They say a picture is worth a thousand words. And when the subject is risk, financial institutions are finding imaginative ways to depict their services.
One recent ad featured a fisherman on the shore of what he thinks is an island. In fact, he's standing on a very large fish, which has its eye on the fisherman's line underwater. The caption reads: "Risk. It isn't always where you expect it to be."
The message is clear: Risk management demands vigilance and planning -- and a helpful banker.
What About Banks Themselves?
But what about the risks that financial institutions face? What tools help mitigate their risks? Where can they turn for help?
One source of help for housing and community portfolio lenders is the Federal Home Loan Bank System, which was created to insure the availability of housing finance throughout the country.
That remains the system's primary purpose. But effective management of a housing portfolio means more than maintaining a source of funding and liquidity. It means managing a variety of risks associated with a housing portfolio and its position in an institution's overall portfolio.
Thus, in carrying out its mission, the 12 regional Home Loan banks have also become important risk mitigators for their members, including (at last count) more than 1,600 commercial banks.
Stockholders are discovering in their Home Loan banks a convenient, affordable, dependable, and often innovative way to manage risks that affect housing lenders.
* Interest Rate Risk. Current rates are low. But prudent managers insure against the risk of rising rates. Those with access to the Home Loan system can rely on advances to match-fund term housing assets.
One example is the Washington State bank with a strong housing commitment and
a portfolio of long-term loans funded by shorter-term deposits.
To minimize interest rate risk, the institution wanted to lengthen liabilities and balance its asset-liability mix with 5-, 10-, and 15-year funds. The solution involved fixed-rate amortizing and balloon advances from the Seattle Home Loan Bank.
Likewise, when funding is priced using a different benchmark than the asset it supports, an institution faces "basis risk."
The problem can be avoided by borrowing in any of the various indexes the Home Loan banks offer, including prime, COFI, Libor, or constant maturity Treasuries.
* Funding and Price Risk. Home Loan bank advances help diversify he sources and maturities of a portfolio lender's funding base. That's increasingly important, considering the nationwide expansion of financial institutions and the shifting of deposits to mutual funds.
Whatever their size, depository institutions can shield themselves against these risks with advances.
By relying solely on deposits as a source of funding, a housing lender can also be vulnerable to price risk, especially if funding marginal asset growth or facing an increase in deposit insurance premiums.
Avoiding a |Hidden' Risk
Higher interest rates to attract new deposits also affect the cost of existing deposits, raising the effective cost of marginal funding far above the nominal rate for new deposits. This "hidden" price risk can be avoided by matching marginal needs with Home Loan bank advances.
One Massachusetts member occasionally has heavy mortgage loan demand without commensurate growth in retail deposits. its traditional source of funds.
Rather than raising funds with higher deposit rates, the institution turned to the Boston Home Loan Bank's "One-to-Eleven-Month Advances." Favorable pricing and ready availability enabled the member to remain competitive in its local market, meeting mortgage demand while keeping down its cost of funds.
Letters of Credit
Another form of funding risk arises when market segmentation or tiering results in higher costs or limited access to important sources of mortgage funds, especially for smaller institutions. Members of the Home Loan system, however, can manage their own counterparty risk by backstopping their participation in these transactions with a triple-A rated Home Loan bank letter of credit.
Members also benefit because the Home Loan banks and their products are flexible. Members of the Dallas bank, for example, have access to a standing line of credit, under which they can take down advances on a same-day basis, at a pre-agreed spread, with no commitment fee. And the term can vary from one day to 20 years or beyond.
Moreover, because it's a triple-A-rated, congressionally chartered enterprise that raises funds in the national capital markets on a consolidated basis, the system always has access to credit at preferred rates.
As a result, the national presence of the system can be viewed as a hedge against regional economic or financial troubles that could raise the cost of credit to uneconomic levels. This can be especially helpful for smaller members with limited funding sources.
* Mortgage Prepayment Risk. A constant cause of concern for all housing lenders, mortgage prepayments threaten an institution with an influx of unneeded cash.
To manage the problem, several Home Loan banks offer a "mortgage matched advance." Developed by the Cincinnati bank, this advance amortizes like a mortgage and permits the member to prepay at frequent intervals without penalty.
Another product, featuring "puttable" advances, allowed a large commercial bank member of the Pittsburgh unit to mitigate both interest rate and prepayment risks, while expanding its housing lending. When it was unable to raise three-year retail CDs at an attractive price, it borrowed competitively priced, three-year puttable advances.
The term of the advances helped the bank manage its interest rate risk, while the put option gave the bank some prepayment protection. In fact, as interest rates declined and the mortgages prepaid, the bank put the advances back to the bank while drawing down new advances at a new rate.
Other members have subdivided advances into "strips" to mirror the repayment pattern of a staggered-term asset pool. In some cases, where a repayment pattern can only be anticipated, a Home Loan bank may arrange an advance that reflects the anticipated prepayment speed.
* Other Business Challenges. Every depository institution must also deal with the challenges of its business environment. For example, no lender can afford to overlook community needs and CRA compliance. To support community lending, the system offers a member of low-cost advance programs, including the Community Investment Program.
For instance, a large midwestern bank recently took a $1.5 million advance through the Des Moines bank's CIP to fund a 64-unit, low-income multifamily rental property. This enabled the member to extend financing at 100 basis points below its standard rates, which means lower rents.