re introduced everything coming due on the same date next year.

And you could end up with a bigger chunk than you thought that you have to replace all at once.

That could be good. It could be risky. Yeah. I mean, you know, if rates do come down, right, that could be good.

If you did that in 2021, I don’t think you feel very good about that.

Then, third – exceptions. This is sort of the granular, you know, root-and-branch, price individual clients.

The value of that is that you can, you can really target strategic clients appropriately, but it’s really a big administrative burden, and then figuring out complex relationships could be a trip.

How do you handle that? It’s becoming nimble with the core system, and trying to figure out if there’s ways to optimize without having to do too much administrative work.

Rack rates, just raise rates, what if you just raise everybody’s rates? The risk there, of course, costliest.

A way to think about that is to think about more attractive client verticals. What do I mean by that?

Certain clientele types are less rate sensitive and are more concerned about other parts of the value proposition of your institution than just the rate.

And then, finally, a strategy you see, in a few places that, again, sort of mixed bag of success is off-balance-sheet sweeps.

And this can either be something done internally, where there’s sort of a money market fund created internally within the company, or it could be external, where there’s a third party that you send deposits to. The problem there, of course, is you’re losing the funding.

The value is you’re keeping the relationship, and you’re getting some fee income for the relationship.

And so maybe you can preserve operating accounts. Maybe you can preserve lending relationships, even if you’re going to lose the rate sensitive balances.

All right, so which strategy to use, right?

So, again, we talked about these valuations, and then we talked about there are five big strategies that we see out there being used by folks to raise funds. Which one should be done?

And that’s going to be totally emerging from your overall business strategy, your client verticals, I keep talking about. And whether you’re really concerned about aggressively growing or replacing funding or whether you’re willing to sort of play a bit more defense. And so, the questions, I think, that I would ask myself here are, do we need to produce that volume now, or do we need easier-to-implement products? And, if so, that’s sort of the CD Special/Super product. And then think about the value proposition associated with that.

If you’re more interested in preserving profitability and targeting particular strategic clients, that’s the exception pricing.

And then, finally, if you find yourself losing clients in a big way to Treasurys and money market funds, that’s thinking about some sort of off-balance sheet sweep proposition.

How do you assess the strategy’s effectiveness?

So you know, we said upfront, if we look at that marginal cost of funds analysis, if the Super product and the CD specials is 15% to 20% kind of cannibalization by that math, you’d probably want to consider managing with exceptions, or you just want to borrow.

Just borrowing there is probably adding value versus cannibalizing your existing book, or pivoting to an exception basis could be more profitable. If CDs are representing that big funding risk; if you find yourself in a position where you’re just kind of doubling down and ending up with these big slugs all at once, you want to think about a non-maturity strategy.

And, you know, sort of a rule of thumb I have here is if 5% of your funding is coming due like really quickly and within a single timeframe, you’re starting to get to a place where that might start to be outsized.

Another key thing that we’ve kind of seen, I think, is coming out of the SVB and First Republic situations is if your total funding in these really rate-sensitive products is starting to approach your contingent funding source, I would consider moderation in that particular interest.

​I think we’re starting to hear anecdotally that a number of regulators are starting to look at that math around what are your sensitive balances as measured by uninsured deposits as measured by super-rate-sensitive deposits versus your contingent funding sources because those are the people and businesses and the funds that are most likely to leave in some kind of stress event – something to think about there. And then finally, you know, if you think about your overall value proposition as an institution, it’s not all price.

There are other parts of the value proposition that different clientele are going to respond to.

Including convenience, safety, service, and other products. So we talked about the risk around that off-balance sheet product, and the solution as you lose the funding.

But you generate fee income and you’re able to retain a lending relationship and an operating account, that might be worth the math relative to the other things.

Alright, let’s flip it over to the other side of the balance sheet and talk about lending strategies.

And I promise this is not some sort of sales pitch here exactly, but or a pitch for magic beans or a magic bullet

But, what if there we were a way to add 25 to 100 basis points on loan spreads systematically, what would that do to your institution?

And this is kind of a bit more bank focus because it’s talking about tax rates, but if your loan rates were 25 basis points higher and you had a balance sheet, like a lot of folks with 80% of the balance sheet loans, 60% fixed rates, 25% tax rate, 9% leverage ratio, you’re going to add ROE of about 1%. If you double that to 50, guess what? That’s 2%.

And if you had a really, really significant extreme situation where you had more, you’re a more loaned up sort of institution and with a higher percentage of fixed-rate loans, the ROE improvement could be 5.5, 6%.

And all you have to do in order to take advantage of this, basically, is improve messaging to clients and data collection and some internal communications with staff.

What am I talking about? I’m talking about prepayment previsions, one of my favorite topics. Alright.

And so, in the fancy sort of institutional fixed income way of talking about this, we’re talking about adding positive convexity. And why is this so valuable?

In part because a lot of institutions have limited opportunities to take advantage of adding positive complexity. Andrew has talked about it a number of times.

A lot of folks have a big residential book, big auto book, and they don’t necessarily have this great opportunity in order to roll down the curve when rates start to fall.

And so that lack of positive convexity means when you do have an opportunity and things like CRE and C&I, maybe some other sort of personal loan situations, to add prepayment penalties and improve your positive convexity profile, either in the lending book or maybe in the investment portfolio through loans that have better prepayment protection, it’s all the more valuable than it is otherwise.

So, let’s take a look at a couple of examples here about the value of this prepayment provision.

So, here’s an example of a five year, 25-year am, $5 million deal priced at 6.75%.

The underlying price on this is FHLB plus 250.

What happens — to Andrew’s point — if rates don’t go to zero, but they go down a little bit from here in a way that’s just a little bit more frankly than what the market is pricing in? Right now, what the market is pricing in two years from now is that a three-year rate will be in the low 3s, something like 3.25%.

Well, what if it goes to 3%? That’s the term rate difference. The then current three-year Treasury — I’m highlighting the first row here – the term rate difference of negative 1%. What’s the present value of the rate change? It’s negative 2.7%, makes sense? 3% times 1%, the present value, that’s $132,000, which means the effective loan on this for went from 6.75%, or the effective yield, rather, went from 6.75% to 5.39%.

And then if you have a situation where term rates decline even more significantly than 1%, which is, again, to Andrew’s point, I don’t think we have to go to zero, but going down a little bit more than what the market’s predicting right now I don’t think that’s an outlandish suggestion. I’m not suggesting that is going to happen, but it’s plausible.

And if those types of scenarios play out, then these prepayment provisions become very, very valuable. So, if term rates were down 1.5%, present value of that is 4.1% and that means the effective loan yield on that would have only been 4.68%. What I’m doing there is about dividing the 4.1% present value over the two years that it was outstanding and subtracting that from the loan rate of 6.75% to get the 4.68%. Guess what? You could’ve bought a two-year Treasury right now for about that.

And so if that were, if that were come to pass, where rates are down and down, actually, not all that much more than what the market’s already predicting will occur and you don’t have a good prepayment provision in there, you could wind up in a situation where, if you had just bought a Treasury right now for a couple of years, you would have wound up actually getting a better yield, let alone all the risks associated with having loans.

Let’s compare a few different styles of prepayments here because I think a criticism I have heard from lending folks is, “That’s great, but we can’t sell it.”

“That’s great, but who can put on a prepayment provision?”

And so, I think there’s sort of three big styles out there that are competing, and what I want to highlight is I think there’s a way to optimize this in a way that sort of meets the needs of everybody. The first style, I think, is by far, the most popular amongst folks is the Step Down. This is sort of the 5, 4, 3, 2, 1. If you get a five-year deal with 5% in year one, 4% in year two, et cetera, all the way down. And the value here is it’s easy.

And there’s not a lot of math here. You just multiply a percentage times the number, have a nice day.

But the problem here is it’s very poor protection in higher interest rate environments. We haven’t been up here in darn near a generation in terms of rates. And so I would identify that this is a higher rate environment and that therefore, there’s probably increasing risk with these Step Down provisions compared to these other styles.

The second style is sort of a more extreme than a lot of folks have heard about yield maintenance. And I think when people say yield maintenance, they mostly mean replacing the loan with a U.S. Treasury for the remaining term.

​So instead of just say that loan at 6.75% is replaced by a U.S. Treasury at that point at 3%.

And so the problem with that style is it’s conflating basis and spread with just the interest rate underlying interest rate index changes itself.

So the good news is it really protects the lender from interest rates and from even having to source additional loans.

The downside to that is a lot of folks, a lot of borrowers, would start to perceive that as potentially being punitive.

And I do think that it’s difficult to sell to folks.

This final style that I’m that I’m trying to highlight here is I’m calling it “Rate Make Whole.”

Basically, this is sort of just mimicking the underlying economics that you would associate with taking a home loan advance or doing a swap deal with a borrower where it’s just predicated on the underlying index itself not this basis risk between the loan and the Treasury.

And so here, the lender is insulated from changes to interest rate risks without really kind of going a bridge too far that would make it really difficult to try to swallow for borrowers.

Alright, let’s take a look at what these numbers mean, right, for the different types of loans that you can have over time.

So, in that, again in that example, if we had a five-year loan, there’s four years remaining, and rates come down certain levels. That Step Down is always 4%. The yield maintenance is really big.

You can see, you know, even at a 1% change, it’s a 13% yield maintenance in that instance. And why is it that high?

It’s that high because you’re going from a loan with a spread to something that has no spread baked into it. So, you’re kind of adding extra elements to it. If you just want the Rate Make Whole, it’s actually 3.5% and would actually be a little bit lower than the Step Down. But then if rates come down anything more than about 115 (bps) or so, that rate make whole provides a lot more protection to the lender without, I think, feeling punitive to the borrower. It’s really just protecting you from the underlying index changes.

And, again, it doesn’t have to be that rates go from 5.5% to 0% –if rates go from 5.5% to 2.5%, that Rate Make Whole will add a lot of value to the institution.28:47 Let’s take a look at where’s that breakeven point.

Here, again, we’re using that same example of what if there are three years remaining, and I’m just going to focus on that middle section that’s comparing the Step Down to the Make Whole, if rates only go down 100 (bps), the Step Down actually wins. But if rates go down anything more than that, the Make Whole wins and starts to win by a very significant degree. And you can see, too, that if it is only 100 (bps), the Step Down wins. But it’s not by very much.

Then when you start getting to these other levels, the difference is really very significant. Both in basis points and dollars.

And again, as an effective yield, it’s really, really, really valuable, especially if you do see a more significant change rates.

So, you know, what are kind of the takeaway here when rates are up, prepayments are really key, and thinking about communication styles to different lenders and borrowers is really important.

Something I’d highlight here is to say, you know, if you’re providing rate certainty to borrowers in a rising rate environment, it’s perfectly reasonable to ask for honoring a commitment if rates happen to go the other way.

And then this last bullet point here, I think very few folks actually capture this data, track it and model it. I think a lot of ALM models just kind of throw their hands up and say, “Geez, we don’t know what’s going to happen with commercial loan prepays, here’s a flat number,” or, “Here’s a couple of numbers based on an interest rate,” as opposed to actually starting to think about the overall value.

​One last piece here on loan sales before I turn it back over to Andrew. You know, we’ve talked in recent webinars about the MPF product that we have, and I just want to highlight again, with rates up and with the way that the world is right now — the MPF product, if you think about loan sales, is a more valuable product than it’s been in some time, both because the nominal rate is higher and because the credit enhancement fees that are being paid on the obligation for the product add extra value. And then finally, because of this LLPA issue that Fannie Mae charges definite LLPAs, whereas the program doesn’t charge definite LLPAs. It’s only a contingent liability that would happen on a very extreme situation.

Then, if we think about what are those LLPAs, where those pockets, where are those places where the LLPAs come most into play? Let’s just look at what each one of those attributes are and what the average value and the range of that value could be.

And then finally, a heat map to try to figure out, you know, where, where does each one of these interact with each other? And what you find is second homes have really punitive LLPAs out there. So if you’re thinking about selling things like second homes, or if you’re thinking about things with different credit scores, that’s where MPF really kind of starts to shine. And again, here’s a chart just showing sort of where those individual pockets of value are.

Well, thank you, Sean. So, you know, let’s flip over to talking about the wholesale side of things, and, you know, debating between a rock and a hard place or a fork in the road, so, you know, pick your analogy. But, you know, there’s decisions to be made right now in terms of, like we said, preparing for a potential turn in the rate and the credit cycles. And we have two paths that we can go in two key areas and say, “Do we start to batten down the hatches and de-lever and build up our capital ratios and get prepared for some potential credit softness? But at the same time, we’re experiencing some margin pressure. And so, you know, our static balance sheet isn’t producing greater income. So, maybe do we say, do we use our capital and look to grow through some of that pressure?” And then there are pros and cons.

And there are times when it doesn’t feel great, certainly, as we get to talking about investment leverage, given how investments haven’t been all too hot over the last year or so.

And the same thing goes for the right-hand side, as we talk about these strategies.

And, say, you know, no one’s in the business of making rate bets or things like that, but our balance sheets do have natural biases that do better or worse in certain scenarios. And do we want immediate relief today for the potential of a pain that may come with consistent, high, higher rates? Or do we want to prepare for that pivot to lower rates?

And then as Sean talked about even, not necessarily, 0% rates, but a little bit lower than where we are now or even a little bit lower than where markets are expecting. So one thing that, you know, you’re probably hearing a lot of right now is in terms of a loss trade or investment portfolio restructuring. And, you know, as an innocent bystander here, we’ll throw out the, you know, make sure you look at the sub-header, the first line, it says there are no free lunches.

It’s arithmetic, and you know, anytime when a loss trade looks particularly good or appealing, it’s because there’s a shift in the risk profile, right? You know, you can’t sell the same asset and replace it with the same asset, and magically it starts to look good. So, you know, when you look at that, more-complicated-than-it-needs-to-be chart on the left-hand side there, all it is comparing this strategy of, if we bought Treasurys in 2021, something that we talked about the time that we observed, and frankly, thought was a smart idea by a lot of institutions when spreads were so narrow and they had so much liquidity and felt compelled to put money to work.

That we saw more banks and credit unions investing in Treasurys, something that they historically haven’t done a lot of to take that pure interest rate risk without doubling down and taking excess amounts of spread risk. So, this is comparing, if we hold those Treasury a five-year Treasury, all the way from ‘21 to 2026.

Alternatively, if we were to sell it here in 2023, at a 10% loss, re-invest into mortgage-backed securities.

Now, why does the math look good in this scenario? Because, like we said, we’re changing our risk profile.

We’re going from a no-spread investment to a wider-spread investment, and this assumption is 100 basis points. So, that the breakeven occurs before the original maturity, which is a good thing, right?

So, we had mentioned last May that, most recently, MBS spreads are relatively attractive right now as wide as they’ve been in the post-2008 era. And certainly, it feels better to be investing in bonds at plus 150 spreads than at plus 25 spreads. So I’d say, you know if you do have the capacity to shift back towards that risk rate.

Yes, you’re adding risk. You’re adding. You’re making a shift in the risk profile.

But if you’re if you’re going from very underweight a certain type of risk to just moderately underweight, then you’re still on a total balance-sheet level doing OK.

If you are in the camp of taking the right fork or the going for the hard place instead of the rock, in terms of, hey, let’s grow through margin pressure, then, you know, as we alluded to, given where spreads are and the shape of the curve that there are some opportunities to consider.

So, you know, we’re not here to opine about particular appeals of specific assets.

But we’ll use, in these examples, a generic mortgage-backed security because it is such a core part of many depository balance sheets. So in terms of putting on the leverage, you know, if you were to short-fund it, well, that’s more of a play for later than now.

Because the spreads, given the inverted yield curve, don’t look particularly great.

But if you are of the mind, and you do have the balance sheet exposure that short rates may be coming down over the short and medium terms, well, then this is going to be an advantageous strategy both for the spread but also your ability to adapt to a speedup in prepayments or even — doesn’t seem like it could happen right now — but explosive deposit growth. You know the second one is intermediate funding, and this is something that we’ve seen a lot of folks do of late. So tiptoe out the curve. So, call it the 1, 3-year part of the curve, where we do see some inversion. So, we do get a little more of that initial spread.

And if we think about this, it’s going to be income statement neutral for an initial period of time, and there is some interest rate risk in the out years. But, you know, we look at a lot of ALCO reports and the NII modeling, and it looks like a Nike swoosh in a lot of situations where there is a little bit of sensitivity to rising rates in the near term, but over the long haul, 24,36, 60 months, even the most liability-sensitive balance sheets begin to show some asset-sensitivity.

So, if your pain point is what’s happening over the next 12 or 18 months, and this is the type of strategy that would align with that. MBS versus structured funding won’t go into it here because we’re going to talk about the HLB Option a little bit later. But, you know, this is where you can really capture some spread benefits and even benefit from if we do get into a “higher for longer” scenario as opposed to the aggressive, quick pivot. And then positively convex assets, as we talked about before, that’s the fancy way of saying prepayment protection. And if you do have a loan book, where, you know, you’re not heavy in commercial, and have the ability to implement those prepayment provisions, right? You have a large resi book or consumer book.

Then, the investment side, you know, I’d give a lot of thought of trying to implement some of that protection there because the markets price that out every day, there’s more availability, you’re not beholden to, “Hey, this is what our loan book looks like and what our customer footprint looks like.” You can do anything you want in the investment portfolio. So, this is a way to solve for X at the balance sheet level.

Prepare now for opportunities later if you’ve been. If you’ve been paying attention to us for a while this, this pops up every now and again.

You know, if we do see some of the dislocations like we saw in 2020 or even 2008, there’s going to be opportunities to buy assets at spreads that, you know, you couldn’t even dream of right now. So, the time to talk about that is now, right?

Because if spreads blowout, it’s tough to socialize the idea to say, “Hey, we’re going to try and do this, or we’re going to go into this new asset class we’ve never participated in,” you know when we’re in the eye of the storm.

So, you know, I’d sit around the table and, you know, do some tabletop exercises and say, “Hey, if municipal bonds blow out by 100 basis points, are we of the mind to be opportunistic and take advantage of that? Or are we going to sit and wait?” And everyone’s going to have a different answer in terms of your balance sheet and the types of assets that you want to have.

But, you know, there’s a number of examples and conversations that we’ve had with folks where, you know, they were prepared and ready and were able to take advantage in some of those periods of extreme volatility.

And really, to strengthen the balance sheet for the long haul.

And, you know, this is going to be asset driven because, fortunately, you have advances that are stable in these types of scenarios relative to what happens on the asset side.

So the same thing where, you know, you want to target, what types of assets we may or may not be interested in, taking advantage of, know how you’re going to fund it, and then, just like we talked about, there’s a number of different ways all along curve that you can do that.

So wholesale funding, you know, first, you know, a couple PSAs here, before we get into three distinct strategies, we want to talk about, is maximizing collateral. And, you know, I don’t think we’ve talked to anybody who doesn’t like maximizing collateral, you know, not that they are necessarily against it, it’s just there’s always competing priorities, right, in terms of, you know, getting ducks in a row. So I’ll point out three things, you know, on your residential pledge.

So, you know, it takes a little bit of rolling up his sleeves, but it can be beneficial in this environment, right? Well, you know, it probably doesn’t hurt to be one step ahead of a regulator question saying, “Hey, you know, what does your liquidity on an off-balance sheet look like?”

​In terms of other loan types, CRE, multi-family, home equity, you know, you’d probably be surprised at the number of members who don’t pledge, who have these on the balance sheet and don’t pledge it.

So, again, I would encourage you to reach out, get on that, get on the calendar for the collateral review folks, and there are going to be opportunities there.

Securities, you know, many depositories are fortunate that, in the normal course of business, they don’t have to pledge securities in order to gain capacity, but we’re not in a normal course of business environment right now.

And so and given the reduced salability, given the underwater marks, you know, we have seen an uptick in folks pledging securities.

So it’s about 30% right now of depositories who are pledging bonds.

And you know, we have had done a lot of work. And then there are things to be concerned with, with moving securities over to the Fed, whether for the BTFP, or the, or the Discount Window. And there are some nuances. If you’re a Massachusetts bank, Securities Corp. considerations, and things of that nature, but reach out to your relationship manager. We’ve been through it all in the last couple of months and can walk you through it.

Rates API.

You may or may not know that, you know, we’ve built a tool where you can get our rates in a very seamless and efficient way into Excel so that you can do, you know, incorporate it into your business intelligence process. So, whether it’s for funds transfer pricing, like Sean talked about, loan pricing, or even just ad hoc analysis.

So, you know, here are snippets from our very easy-to-use FAQ document. You can see step one is open the workbook. And step seven is data is ready to use. And probably doesn’t take more than a couple of minutes, right? Yeah, no, I’m kidding. I’m going to endorse this because I know that I wasn’t wise to the fact that this tool really existed until fairly recently and how valuable it was.

It was really easy to set up, and it was really easy for me to use, and I would say that if I weren’t basically paid to say that [laughter]. It’s a really valuable tool that’s underutilized right now.

Yeah, so, you know, reach out to your relationship manager or to us afterwards, and we can get you set up. Like we said, it’s very easy to use, and, you know, I just got a message from Dan Redmond. He said that the first ten members who call and ask about the API get ten basis points…no, no, that’s absolutely not the truth, but, you know, but still, follow up, and, you know, I think you’ll find this to be a valuable resource.

You know, we do these webinars, and they’re a blast, and we come at it from a holistic, you know, 30,000-foot view, because that’s, that’s what balance sheet management is, right? But sometimes you need to get, you know, a little more narrowly focused.

So, I’d invite you to check out our website, and our Strategies and Insights section, where we have this new series, where it’s simply titled How It Works, where we take a specific, narrow dive into number of advance products.

Because, you know, you may be interested in using it and looking at it, but you know, you have to be able to communicate it to internal stakeholders and then know it backward and forwards, so it’s our hope that as you look at some of the solutions, you have the supporting documentation and resources there for you.

So, you know, we’ll go through three quick things here. So, what the shape of the yield curve presents interesting opportunities. So, you know, we can talk about bullet, barbell or ladder. And what are the pros and cons of doing any of these strategies?

Alternatively, we can pair an overnight position in the Daily Cash Manager with a one-year Classic, and that nets out to an average of six months. Now, in this case, that is a Day One savings of about 19 basis points. And I say “Day One” because, obviously, there is some repricing risk with that overnight position.

There’s…that’s a benefit. You know, depending on what happens with rates. If rates go lower, you’ll want to have that faster repricing frequency. And also, as I alluded to before, if investment cash flows speed up or if deposit growth accelerates and your need for wholesale funding will decline, well, then you’ll want to have the shortest possible maturities so that you can happily hand it back to us.

You know when we talk about blended exposures, right, we look at this matrix here in the top right and the bottom left are pretty intuitive. The bottom left, we take an overnight advance, and we’re not getting much in terms of rate protection or in term liquidity protection.

We go to the top right, we borrow long-term fixed, we get liquidity protection, and we get interest rate protection, but maybe your balance sheet doesn’t need that that bundled package for those two different risks.

So, the top left is where, you know, we have seen and heard from members that it’s an exposure that, and a risk profile that a lot of folks are in right now, where they sure could use some more liquidity, protection.

But they’re not as concerned about the rate protection, right? They’re, asset-sensitive, or they want to be asset-sensitive.

So, you know, the term floaters have an awful lot of appeal in this market. And, you know, we’ve talked about this advance for a while. We had a webinar in the middle of February and I, and we said it’s an optimal setup for this type of advance. We did not know what was going to happen with SVB about three weeks after we had that webinar, but I should’ve said that and said, yes, we absolutely knew that that was going to happen. But I’ll invite you to look at these three main characteristics here about this advance in terms of providing long-term liquidity.

So, maturities over one year are going to be supportive of liquidity metrics, as opposed to rolling short-term, wholesale funding. Short-term rate exposure – the advance adjusts in rate every four weeks. Again, that short-term sensitivity is maybe something that you want and need.

And then the last one is key — it’s the prepayment flexibility.

So every time that rate resets at four weeks, this advance, the Discount Note Auction-Floater Advance, you have the ability to prepay in full or in part this advance. So you’re getting the benefits of long-term liquidity, you’re getting the short-term repricing, but you’re also getting the ability to give back the advance, if your wholesale funding needs happen to decline.

Then the real cherry on the top is you can see on the bottom, you know, given current market dynamics, the rate has been inside of the one-month Classic Advance.

So, not only are you getting those long-term liquidity and flexibility benefits, but you’re also getting some cost savings, even if it’s just modest.

So, you know, it’s something interesting to be aware of.

Shorter maturity, HLB-Option Advances. So, you know, we’ve talked about this for a bit, you know, the put-able advances, given the volatility in the market and the shape of the yield curve, have been a very popular funding tool for members.

​But what’s really fascinating is that over the last 12 months or so, we’ve seen a different experience versus historically, what has been the case where the volume, historically, has been concentrated, where the lowest rate is. Right?

Where you’re selling the most optionality and the longest maturity. The shortest final.

But given how fast and aggressive rates moved on the front end of the curve, right?

No one here needs to be reminded of the 500-basis point move in a year, in short-term rates, that there’s been some significant value created for the shorter maturity finals. And why do those have value? Because you’re still able to capture cost savings.

So, in this example, HLB Options with two-year maturities are still able to produce 75 to 100 basis points of cost savings versus the short-term Classics, but you don’t have the tail risk of the longer maturities. So, you can see the blue line on the bottom. You know, you can get inside of 3% right now, in a 10-year, three-month type of structure.

But if we do have the fast pivot and rates go down more than they’re expecting, there’s going to be some extension.

And you’ll be OK for now because you do have some of that distance between the 5s and the 2s. But, you know, when you think about the shorter maturities, you don’t have that extension risk.

And, but you are saving, you know, interest expense right off the bat.

​And we have seen a number of members who have had a rolling short-term position, and have over time, began to peel off some of that, that position into two-year/three-month structures, like it’s noted here, 4.44% or three-year/six-month or three-year/one-year, things of that nature. So, it’s been a very popular strategy in all shapes and sizes, in terms of the structures and also the types of balance sheets and members who have been taking advantage. So, that brings us to the end here. I will, once again, thank you for your time. And this has been, you know, continues to be an interesting environment, and for folks like Sean and I, that get a kick out of this stuff, you know, there’s no shortage of material. So hopefully, you found some value in some of the things that we talked about. And as always, if there are things that you saw here that are interesting and worthy of follow up, we’re always available at a moment’s notice and reach out to us or your relationship managers. And we’re happy to do what we can to be of assistance. So, with that, we’ll wrap things up. And thank you very much. Thank you.