Pub. 6 2018 Issue 3

www.uba.org 20 We’ve been here before. Five years have passed since the 2013 “taper tantrum” that was precipitated by the Federal Reserve’s mere mention of the wind-down of the central bank’s long-time asset purchase program. Back then, the fixed income markets unraveled, investment portfolio market values diminished and members of the regulatory community challenged institutions to support increased capital levels as a result of deteriorating investment values. Today, while no one can be certain of the direction of rates, the short-end of the yield curve is under the influence of well-tele- graphed Fed tightening. Coincidentally, although the yield curve has been relatively flat, public debt levels have expanded non-linearly in recent years, causing concern for rising rates in the longer-end of the yield curve. As market values erode on the left-hand side of the balance sheet, the logical question becomes: “Can the right-hand side of the balance sheet create offsetting gains in value?” With some help on the funding side, the answer can be “yes.” A Funding Counterweight to Declining Portfolio Market Value Although investments that are classified as “Available for Sale” or “Held to Maturity” need not immediately have their market values flow directly to net income, their intrinsic values will rise and fall based on interest rate levels. The same phenome- non should hold true for liabilities. However, the asymmetrical properties of many funding sources prevent intrinsic value from being exercisable when rates rise. In theory, a debt issuer should be in the position of prepaying funding and gaining a credit for the debt’s intrinsic value if prevailing interest rates are material- ly above the rate at which the debt was originally issued. What prevents the exercise of intrinsic value of funding is often found in the contractual terms of the funding instrument. Many sourc- es of term funding, (e.g. brokered CD’s and “asymmetrical” term advances) do not enable issuers to exercise intrinsic value prior to maturity in the form of a credit at the time of prepay- ment. Enter the concept of symmetrical funding. Symmetrical Funding Symmetrical funding structures, as exemplified by the Federal Home Loan Bank of Des Moines symmetrical advance, can create a gain in the event it is prepaid in an interest rate environ- ment that is higher than what had existed when the advance was originated, via terminating the funding prior to maturity. To monetize the value, the borrower would simply need to prepay the funding prior to its maturity. Figure 1 shows the lost value, or opportunity loss associated with the difference between an asymmetrical and a symmetrical advance, using the example of a five-year funding under a rising rate environment. For example, under a rate rise of 200 bps, a $1 million notional advance would represent a $77,358 credit vs. an asymmetrical advance that would not carry a credit at all. With a symmetrical feature, the borrower could simply pre-pay the advance and have their DDA credited for the $77,358 of intrinsic value. Conversely, if interest rates were to decline, a borrower, if they elected to prepay, would do so irrespective of the sym- metrical prepayment feature being in place. However, if interest rates were to rise, a credit could be applied to a funding with a symmetrical prepayment feature, allowing a borrower to repay the advance at an amount below the outstanding par value. Figure 1. Example of the Prepayment Credit and Fee Impact on Advances With and Without the Symmetrical Feature RISING RATES? DEFEND YOUR PORTFOLIO’S MARKET VALUE WITH SYMMETRICAL FUNDING John Biestman, Federal Home Loan Bank of Des Moines