Academic journal article ABA Banking Journal

Callable Advances: Low Rates. .at a Price

Academic journal article ABA Banking Journal

Callable Advances: Low Rates. .at a Price

Article excerpt

Advance                 Initial rate

1-year bullet              5.86%

5-year bullet              6.08%

5-year non-call 1-year     5.35%

4-year bullet              6.06%

5-year non-call 3-month    5.17%





5 year bullet: advance Rates    Rates   Rates up Rates up

  Horizon: 1 year/      down  unchanged   100      200

  Coupon: 6.08%         100

Horizon yield          5.06%    6.06%    7.06%    8.06%

Horizon price          103.65   100.07   96.64    93.34

Reinvestment rate      5.25%    5.75%    6.25%    6.75%

Total Cost             9.58%    6.14%    2.79%   -0.48%





5- year all 1-year advance Rates    Rates   Rates up Rates up

Horizon: 1 year             down  unchanged   100      200

Coupon: 5.35%               100

Horizon yield              4.61%    5.17%    5.35%    5.35%

Horizon price              102.68  100.64    100.00   100.00

Reinvestment rate          5.25%    5.75%    6.25%    6.75%

Total Cost                 7.94%    5.98%    5.36%    5.37%





                         Rates     Rates   Rates up Rates up

Selected securities     down 100 unchanged   100      200

1-year advance           5.86%     5.86%    5.86%    5.86%

5-year bullet advance    9.58%     6.14%    2.79%    -0.48%

5-year call 1-year adv.  7.94%     5.98%    5.36%    5.37%

Combination              7.72%     6.00%    4.33%    2.69%





Banks have experienced declining net interest margins as rates have fallen over the last year. Many banks have responded by initiating new strategies to prop up declining margins. These strategies all entail taking on additional risk (although this risk is often not fully quantified). There are four risk-taking strategies banks typically employ to improve declining margins. These include taking more interest-rate risk by extending the portfolio, increasing option or credit risk to obtain "higher yields," lowering the overall cost of funds (and risk losing depositors), or implementing a leverage strategy to add to current earnings.

Here we will focus on this last strategy, that of leveraging to add to earnings. We believe that today's rate environment is not the most advantageous for leveraging the bank's balance sheet. Still, faced with earnings pressures, many banks feel compelled to consider such a strategy. The purpose of this article is to examine the liability side of this transaction. In particular, we will analyze an increasingly popular funding strategy for leverage, the callable borrowing, or what we refer to as a "callable advance."

Callable advances are borrowings (liabilities) where the lender, usually the Federal Home Loan Bank (FHLB), reserves the right to "call" the advance before maturity but not before some predetermined call date. For example, the FHLB may lend an amount for five years but reserve the right to call the loan at or after one year. We would call this a 5-year non-call 1-year advance.

Confusing nomenclature

Interestingly, the Federal Home Loan Banks have seven different names for what is essentially the same product. Only one of the 12 regional FHLBs actually refer to these advances as callable advances. The most popular name is a convertible advance." Some of the FHLBs use this name because instead of calling your advance outright, they "convert" it to a floating-rate advance at the prevailing rate. The borrower then has the option to "put" this new advance back to the FHLB. Because of this put feature, some of the FHLBs refer to this advance as a putable convertible advance.

But aren't these convertible advances the same thing as the callable advance? Since the FHLB is converting the advance to another advance that is by definition worth par, they are in effect calling the advance at par. The put option that the borrower has here is virtually worthless.

To my surprise, some of the FHLBs actually refer to the callable advance as a putable advance. …

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