Pub. 6 2018 Issue 3

Issue 3. 2018 21 Hedging the Investment Portfolio Using Symmetrical Funding Symmetrical funding can be an effective means of offsetting losses in fixed-rate investments caused by higher interest rates, or for that matter, mortgages, loans and even credit losses. As an example, as illustrated in Figure 2, consider a $653 million book value port- folio consisting of treasuries, agencies, municipal securities and mortgage-backed securities. The portfolio duration is 2.55 years. Again, the longer the duration, the more susceptibility to market value loss as a result of rising rates. Under varying parallel rate shocks, market value losses accumulate as rates rise – with deteri- oration of almost 20% in an up 300 bps scenario. This phenomenon is what has historically concerned the regulatory community in terms of available liquidity and capital. Alternatively, consider the simultaneous impact, this time on the positive side, of booking as a partial offset, $175 million in the form of laddered 2/3/4-year symmetrical funding. In an up 300 bps scenario, rising rate impact is somewhat cushioned, yielding a net market value loss of approximately 14%. While we are incrementally paying 11 bps in NIM impact in an up 300 bps scenario, we are recouping about 25% of the hit that we would otherwise take to tangible equity. Figure 2. Example Market Value Impact of Rising Rates on an Investment Portfo- lio that is Partially Funded with a Ladder of Symmetrical Term Advances vs. an Investment Portfolio without Symmetrical Term Advance Funding The analysis in Figure 2 shows that the losses in the investment portfolio continue under rising rates, leading to substantial losses on the portfolio. However, by imple- menting a laddered, symmetrical funding structure for a portion of the investment portfolio, an investor can limit the net impact of rising rates as measured by the portfolio’s net market value, and ultimately the institution’s tangible equity. Coming Out in the Wash Over the past ten years, depositories have experienced significant increases in liquidity. Much of this liquidity has been deployed in securities. Since 2008, increases in security portfolios consisted of 55% and 25% for banks and credit unions, respectively. Slackening post-crisis loan demand and significant margin compression caused many institutions to seek additional return by investing further out on the yield curve, exposing them to duration risk. Market values of funding with the symmet- rical prepayment feature offset fixed-rate security portfolio valuations. Therein lies the benefit: In a rising rate environment, the symmetrical prepayment feature can create unrealized gains on the liability side of the balance sheet that can be monetized. In re- ality, it can all (or, at least, partially) “come out in the wash.” n