Peer Analysis and Balance Sheet Strategies Update August 2023

Well, hello, everyone. Thank you for joining us today. I’m Andrew, this is Sean. And we’re happy to have you with us here for our latest installment of our webinar. So, if you’ve been with us before, you probably know the drill, what we’ll cover. If not, if for the first time, welcome.

So we’ll, we’ll take a 30,000-foot view of what’s happening in the capital markets in the economy, but from a lens that we think is practical for, you know, a depository managing their balance sheet in this environment.

The second thing is we’ll take a deep dive into what’s happening and things that jumped off the page for us when looking at the second quarter financials of our member institutions here in New England.

And then, lastly, you know, we’ll take a look at some of the levers that are interesting to us in terms of strategic things that we can be doing on both sides of the balance sheet to navigate through this very unique time.

So, you know, we know that you come to the Home Loan Bank of Boston for a lot of different things. Some would say liquidity and funding are high up on that list.

Others would say the intersection of pop culture and sports references with what’s happening in the banking world.

So, you know, there are two movies out recently, Barbie and Oppenheimer, slightly different tones.

And, you know, one of the things that came through our minds was, you know, if you look at that the different tones, it kind of describes the deposit gathering and retention process in 2021 relative to how it feels in 2023.

And if you haven’t yet seen these movies, Barbie is the one on the left in pink. Smiling and happy.

So, you know, that’s kind of, you know, where things are at.

So, let’s jump right into talking about what’s happening in the markets and the economy.

So, first and foremost, no surprise to anybody, short-term rates have risen comfortably above 5%.

We had our first pause, skip, halt, or whatever you want to call it in terms of rate hikes in June. But then, in July, rates did go up 25 basis points again.

But one of the interesting things to us was looking at the reverse repo facility that the Fed provides for, if you’re not familiar, the non-depositories who don’t have access to interest on reserve balances where they can transact with the Fed and get that rate.

So balances have come down by about $400 billion over the last few months or so.

And it’s really been driven by a couple of different things. One, the turning point, was pretty much right after the debt ceiling situation was avoided.So, there was this build-up of lack of Treasury Bill issuance that those floodgates have opened back up, so the supply of T-Bills going into the market.

The other thing is that, you know, nominal rates are just, frankly, flat, high.

So and…we’re getting potentially closer, and we’ll talk about this in a little bit, about being towards the end of the hiking cycle. So there’s motivation from financial market participants to term out on the asset side. Again, something we will get to a little bit later.
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Now, why does this all matter to depositories? This non-depository activity.

I think, you know, as we’ve all learned over the last year or so, the Treasury Market and Money Market Fund complex, and the money market funds are the bulk of the activity and the volume that goes into this reverse repo facility, that they are a true, you know, competition for bank deposits, in terms of the rates they’re able to pay and where excess funds can go.

So, knowing the conditions, and what is happening, in terms of T-Bills and money markets as viable alternatives for the customer’s short-term liquidity, it’s something to take note of.

So, thinking about the yield curve, here is a measure going back 40 years of the steepness between the three-month Treasury and the ten-year Treasury.

Now, we’ve all seen and heard in many different channels this idea of, you know, once the curve is inverted, you know, the world’s going to end, and recession is right around the corner and short-term rates are going to be going lower in short order.

Hang on one second. I just want to make sure that we have the slides properly presented here. Stacy, can we see the slides now? OK, good. Apologies for that hiccup there.

So, go back to yield curve first. So, when we look back at the last 40 years, you know, we’ve annotated with the arrow there, the instances where this measure of the yield curve has inverted.

And one of the things that hopefully jumps out, or there’s two things that jump out, is one, the level of inversion that we’re experiencing now is it’s much deeper than where it’s been historically. So to the tune of about 50 or 75 basis points more inverted.

And now, with every passing day, we’re getting to a longer timeframe where rates were inverted.

So, moral of the story is it’s been expensive and costly to be too early on this bet, that inversion means short rates are going down, or even long rates are going down to some extent, as well.

At some point, rates will go down, we think, but until we get there, there’s going to be considerable impacts on being a spread lender that an inverted curve does not create the ideal backdrop for that.

Inflation, we rewind about a year or so ago, and inflation was all anybody was talking about within the markets, but even, you know, to casual people who aren’t in the bank and credit union world.

So year-over-year CPI has returned to “normalish” levels, down to 3.3% as of last month, relative to the 8/9% that did hit early in this year.

And, you know, that’s to be expected because of the way it’s calculated, that it’s coming off of relatively elevated levels, that makes it difficult to grow in perpetuity at such high, high levels.

But here in green is an interesting metric, and it’s one of the key indicators that the Fed has indicated that they keep an eye on. So, it’s the five-year inflation rate, five-year forward, and this is pulled out from the market for TIPS, inflation-protected securities.

And this measure has been creeping up slightly such that it’s at the highest level that it’s been since 2014.

​Now, again, why is this important to managers of a bank and credit union balance sheet? One, the health of the consumer, the business, and the business customers, is really paramount as a driver to the business. But the other aspect of it is that, and we’ve seen this over the last couple of months, and we saw this at the end of 2022 as well, is that when the long end of the curve gets ahead of the short end, as is typically the case,

If they get into a staring contest with the short, with what’s happening with short-term rates, and the Fed being steadfast in continuing to raise rates, then they’re prone and open the possibility of sell-offs.

In that intermediate and long end of the curve, which can be painful for evaluations on fixed-rate assets, like what we have in the bond portfolio, as well as off on the lending side.

So, when you have this, you know, this challenge, between, what the curve is saying, but also what is the Fed is saying, and what inflation metrics are saying. It really creates a challenging environment.

Yeah and, Andrew, one of the key ways that we’ve seen inflation manifest, of course, is in housing costs.

So here’s a look at what housing prices have done in major metro areas around New England since the turn of the century, since 2000.

It’s an index that I’ve taken off Freddie Mac’s data, so, what they do is they basically take all the information for all the loans sold.

In these metros, and then identify, what the relative value of housing is over time.

Everything is indexed to 100 as of December 2000, and then you see the line for each one of these metros over the past we years, basically.

And it turns out that Portland, Maine, and Burlington, Vermont, are the most, the best-performing metros in that timeframe.

​Connecticut’s obviously kind of struggled, but what’s really amazing about it is that more than 50% increases in some of these metros, including those best performing ones just in the past three years, and up over 200% basically tripled plus over the course of the 21st century.

So really remarkable performance over that timeframe. One other thing I didn’t put in here is that in a lot of West Coast markets, you have actually seen some declines year over year. So one of the questions is whether some of that will…..will some of that end up translating to other parts of the country over time? But New England has really performed very well compared to other places around the country. But what that translates into is housing affordability issues, of course.

So what I did here is to try to say, you know, what if you were that sort of marginal person, looking at first-time home purchase that you had pretty good income and you’re looking at a potentially affordable property in one of those markets like a Portland or a Burlington and the home price here, I assumed was about $400,000, from 2020. It went up to the extent that the index is actually showing you, from $390K to $430K in this example.

And then, in 2023, now, that same home, if you were in again, one of those same markets, it’s gone up about 50% in the past few years, it’s $640,000.

Meanwhile, your income’s probably only gone up 10/12% over the past few years, which means that your down payment has to go up over $40,000 if you’re trying to target that 20% down payment.

And then the big thing here, of course, is that interest rates have gone from 3.75% down to 3.00% back to 7.00%.

And so, the P&I, including a tax payment, here, has gone from an affordable 25% of income to a very unaffordable 48% of gross income.

You know, 28% sort of being that magic underwriting number that a lot of a lot of institutions use when trying to think about mortgage underwriting.

So, very unaffordable for a lot of folks out there right now. So, a lot of folks are getting squeezed out of the market.

But, if you think about that, I question how could that be the case. How can it be the case that most people can’t afford a home?

Sort of by definition, if that’s going to occur, you would think home prices would decline, but we’re showing that they’re actually still going up.

What’s actually happening here is housing inventory, I suspect, is what’s really driving this.

And so this is a look at housing inventory as far back as they have data, going back to about 2016.

You can see that usually at this time of year, it’s a very highly seasonal pattern about home listings, but at this time of year, there’s usually 1.3 million homes that are on the market nationally, and right now, there’s about 650,000 as of July.

So, we’re literally at about half the level of inventory that you would normally, excuse me, expect to see at this time.

And so, I think that’s, that’s what’s happening, is that there are just so few homes because people are locked into those 3% mortgages. They don’t want to move.

And so, right now, there’s probably 650,000 or a million homes out there that would otherwise be out there where the current owners are saying, “Eh, I’m going to stick around for my 3% mortgage instead of trying to find a 7% mortgage if I have to move.”

And I think what’s happening there, ironically, is that that’s forcing a lot of people who would otherwise buy homes into the rental market, which then pushes up rental prices, which then translates back into the inflation numbers.

So ironically, the higher rates are actually potentially triggering the inflation numbers, at this point. If you look at CPI last quarter, the single biggest stand-out component that still has a high year-over-year value is housing – owner’s equivalent rent.

And that’s being driven, I think, by this dynamic of almost artificially limited supply because of the rate environment causing more renters, which drives up rental prices.

So if this dynamic shifts around, if we do get a rate pivot, or I think there are a couple of other theories I’ve heard about, Airbnb and VRBO kind-of owners potentially selling some properties, or turning them into rental properties, to sort of alleviate some of this build-up that’s happening right now, that might be a catalyst for changing this dynamic.

But right now, it’s a really, it’s a challenging dynamic, and a lot of people don’t think it’s going to go away in the immediate future.

All right, so that, you know, leads us into the second section here, and we’re going to take a look specifically at what’s happening on our balance sheets.

So we’ll cover recover, a fair amount of ground. And first and foremost really is, shouldn’t be much surprise.

You know, what’s happening on the deposit side of the balance sheet is the big driver of all things profitability and risk right now. So Sean is going to come at it from every angle. Yeah, thanks, Andrew. So obviously, everyone is talking about deposits and funding out there.

And so I wanted to take a look at sort of the deposit mix that we can see from Call report data.

This is showing a sort of mix between time deposit CDs, and nonmaturity deposits since the rising rate cycle began. I’m identifying that cycle as starting Q1 2022. The first hike was in March if you remember that far back. There was only one modest hike at the time in mid-March. So, since that timeframe, we’ve seen deposits or CDs rather go from about 13% of the overall deposit mix to about 21% over 21%.

Then at credit unions, it’s almost the exact same numbers. It’s actually kind of eerily, eerily similar that there are 13% going to 21%.

So, you can see the over 60% growth in CDs over this period of time since rising rates began. And you’ve really seeing it accelerate in the past quarter or two compared to where it started again, to kind of look back and forth on these charts.

We had very little reaction at the beginning and then starting late last year. And I think this is highly related to the fact that overall deposits started to really meaningfully decline in September of last year.

You really started to see this mix change on the Balance Sheet. And then, beyond CDs, let’s take a look at the overall funding mix.

If we split this up between sort of core deposits and those aspects of deposits or funding rather that are not core. Things like borrowings, sweep deposits and listing deposits, and brokered CDs.

Again, what we’ve seen over this timeframe, is a lot of people have very, very little wholesale funding at the start of the rising rate cycle, kind of makes sense because liquidity to that Barbie slide was very, very ample in 2020, 2021, a lot of people paid down, wholesale funding. So, they started this cycle with a pretty minimal amount. For banks, it was about 6%.

And now, quarter by quarter, it’s been increasing every single quarter.

And now it’s about 19% of the overall mix is through non-core sources — so we’ve seen core deposits in this timeframe, actually decline 5.5%.

I know at the end of last year, we tried to take a look at what does rising rates from the Federal Reserve and a shrinking Federal Reserve Balance Sheet mean for depositories.

And we offered the idea that it’s going to be really, really difficult to have core deposit growth in 2023.

When people think about budgeting, it’s going to be really hard to put in a positive number there just because the dynamics are so working against everybody; it doesn’t mean any given institution can’t outperform, and many are, but in the aggregate, it does mean that the whole system is probably going to shrink. And indeed, that’s what we’re seeing.

That cycle to date is -5%.

Credit unions have fared a lot better, actually, though.

So in this cycle to date, credit unions actually have had core growth of 4.5%. So banks are actually down. Member banks, down 5% in core deposits since the cycle began — credit unions have outperformed, up 4.3%.

And so what I think about there is the fact that it’s probably the mix of clientele that’s actually driving some of this behavior.

Where commercial clients are the ones that are going to the external sources that are going into things like Treasuries, and it’s less so personal. Or they’re going into money market mutual funds, or they’re spending money more so than the personal piece to try to explain the difference.

As a result, credit unions have used less wholesale funding. So their overall mix has gone from about three odd percent, up to 7% or 8%, compared to banks at about 19%.

So, that’s a good segue into talking about advance and wholesale usage. And, as Sean showed us with the deposit metrics, credit unions have had less need for wholesale funding because they’ve been able to retain and grow deposits at a better clip relative to banks.

So, there are two things that jump out here, you know, one we just mentioned here, the credit union vs. bank dynamic. So, you know, when you look at the percentage of credit unions and banks who had more than 3% advances-to-assets, and look at three different time periods: 12/31/19 — that was before the cut cycle — 3/31/22 — that was right before the start of the hike cycle — and then here we are today.

So we can see that down, then back up, path as we bucket credit unions and banks by various sizes. But, you know, at every size interval, with the exception of, interestingly, $250 million to $1 billion in assets where credit union borrowings right now are on par with the need for advances from banks in that same asset bucket. Again, because of the deposit experience, advance usage has been lighter.

And we can the other thing that jumps out is the size dynamic that, generally speaking, the larger the institution, the more likely they are to have a reliance on advances.

So that’s whether that’s an excess of 3%, not considerable but a decent sized part of the funding mix, but also, looking at on the bottom panel here, members who have no advances. So you can see the credit union, those green bars, you know, extend much further out to the right than in each asset-size bucket, credit unions…there’s more credit unions who have zero advances on the books relative to banks.

Yeah, and so as we talk about sort of that core deposit performance and sort of the funding mix changes, how have funding costs evolved over time?

At the start of this cycle, credit unions actually were paying more on overall funding, and at this point, are paying less because the accelerated costs have increased for banks.

What we’ve seen here is that you know, at the, at the start of this cycle, you know, it’s hard to remember that SOFR back in the spring of 2022, was < 10 basis points — I think the average was 8 or 9 basis points we had on the slide, nine basis points in Q1 — most recently was about 5%.

And in that timeframe, overall costs for banks have gone from 16 bps up to 152 bps. And for credit unions from 35 bps up to 113 bps. So we’re seeing this every quarter — we’re seeing the actual expense increase by more than the prior quarter. Kind of makes sense that there’s a significant lag at the early stages of the cycle, there isn’t as much re-pricing going on out there. And in the later stages of the cycle there is probably going to be more re-pricing, but it’s interesting to see how this dynamic is playing out over the cycle to date.

Then the other thing to think about is sort of the overall beta. So this is the overall beta book – this isn’t what’s going with betas in a particular product, but for the overall structure of deposits — bank beta cycle-to-date about 28% and for credit unions only 16%.

So that’s pretty darn low. I think that’s really strong performance so far. But one of the questions is going to be how does that play out over time?

NIM. You know, NIM was a struggle for a lot of people this past quarter and maybe a struggle going forward for some folks. 90% of our member banks this quarter actually saw declining NIM. It was only about 50% for credit unions, again coming back to that funding mix sort of dynamic that’s going on there.

This particular chart shows two histograms here, and each one of these bars represents a ten-basis-point change in NIM.

Everybody to the left of those green sort of bars in the middle is negative, and then everybody to the right is positive.

And what you see, if you look at the bank dynamics there is that 56 and 58 are the biggest buckets between negative ten and negative 30 basis points of NIM just this quarter.

On credit unions, it’s a much more mixed bag. The single biggest bucket is 0 to 10 on a negative NIM, but it’s really kind of all over the place. And the median is only negative one. Some of the credit union dynamics are a little skewed because some of the bigger credit unions actually have more NIM decline this time.

But it’s, it’s a situation where there’s a divergence that’s happening between our membership base. So the bias is definitely towards declining NIM at this point.

And what’s pushing it? It’s deposit pricing. No surprise.

Quarter-over-quarter, asset rates went up about 24 basis points at banks and 23 basis points at credit unions.

And then the liability rate overwhelmingly, as a consequence of just the positive repricing, not the mix. You can see the mix changes here, but it’s overwhelmingly deposit pricing leading to those dynamics .

I mean, didn’t we think the higher rates going to help profitability? They did for a hot minute there, I think, but you can see year-over-year changes, again, that liabilities are actually outpacing the asset pricing over the course of the past year for banks.

It’s the inverse relationship for credit unions, which is leading to the outperformance of credit unions.

Something else that’s worth noting here is that the asset mix changes; basically, cash going into loans or investment cash flows that are winding up in loans improving profitability for banks is more than being offset by that same dynamic on the liability side, where core deposits are leaving and being replaced with more expensive funding.

Then on credit unions, it’s just the opposite again, where the core deposit outperformance is actually leading to a favorable mix shift and also helping the NIM change year over year.

Let’s go back in the Wayback Machine to actually see how this has played out over time.

And you can see that NIM really did improve into the end of last year.

And even into Q1 for a lot of people, but in the past quarter really started to decline, and again, you see that sort of credit union versus bank dynamic play out.

​All right, so one of the things I think about here is to say, all right, are we done? How much further do we have to go?

So we’ve had all this deposit re-pricing — we had a lot of deposit re-pricing this particular quarter.

Are we…we think the rising rate cycle might be coming to a close? A lot of people think we’re done, or there’s only one more hike.

What could happen with deposit pricing?

So, I said, let’s compare this cycle to what happened from 2004 to 2006.

So, if you can remember that far back, in the second quarter of June 2004 to the very beginning of the third quarter, July 2006, the Fed Funds rate went from 1% to 5.25%, so 425 basis points of movement.

This is bank members at that point in time, existing bank members at that point in time.

At that point, overall deposits were higher than what the Fed Funds Rate was: 1.18% versus 1.00%, similar to this environment, where it started at 0.16% versus 0.09% for SOFR. And then a year into it, overall deposit expenses are very similar to what they are today – 1.64% versus 1.52% today.

But Fed Funds wasn’t, didn’t go up quite as quickly in that timeframe. It was a 25-basis point drip in that cycle, every single meeting — it wasn’t that 75 basis point leaps that we saw in the summer of last year.

And so, the consequence here is that, and by the end of that cycle are in sort of the, the end of the rising rate cycle, and then going into the pause — the hold of the Fed at 5.25% — bank deposit expenses went into the mid twos, and almost to 3% in the summer of 2007 on the eve of the Great Financial Crisis.

And so it’s something to think about is, are we closer to the end in deposit re-pricing? Or are we maybe only halfway there? Is there another 50 to 100 basis points — or more — potentially of deposit expenses?

I think we’re going to see different dynamics play out at different institutions in the coming year, but it does sound, you know the Fed sounds pretty hawkish, and it does seem like we’re going to have a pause up here, if not another hike for coming quarters. So, we’ll see how this deposit expense plays out over time.

And as a consequence, probably of that, what we are also seeing, from all the data that we collect on the Call Report here, is that more institutions are extending funding and are doing more swaps to hedge activity.

So, this is a look both at the amounts on the lower bars of funding that’s greater than a year, including structured advances, and then the lighter bars are the total notional — the total amount – of reported interest rate risk derivatives that are on balance sheets. And you can see that every quarter that has been increasing.

Probably no surprise, as more people start, refining some of the assumptions in their modeling to think about what could happen, what’s going on over time?

You know, bank NIM at 2.93% — if we think about, “Is there 100 basis points more at risk – plus — of deposit expenses, some of the assets will re-price…could be another 50 basis points – plus — of decline in bank NIM coming up.

And so I think that’s what’s sort of driving a lot of this activity, where people are saying, “No mas. We have to extend some of our funding, we have to be able to survive sort of this environment.” Something else that’s worth noting here is that it’s sort of similar to the advance dynamic that Andrew was talking about there where the “bigger you are, the more likely you are to borrow or the more likely you are to do different kinds of activity.”

Same thing here with hedging and with extension. You know, we see that about half of our banks use derivatives, and only a handful of credit unions use derivatives. And of our 25 largest banks, only two report no derivatives use whatsoever.

So basically, almost everybody over $3 billion, with two or three exceptions, are using derivatives in some form or fashion.

And something else that I didn’t, I didn’t highlight on the CD mix because we’re talking here about funding that’s going longer.

The actual client CDs have gotten shorter in the past couple of quarters.

​And so, it’s tough to know exactly what’s going on there. But my, my read between the lines on that is, it’s more shorter-term CD specials where institutions are putting out 11-month specials 9-month specials to try to attract more deposits, and then that’s driving a shorter amount of CDs versus it’s a way to manage the pricing exception process that we talked about in our last webinar.

But it’s not crystal clear exactly what’s happening there.

But it used to be the case until the last couple of quarters that about 30% of CDs were more than a year. Right now, it’s down to 18% of CDs are more than a year. So that is changing as well

And then something else, you know, there was a lot of concern about bank safety back in March. I don’t know if you’ve heard anything about that.

So, uninsured deposits were one of the focuses.

And it’s one of the focuses going forward to think about different ways that bank regulators, and credit union regulators, will look at what’s going on with risk, potential risk for your institution.

So, what has actually happened with uninsured deposits? Well you can see for those institutions that report uninsured deposits, and for banks, it’s only banks above $1 billion that are actually required to report this, that number has decreased from about 36% to 31%.

That’s about $10 billion, $12 billion of the overall book. So, you know, that’s a little bit surprising to me that it’s not more frankly. It’s clearly declined significantly in the past couple of quarters.

I’m not surprised by that, but the degree of that decline is probably not as much as I might otherwise think.

And at credit unions, probably no surprise, more personal clients, and so, you end up in a situation where there’s just much less uninsured shares overall at credit unions.

So, you know, a lot of talk has been about the positive funding side, and rightly so. We’re one of the people talking about it a lot, but what I think has kind of flown under the radar a little bit is how strong loan growth has been.

So here we’re looking at annualized loan growth, 25th, 50th and 75th percentile.

And wanted to see how we’re faring now for the last few quarters, relative to ‘18 and ‘19, the last time we were in a high-cost cycle.

And just to make the graphic a little bit cleaner stripped out the period of 2020 and 2021 to give us a little whitespace to really lock in here.

The thing that jumps out here is there’s an interesting dynamic, kind of what we talked about before, with the way the year-over-year CPI changes are done.

There’s an asterisk involved when you’re looking at quarter-over-quarter or year-over-year changes.

So the fact that loan growth has come down to that 6 to 8 percent range annualized in this most recent quarter, that’s one that’s still a pretty good level in and of itself. The fact that it’s coming down, to me, isn’t really terribly concerning because to grow after three consecutive quarters of double digit growth, is pretty exceptional.

So when you also throw in the fact that in an inverted curve, as we mentioned before, is not probably the optimal scenario to be putting the pedal to the metal on loan growth and to have it be accretive to margin.

So, the takeaway here is that as we’ve seen loan demand recover, I think the consensus where most managers are at is that margin contraction is on the horizon. There’s really no debating that. That growing through it is the path forward, and it comes down to trusting the process on the decisions we’re making on the credit side of the house.

So, what areas are driving this loan growth? And we’ve touched upon this in past webinars. Is that the residential side, despite what we can see in front of our face, in terms of, “Well the refi market is dead given where rates are, right now; it’s largely a purchase market.”

So the fact that residential loans have been continuing to grow at a pretty aggressive clip. So 81% of banks saw quarter-over-quarter dollar growth in this most recent quarter.

This tells you that when you compare, that you have these two dynamics of what do prepayments and refis and how do we compare that versus a lower level of origination? Which dynamic is more important than maybe prepays aren’t as important, in terms of the ability to grow the balance sheet, as we once thought? The other dynamic here is the ARM market relative to fixed rates have picked up. And so those are certainly a balance sheet product.

But we can say, you know, because our MPF, our secondary market program, that you know, the activity there has been through the roof over the last couple quarters…excuse me, months. So certainly, there are conventional fixed-rate mortgages being made.

And the takeaway there is that liquidity is getting that much tighter and tighter. So that keep/sell decision –we’ll talk about that a little bit more – is skewing towards the sell.

You know more granularly, looking at CRE and autos — CRE for banks, autos for credit unions — being primary categories, steady as she goes for banks and CRE, in terms of growth and activity there. Autos have cooled off a little bit. But still, you know, growing for most, even if it’s not to the level of the end of last year when things were really firing on all cylinders.

On the investment side of things…So, you know, a quick thank you to, we had a summer intern here. She was very helpful in putting together this slide, and she now knows everything about what’s happening in the investment portfolio at banks and credit unions.

So, a lot that was good to see. There’s a very interesting dynamic that credit unions had much, much shorter durations going into the falling rate cycle.

And investment yields were very, very low.

And as rates persisted at that 0% range, we got to, if you look on the right-hand side, that big, green section in the middle, that nearly 80% of credit unions had investment yields below 1%.

But then, as rates started to move up in the middle of 2022, because they had that ability to re-price the portfolio that much quicker, it really changed rather rapidly to where about 35% of credit unions now have investment yields over 3%, which is far and away better than what we had coming into the cycle in 2020.

Banks have been a little more measured in those changes, although they did slowly but surely start to see improvement.

One thing that really jumps out when we’re looking at the bank data, is that the investment yield, immediate investment yield, only improved by one basis point this most recent quarter and that contrasts to about 10 to 15 basis points change, positive changes, going back to the last few quarters.

Now, this tells us right there are three things you can do with the investment portfolio.

You can replace and grow, you can replace, or you can just let runoff contract the size of the portfolio.

So, for a while, we were in, not just a replace, but replace and grow mode.

Now that we’re seeing investment yields only go up by one basis point in this world, where most have book yields into the 2% to 3% range, and the marginal investment is in the 4% to 5% range, this tells you that liquidity is at a premium, and we’re not even getting to the place in terms of the activity and the balance sheet mix.

Credit has held up, which, you know, there’s been all this focus on interest rate risk and liquidity risk, but you know, credit risk is usually the one that keeps us up at night.

Provisioning is starting to tick up a little bit more at credit unions than at banks, but still paling to what we saw back in 2020. And then, accordingly, on the loan loss reserves to the loan side of things, credit unions are more or less back to where they were end of 2019, where banks, you know, whether we’re looking at the middle of the road or on the extremes, have lower levels of reserves put away.

Let’s you know, get to Section Three, and wrap things up. So Sean is going to go over a couple of things on the asset side of the Balance Sheet. I will tackle the liabilities, and as I say that now I realize that probably not the first time I’ve been called the liability, but usually, I’m not the one saying it. So here I am self-reporting.

So, you know, let’s, you know, Sean will go through a couple of things on the asset side. To match your self-effacement, I’ve been accused of being a Poindexter. So, I’m going to be a little bit of a Poindexter and just highlight some of the fixed income terminology that we’ve tossed around that I think should be guiding folks as they think about their actions in coming quarters in this potentially pivotal time. Convexity. What the heck is “convexity?” We toss that word around a lot.

It’s positive convexity versus negative convexity. Positive convexity — positively convex assets are those things that will increase in price significantly as rates decline.

Why would they increase significantly? Because there is a lockout or prepayment — that you are assured of getting your cash flows, or more assured of getting your cash flows, compared to other instruments.

So, think about something like a bullet bond, a bullet debenture, and you’re getting paid…it’s issued recently and you’re getting paid 4.5% on it. And now, rates decline a couple of hundred basis points, you’ll still get your 4.5% for the remaining term. That’s a positively convex asset, versus a negatively convex asset which is something like a mortgage, a recent vintage high coupon mortgage.

So if rates do decline a couple of hundred basis points, then a lot of these mortgages that have been booked in the past year are very likely to refinance in that event.

So, everything that doesn’t have sort of that really tight prepayment language around it is more negatively convex. In our last webinar, if you want to explore more about that was talked about in depth in our last webinar about protecting margins with convexity.

​To that point, let’s pop over to the next one and just highlight that, you know, mortgage rates are up a lot. So I wanted to take a look at what are…what’s the 30-year history of that 30-year mortgage rate?

So, if we go back all the way back to the early ‘90s, you can see that a couple of years after that, that timeframe coming out of that recession, that ‘91 recession, get into the start of sort of the dot com era.

The mid-late ‘90s, mortgage rates were as high as 9% in that timeframe.

And we’re today at about 7%.

This most recent Fed data was at 6.95% a week or two ago.38:04 And so, we haven’t seen these rates, really, since the turn of the century.

It’s been, it’s been 20 odd years since we’ve seen anything like this. And it’s been about a year that we’ve seen rates in the 6%-7% range. And so, we are building up, even though inventory, as I talked about earlier, is low, volume is relatively low, we are seeing more traction in our MPF Product.

I think that’s happening because people need liquidity and there are still folks out there buying homes.

And I think a lot of these mortgages that are coming on are probably higher risk to refi in a certain environment, if there is more of a pivot coming in the next couple quarters or next year.

And so, now as I think about balance sheet management strategies, something to really think about is how much we really want to balance sheet these kind of higher-coupon mortgages. It looks good today. But the real risk, of course, is that there is a refi boom. And all these will come right back at you. And so you’ll have this sort of inverse dynamic of straining liquidity today to put on a mortgage that doesn’t last long…a whole lot of time.

And then, when it does refinance, you get the liquidity back. So you have this kind of trap of using your liquidity to get something that will disappear the second it becomes more attractive to you.

And so, something to think about in terms of being a balance sheet manager is how much do you really want to keep of these higher-level mortgages?

And again, we have the MPF Product that allows you to sell those mortgages directly to us where we basically assume that risk and it frees up your balance sheet for extra liquidity.

​So we spent a lot of time in Section Two talking about deposits and all the things happening there, and Sean mentioned the relatively short nature of the CDs, and we had the good fortune of being able to talk to a lot of banks and credit unions across the region.

And as we go out to meetings, we talk with people. We see a lot of the same type of things — the 5% CD for five months. The odd-term specials. And all that.

So, you know, I’ll throw out what seems like an out-of-the-box idea. But maybe, as we talk through it, it doesn’t seem so out of the box.

Is the idea of rather than trying to entice customers with the shorter terms test the waters with the long term.

Now, there are a couple of things working against us there is that the retail customer doesn’t necessarily understand your process, the idea of an inverted curve about, “Well, why are you going to give me less interest the further out I go?”

So, but maybe the counter to that is we haven’t been at these levels of rates that are readily available on bank deposits in a long time. So, right, you know, when short-term rates are at zero, and long-term rates are at one, trying to entice someone to go to one. Good luck. It probably doesn’t move the needle by math or just by personality.

But the tradeoff between 5% and 4%, maybe 4%, to lock in someone who’s paying attention to the news, they hear that the pivot is coming soon and that there may be some opportunity there.

And use our advance curve to guide your pricing.

So, here you can see for the green bars, the shorter terms, I use less 50 basis points, and for the longer term, less 75 bps.

So, you know, honestly, like, I think, north of 5% inside of a year is table stakes in order to be able to bring in deposits.

But, you know, I’d ask this question, say, you know, 5% with an inverted curve for five months, how much is that doing for you beyond just simply being funding?

What is it doing for you in terms of margin, interest rate risk, or liquidity risk?

​Probably, it’s filling the gap as a defensive measure, right? The customer says, match my rate, or I’m leaving. Absolutely.

Keep that, keep them in the mix, but in terms of new money and training folks not to be so price sensitive, then maybe trying to tiptoe out the curve would be advantageous.

And if you subscribe to the theory that the funding profile informs what you can do on the asset side, well, you’re able to move out to two to three years on your CDs instead of five or six months, well, then, that affords you some ability to take a little bit more interest rate risk on the asset side, whether by loans or investments.

You know, again, I’ll throw out some numbers here that honestly surprised me when I looked at it.

That quarter over quarter, 16% of banks increased the amount of CDs is greater than three years as a percentage of their funding mix. And on the credit union side, it was 31%. So, honestly, I thought those numbers were going to be less — single digit numbers.

Especially when you consider that, there’s probably some roll down effect, right? Something with 3.1 goes to 2.8 over the course of the quarter.

So, the fact that you know, there was, it wasn’t a majority, but there were a meaningful amount of banks and credit unions who were able to move the needle a little bit.

Maybe it’s something to consider when you look at the shape of the curve and where things are at.

Putable Advances, the HLB-Option Advance in particular, if you’ve been paying attention to us, you know that this has been on the top of the stack of good ideas for the better part of a year. Probably a little more than that.

And, you know, one of the beauties of this product, other than the rate itself, provide some margin relief is that because of the customizable nature, that you can really calibrate the amount of risk that you want to take or the objective that you’re trying to accomplish here.

So I’ll throw out three examples of the approaches that members have taken that are nominally within that same advance type.

But when you look at the applications, you know, they really aren’t the same product, and we’ll get into that right now. So, here, we’ve seen a lot of folks who have been rolling short-term funding, whether it’s overnight borrowings or rolling one month and start to peel a little bit of that amount off into using some of the HLB Option and really keeping the maturities tight and really preventing some of that extension risk.

So, in the example of using a two-year final potential final maturity with a three-month lockout at 4.73% as of the other day, that took…that’s almost 90 basis points savings versus a three-month Classic, so you’re able to capture some cost benefits, but, but really keeping the potential extension risk at bay.

On the other side of the equation, if the motivation to really support margin in the current period is the primary goal, then the longer you go out on the potential final maturity, the lower you’ll be able to push the rate.

So, it’s similar to where, because we know that the potential variability of the cash flows is greater when you have a longer maturity — in the same way, you’re going to buy a 30-year mortgage-backed security, you’d expect more spread than when you go to buy a 10-year mortgage mortgage-backed security. So, in a 10-year/6-month structure you’d be able to get just about 200 basis points of savings versus the Classic bullet.

Then you want to combine some of those concepts and provide some interest rate risk and liquidity support.

Well, then we’ve seen folks extend that lockout period to get some costs and funding certainty for a period of time. Some structures like the 5-year/1-year.

Again, you can get to about 150 basis points of savings versus the one-year bullet, something that many folks are doing as well.

Then, you know, we’ve talked a lot about a potential pivot and a move in short-term rates and liquidity being at a premium right now.

So, when you talk about those two things, rate direction and liquidity risk, the things that immediately come to the top of mind are floating rate advances.

So, when you look at a nine-month Classic Advance, fixed-rate, versus a nine-month SOFR-Indexed Advance, the day-one rate is very similar — within a basis point or two.

But as you can see by this graphic, the green versus the blue, that obviously, the floating rate advance has a floating rate component that is comprising a bulk of the rate because rates are so comfortably above 5%.

So if we do see a sharp pivot and, we do see a re-pricing, then you’re going to want funding, whether deposits or wholesale, that has that down rate beta of one or very close to it, and certainly, the floating rate advance is going to give you that, and I go back to that one of Sean’s slides there and looking at that ’04-’09 experience, and the thing that really concerns me is looking at that gap along the right-hand side where Fed Funds come down considerably, and the deposit expense was going the other way other way. I mean, well, it declined a little bit, but it did not…it was elevated and did not even come close to moving one-to-one with where rates would come.

So that tells us that even if we see a pivot tomorrow, that deposit costs are probably not going to pivot right alongside with them.

So certainly, the floating rate advances are going to give you that.

On the right-hand side, the other advance in the floating rate bucket will be the Discount Note Auction Floater, the DNA Floater.

We’ve mentioned this in previous instances.

But the benefits really boil down to the three things you see there.

So if those check boxes are for you in terms of what you’re trying to do and trying to accomplish, then it’s going to be something that’s worthwhile to consider.

And, you know, I’ll make a point that even if you don’t see something in our daily rate e-mail, it doesn’t mean that it’s not available on a regular basis. So always call your relationship manager. Call the desk.

We are always available to talk through this, and if the past 45 minutes and the past ten webinars weren’t proof enough that we enjoy doing this stuff. We could talk about this for probably way more than 45 minutes. We won’t subject you to that, I promise.

But, you know, we’ll provide whatever we’re able to do for you.

So, you know, this brings us to the end. You know, we really appreciate your time and attendance.

I will say, that we have some, some really neat stuff planned out for the rest of the year. You may have seen a Save the Date for the CEO/CFO Roundtable. That’s an in-person event that’s coming in November, always something that everyone looks forward to.

We have some more articles, webinars, and case studies that Sean and I will be putting forth.

We also have some guest speakers coming on board, Voya Investment Management, next month to talk about some bond portfolio ideas. We also have some folks from Colliers International to talk about the commercial real estate trends here in New England and nationally. That’ll be coming in October.

So, hopefully, we’re providing some timely and relevant things for you.

And we continue to be there to provide all the support in whatever way, shape, or form you may need. So, thank you again. We appreciate everything, and I hope you have a great rest of your day.