November 29, 2012

What goes up must come down: Managing Interest-Rate Risk with the new Fixed-Rate with Cap

  • Potential Benefits of the Fixed-Rate with Cap:
  • Helps provide protection against rising interest rates (lowers a member’s cost of funds as rates rise)
  • Flexible medium- to long-term funding option best used to extend liabilities, potentially enhance spreads, and preserve margins
  • Helps achieve operational ease — has the benefits of an interest rate cap and may potentially be accounted for without the issues associated with stand-alone derivatives. Members are advised to consult with their accountant in order to confirm the appropriate accounting treatment.

On October 15, 2012, the FHLBNY  introduced a new advance product called the Fixed-Rate Advance with a LIBOR Cap (Fixed-Rate with Cap). This new product is a hybrid funding option that combines a fixed-rate borrowing with an embedded interest-rate cap that is tied to the 3-Month LIBOR rate, with maturities from 1 to 10 years.

Fixed-Rate with Cap

The advance rate would remain fixed, but may be reduced quarterly if 3-Month LIBOR rises above an agreed upon strike threshold (cap). Rates will adjust depending on the number of basis points 3-Month LIBOR is above the cap, either on a one-to-one basis (1×) or by a basis point for every two basis points (0.5×) the index is over the cap with a “floor” of zero percent. As rates rise and assets extend, the rate on the Fixed-Rate with Cap will decline, lowering the member’s cost of funds. If 3-Month LIBOR falls back below the strike threshold on a reset date, the advance would return to its original fixed rate.

Interest-Rate Risk Management – A Historical Perspective

The U.S. economy of late 1970s and early 1980s was impacted by significant inflation and unemployment, volatile interest rates, inverted yield curves, and the phase-out of Regulation Q1 — all contributing to a high level of “underwater” assets held at financial institutions.

Treasury Yield Curve - Historical Perspective

Looking at the yield curve from 1981, short-term rates skyrocketed causing an inverted yield curve. Institutions that were funding their long-term assets with short-term funding found themselves paying substantially higher rates to their depositors than they were receiving on their long-term assets. As a result, several institutions were driven toward insolvency, incurring large losses and depleting capital levels.

Over the past 30 years there has been an evolution in regulation, with an amplified focus on interest-rate risk management. Asset liability management processes have evolved significantly, requiring a more detailed and complex examination of the balance sheet and its attributes.

Responding to the times, institutions would come to rely on medium- and long-term wholesale funding as instruments to manage duration gap and to preserve spread. Additionally, reliance on derivative instruments (interest rate swaps, caps, and floors) increased significantly to more closely “match-fund” asset classes without inflating the balance sheet. However, the introduction of FASB 133 in the late 1990s made the use of derivatives more complex, requiring institutions to adhere to very specific accounting standards throughout the life of the instrument, or risk being required to mark-to-market their derivative, which could lead to earnings volatility.

1 Regulation Q, which imposed interest rate ceilings on deposits, was phased out over a period of six years, from 1981 to 1986.

Today’s Rate Environment

As the current interest rate cycle progresses, the yield curve continues to flatten with some benchmark rates reaching surprisingly low levels. Due to the Fed’s monetary policy, combined with uncertainty surrounding the European debt crisis, long-term Treasuries have continued to drift down to new lows, and the mortgage markets have followed. Mortgage rates are now at record lows with traditional 15-year and 30-year fixed-rate mortgages hovering at 2.75% and 3.50%, respectively.

Some members have looked to reduce interest-rate risk by selling their long-term fixed-rate mortgage production to the FHLBNY’s Mortgage Partnership Finance® (MPF®) Program. Pressure on net interest margins and lower yields on alternative investment options incent others to portfolio a portion of their fixed-rate mortgage production, while addressing and managing interest-rate risk using the FHLBNY’s medium- and long-term advances. Now members will be able to hedge their loan production in yet another way…

The Fixed-Rate with Cap can be an effective tool to mitigate interest-rate risk in a rising rate environment. By locking in a minimum spread and reducing a member’s cost of funds as 3-Month LIBOR rises above the embedded cap, the Fixed-Rate with Cap can assist liability-sensitive members with addressing funding mismatches associated with holding long-term assets.Fixed-Rate with Cap 1x Multiplpier

Let’s take a look at example of a hypothetical 5-year Fixed-Rate with Cap, with a cap of 1.75% and 1× multiplier, and an initial rate of 1.30% (11 basis points above the 5-year Fixed-Rate Advance, as of 9/19/12).

A rising rate environment was incorporated in this example where 3-Month LIBOR steadily rises and breaches the cap in the third quarter of year three. The Fixed-Rate with Cap would remain at 1.30% throughout the first two years of this scenario, beginning to re-price downward in the third quarter of year three as 3-Month LIBOR rises above the 1.75% cap. Following the example, by the end of year five 3-Month LIBOR reaches 4.41% and the advance rate is floored at zero percent. If 3-Month LIBOR never breaks through the cap the advance rate would remain at 1.30%. If 3-Month LIBOR declined back below the cap on a reset date, the advance rate would return to its initial rate.

In this example, the Fixed-Rate with Cap would lower the member’s cost of funds on this advance, offsetting increases in interest expense experienced across their interest-bearing deposit base or other wholesale borrowing categories.

If you would like to learn more about this new product offering and its possible effectiveness for your institution, contact a Calling Officer at (212) 441-6700. The FHLBNY is always looking for new ways to meet the needs of its members and we look forward to hearing from you.