1. Bank Liquidity and Wholesale Funding Part I Federal Home Loan Bank Advance Trends

2. 2 In this section, we will look at:  Historical perspective  Advance types  Prepayment options and impact  Use of advances

3. 3 Historical Perspective Fundamental business of the FHLB is to provide: – Advances and other credit products – Wide range of maturities

4. 4 Historical Perspective (cont.)  Created by Congress in 1932  Initially capitalized with government funds  Members have provided all FHLB capital for last 50 years  FHLB offers funds – called advances – to its members

5. 5 The 1980’s  FHLB and member institutions became an integral part of home mortgage financing system  These institutions experienced significant losses during the 1980’s as a result of: – Severe recession – Record high interest rates – Deregulation

6. 6 Cost of Failed Thrifts Congress:  Restructured home mortgage financing system in 1989  Expanded membership eligibility in FHLB

7. 7 FHLB Structure  There are 12 FHLB banks  Each operated as a separate entity  All under FHFB’s supervisory and regulatory frameworks

8. 8 Trends Due to legislative changes in 1999, it is reasonable to expect growth in: – FHLB membership – FHLB advances

9. 9 Title VI of Gramm-Leach Bliley Act  Federal Home Loan Bank Modernization Act  Enacted 11/12/99  First major legislation that made changes to the FHLB system

10. 10 Change 1: Membership  FHLB required institutions to have at least 10% of total assets in residential mortgage loans.  Requirement caused a hardship on smaller institutions  Financial Modernization Act exempts Community Financial Institutions from requirement

11. 11 Change 2: Pledging  Added loan categories that may be pledged as collateral  Previously, only mortgage loans were eligible as collateral

12. 12 Additional Types of Collateral  Agricultural Loans  Small Farm Loans  Small Business Loans  Home Equity Loans  Manufactured Housing Loans  Residential Construction Loans  First and Junior-lien Mortgage Loans  Mortgage-Backed Securities

13. 13 Change 3: Reduced Cost  Applies to banks with less than $500 million in total assets  Makes access to system less expensive for community banks

14. 14 In this section, we will look at:  Historical perspective  Advance types  Prepayment options and impact  Use of advances

15. 15 Categories of Advances  Fixed rate/fixed term  Amortizing  Putable  Overnight  Warehouse lines of credit  Indexed  Capped floating rate  Convertible  Callable

16. 16 It is important to understand that…  Each FHLB offers many different advance plans  Each FHLB operates independently – Product names are not uniform – Characteristics are not uniform

17. 17 Despite Differences…  Overnight  Short-term  Medium-term  Long-term  Fixed-rate  Variable-rate  Structured  Amortizing Each FHLB generally offers the following advances:

18. 18 Tailored to Meet Needs  Many advance plans tailored  Example: – Customize advance with same index and amortization schedule as bank asset it funds – Called index amortizing advance

19. 19 Use caution when…  Reviewing an FHLB’s advance program  Assessing structured advance products with embedded options Always review from perspective of who controls the option!

20. 20 Fixed Rate/Fixed Term Advance  Interest due monthly  Principal due at maturity  Four available terms – 1-3 weeks – 1-9 months – 1-10 years – 20 years

21. 21 Amortizing Advance  Fixed rate and term  Monthly principal and interest  Periodic prepayments allowed  Terms: 2, 3, 5, 7, 10, 15, and 20 years  Maturity/amortizing options include: – 5 year maturity/20 year amortization – 10 year maturity/20 year amortization – 20 year maturity/30 year amortization

22. 22 Putable Advance  Fixed rate  Repayable on put date without a fee  Terms: – Maturity/first put date 3 years/1 year 5 years/1 year 5 years/3 years 7 years/1 year 7 years/3 years 10 years/3 years – Subsequent put dates every six months

23. 23 Other Advances  Overnight  Warehouse – Floating rate – May be paid down – May be borrowed against at any time  Indexed  Capped – Floating rate – Various caps and maturities

24. 24 Convertible Advance  Available at fixed rate until maturity  FHLB may convert rate to floating after lock-out period  No prepayments allowed while rate is fixed  Prepayments allowed if rate converts to floating  Various terms and lock-outs available

25. 25 Callable Advance  Fixed rate  Callable semi-annually  Various maturities and lock-outs

26. 26 Convertible vs. Callable Within the system:  Banks may use terms interchangeably or  Both may be referred to as convertible

27. 27 Advances with Options  Cancellation dates: – “Euro” structure – “Bermudian” Structure  FHLB notifies member 3-5 days before cancellation  If FHLB cancels, borrower can pay off or roll outstanding amount into another advance type

28. 28 Obligated by Law Term:  For remaining duration of advance that was called, or  An agreed upon term to maturity Rate:  At the current rate at time of cancellation, or  A predetermined rate agreed upon by both the member and FHLB The FHLB is obligated by law to replace funding for an advance that is cancelled.

29. 29 In this section, we will look at:  Historical perspective  Advance types  Prepayment options and impact  Use of advances

30. 30 Prepayment Options and Balance Sheets  Options impact balance sheets  Advances can be prepaid subject to a fee  Fee to prepay advance with option, generally higher  Fee to prepay straight advance, generally lower

31. 31 Fee Structure = FHLB's hedge- unwind cost + Present Value of Foregone Profit on Advance

32. 32 When Prepaying Advances, Consider:  Accounting treatment  Balance sheet impact  Income statement impact  Interest rate risk considerations

33. 33 Before Prepaying Advances, Consider:  Future revenue growth enhancement  Positive impact on net interest margin, cost of borrowings, and cost of funds  Management’s comfort level with significant restructuring charge  Likely dilution of current year EPS and book value  Possible impact on bank’s dividend  Market’s perception of restructuring charge

34. 34 Analysts Recommend  Modifying high-cost FHLB advances  Using interest rate swaps to lower borrowing costs

35. 35 Modifying FHLB Advances  Accomplished by: – Extending maturity date of advance, and – Rolling net present value into funding cost of new structure  Must comply with FASB's EITF 96-19

36. 36 The Appeal and the Reality  Restructuring is appealing to banks that need to reduce borrowing costs without taking an upfront hit to earnings  Guidelines for modifications of advances differ among FHLBs  Moratorium in some districts

37. 37 In this section, we will look at:  Historical perspective  Advance types  Prepayment options and impact  Use of advances

38. 38 Advantages of FHLB Advances  Can pledge variety of assets as collateral  Many types of advances to choose from  Considered to be stable source of funds  Easy accessibility to funding

39. 39 Use of Advances  Core deposit runoff  Growth in existing or new business lines  Additional source of liquidity  Improvement in return of equity through balance sheet leverage  Management of interest rate risk

40. 40 Return on Equity (ROE)  Advances used to increase ROE through balance sheet leverage  Increase asset size  Reduce capital ratios  Increase ROE

41. 41 Leverage Strategies and ROE  Leverage strategies tend to increase ROE  Some leverage strategies look good on paper but do not perform well in reality  Bank should stress test strategies prior to acquisition  Leverage strategy is consistent with the bank's economic outlook and trends

42. 42 Management of Interest Rate Risk (IRR)  Advances can be matched with specific assets to reduce the bank's IRR position  Advances provide option vs. raising a significant quantity of 10-year core deposits to match against mortgage loans with 10- year lives

43. 43 A Community Bank Funding Option Advances are a new funding option that can be:  Raised quickly  Secured in large and certain quantities  Secured with less liquid collateral

44. 44 In the next section… Select the next section, Presentation Review, to continue.