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Mitigating Margin Compression: Should You Be Selling Options To Reduce Cost?

With increasing funding cost and the availability of high yielding assets in limited supply, the majority of FHLBank Pittsburgh members are experiencing margin compression. In fact, margin compression is affecting banks of all asset sizes, causing CFOs to look for ways to reduce funding cost and thereby improve margin.

In response, the marketplace is reintroducing funding products in which you can sell options to buy down the rate. This “cheapened” funding can come in the form of FHLBank’s Convertible Select product or, in the case of alternative funders, a structured repo. Some members are also looking at restructuring their current wholesale funding portfolio by again selling options to bring down funding cost.

In either case, you should conduct a complete interest rate risk analysis of these strategies – along with a review for fit against your balance sheet – to ensure that any benefit to current net interest margin will not cause any undue pressure on future net interest margin. Remember that, in all cases, the selling of options will be exercised when most advantageous to the wholesale funding lender.

Average Net Interest Margin of FHLBank Pittsburgh Bank and Thrifts
from 06/30/05 to 6/30/06

Convertible Select Advances & Structured Repos

Since 1996, FHLBank Pittsburgh has offered the Convertible Select advance product, and many members have taken down this type of funding with varying degrees of success. In its most basic form, Convertible Select is fixed-rate funding that is discounted from standard funding in exchange for giving FHLBank the option(s) to convert the advance to variable rate funding at specific dates during the life of the advance.

Another version of this product carries an initial sub-LIBOR floating rate for a certain period, then flips into a fixed-rate that acts like a standard Convertible Select advance. Once it becomes a fixed-rate advance, it can be converted to 3-month LIBOR plus a spread at the option of FHLBank.

Example: The 3-year/1-year Convertible Select Advance (Float to Multiple) would start out as a 3-month LIBOR – .50% floating rate loan for the first year. It would then convert to a rate of 5.10% for the remaining two years, during which time FHLBank can exercise its option and convert the loan to 3-month LIBOR + 18%.*

Alternative funders show this version of Convertible Select to banks in structured repo form. Instead of a final rate conversion – as in the case of Convertible Select – the funds would be converted to a rate of 5.10% at the end of the first year but are then subject to being called by the lender thereafter.

While the Convertible Select advance and the structured repo product vary slightly from each other, one thing remains constant: in a rates-up scenario, the funding will either be converted or called; in a down-rates scenario, the funds will stay outstanding at an above-market rate.

Restructuring Your Wholesale Funding Portfolio

Selling options can also help you in restructuring your wholesale funding portfolio. You may, for instance, hold wholesale funding that carries unfavorable interest rates higher than the current market rates and that, if prepaid, would incur a substantial prepayment penalty or fee. In some instances, the penalty or fee can be wrapped into the interest rate of a new structure so that no “up-front” penalty or fee is incurred and the restructured funding carries a lower interest rate. This is occasionally achieved by extending the maturity of the funding so that the penalty or fee can be spread over time.

For example, consider a Convertible Select advance taken down in 2000 that will mature in 2010. This $10,000,000 advance carries an interest rate of 6.19% and, if prepaid, would incur a fee of $447,000 (or 447 bps). This advance could be restructured by extending the maturity and spreading the 447 bps over the life of the new structure through the new interest rate of the advance.

In this example, if the old convertible structure were restructured into a new 10-year/1-year Convertible Select, the new advance rate would be 5.30%. This rate of 5.30% is still higher than a rate on a new Convertible Select advance of 4.43%, but it is still lower than the 6.19% rate that was associated with your old advance.

A word of caution: Restructuring does not work for all advances! Some advances contain large prepayment penalties or fees that cannot be effectively embedded into the rate of a new structure. Structures that have long remaining terms to maturity normally don’t produce any benefit since there is no room for maturity extension. Also, please remember: in the case of restructuring Convertible Select advances, lengthening the maturity also adds additional optionality, meaning you are giving FHLBank more chances to convert your loan at times that are advantageous for FHLBank to do so.

Short-term Benefit

What these strategies provide you is short-term benefit. To reduce rate on new or existing wholesale funding structures, you must sell additional options to either the FHLBank or a repo broker/dealer. You may reduce funding cost in the near term, but these structures will become more costly to you in the future. Again, if rates rise, these structures will be converted or called and you will have to refund your balance sheet in a higher interest rate environment. If rates fall, you will be locked into funding with higher than market interest rates. As you may know from experience, short-term fixes may work against your ability to execute your long-term business goals.

Other Options

Before looking into these cost-reducing strategies, you may want to consider other options. You may want to review pricing on deposits to make sure you’re not overpaying for this source of funds (see Partnership Makes Sense in Current Mortgage Environment). You may also want to consider restructuring your assets along with your liabilities to reposition your bank to perform better in the future. If you still have the need to execute any of the cost reduction strategies, you may want to do it in a limited fashion – even FHLBank Pittsburgh places limits on the amount of Convertible Select advance balances any one member can hold.

We at FHLBank Pittsburgh are committed to working with you, our members, to ensure your long-term strength in the marketplace. Contact the Member Money Desk at 1-800-288-3400 or consult with your Relationship Manager to discuss the strategy best for you.

* Rates shown are samples. As with other Convertible Select loans, the member has the option to repay the loan without fee during the conversion period if the funding is converted to 3-month LIBOR plus a spread.

NOTES

The shift from -400 to +400 basis points represents a parallel shift in the interest rate swap curve. Negative numbers represent prepayment penalty indications to the member and that the loan will most likely not be converted, based on market conditions set forth, on its next possible conversion date. Positive values indicate that the loan will most likely be converted, based on market conditions set forth, on its next possible conversion date. However, conversion of such loan is determined by several market conditions including, but not limited to, the overall level of interest rates, interest rate volatility and steepness of the yield curve. For Convertible loans including strike rates, the relationship between the strike rate and the index rate is the sole variable that effects the chance of conversion. Given the loan contract, no payment to member banks would occur when the market value is positive.

DISCLAIMER

FHLBank Pittsburgh has taken reasonable steps to compile the data presented in this article, or has obtained such data from generally available public sources; FHLBank makes no representations or warranties, express or implied, and assumes no responsibility or liability, as to the accuracy and completeness of any such data. The values presented in this article are indications only; the actual amounts may vary. This material is not an offer to sell or buy any security or financial product, and the information in these materials is subject to change. The information set forth is provided for discussion and informational purposes only by FHLBank. FHLBank reserves the right to revise or change the data presented in this article at any time without a direct or inferred obligation to notify any person of such revisions or changes. All terms are subject to change without notice. Any member who engages in any transaction described in this material will be required to execute a written agreement with FHLBank that will govern the terms and conditions of that transaction. It is the member's sole responsibility to review any such agreement prior to signing it. In the event of any inconsistencies between this information and any such agreement, the agreement shall be determinative.