Pub. 6 2018 Issue 1

www.uba.org 8 H ave you asked yourself: “Is loan competition rampant in my market”? “Is my Return on Equity (ROE) threat- ened?” “How can I gain more fee income?” “Are there funding alternatives I can offer to my customers who are look- ing to finance: housing developments, multi-family structures, healthcare facilities, job-producing commercial facilities and/or schools?” The Variable Rate Demand Note Funding Alternative If you’ve answered ‘yes’ to any of above questions, ask yourself one more: “Have you heard of the variable rate demand note (“VRDN”) market?” The $125 billion VRDN market has been in existence for over 30 years. VRDN paper is a frequent invest- ment used by money market and cash funds that require viable ‘AAA’ ratings. Rates re-set on a regular basis, typically weekly – based upon their continued remarketing capability. VRDN’s have historically traded closely with such money market indices as the 30-day Libor index. They can be structured on either a taxable or a tax-free basis. VRDN structures feature direct-pay letters of credit (LOC) issued by banks in favor of bondholders, confirming letters of credit issued by a Federal Home Loan Bank, and a re-marketing agent that ensures that the bonds are continually placed with an investor. Like any bond structure, upon origination, VRDNs require bank and bond counsel, a bond trustee and affirmation by a rating agency. Purposes typi- cally encompass construction, acquisition and/or permanent fi- nancing. The VRDN structure offers flexible terms to a borrow- er, including: customized amortization, optional prepayment of principal and call/redemption provisions on short notice. As illustrated in Figure 1, under a VRDN structure, a borrower or project (taxable or tax-free) obtains funds from bondhold- ers. Because the bondholder lacks the ability to underwrite the credit capacity of the borrower, the structure requires outside backing in order to procure a ‘AAA’ rating. How is this rating achieved? A bank that is a member of Federal Home Loan Bank of Des Moines (FHLB Des Moines) issues a direct-pay letter of credit in favor of the bondholders, based on the member bank’s own underwriting of the borrower’s/project’s credit viability. In order to procure the strong rating, FHLB Des Moines confirms the letter of credit issued by its member. The Role of FHLB Des Moines Confirming LOC in the VRDN Structure FHLB Des Moines has historically issued letters of credit on behalf of its member institutions in order to enhance the financing of residential or community lending-related projects. Figure 1. Variable Rate Demand Note Transaction Flow Confirming LOC’s typically cover taxable non-housing trans- actions, or taxable as well as tax-free housing related bond issues. In terms of evaluating a project or borrower, the member bank issuing the direct pay letter of credit would underwrite the obligation in much the same manner as a direct loan. From the perspective of the bondholder, the ‘AAA/AA+’ rating of FHLB Des Moines as the confirming LOC pro- vider behind the member bank’s direct-pay letter of credit, represents the ultimate source of repayment of principal and interest. In obtaining a confirming LOC, an FHLB Des Moines member bank would absorb capacity against its credit and collateral capacity. However, no activity stock purchases in the FHLB Des Moines would be required. Advantages of the VRDN/LOC Structure: There are multiple advantages to borrowers, as well as banks in funding projects with a VRDN/LOC structure. To the bank, there is an opportunity to issue direct-pay letters of credit that can represent off-balance-sheet sources of fee income. Without an FHLB Des Moines confirming letter of credit, there would be limited ability to issue directly. Also, to the extent that the size of a bank falls within allowable regu- latory limits, the letter of credit (treated on the balance sheet as a contingent liability, unless drawn upon), could result in favorable capital risk weighing treatment versus making a direct loan. Under the right circumstances, the all-in struc- Variable Rate Demand Notes and Letters of Credit: A Unique Way for Banks to Generate Fee Income and Superior Returns