Q&A with Emily Hollis

Emily Hollis
May 6, 2008 | COMMENTS

Question: What should be our balance sheet strategy given what is happening in the markets?

First and foremost, drop your deposit rates—fast!

We are presently in the most severe credit crisis for the modern era. The crisis is causing the government to take quick and drastic actions. The Fed has dropped the target Fed Funds rate from 5.25% in late October to 2.25%. Consequently, the 91-day T-Bill reached a low of 58 basis points (bps) on March 20, 2008. Yes, that is correct, 0.58% dropping from 5.0% in August of 2007. The two-year Treasury is hovering around 1.75% and the ten-year Treasury is around 3.50%. Mortgage rates are stubbornly high as liquidity for the purchase of loans remains low.

It appears that credit unions are somewhat reluctant to drop deposit rates as rates offered by local competitors remain stubbornly high; however, remember that money market funds have dropped to 2.25% (or less) and stocks are suffering!

Some dealers expect overnight rates to drop to 1.50% only to be followed by a rapid rise in rates as the crisis subsides. The Federal Reserve must then revert to fighting inflation so be careful in going out too far on the yield curve.

The Federal Reserve has come to the market with three new channels to provide liquidity to the street. The Fed established the Term Auction Facility (TAF) in which direct loans are made to banks and can be backed by a wide variety of collateral, including subprime mortgages. The auctions were increased from the initial $60 billion to $100 billion per month. They also established the Term Security Lending Facility (TSLF) which allows primary dealers to borrow as much as $200 billion of Treasury securities from the Fed's $713 billion portfolio. This is critical in allowing dealers to lighten illiquid inventory. Collateral accepted in this "debt swap” includes AAA-rated residential and commercial mortgage-backed securities which is unprecedented. The Fed then opened the discount window to the primary dealers (although with tighter restrictions on collateral) through its Primary Dealer Credit Facility (PDCF), which has saved one and possibly three broker dealers from bankruptcy. The extraordinary measures taken by the Federal Reserve will allow dealers to pledge AAA-rated performing ABS securities and should help to alleviate dealer capital constraints.

Treasury Secretary Henry Paulson's “Blueprint for Regulatory Reform” has proposed a plan for a broad overhaul of the financial services regulatory structure. He contends that the current structure of regulating banks, securities firms and insurance companies is outmoded and that the Federal Reserve should expand its oversight beyond banks. Under the plan, which would take years to implement, the SEC and Commodities Futures Trading Commission (CFTC) would be combined, as would the OTS, the OCC the FDIC and the NCUA.

So what should you do?

• Lower your deposit rates, particularly CDs.
• If you can, issue prime, non-conforming mortgages to your membership. Jumbo loans can attract rates over 6.50%, and although default rates have risen in prime loans, they are still well worth the risk.
• For those with more risk tolerance, there continue to be great investment opportunities out there in non-conforming AAA- rated securities that have excellent credit support. Some hybrid prime adjustable rate mortgage securities are yielding close to 7%. Just remember, there can be huge variance in risk amongst AAA-rated securities these days. Stay away from the 2006 and early 2007 vintages and check and double check the credit support with credit shocks.
• Additional income can be generated by leverage strategies using investments such as agency hybrid securities. Borrowing rates are historically low and mortgage spreads are historically high. Again, be careful with duration mismatches of the leverage trades.

I plan to describe in detail some sample leverage strategies next month which will offer suggestions for potential transactions and highlight key areas on which to focus.

Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com. Margot Strong, director of business development, may be reached at mstrong@almfirst.com.