Bank Notes

By Henry Hu, Director, Member Business

The dramatic collapse in interest rates earlier this year has resulted in legacy liabilities, including Advances, appearing comparatively expensive. Choosing to prepay any of these liabilities under these circumstances could result in significant prepayment fees.  

Fortunately, there is an alternative strategy to going the prepayment route: modifying the existing Advance by extending its maturity date. The clear benefit of this strategy is that the cost associated with modifying the Advance would be less than a comparable prepayment fee, and the borrower would have a lower funding cost by extending the term of the liability at the reduced rate. 

Let’s explore further….

Our Simplified Approach: Extending an Advance
By extending an Advance, the comparatively high cost of the existing Advance can be spread out over a longer period. This will increase the earnings over the original term of the Advance and improve the net interest margin, while providing the borrower with the stability of longer-term funding.

November 12, 2020 | FHLBank San Francisco

Until recently, a member interested in pursuing this extension strategy could prepay an Advance, redraw a similar amount, and account for the interest rate on a blended basis, successfully locking in today’s low base rates and incorporating any associated fees. The Bank has recently made this process much less complicated by allowing Advance modifications, which have the added benefit of reducing some of the costs embedded in the process.

Consider a member that has an Advance with a coupon of 2.96 percent maturing in one year: the member can now do an Advance modification to extend the Advance to a five-year advance and the new Advance rate would be just 1.13 percent. Another option would be to extend the Advance to a three-year Advance, bringing the modified Advance rate down 1.30 percent.

Benefits of Longer Extensions
Given today’s low Advance rates and flat yield curve, Advance modifications naturally benefit from a longer extension, which distributes the mark-to-market costs of the original advance over a much longer period of time. This can be helpful to members experiencing some immediate profitability pressures along with, ideally, enhanced future prospects, perhaps as a result of growth initiatives or the culmination of a successful financial turnaround.

In terms of financial statement metrics, the Advance modification will result in improvements in net interest margin, net interest income, and the interest rate risk profile of the balance sheet. With a stronger interest rate risk profile, members can, in turn, offer term loans to their customers, capturing favorable interest rate and credit spreads while diversifying their loan concentrations. Last, but not least, advance modifications are a low-cost option for those who want to replace term funding from CDs rolling off the balance sheet and minimize the repricing of existing deposits.

To sum up, the Bank is now offering a simplified approach to the Advance modification process with reduced fees embedded in it. Instead of prepaying an Advance and booking a borrowing with a longer term, Advance modification will enable members to achieve the same result in a single step.

Interested in learning more about this innovative option to extend term funding, manage interest rate risk, and enhance earnings in the immediate term? Contact the Members Services Desk at (415) 616-2500, or your Relationship Manager.