Pub. 6 2018 Issue 1

Issue 1. 2018 9 Feature Direct Loan VRDN/LOCTransaction Equity Required 10.0% 5.0% Cash Required 100.0% 0.0% Liquidity Required 100.0% 0.0% Fee Income None Yes Figure 4 compares a borrower’s all-in funding cost using a VRDN/LOC structure versus a direct loan. Both scenarios assume a funding base of 1.50 percent, approximating a Libor indication. The VRDN/LOC alternative would also include estimates to cover FHLB Des Moines LOC, remarketing and trustee fees. Closing costs of a VRDN/LOC structure would log- ically exceed that of a direct loan and would include legal, issuance and bank origination fees. Differences between closing costs of direct loans and all-in LOC transactions could be further qualified in consultation with transaction intermediaries. Several factors have historically supported the success- ful re-marketing of VRDN’s, mainly continued strong demand by money market funds for highly-rated credits backed by FHLB Des Moines. In the unlikely event of a failed remarketing of an FHLB Des Moines-backed VRDN, the member bank LOC could be drawn, converting the contingent liability to an on-balance sheet asset. In this event, a pre-set drawn interest rate is typically set above where the LOC-issuing bank would be making conventional loans at the time. A Competitive Funding Advantage A combination of the Variable Rate Demand Note/ Confirming Letter of Credit funding structure holds multiple advantages. Banks can issue letters of credit and derive fee income that they otherwise couldn’t achieve without the confirmation of FHLB Des Moines. In turn, banks are able to offer their customers a competitive funding rate and unique structure, versus simply providing commodity loan pricing. n Figure 2. Bank Perspective: Direct Loan Features vs. VRDN Direct Pay LOC Features Figure 3 demonstrates a representative comparison between the risk-adjusted return on a transaction’s equity to a bank using a VRDN/LOC structure versus a direct loan. Assumptions call for a borrower subject to a loan spread of 3.00 percent. Yet, under a VRDN/LOC scenario, the borrower would be assessed a direct-pay letter of credit fee of 2.00 percent. Why the difference? Favorable capital risk weighting treatment that could be accorded to the bank. Under this example, the ROE achieved on a VRDN/LOC transaction clearly exceeds that of making a direct loan. ture can result in superior returns on equity. Furthermore, banks can offer a unique funding alternative that can help retain and grow business relationships. Customers of banks also can benefit from the structure. Through using their bank’s membership with FHLB Des Moines, the ‘AAA/ AA+’ rating on the notes may filter down to a lower all-in funding rate versus obtaining a direct loan. Figure 2 highlights a comparison of a bank lending directly, versus issuing a direct pay letter of credit in a VRDN transaction. In the latter case, subject to regulatory treatment; because of the contingent, undrawn liability status, equity required on the direct-pay letter of credit could require one-half the amount of equity required on a direct loan. Because funding would be drawn from bondholders, no liquidity would be required. Feature Direct Loan VRDN/LOCTransaction Spread 3.00% 2.00% Spread Income $300,000 $200,000 Equity Requirement (10%-5%) $1,000,000 $500,000 ROE 30.00% 40.00% After-Tax ROE (35% Rate) 19.50% 26.00% Advantages DirectLoan VRDN/LOC- Transaction Spread 3.00% 2.00% Bond Rate (appx. Fed Funds) 1.500% 1.500% FHLB Confirmation n/a 0.115% Remarketing Fee n/a 0.125% All-In Rate 4.500% 3.765% Figure 4. Hypothetical Comparison of Borrower Funding Cost – Direct Loan vs. All-In Cost of VRDN/LOC transaction Figure 3. Risk-Adjusted ROE to a Bank on a Hypothetical $10 million VRDN Di- rect-Pay Letter of Credit vs. a Direct Loan