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Forward Starting Advances Balance Liquidity Needs with Interest-Rate Risk Management

March 2013Many financial institutions continue to have significant liquidity on their balance sheets resulting from depressed loan demand of the last few years and higher retail deposit balances. As the economy and housing market recover, some financial institutions are seeing a healthy uptick in mortgage demand, while others are competing for commercial loan opportunities. While this growing loan production may not require an immediate need for wholesale funding for liquidity purposes, financial institutions are looking for solutions to help them manage the interest-rate risk associated with increased loan originations.  

In 2012, FHLBank Atlanta introduced a forward starting feature to its advance portfolio to help shareholders address this dilemma. A forward starting advance enables shareholders to lock in an interest rate while delaying funding of the advance until a specified date in the future. It provides the opportunity to benefit from the current low interest-rate environment without having to take down funding today. Interest payments on the advance begin when the advance is funded.

Any structured advance can be forward starting, including the Fixed Rate Hybrid, Floating-to-Fixed, amortizing, and others. The advance has all of the features and benefits of the selected structure once it has funded.

When to use a Forward Starting Advance

Forward starting advances have many potential applications and are particularly useful to:

  • - Hedge tail risk on loans originated and held in portfolio
  • Obtain interest-rate protection in a rising rate environment without taking on additional funding today 
  • Manage anticipated deposit runoff or uncertainty in the future
  • Lock in an interest rate for a future maturity 
  • As an added benefit, the forward starting advance can include an amortizing schedule to closely match an amortizing loan or pool of loans

Forward Starting vs. Funding Today

A simple example compares a five-year Fixed Rate Hybrid advance, starting one year forward, to a six-year Fixed Rate Hybrid that funds immediately. The forward starting structure has an interest rate of 1.58% and a final maturity six years from today, compared to 1.40% for the standard Fixed Rate Hybrid. While the standard advance has a lower rate, the shareholder would pay an additional year of interest. The forward starting feature allows the shareholder to defer funding and interest by a year, while still achieving the same maturity date, making it the favorable structure.

Forward Starting Vs. Funding Today

A recent shareholder example demonstrates how a forward starting advance can help financial institutions hedge interest-rate risk and manage deposit runoff. Apple Federal Credit Union (Apple FCU), which serves educators and their families in northern Virginia, was seeking a solution to hedge interest-rate risk associated with mortgages originated in the fourth quarter of 2012 and held in portfolio. Working with FHLBank Atlanta, Apple FCU structured a seven-year Fixed Rate Hybrid forward starting advance with an embedded interest rate cap. The interest rate cap is set at a strike rate based on three-month LIBOR and provides additional protection if interest rates rise. The advance interest rate is fixed; however, if three-month LIBOR rises above the strike rate of the cap, the advance rate will begin to float down, providing the credit union with an increasing spread to the mortgages the advance is hedging.

While Apple FCU needed the advance for hedging purposes, it did not need the added liquidity in the fourth quarter. However, the credit union is anticipating seasonal deposit runoff in July and August of 2013 related to a decision by one of its largest education sponsors to change its teacher pay schedule from a 12-month to a 10-month cycle. To ensure liquidity during this period, Apple FCU structured its Fixed Rate Hybrid advance to be forward starting and fund in July.

According to Chris Cooper, chief financial officer for Apple FCU, this new forward starting capability provides important flexibility for the credit union and is a feature that he expects to use in the future.

“The forward starting structure works great and gives us the ability to hedge interest-rate risk at any time of year,” said Cooper. “We can lock in an interest rate and we’re protected if rates rise. At the same time, we’re delaying funding until we need the liquidity.”

Other Terms and Considerations

Pricing, maturity, and interest payments for a forward starting advance are based on the terms of the specific structure selected. Shareholders can terminate a forward starting advance before the funding date subject to a fee. Collateral is required during the entire life of the advance; however, during the forward starting period, the collateral requirement is reduced.

For more information on how a forward starting advance can help your institution manage liquidity and risk, contact your FHLBank Atlanta Relationship Manager.

© 2013 Federal Home Loan Bank of Atlanta, All Rights Reserved. 1475 Peachtree Street NE, Atlanta, GA 30309

The Federal Home Loan Bank of Atlanta is not a registered investment advisor. Nothing herein is an offer to sell or a solicitation of an offer to buy any securities or derivative products. You should consult your own legal, financial and accounting advisors before entering into any transaction.

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