The credit scare/crunch may present a great opportunity for many independent banks who depended on regional home bank system for the funding. This morning Fed funds traded at only 0.25-0.75%, plenty liquidity for banks if you can access it. At the same time Libor 1M and 3M rates went up over 10 bps at 4.11% and 4.33%, indicating extremely tight credit markets. Due to the enormous liquidity Fed has pumped into the system, the funding cost from FHLB, like FHLB Boston, are significantly cheaper than Libor markets. For example, FHLB Boston this morning offered 0.85%, 0.95%, 1.19% and 1.75% for 1 week, 2 week, 1 month and 2 month fundings for its members. On the asset sides, agency (Fannie , Freddie and FHLB) debts were priced at level never seen before in term of spread to treasury in history. Two year agency yield spread is 100 bp over same maturity treasury, historically it has been only between 20 - 30 bps (see the first chart from Bloomberg) and 2 year swap spread had widen over 150 bps over treasury, a historical record (the second Bloomberg chart). FHLB issued $400 millions 1 yr maturity callable note (Bermuda) at 4.00% yesterday. For community banks, this offers a great opportunity to take advantages the dislocations between Fed fund market and Libor market to book some real juice spreads by leveraging balance with very limited interest risk exposure.
If we laddered FHLB short term funding from 1 week to 3 month, and invest in the new 1 yr/3m nc agenecy note at par with yield 4.00%, the bank would be able to lock in spread of whopping 250 bps for next couple of month (See table below).
Parallel curve shift assumed; horizon date 4/1/2009
The most likely outcome is that asset will be called away considering the extraordinary fear and uncertainty in the credit market, we should not be surprised if calm and rational gradually return in the next couple of quarters with or without $700 billions government's rescue packages. The credit spread would narrow and eventually back to norm. The agency spread to treasury currently is not only wide but even much wider than before Uncle Sam took over Freddie and Fannie. Agency debts got the explicit back from government, this temporary indiscriminate sell off from distressed institutions would come to end. Any sign of relief in the market, the asset will come off book so you enjoy 250 bps spread for a quarter. Certainly the only downside is that relative short during of asset and only enjoy income for a quarter or so.
If we laddered FHLB short term funding from 1 week to 3 month, and invest in the new 1 yr/3m nc agenecy note at par with yield 4.00%, the bank would be able to lock in spread of whopping 250 bps for next couple of month (See table below).| 50 bps Down | Base case | 50 bps Up | |
| 1 wk | 0.35% | 0.85% | 1.35% |
| 2 wk | 0.45% | 0.95% | 1.45% |
| 1 month | 0.69% | 1.19% | 1.69% |
| 2 month | 1.25% | 1.75% | 2.25% |
| 3 month | 2.25% | 2.75% | 3.25% |
| Blended Short term FHLB Funding | 1.00% | 1.50% | 2.00% |
| FHLB 4.00 10/6/09 | 4.00% | 4.00% | 4.00% |
| Yield Spread | 3.00% | 2.50% | 2.00% |
| Price Return | 0.01% | 0.00% | -0.25% |
| Total Return | 3.01% | 2.50% | 1.75% |
The most likely outcome is that asset will be called away considering the extraordinary fear and uncertainty in the credit market, we should not be surprised if calm and rational gradually return in the next couple of quarters with or without $700 billions government's rescue packages. The credit spread would narrow and eventually back to norm. The agency spread to treasury currently is not only wide but even much wider than before Uncle Sam took over Freddie and Fannie. Agency debts got the explicit back from government, this temporary indiscriminate sell off from distressed institutions would come to end. Any sign of relief in the market, the asset will come off book so you enjoy 250 bps spread for a quarter. Certainly the only downside is that relative short during of asset and only enjoy income for a quarter or so.