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Hedge Select Loans Protect Income, May Ease Accounting Burden

Asset liability management decisions are less difficult to make at the top or bottom of an interest rate cycle, but what about the current rate environment? Minutes from the March 20-21 meeting of the policy-setting Federal Open Market Committee (FOMC) show that, despite sluggish economic activity in recent months, core inflation remains a concern. Will the Federal Reserve begin easing rates soon, as the implied forward curve is suggesting? Or will inflation force them to raise rates yet again?

Trying to determine exactly when rates will change, and to what extent, is a high risk proposition that could prove costly to your institution if you make the wrong choice. Prudent bankers know that it's best to fund their balance sheet based on their institution’s interest rate risk profile, and not on the latest rate forecast.

The Hedge Select Loan

To protect future income streams, some banks are purchasing interest rate floors and caps as a hedge against rate moves that could negatively impact margins. At the same time, members are turning to the affordability of FHLBank advances for their liquidity needs to avoid being caught up in the recent wave of irrationally priced deposit promotions that cannibalize lower-cost core deposits.

FHLBank Pittsburgh’s Hedge Select loan enables members to combine an interest rate floor or cap with an advance borrowing that is not only cost effective, but also may offer some potential advantages with respect to accounting treatment under Statement of Financial Accounting Standards No. 133 - Accounting for Derivative Instruments and Hedging Activities (FAS133).

Hedge Select Protects Income

Depending on the composition of its balance sheet, your bank may be asset-sensitive and therefore have considerable exposure to falling interest rates. For example, if your institution has a portfolio of home equity lines of credit that reset monthly based on a rate index (such as Prime or LIBOR), the yield on that portfolio will only decrease as interest rates fall.

For banks that are asset-sensitive, an interest rate floor serves as a hedge that helps protect the bank against margin compression during falling interest rates. For example, in a declining rate environment, the downward re-pricing of time deposits may lag the more rapid reduction in yield earned on variable-rate assets, such as the home equity lines mentioned above. An Adjustable-Rate Hedge Select Loan with Embedded Floor can help to offset this lag through the accelerated reduction in the Hedge Select advance’s interest rate, which occurs once the applicable index rate falls below the established floor.

Currently, the cost for this type of option is relatively inexpensive given the overall shape of the yield curve and the historically low level of interest rate volatility. As of April 17, 2007, the indicative interest rate on a $5.0 million Adjustable-Rate Hedge Select Loan with Embedded Floor set at 4.00% on 3-Month LIBOR for 2 years equaled 3-Month LIBOR plus 21 basis points or 5.57%. On the same day, the indicative interest rate on a $5.0 million Adjustable-Rate Advance for 2 years that did not contain a floor was 3-Month LIBOR plus 7 basis points or 5.43%. As this pricing example demonstrates, in today’s market an asset-sensitive bank that is looking to hedge its net interest margin against falling interest rates over the next two years can buy a considerable amount of protection for a modest 14 basis points per annum.

Hedge Select May Ease Accounting Burden

An alternative approach to purchasing a Hedge Select Loan with Embedded Floor would be to purchase the interest rate floor outright. In order to avoid earnings volatility associated with marking to market the floor, the purchaser would likely have to comply with the extensive FAS133 hedge accounting requirements.

Alternatively, by entering into a Hedge Select Loan with Embedded Floor, which may be structured such that bifurcation of the embedded floor is not required under FAS 133, a member bank may benefit from interest rate protection without the earnings volatility. Because the determination of whether or not bifurcation of an embedded derivative is required under FAS 133 can be very complex, we strongly advise that you consult your institution’s accounting advisor to determine if the Hedge Select loan will work for you.

Other Product Options

Of course, not all banks are asset-sensitive. If your institution’s balance sheet is exposed to rising interest rates, continuing to rely heavily on short-term fixed-rate funding or traditional adjustable-rate advances, with the hope that the Federal Reserve has finished tightening rates, could prove costly if market conditions pressure the Fed into another rate hike. Liability-sensitive banks may want to consider Adjustable-Rate Hedge Select Loans with Embedded Caps to protect against further rate increases, while retaining the flexibility to take advantage of lower-cost funding should short-term rates decline.

Similar to the dynamic of the interest rate floor but in reverse, should the applicable interest rate index rise, the loan rate on the Adjustable-Rate Hedge Select Loan with Embedded Cap will never rise above the cap rate. Based on April 17, 2007 rate indications, a $10.0 million Adjustable-Rate Hedge Select Loan with Embedded Cap on 3-Month LIBOR with a cap of 5.50% for 2 years would be priced at 3-Month LIBOR plus 16 basis points versus 3-Month LIBOR plus 2 basis points for a 2-year Adjustable-Rate Advance without the cap. The affordability of options to protect against an upward shift in interest rates while retaining the ability to benefit from rate declines is again evident in this example, and liability-sensitive banks should take note. As with the Hedge Select Loan with Embedded Floor, embedding an interest rate cap in a Hedge Select loan may offer benefits with respect to accounting treatment.

Whether you believe interest rates will increase, decrease or remain unchanged for the foreseeable future, the biggest risk you face is not taking advantage of current market conditions to put in place structures that can protect your bank’s future income streams. For additional information on the Hedge Select advance, contact your FHLBank Pittsburgh Relationship Manager, or call the Member Money Desk toll-free at 800-288-3400, ext. 4000.

DISCLAIMER
The rates and other terms used in this article are for informational purposes only and subject to change at any time without notice of any kind. The information presented is not investment, business or accounting advice, nor is it an offer to extend credit or buy any security or financial product. Readers must not rely on any of this information when making any investment, business, credit or accounting decision. Any customer interested in any Hedge Select product is advised to consult with its accounting advisor.

FHLBank products are governed by various agreements between FHLBank and its customers, as well as certain FHLBank policies and applicable regulations. In the event of any inconsistencies between information contained in this article and such agreements, policies and regulations, the agreements, policies and regulations will be determinative.