Market Intelligence

Wholesale Funding Strategies Flourish Again
By Steve Twersky, Senior Vice President and Manager, Portfolio Strategies Group, FTN Financial Capital Markets

What a difference a year makes. In March 2007, the yield curve was inverted, sector spreads were at historical lows and the risks of wholesale leverage strategies far outweighed the rewards. It’s no wonder so many financial institutions were deleveraging. Roll forward 12 months, and the world is a far different place. It’s as if the stars have lined up for those with excess capital that want to put on earnings enhancement strategies. The key factors driving this change include:

Agency MBS spreads have moved out to their widest level in over 20 years. As Chart 1 shows, we’ve far outpaced the widening that occurred even in 2002 and 2003. Unlike in 2002 and 2003, though, when refi activity was the primary spread driver, the sharp drop in liquidity for large institutional buyers (and its impact on demand) has been the primary driver in the current widening. Because refi activity is likely to be much more subdued this cycle, these historically wide spreads offer exceptional value.

The curve has steepened sharply over the last 6 months. Chart 2 shows the spread between the 2- and 10-year treasury yield going back to early 2002. After being flat to inverted for 1.5 years, this spread has shot up to 200 basis points. While shy of the 250 spread we saw for a short time in 2003, this sharp widening, combined with the very wide spreads in MBS, provides substantial leverage spread for moderate term mismatches.

The risk reward trade-off on convertible advances is now tipped much more towards the reward side of the scale. One of the key risks with convertible advances is that rates fall and institutions end up with long-term, high-cost borrowings. This happened to a lot of institutions that took down long-term convertibles in 2000 through 2002 at costs as high as 6.5%. With most convertibles now priced well below 3%, their risk profile is very different. Given the very low levels, it’s likely they will be converted well before maturity. If they aren’t, however, it’s difficult to imagine that they would be very burdensome over the long term.

Beyond the macro issues discussed above, it is also a very opportune time for many institutions to put on a leverage strategy. Earnings are generally down and there is still time to have a very big impact on the current year. Additionally, many institutions deleveraged over the last few years and have excess capital that can be put to work.

For those looking for a starting point to consider a wholesale leverage strategy I often find a matrix like the one shown below helps. This looks at using a host of different advance structure combinations to fund 20-year Agency MBS (levels shown below are as of Friday, March 21).

Option Two of the matrix, which mixes a ladder of bullet maturities with convertibles, has been an approach many have taken. Others have used either bullets or convertibles exclusively, as is shown in Options One and Three.

Option Four is an interesting approach we have also seen used. This option is structured to be similar to the all bullet approach of Option One. Except, based on the assumption that the convertibles will likely be converted at the first opportunity, this option uses convertibles in the place of bullets for four “rungs” of the ladder, where the conversion date matches the desired bullet maturity. The risk to this approach is that the advances don’t get converted, but with an average cost of 2.53% in the four convertibles, this would seem to be very manageable.

From this point it’s important to make sure the strategy provides a good fit to the institution’s overall interest rate risk profile. All of these strategies will add some degree of risk, but they can often be structured to complement your current profile. The potential incremental impact or earnings is so great, however, that all institutions with excess capital should at least evaluate whether a strategy makes sense for them.

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