Generating More Yield, Safely

FHLBank advances can provide a low-risk funding option for more profitable fixed-rate mortgage lending

By David Fisher

Finding quality investments is certainly challenging for community banks. As the Federal Reserve works to stimulate the economy through its quantitative easing initiative, investment spreads have compressed to historic lows. In the current low-interest-rate environment, institutional portfolio managers are forced to either stay short—and hope for wider spreads and higher yields—or extend out on the yield curve to lock in slightly higher yields for what may be a very long time.

Meanwhile, loan growth for many community banks has been fairly sluggish relative to the high volume of liquidity flowing onto their balance sheets.

One of the bright spots in this environment has been the residential mortgage market. Mortgage volumes have been strong for several years, helping community banks to significantly improve their earnings by selling their loans into the secondary market. Recently, however, spreads between the primary and secondary mortgage markets have widened significantly, making it attractive for institutions to hold mortgages on their balance sheet.

Recent trends associated with increased guarantee fees and other price adjustments imposed by Fannie Mae and Freddie Mac have resulted in increasingly wider interest-rate spreads between the two markets, which makes holding the primary mortgages much more profitable than buying mortgage-backed securities.

Striking a balance

How can community banks earn this additional spread income without taking too much interest rate risk? Perhaps an example of how a Federal Home Loan Bank (FHLBank) manages its mortgage loan portfolio will demonstrate that it is possible for community banks to earn spread income without taking undue risk.

Several of the regional FHLBanks offer mortgage programs that purchase 15- and 30-year fixed-rate mortgages from their members. These mortgages are held on the FHLBanks’ balance sheets, where the assets are funded with the objective of receiving an appropriate spread over the life of the loans. The FHLBank Topeka uses a blend of fixed and callable debt to help manage the funding in a variety of interest-rate environments.

A key advantage of using callable funding is the ability to call or refinance the funding in a falling interest-rate environment, which allows the FHLBank Topeka to match the loan cash flow and manage spread as interest rates fall. The longer maturities of the fixed and callable debt also provide valuable fixed-rate funding as interest rates rise.

In this example, the loans are profitably funded if either rates increase 400 basis points or if rates fall another 100 basis points.

In a similar fashion, through the use of term and callable advances, community banks can profitably place their residential mortgage loans in portfolio, while also protecting against future interest-rate changes. Advances are widely used for short-term liquidity, but there is a unique opportunity today to use advances to grow loans without taking undue risks.

Strategy Summary

Tables I and II illustrate a strategy that can be used to fund 15-year fixed-rate mortgages. Similar to the strategy employed by the FHLBank Topeka, the funding is a mix of fixed and callable advances that provides the flexibility to manage the loan cash flow in both rising and falling interest-rate environments. The weighted average cost of the advances is 1.23 percent. With the loans yielding 3.15 percent, the initial base case spread on the transaction is 1.92 percent.

The transaction is well matched with a net duration of approximately one year or less in all modeled interest-rate scenarios. The callable funding can be unwound as mortgage prepayments increase in the falling interest-rate environment. In addition, the longer-term funding locks in the funding cost in the base and rising interest rate scenarios.

While gains on the sale of mortgages have enhanced earnings over the past several years, the spread generated by holding mortgages allows community financial institutions to essentially break even in the first year as well as generate earnings in future years. At press time, the gain on the sale of a 15-year fixed-rate mortgage with a 3.15 percent note rate was approximately 1.25 percent.

Tables III and IV illustrate the spread and income being generated in different interest-rate scenarios over a five-year period. The projections assume all asset cash flow and funding shortages receive a Fed funds equivalent yield or cost.

Income and Spread Summary

The assets and liabilities are closely matched in all interest-rate scenarios, the average spread over five years in all scenarios is 1.21 percent. A significant advantage to holding the mortgages is the spread income generated in future years, which can help offset possible reductions in income that will likely occur as loan volume slows and the gains on the sale of mortgages decline.

Community banks have the ability to implement this type of strategy based on their loan growth needs and profitability objectives. Advances can typically be accessed in smaller amounts, or combined with other advance funding to reach size minimums. This flexibility allows community banks to build a portfolio of loans that is appropriate for their balance sheet size and mix.

Before taking any investment steps, community banks should contact their regional FHLBank about their mortgage funding options available through the offered advance programs.

The credit quality of the mortgages sold into the FHLBank Topeka’s mortgage program has been very strong with average annual losses ranging from one to four basis points. Low credit losses combined with relatively high spreads make residential mortgages one of the best assets community financial institutions can put on their balance sheets. Combining FHLBank members’ strong underwriting with the funding flexibility of advances can help grow sustainable earnings and improve the growth and profitability of your community bank.

David Fisher is executive senior vice president and chief operating officer for the Federal Home Loan Bank Topeka.

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