Flash in the Pan - Episode 21

last updated on Tuesday, August 31, 2021 in General

Hello and thank you for joining us for another episode of “The Insider”, a monthly podcast production of the Federal Home Loan Bank of Des Moines and your source for industry news, strategies and key information about the Bank. This is your host, John Biestman, Senior Relationship Manager.

Oh, the idioms in life. We hear them so often that we seldom know what they mean or how they were derived! Consider the well-worn phrase, “flash in the pan.” The term refers to a surprising, promising and short-term success or performance that will not likely repeat. It’s a bit like when many of us that sign gym contracts and zealously diet during January and lose five pounds, only to gain five pounds a few months later. A flash in the pan.

As to the origins of the expression, muskets or flintlock guns of the early 1600’s had priming pans that served as reservoirs for gun powder. Once triggered, the resulting spark against the flint piece flashed into the pan and ignited the combustion chamber.

On to the connection with the 2021 financial markets. A new phrase, “flash recession” seems to have entered the late-summer vernacular, as described in a recent Bank of America strategy piece that forecast a Delta-variant induced slowdown to take place before the end of the year.

For months now, with rising inflation, supply chain constraints and surging consumer demand; many, including myself have been puzzled about the Fed’s reticence to deviate from its path of monetary ease.

The market didn’t seem surprised, as the world obviously changed in August with the expansion of the Delta variant in many parts of the country. Among the signs that were cited in the Bank of America forecast:

• A flattening yield curve. The spread between two-year and ten-year Treasuries has declined by approximately 40 basis points over the past 90 days.
• Deteriorating commodity prices, especially in metals and lumber.

Perhaps, these slowing barometers are related to increasing remarks from Fed officials on the imminent timing of prospective tapering of Treasury and mortgage purchases. Since tapering represents a reduction in systemic liquidity, there could be reason to believe that there is association between recent inflation increases and the sheer amount of liquidity that is in the financial system.

The long-ago established operational definition of a recession as defined by the National Bureau of Economic Research is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

On the surface, this definition is quite straightforward, either we are in a recession or we aren’t. In reality, though, we just don’t know, quite often, until after a recession has occurred! We do look for signs while we are in the middle of a recession however; an example being the act of “insourcing,” or doing something yourself that you used to pay others to do.

For instance, if you’ve insourced your dry cleaning and the loads of un-ironed shirts continue to pile up, you’re insourcing – a typical coincident indicator of a recession.

Perhaps just as important to the financial markets is the alphabet soup associated with the amplitude and period of a recession, as they would say in the physics world.

“W” represents a double dip recession, with a false expansion or “flash in the pan” in the middle. Think 1980-82 and stagflation. As far as 1980’s most popular song and the Academy Award-winning film? I’ll give you the answers at the end of the podcast.

“V” is a rapid recovery whose trajectory on the way down is the same as it is on the way up. Think ‘90-‘91 and the commercial real estate and hedge fund issues.

“U” is for a sharp recession that stays that way for a protracted period. Think ‘73-‘75.

A derivation of the “U-shaped” recession is the “L-shaped” recession. Think Japan in the mid-‘90’s, from which 20% GDP was reduced from the economy and literally took decades to replenish.

Should a flash recession scenario come to pass, never before would there have been recession (be it a “flash recession or worse) in which there has been so much liquidity infused into the financial system. In theory, any demand-induced recession (i.e. delta variant-induced or otherwise) would result in such symptoms as: rising unemployment, reduced consumer and capital expenditures, slowing business activity and declining inflation and credit tightening.

Let’s play on that last symptom, credit tightening, and how to prepare for that scenario. If credit tightens, you’re going to want to secure as much credit capacity now, before you may need it.

That brings us to the subject of optimizing your collateral position from FHLB Des Moines and getting those ducks in a row. Bankers don’t like surprises. Don’t be in the position of thinking about why a baseball keeps getting larger…and then it hits you. Prepare now, during the time when you may think that credit capacity is hardly a burning issue.

Our goal at FHLB Des Moines is really two-fold:

1. To help members pledge an amount of collateral to optimize their borrowing capacity and
2. Ensure that FHLB Des Moines can procure and liquidate eligible and marketable collateral should there ever be an event of default. Our aim on the second objective is to protect the value of the members’ invested capital in the cooperative.

As many of you on this podcast know, advance capacity is determined to be the lesser of the member’s assigned credit limit or the discounted value of pledged collateral.

That discounted value, or haircut is determined by two variables:

1. An assigned categorical loan-to-value ratio that is periodically updated and
2. An adjusted Eligibility Factor that is determined when FHLB Des Moines Collateral Review team conducts a Member Collateral Valuation review, or “MCV.” While these reviews have historically been conducted onsite, many recent MCV’s have been conducted remotely due to pandemic conditions. During an MCV, eligibility factors are determined through evaluating a member’s loan file consistency and loan underwriting documentation and eligibility. Examples of variables that are reviewed include: documented repayment ability, income and asset verification, evidence of appraisal and other valuation, lien verification and credit underwriting documentation.

We’re adding resources that can help members better understand how to optimize their advance collateral capacity, and of equal importance, how to optimize their total borrowing capacity. There are several important action steps to take:

1. Contact your Relationship Manager to conduct a collateral optimization analysis that involves screening your call report against the many collateral categories that are eligible for pledging.
2. As part of your liquidity planning process, use scenario analysis involving the potential impact of different credit and economic conditions against your projected credit and collateral availability. Remember that a primary variable to input is the amount of eligible collateral you project to have on hand, even before projecting the impact of other variables including LTV’s and eligibility factors.
3. Learn how to prepare for a Member Collateral Review and maximize your collateral eligibility factors.

Even though, our members collectively do an outstanding job at pledging only eligible loans and minimize reporting errors by attaining average eligibility from MCV reviews of around 90 percent, there’s more work to do. We want to better prepare members for pending and future Member Collateral Valuations.

So, we’ll be rolling out a long-term, comprehensive collateral training process. We’ll keep you posted on the roll-out of these upcoming virtual training opportunities. We know that eligibility rules, documentation requirements and the like can sometimes appear complex and intimidating.

We want to make the collateral pledging process easier for you and allow you to optimally access FHLB Des Moines competitive pricing, attractive dividend and advance product features.

One other important note that perhaps indicates that that the transition to the Secured Overnight Financing Rate or SOFR is not a flash in the pan. The ARRC or Alternative Rate Reference Committee recently approved the CME Group’s forward-looking SOFR benchmarks with one, three and six-month maturities.

These benchmarks are based on the CME’s SOFR future trading activity. The expectation is that the ARRC endorsement will promote increased adoption of term cash SOFR markets and spur liquidity in SOFR term markets. SOFR had not previously seen any material cash term structures. Expect larger, multi-bank and syndicated loans to adopt these term pricing structures soon.

By the way, the top song at the height of the recession in 1980 was Blondie’s “Call Me.” Best picture: “Kramer vs. Kramer.” OK. For the bonus round…1990. It was “Hold On” by Wilson Phillips and “Dances with Wolves.” I never would have gotten those. I don’t think I ever heard of or saw them. I must have slept through that recession! Like short-lived economic downturns, perhaps they were also just flashes in the pan.

Stay well and we’ll see you next time on the FHLB Des Moines Insider Podcast. Optimize your collateral and borrowing capacity. Thanks for tuning in.

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