Derivatives market update for financial institutions
- March 20, 2020
Financial Institutions | Kennett Square, PA
Managing Partner, Board Member
Global Head of Financial Institutions
Kennett Square, PA
SummarySee how financial institutions are dealing with recent market volatility as well as a wide range of issues from net interest margin pressures and asset-liability management.
During the past few weeks, we have seen extreme volatility in the markets as equities have declined over 30%, the 10-year Treasury reached an all-time low and the Federal Reserve announced two emergency rate cuts totaling 150 basis points. Many financial institutions are dealing with a wide range of issues from staffing and alternative work environments to net interest margin pressures and asset-liability management. We wanted to share some of the topics we are currently discussing with clients and offer our assistance to your institution.
Balance sheet hedging
The violent drop in rates has resulted in a lot of discussions and hedging activity with financial institutions looking to optimize the liability side of their balance sheet. Pay fixed swap rates are near historic lows, and they are especially attractive when compared to alternatives such as FHLB term advances. Furthermore, the current basis between LIBOR and collateralized borrowing rates such as short-term FHLB advances and products tied to Fed Funds (MMDAs) and Treasuries (Brokered CDs) is very wide in favor of borrowers. This positive basis is creating additional incentive to consider LIBOR-based swaps, although it may be relatively short-lived depending on market dynamics. For those institutions looking to transition away from LIBOR, overnight funding structures using Fed Funds-based swaps have also become popular. Lastly, for those institutions who had hedged for this decline in rates, we have seen a strong interest in profit-taking strategies. Since every situation is unique, we encourage you to reach out to us to discuss your hedging objectives in more detail.
Loans with interest rate floors
Financial institutions are looking to protect margin by including interest rate floors in commercial loans. We have seen floors used in commercial real estate and industrial loans with varying strike prices. When utilizing swaps on loans that have embedded floors, it is important that financial institutions and their borrowers understand the impact of also embedding an offsetting floor in the swap. We have a helpful video on the subject and would be happy to discuss the topic and help you quantify the economic impact.
Debt service relief on loans with swaps
A growing dilemma for many regional and community banks has been the concept around providing debt service relief for certain customers. We have had numerous conversations with clients about how this could impact related hedging transactions. While there are a few different alternatives available, we would welcome the opportunity to discuss with you the considerations of each.
Market valuations and counterparty exposures
During volatile times like these, it is important that financial institutions can quantify the value of their hedging contracts and determine their net exposures with borrowers and dealers. Our online technology platform provides 24/7 access to trade details, valuations, exposures, and customized management reporting. Additionally, a collateral management tool tracks daily collateral positions for existing trades to ensure the appropriate amount of collateral is being provided to support changing mark-to-market valuations. We have also worked with some clients to adjust the methodology they use for estimating credit exposure to a more conservative factor-based approach.
The derivatives market has been very functional despite several days of over 25 basis point swings. We have seen some dealers widen their pricing, but many are still quite competitive with execution levels within a few basis points or less from mid-market. Our trading team at Chatham, which facilitates over $2B a day on average, has made the needed adjustments for operating in this market. One important change is that market liquidity now fades after 4 p.m. EST as many dealers focus on assessing their value-at-risk and closing their trading books for the day. Many of our clients are using our real-time pricing and valuation tools to stay abreast of these quickly moving markets.
We have fielded a few calls and emails asking if the current market environment will delay the LIBOR discontinuation scheduled for December 31, 2021. At this time, there have not been any announcements changing the well-established timeline. We will be sure to update clients if that speculation becomes a reality. The only item that has been pushed back is ISDA’s consultation around pre-cessation fallbacks. The deadline for submitting responses for this consultation has been revised to April 1, 2020.
Accounting Standard Codification 848
On March 12, 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) 2020-04, Reference Rate Reform (“ASC 848”): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. Balance sheet hedging programs are subject to the optional expedients that allow hedging relationships to continue without de-designation. Chatham issued a bulletin in response to this announcement on March 16, 2020. Please reach out to us with any questions, and we can leverage the deep resources of our 50-person Hedge Accounting team.
Chatham business continuity
Many clients have recently asked Chatham to provide updates regarding our readiness and capabilities given the COVID-19 situation. Because of early action taken by our leadership, we have experienced no interruptions to our business. As of March 23, 2020, more than 600 members of our team are serving clients from home offices. Additionally, we have a team of business continuity experts evaluating and responding to any specific client requests for additional information.
How can we help?
Send us a message to discuss how we can help launch or grow your interest rate derivatives program.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0087