Mortgage lenders with strong deposit bases may not face many challenges funding mortgage production, but those that hold long-term loans in portfolio still face interest-rate risk. Given the historically low interest-rate environment and recent volatility in the markets, now may be a good time to lock in an interest rate for term funding. How can a lender that’s flush with retail deposits balance its liquidity and interest-rate risk management needs?
Prepare and Compete Later
- Goal: Introduce new 10-year and 15-year fixed-rate mortgage portfolio product while managing interest-rate risk.
- Solution: Forward Starting advance with two-year forward starting period and three-year fixed-rate period. Fund loans off deposits for first two years and take on advance funding at year three.
- Result: Savings of $337,000 in interest expense on a $10 million advance compared to a traditional five-year Fixed Rate Credit Hybrid advance.
A small community bank in Athens, GA, has built a deposit base from its local municipality, as well as from individuals in the surrounding counties. It has a strong market presence that has allowed it to gather deposits and provide banking services to its clients. It has offered 3/1 and 5/1 ARMs, along with HELOCs, to meet the residential mortgage needs of its customers. With rates at historically low levels over the past several years, several of the institution’s competitors began offering 10-year and 15-year residential mortgage loans.
In 2014, the community bank’s management decided that it needed to revamp its mortgage loan offerings to retain existing customers and add new ones. To offer the longer-term loans that its residential customers were seeking, management had to become comfortable with a portfolio mortgage strategy.
While funding the loans was not a significant concern due to its strong depositor base, the interest-rate risk that these loans would generate was an issue. How could the bank offer competitively-priced term mortgage loans without exposing itself to a significant increase in interest-rate risk?
The management team decided to use a Forward Starting advance from FHLBank Atlanta to help offset the interest-rate risk generated by the pool of longer-term loans. They identified the interest-rate exposure of this new loan program to be at the five-year mark. Instead of borrowing a traditional five-year Fixed Rate Credit advance and placing the funds on its balance sheet today, the bank borrowed $10 million using a two-year forward starting, three-year Fixed Rate Credit Hybrid advance. This gave their management team the ability to lock in a three-year fixed-rate advance at today’s funding costs, but not actually place the funds on the balance sheet – or incur interest costs – for two years.
The community bank will fund the pool of fixed-rate mortgages for the first two years from its robust deposit base, and then at the end of the two-year mark, will automatically receive the advance funds at a rate negotiated up front with FHLBank Atlanta. The rate on the Forward Starting advance is 2.46 percent, which is 31 basis points above the rate on a five-year Fixed Rate Credit Hybrid advance. However, since the Forward Starting advance is only funded for the last three years, the total interest cost is $738,000, which represents a $337,000 savings over a five-year Fixed Rate Credit Hybrid advance.
Strategic Benefits of Forward Starting Advance
- Compete for Members: Offering an intermediate-term fixed-rate portfolio product for which the funding and pricing are fixed for a known time provides loan officers the opportunity to retain existing customers and attract new ones.
- Keep Costs Low: The forward starting feature enables institutions to leverage a strong deposit base to fund the first three years of the pool, then use an advance negotiated at today’s low rates to fund the next two years. Because the advance is on the balance sheet for less time than a traditional advance carrying the same term, total interest cost is significantly lower.
- Lock in Interest Rate Protection at Today’s Lower Rates: Locking in funding at today’s lower rates can potentially help mitigate interest-rate risk at the five-year mark when management was most concerned about its exposure.
- Achieve Portfolio Growth: The bank has the opportunity to grow its loan portfolio by attracting high-quality mortgage business from both existing and new clients at yields more attractive than other investment alternatives.
- Easy to Explain: The strategy is easy to explain to regulators, ALCO, or the board of directors.
FHLBank Atlanta is the NAFCU Services Preferred Partner for Credit Union Liquidity and Financing Services. Learn more about our Preferred Partner by visiting nafcu.org/FHLBank_Atlanta.