Seeking Alfa - Episode 26
last updated on Tuesday, March 1, 2022 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.
Last week, I spoke with my son, an aspiring first-time homebuyer with a small dilemma. After over a year of searching and 23 failed offers for a new home in the Denver area, he and his family won a builder’s “lottery,” selected their site, wooden floors and countertops. Thinking that their luck had changed, along came a quandary that had not been considered until now – rising mortgage rates. Adding insult to injury, the S&P CoreLogic Case-Shiller Home Price Index rose 18.8% in 2021. That was the largest rate of increase in 34 years.
Assuming that the permit process and the availability of labor and materials is predictable (assume away!), his family is assuming that they will be able to move into their yet-to-be built home by the December holidays. On the interest rate front, their builder offered them an extended rate lock program with multiple combinations and permutations. The rate on the extended lock was dependent upon whether the borrower would have the option to re-lock or float-down the rate before closing. Other variables included: the amount of required upfront money for the cost of the lock, whether the upfront money would be refunded at close. So, an extended lock with an upfront fee that was refundable at loan closing would bear a higher loan coupon; whereas a higher upfront fee that was not refundable would bear the lowest loan coupon. In any event, we spent three hours on the phone with the present value functions of our calculators in overdrive, tossing around multiple assumptions on rate outcomes and expected length of ownership of the new home.
With interest rates on the rise just as planned capital expenditures (be they homes that are being constructed or industrial buildings that have just been permitted) are coming off the drawing board, many financial institutions are thinking about how they can design and price products that can enable their customers to hedge their future interest coverage against the growing possibility of rising interest rates. A foundational funding source for this sort of hedging strategy is a forward-starting advance structure. A forward-starting advance allows a member to, particularly in a rising rate environment, lock in a rate now for an advance that would settle on a pre-determined future date. Consider a situation similar to my son’s in which a member wishes to fund a loan with a forward start feature. Whether you’re considering single family mortgage customers that are looking for a loan with a future starting date or a commercial customer that is in search of a mini-perm loan, take a look at current forward starting rate levels.
As an example, presently, the spread between “regular settle” and one-year forward settle advance rates is negligible, particularly with longer nominal maturity dates. As of the date of this podcast the non-dividend-adjusted rate on 20-year advances was 3.15%, while those with a one-year forward started were quoted at 3.14%. That’s slightly lower than the regular settle advance rate!
There may be other reasons to consider forward-starting funding structures while portions of the yield curve remain relatively flat. If your institution sees an environment in which economic activity continues to accelerate as rates rise, locking in funding for future settlement would parallel such a view. Also, we know that deposits remain prolific, and continue to fund long-term assets. Should deposit betas increase and rates increase, margin pressure could ensue and could warrant a balance sheet hedge against rising deposit costs in the form of locked-in rates that can be procured from a forward-starting advance. Check on current forward starting advance levels with your Relationship Manager. We’ll help you compare rates with those of regular maturities as well as with implied forward yield curve rates.
Evidence continues to point to a consumer whose higher wages, full employment and deployment of savings accumulated during the pandemic. Consumer continue to spend in spite of inflation numbers that are breaking 40-year heat records. You’ve heard the headline inflation figures, so I won’t bore you. However, one of my favorite recent real-life examples comes from the car world. Recent data from Edmunds Automotive pointed out that 82% of new car purchases were made above MSRP during January; in fact, on average $728 above MSRP. Last January, only 3% of cars were purchased above MSRP. So much for haggling. To add insult to injury, in addition to a perpetuating semiconductor shortage, remember that Russia is the world’s largest producers of palladium, a key component for catalytic converters. So, for this podcast’s trivia question with the answer to be revealed at the end, “which brand of car continued to sell at the largest discount below MSRP, even in today’s trying times?”
So, as we approach the Ides of March, we’ll soon see how measured the Fed’s next change in the targeted funds rate will be. The CME Fed Watch tool now projects a 59% probability of a 25-basis point rate hike and a 41% chance of a 50-basis point hike. One month ago, the projection of a 25-basis point hike stood at 89%. Perhaps the ratcheting up in forecasts may be ascribed to strong retail sales, not-so-measured remarks on the part of some Fed officials regarding inflation, the prospect of additional global supply chain disruptions and increased demand that could take place if COVID numbers continue to improve. Oh, and our weekly tracking of the size of the Fed’s balance sheet still shows that it’s stuck in neutral at $8.9 trillion. We’re waiting for a reading that shows a decline for a further sign that action speaks louder than words.
As financial markets justifiably remain on inflation watch, we wrote an article in the February edition of the Washington Bankers Association’s “Issues and Answers” on the subject of inflation’s so-called break-even level. That level, published daily by the Federal Reserve Bank of St. Louis still sits slightly above 2.80% percent in the five-year sector. This break-even level is essentially a market rate proxy for inflation expectations. It’s the difference in rate between Treasury Inflation-Protected Bonds or “TIPS” and their counterpart Treasury yields. This 2.80% break-even level can be translated into the market’s projection that an investor would be better off owning inflation-adjusted TIPS than standard five-year Treasuries should inflation be higher than the break-even rate over that five-year period.
So, with the market expecting inflation to approach 3% over the next few years, it’s worthwhile to compare break-even inflation levels with corresponding levels of funding. As an example, dividend-adjusted five-year advance rates are currently posted in the vicinity of 2%. One interpretation: funding levels remain priced through inflationary expectations by almost one percent, implying the ability to borrow at negative real interest rates. As you continue to measure and monitor the prospective impact of inflation on your net interest margin and market value of equity, it may be a good idea to regularly include the break-even inflation level in your ALCO meeting packages.
Now that cocktail parties are few and far between and no longer present a viable venue for impressing others with new acronyms, I admit having been slow to learn about the NFT phenomenon, but it’s never too late. Non-Fungible Tokens are really nothing more than data units that are stored on a blockchain. They are one-of-a kind assets that exist in the digital world. Blockchains, of course, are registries that guarantee that a digital asset is incontrovertibly unique. After being registered and authenticated on a blockchain, these digital assets can be traded and owned just as any physical asset. NFT’s have gained recent notoriety through completed transactions of “unique,” original first-edition digital art in the millions of dollars. We’ll leave alone the question of the inherent value of first-edition paintings and books, let alone digital art for another day and sort out the potential role of financial institutions in this new, dare I call it, trading mania.
NFT’s and their “wallets” or exchanges should be on your radar, as there are goods that are being transacted, albeit in the digital world as opposed to the physical world. Some larger international banks are already providing services on behalf of the exchange of digital assets through such services as trading or custody. Who knows? Perhaps digital assets will be used as collateral or count as exchangeable assets when applying for credit in much the same manner as a book or painting collection. Remember that value is in the eyes of the beholder and is represented by a price at which buyers and sellers execute a transaction. More so, if there is a liquid market for any such unique asset. As risk managers, however, we’ll be on alert for such real-world threats as security, money laundering, privacy and the like. NFT’s. Tulip bulbs? South Seas bubble? Next opportunity for fee income? Either way, keep them on your radar.
Back on earth and addressing my earlier question of which car type had the distinction of recording the lowest average transaction price below MSRP for the month of January. Drum roll: The Alfa Romeo at $3,421 below.
So, aside from seeking an Alfa, other take-aways from this month’s podcast: Look for pockets of the yield curve that offer interesting prospects for forward-starting opportunities to lock in a rate today. As an example, one-year locks for longer nominal maturities have been trading on top of identical maturities without a lock. Contact your Relationship Manager to further explore this funding option. Watch the relationship between available funding levels and the market’s expectations for inflation. Finally, monitor the NFT phenomenon. Whether or not there will be future opportunities to seize upon, it’s entertaining and could be useful in the event cocktail parties are ever resurrected!
Join us in April and May for the return of our Regional Member Meetings (RMMs) in six locations around our district! These engaging and interactive meetings will provide you with actionable balance sheet management steps and tools to maximize your FHLB Des Moines membership.
Stay well and we’ll see you next time on the FHLB Des Moines Insider Podcast. Thanks for tuning in.
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