Prepayment Option Adds Value to FHLBank Loans
On September 28, FHLBank Pittsburgh announced it is extending the “symmetrical prepayment option” to Fixed-rate, Mid-term Repo loans (traditionally called “advances”). This enhancement adds significant value to member financial institutions borrowing wholesale funding from FHLBank.
“We continuously review and update our credit products to make sure they offer maximum value to our members,” said Craig Jordan, FHLBank Pittsburgh’s Director of Member Services. “Our Mid-Term Repo loan is already a cost effective alternative to wholesale funding, such as repurchase agreements, and the addition of the symmetrical prepayment option makes it even more competitive.”
Symmetrical Prepayment Option Creates Potential for Positive Gains
Already available on Hedge Select loan products, as well as the Prepayment Linked Loan, the symmetrical prepayment option essentially allows borrowers to realize a positive gain of up to 10% of the loan amount should a shift in interest rates result in an increase in the loan’s market value. The same type of prepayment option can now be included on new Fixed-rate, Mid-term Repo loans with terms ranging from six months to three years that have initial principal amounts totalling $5M or greater (i.e. loans for which, under current funding guidelines, FHLBank Pittsburgh enters into an offsetting hedge).
The current limit on the positive gain that can be realized – up to 10% of the loan amount at the time of prepayment – offers a surprising amount of potential upside given historic levels of interest rate volatility. For example, assume that an FHLBank Pittsburgh member decides to enter into a $5M Fixed-rate, Mid-term Repo loan for two years and elects the symmetrical prepayment option. Furthermore, assume that the funding date for this loan is 10/22/07, the maturity date is 10/22/09, interest payments are due quarterly at an annualized fixed rate of 4.46% (actual/360 day count), and the outstanding principal is due in full at maturity. (These are standard conventions for FHLBank Pittsburgh Fixed-rate, Mid-term Repo loans.)
A Yield Curve Hypothetical
What would happen to the market value of the above loan if, six months after the funding date, the Yield Curve returned to a steeper, more “normal” shape, and therefore the interest rate for a loan that is comparable to the 18-month remaining term rose? The chart below contains data on the amount of the gain realized from the increase in market value, which would result from 25 basis point increases in the interest rate on a comparable loan. The value of the gain is reported in both dollars and as a percentage of the outstanding principal at the time of prepayment (4/22/08), net of accrued interest due on the loan.
*Net of accrued interest due on the loan at the time of prepayment
As the above chart illustrates, even if market interest rates climb a full 300 basis points at the time of prepayment, the gain realized on the increase in market value of this loan is less than one-half of the option’s limitation of 10% of the principal amount. In fact, based on the above assumptions, the interest rate on a comparable 18-month FHLBank loan as of 4/22/08 would have to increase by more than 724 basis points if the gain on prepayment were to exceed the 10% limitation. So unless there is an extreme rise in interest rates, the 10% limitation is not particularly significant as the borrower would be able to realize all of the gain. A borrower can also initiate prepayments at any time before the 10% limit is reached over the life of the loan.
Of course, some financial institutions would find it beneficial to hold onto intermediate-term, fixed-rate funding if its nominal interest cost was below the current market rate. Nevertheless, if a change in market conditions or operating strategy during this six-month period resulted in a shift in the borrower’s overall mix of assets or liabilities, prepaying the loan and realizing the gain could prove to be the more appropriate decision.
Please note that an addendum to the Open RepoPlus, RepoPlus, and Mid-term Repo Master Application must be executed for each Mid-term Repo loan that includes the symmetrical prepayment option. Furthermore, FHLBank Pittsburgh members should consult with their own financial, tax and legal advisors and regulators regarding treatment of this option. Finally, because it is a pilot program, the offering of this prepayment option will be reviewed periodically and may be changed or discontinued at some future date without notice.
Feel free to call the Member Money Desk at 1-800-288-3400 x4000 or your relationship manager with any questions regarding this new loan feature.
The FHLBank Pittsburgh has taken reasonable steps to compile the data presented in this article. FHLBank Pittsburgh makes no representations or warranties, express or implied, as to the accuracy, completeness and timeliness of any assumptions or any other data presented in the article.
The information presented in the article is not investment or business 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 or credit decision.
FHLBank Pittsburgh products are governed by various agreements between FHLBank Pittsburgh and its customers, as well as certain FHLBank Pittsburgh 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.