The escalation of interest rates since the beginning of this year has set the stage for the 11th district cost-of-funds index to rise.

Investors in cost-of-funds-indexed mortgage securities have been eager to assess the potential near-term increase in the funds index versus that of other interest-rate indexes such as the one-month Libor and the one-year constant maturity Treasury.

We project that by April 1995, the funds index will rise a minimum of 86 basis points to around 4.5%. If short-term rates rise further by 100 basis points over the next year, the funds index will top 5%.

While the volatility of the funds index has been historically high in recent months, we believe that it will decline in the near term. The projected level and volatility of the funds index have important relative-value implications for cost-of-funds index securities.

Qualitative Approach

We base our projection on the analysis of the composition and the associated interest cost of the funds index. This qualitative approach presents an alternative to the quantitative analysis of econometric models.

These models attempt to explain the past behavior of the cost-of-funds index and project its future level based primarily on the movement of combinations of short-term and long-term interest rates.

The funds index represents the annualized weighted average interest paid on all their sources of funds by savings institutions that are members of the Federal Home Loan Banks and insured by the Savings Associations Insurance Fund.

The 11th district Federal Home Loan Bank, in San Francisco, covers Arizona, California, and Nevada. However, California has consistently accounted for more than 90% of member institutions in the 11th district. The San Francisco FHLB calculates and publishes the funds index on a monthly basis.

Deposits Most Important

There are three sources of funds for the index: deposits, FHLB advances, and other borrowings. Deposits have always been the most important. They account for a minimum of 70% of the index.

The rates paid on deposits are lower than that on comparable maturity advances and other borrowings. The maturity of deposits generally ranges from overnight to five years.

Advances are borrowings from the 11th district bank. Depending on the purpose of funding, the interest paid on advances can be either fixed or adjustable, with a maturity ranging from one day to 15 years.

In general, there is a severe penalty for prepaying advances. For comparable maturity, the interest on advances is usually higher than deposits but lower than other borrowings.

Other borrowings include reverse repurchase agreements (reverse repos), subordinated debt, commercial bank loans, commercial paper, and other miscellaneous borrowings.

Moves Less Quickly

Reverse repos are a major item of other borrowings. The interest on other borrowings is significantly higher than deposits and advances.

Since the cost-of-funds scale is an index that represents the weighted average interest paid on various liabilities of numerous maturities, it does not move as quickly in response to the daily change in market conditions as any other type of interest rate.

Also, the index is calculated on a monthly basis with the weights being the month-end balance of liabilities it cannot reflect the short-term fluctuation of money market conditions during the month.

For these reasons, the monthly fluctuation of the index, or its volatility, is exceedingly slow in comparison to that of short-term interest rate series such as Libor and constant maturity Treasuries.

Not Just Rate-Driven

The funds index differs from all interest rate series in one important aspect: Its volatility is the result not just of changes in interest rates. For example, if any of the short-term rates remains unchanged for a year, its volatility will eventually drop to zero.

But this is not true for the cost-of-funds index. In addition to the change in interest rates of various maturities, its volatility also comes from the change in its composition. In fact, even if the entire yield curve remains unchanged for a year, the funds index will still fluctuate because of the rollover and the repricing of matured liabilities.

Unless the old liabilities are replaced by the new ones with precisely the same interest cost and maturity - a highly unlikely if not impossible scenario - the composition of the funds index will change. This change causes the index to fluctuate without any change in interest rates.

Since its first publication in August 1981, the composition of the funds index has changed constantly. The changes have been the result of a varying interest rate environment, depositors' maturity preference, and funding strategies of member institutions.

Moderate Rise

Over the next year, the index is likely to rise much more moderately than other short-term rates and with declining volatility.

As a result of a long decline in short-term interest rates that started in late 1989, the index dropped in March to its lowest level, 3.629%. In April, the funds index rose only 43 basis points to 3.672%. But, in percent change, this was a 1.18% rise, the second largest since June 1989.

The index is expected to rise more moderately because the liabilities that will be repriced within the next year consist primarily of low-cost deposits.

Specifically, three liabilities will be repriced: money-market deposits, fixed-rate deposits with maturities of less than one year, and reverse repos. These three components make up 58.4% of the index as of this year's first quarter.

Money market deposits, which are the cheapest sources of funds for savings institutions, account for a record high of 27.5% of the funds index. While deposits with less-than-one-year maturities carry a modestly higher interest cost, they constitute record low of 25.1% of the index. The remaining portion that will be repriced are reverse repos which have a much higher interest cost, but it constituted only 5.8% of the index.

We project that from May 1994 to April 1995, the index will rise a minimum 86 basis points to 4.532%. This projection takes into consideration the sharp rise in Libor and CMT.

Additionally, this projection assumes that short-term interest rates remain unchanged for one year. It further assumes that Libor approximates the interest cost of money-market deposits and reverse repos, and that CMT represents the interest on less-than-one-year deposits.

Going forward, however, unless the U.S. economic growth moderates significantly, short-term rates are likely to rise further. And the funds index is likely to rise more than 86 basis points over the next year. If both Libor and CMT escalate another 100 basis points over the next 12 months to 5.34% and 6.29%, respectively, the funds index is likely to rise an additional 58 basis points to 5.11%.

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