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Jefferies & Company, Inc. Member SIPC. FHLB and Agency Strategies. GIOA 2009. March 26, 2009 Mike Effron Agency Trading. J:\ST\OTHER\PRESENTATIONS & TEMPLATES\TEMPLATES\JEFPOINT.PPT 2/26/09 2:59 PM. Disclaimer.

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slide1

Jefferies & Company, Inc.

Member SIPC

FHLB and Agency Strategies

GIOA 2009

March 26, 2009

Mike Effron

Agency Trading

J:\ST\OTHER\PRESENTATIONS & TEMPLATES\TEMPLATES\JEFPOINT.PPT 2/26/09 2:59 PM

disclaimer
Disclaimer

The information contained herein is based on sources that we believe to be reliable, but we do not represent that it is accurate or complete. Additional and supporting information is available upon request. It is not to be considered an offer to sell or solicitation of an offer to buy the securities or other products discussed herein. This information is provided for informational purposes only and is intended solely for your use and may not be quoted, circulated or otherwise referred to without our express consent. Any commentary contained herein was prepared by trading desk personnel. This is not a research report and the commentary contained herein should not be considered to be research. All prices, yields and opinions expressed are indicative only and are subject to change without notice. Jefferies & Company, Inc. and its affiliates (collectively "Jefferies"), may have a position in the securities or other products discussed herein, and may make purchases from and/or sales to customers on a principal basis or as agent for another person. Jefferies also may have acted as an underwriter of such securities or other products, and may currently be providing investment banking services to the issuers of such securities products.

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table of contents
Table of Contents
  • Recent Events
  • System Overview and Mission Statement
  • FHLBanks Selected Financials
  • System Funding Trends
  • Role of the FHLB Office of Finance
  • Trade Process
  • Current Trends in Callable Issuance
  • Investment Strategy: Using Step-ups
fhlb recent events
FHLB Recent Events
  • New housing GSE regulator, Federal Housing Finance Agency (FHFA)
      • Created on July 30, 2008 to oversee FHLB, FHLMC and FNMA
  • All 12 FHLB’s are now SEC reporting Banks
      • As of March 13, all Banks have reported 8k’s and unaudited 2008 financial results
  • Effective January 30, 2009 the FHFA released capital classifications and regulatory Prompt Corrective Action (PCA)
  • As of December 31, 2008 the FHLB system has a total GAAP capital base of $51.4 billion
  • As of December 31, 2008 the FHLB system has regulatory capital of $59.7 billion
  • System total assets are $1.349 trillion
      • Increase of 6.1% from December 31, 2007
  • System net income for 2008 of $1.249 billion
      • Decline of $1.578 billion from 2007

Source: FHLB Office of Finance website

fhlb recent events cont d
FHLB Recent Events- Cont’d
  • Effective January 30, 2009 the FHFA instituted a series of defined capital adequacy levels
  • Requirement involves three metrics
      • Total Capital Ratio = 4.00% minimum
        • ALL Banks meet or exceed this hurdle
        • 4.50% for FHLBChicago
      • Leverage Capital Ratio = 5.00% minimum
      • Risk-Based Capital = three factors determine the minimum
        • Credit Risk
        • Market Risk
        • Operational Risk
  • FHLBanks can receive one of four capital classifications
      • Adequately Capitalized
      • Undercapitalized
      • Significantly Undercapitalized
      • Critically Undercapitalized

Source: FHLBanks Office of Finance

fhlb recent events cont d6
FHLB Recent Events- Cont’d
  • For detailed analysis and up to date financial information, please view the FHLBanks Office of Finance Website at:
      • www.fhlb-of.com

Source: FHLBanks Office of Finance

fhlb system overview
FHLB System Overview
  • 12 Independent Regional Banks
  • Member –owned Cooperatives
  • All regulated by Federal Housing Finance Agency (FHFA)
  • All SEC Reporting Entities
  • System overall triple-A rating by Moody’s and S&P
  • Eligible for GSE Credit Facility
      • Effective September 7, 2008
  • All debt issued by individual Banks under a consolidated program.
  • All debt is “System” Debt (Joint and Several Obligations)
      • Entire system stands behind each bank’s debt.
      • Debt issuance to public is transparent and available via SEC 8k filings
fhlb member bank ratings
FHLB Member Bank Ratings

(1) Source: Moody’s Long-Term Deposit ratings as of Feb. 2009

S&P as of Sept. 2008

system mission and history
System Mission and History
  • The primary purpose of the FHLBanks is to ensure the flow of credit and other services for housing and community development to member financial institutions. This liquidity serves the public by enhancing the availability of residential mortgage and community investment funds. As cooperatives, the FHLBanks seek to maintain a balance between their public policy mission and the obligation to provide adequate returns on the capital supplied by members. The FHLBanks achieve this balance by delivering low-cost financing, and providing members a viable alternative to the secondary mortgage market via the mortgage loan programs, while paying a dividend. The FHLBanks also help members with other local housing and community development needs through self-funded affordable housing programs. (1)
  • Exempt from state and local taxes.
  • Loans are made in the form of collateralized advances.
  • Created in 1932 by an Act of Congress.
  • (1)FHLBanks Office of Finance website.
fhlb selected financials balance sheet
FHLB Selected Financials- Balance Sheet
  • Total System Assets
    • Advances (secured loans to members)
    • Investments include MBS, overnight/term Federal funds sold, CD’s, commercial paper and GSE securities

In Millions

Source FHLB Office of Finance

fhlb selected financials liabilities and capital
FHLB Selected Financials-Liabilities and Capital
  • Total System Liabilities and Capital
    • Consolidated Obligations (Debt Issuance)
    • Total Capital Stock
    • Retained Earnings

In millions

Source FHLB Office of Finance

(1) Total GAAP combined capital

funding trends
Funding Trends

Source: FHLB Office of Finance

funding trends changes in fhlb funding mix
Funding Trends-Changes in FHLB Funding Mix

Source:FHLB Office of Finance

fhlb office of finance
FHLB Office of Finance
  • Acts as the aggregator of issuance
  • Coordinates all debt issuance activities (marketing, pricing, terms)
  • Main intermediary between System Banks and Dealers
  • Develops and monitors issuance practices
  • Manages all debt programs
      • Discount notes
      • Bullets
        • Taps, mtn’s, globals
      • Structured
        • Callables, floaters, range notes, other structured notes
    • Monitors all call notifications
the trade process callable auction
The Trade Process- Callable Auction
  • Primary source for funding MBS portfolio
  • Driven by each Home Loan Bank
  • Needs are determined daily by 9:45 a.m. est.
  • Auctions posted at 10:00 a.m. est.
  • Round 1 is at 10:30 a.m. est. (round 2 is at 11:00 a.m. est. if necessary)
  • Web based auction
  • Lowest Coupon or lowest cost to pricing life date wins
  • Dealers bid Coupon and Concessions
the trade process callable auction cont d
The Trade Process- Callable Auction- cont’d
  • Call style is always American
  • Bidding syndicates are permitted
  • Post auction issues can be reopened or upsized with mutual agreement from FHLB and underwriter(s)
  • Auction structure determined by each Home Loan Bank to match funding needs
  • Multiple Banks can participate in an issue on a consolidated basis
  • Auctions can fail if bids are not acceptable to the Home Loan Banks
  • Award size can be less than original auction amount
fhlb auction website
FHLB Auction Website

Source: FHLB Office of Finance website

www.fhlb-of.com

the trade process for taps
The Trade Process for TAPS
  • Driven by each FHLB’s specific needs
  • Needs are determined daily in coordination with the Office of Finance
  • Auctions posted at 11:00 a.m. est.
  • Bidding commences at 11:30 a.m.
      • If needed, second auction commences at 12 pm
  • Web based auction
  • Spread bid versus Treasury all-in
      • I.e. for the 2yr TAP you bid a spread versus the 2yr Tsy.
the trade process for taps cont d
The Trade Process for TAPS- Cont’d
  • Coupon determined the first time it’s issued
      • New auction cycle is every quarter
      • Set in 1/8 increments
      • Can pay premium or discount
  • Previous cycles can be reopened
      • OID and large premium considerations would apply
  • No bidding syndicate
      • Each dealer must bid a minimum of $25mm
      • If less than $25mm must bid for the entire size
      • Can place multiple bids
      • After auction, no reopening until next day’s TAP auction
  • Specific maturities chosen by each Bank based upon it’s funding needs
trade process negotiated transactions
Trade Process- Negotiated Transactions
  • Dealers receive a variety of swap levels from swap dealers
  • Dealers contact any or all of the 12 FHLBanks to determine funding needs
  • Each Bank states funding targets
      • Office of Finance monitors and has oversight on funding targets
  • Each dealer negotiates structures with individual system Banks
  • No transactions are exclusive
      • Multiple Banks can do exact trades with multiple dealers
      • Deals that are >$25mm will receive one hour protection
      • Global transactions have additional structure black out periods
trade process negotiated transactions21
Trade Process- Negotiated Transactions
  • 3 ways to create a negotiated bond:
      • Customer inquiry
        • Customer has asked a dealer(s) to price up a specific transaction
      • Dealer inquiry
      • System bank(s) inquiry
        • Bank approaches a dealer(s) with a transaction
    • Trade entry is via e-Negotiated website
    • Dealer arranges FHLbank(s) and swap dealer
      • Conference call with the Office of Finance, underwriters, swap dealer and representative from individual Bank
      • Read over terms, agree, trade done
trade process modeling trade for bloomberg
Trade Process- Modeling Trade for Bloomberg
  • Use function SNCD
  • Complete the details and send to Bloomberg
  • Once trade is modeled on SNDC analytics can be run
  • Trades can be modeled but not sent to Bloomberg
  • SNDC allows an option to post trades to New Issue Monitor (NIM2)
  • What determines posting to NIM2
      • Dealer
      • Customer
      • Office of Finance
bermudan spread grid an illustration
*Bermudan Spread Grid-an illustration

*this is for illustration purposes only and may not reflect actual levels

recent trends in callable issuance
Recent Trends in Callable Issuance
  • Shift in issuance from callable auctions to large negotiated deals
  • Shift in call issuance from shorter lock-outs to longer lock-outs
  • Increase issuance in step-up notes
return of the 1 billion deal size
Return of the $1 billion deal size
  • Over 25 callable issues since February 1 with issue size greater than $1bln
  • All issuance has been FHLMC and FNMA only
  • Minimum of one year lock out and all have been European calls
  • FNMA has issued $23.4 billion in 12 deals
  • FHLMC has issued $22.5 billion in 15 deals
  • Substantial coupon pick-up versus smaller deals
      • Including those at the $250 million index eligible deal size
  • Large liquid deals with strong secondary market support
  • Customer demand appears strong with limited dealer inventories
  • Short settlement dates

Source: Bloomberg data from Feb. 1 to March 6, 2009

increased reliance on fhlb and ffcb callable auctions
Increased Reliance on FHLB and FFCB Callable Auctions
  • From mid 2007 this is essentially the only way to acquire bonds with short lock-outs
  • Almost daily auctions by both issuers with the ability to upsize
  • Auctions driven by agency call volume and not dealer inquiry
  • No ability to customize trades and call types are always American
  • Clearing levels can be wider than negotiated issues
      • In some cases by 50bps
      • Best way to acquire bonds with short lock outs (3 and 6 month)
  • Dealers are required to bid in auctions and have limited input on structure type
  • Recently, auction volume has slowed dramatically
      • Not as many bonds being called
      • Balance sheet growth has been limited
longer versus shorter lock outs
Longer versus Shorter Lock-outs
  • Longer lock-outs have been pricing with higher coupons than shorter lock-outs
      • In normal times this process is reversed
      • The shorter the lock, the higher the coupon
  • Agencies are viewing 3 and 6 months lock-outs versus issuing discount notes
      • If they can issue a 3 month discount note at EDSF- 97, why issue a 2nc3mo?
  • Discount notes are trading very rich vs. EDSF
  • Agencies have need for longer duration liabilities
      • Funding levels for longer lock-outs are much more aggressive
      • Recent success in issuing large bullet issues to secure term funding
longer versus shorter lock outs cont d
Longer versus Shorter Lock-outs - cont’d
  • Investors with bullish views will prefer short lock-outs as discount note alternatives
      • Also prefer European style calls to lock in duration
      • Barbell positions with short lock bonds and European calls
  • Bearish investors prefer shorter lock-outs and step-up bonds
      • Traditionally shorter locks have had higher coupons
      • In rising rate environment view is that nothing gets called
      • Secure the highest coupon possible
  • Current environment has made that strategy very difficult
  • In theory, the more calls the higher coupon will be
      • Additional compensation for selling more call options should translate into higher coupon
      • A 3nc1yr semi-ann berm has four call options to sell vs. only one on a European
discount note funding matrix
Discount Note Funding Matrix

As of March 6, 2009

Source: FHLB discount note window

increased issuance of step ups
Increased Issuance of Step-ups
  • Issuance has been in all maturity tenors
  • Multi-steps, one-time steps and canary steps
  • Predominate issuers have been FHLMC and FNMA
  • Shape of the yield curve and absolute level of rates is driven by customer demand
  • On a forward curve basis, some look very attractive
  • Defensive trade against a rising rate or flat rate scenario
  • Underperformance if bond is called early in the step process
using step ups in your investing strategy
Using Step-ups in Your Investing Strategy
  • Short maturity step-ups seem to fit better with public entity accounts
  • Buyers of step-ups tend to be defensive in nature (bearish)
      • Hybrid between adding the duration vis-à-vis bullet and;
      • not giving up the coupon of a callable bond
  • The lower the initial coupon the less probable the bond gets called at the initial call date
  • Make sure you compare the step-up versus a variety of alternative investments
      • Fixed-rate callables
      • Discount note
      • Short-bullets
    • Make use of the forward curve analysis on Bloomberg
      • EDSF and FWCV
step ups cont d
Step-ups – Cont’d
  • Step-up example of a 2yr-nc1yr 1x
      • Fhlmc 2.00 3/16/11-3/10 1x
      • Fhlmc step 3/18/11-3/10 1x 1.50% for year 1; 2.75% for year 2
compare alternatives to 2nc1 1x trade
Compare alternatives to 2nc1 1x trade
  • Review forward FHLMC bullet curve
      • 1yr rate/1yr forward shows 2.05%
        • This implies that 1yr bullets in 1yr will yield 2.05%
  • Compare vs. a 1 year bullet investment now
      • Current 1 year bullet yields 1.05%
    • Calculate and compare breakeven for the 1yr bullet
        • Use Bloomberg GA3 function
        • In this example the breakeven’s are
        • 2.954% for the fixed callable and;
        • 3.192% for the step-up
          • See example
summary fixed vs step up callable
Summary- fixed vs. step-up callable
  • If you are bearish on front end rates
      • The step should out perform as neither bond gets called an you receive the benefit of the higher back end coupon.
  • If you are bullish on front end rates
      • The fixed bond should out perform as both bonds get called allowing for a higher YTC.
    • If you believe volatility will rise
      • The likelihood of the step getting called is decreased, all else being equal, with higher volatility a new bond would be issued with a higher coupon
    • If you believe volatility will fall
      • The likelihood of the step getting called is increased, all else being equal, with lower volatility a new bond would be issued with a lower coupon
step up performance
Step-up Performance
  • Commonly used evaluation methodology
      • IRR
      • YTM/YTC
      • OAS
      • Total Return Analysis (TRA)
  • How would Step-ups underperform vs. traditional callable bonds?
      • Called before the average coupons would have exceeded a non-step
      • Not called as expected
        • Duration extends in a rising rate environment
      • Need to sell prior to maturity
        • Liquidity may not be what you think