Putting Your Excess Liquidity To Work

[Intro]: Helping community bankers grow themselves, their team, and their profits, this is the community bank podcast. Now here are your hosts, Eric Bagwell and Tom Fitzgerald.

Eric: Welcome to the community bank podcast coming to you from Atlanta, Georgia. I’m Eric Bagwell, Director of Sales and Marketing for the correspondent division of center state Bank. Joining me as always, Tom Fitzgerald Tom is our strategist in the capital markets area, Tom you doing okay?

Tom: I am doing good Eric thank you.

Eric: Well, Tom mentioned earlier he’s back his element for this show. We’re going to talk about investment portfolio management which we, we had a show probably a month and a half ago, and it was our most listened to show. So Tom is excited about today. But before we get started there, I just want to remind everybody that you can go out to Spotify iTunes, please subscribe to our podcast out there. If you do, you will be notified once the show post, I think we’re up to just under 1400 listens for a month. So we’re excited. And Tom, this is a milestone for us. There’s a local radio show here in Atlanta, Sports Talk. I think they’ve done like 12,000 shows together. This is our tenth so big deal we made it to double digits on the net, they said it would never stick.

Tom: You know, you know the longest journey begins with a single step so we’re getting there.

Eric: Ancient Chinese proverb, good call there so. Well, let’s get to our guest today. We’re thrilled to have these folks. Patty Gorman. Patty is actually in the studio with us today. She’s a bond salesman, works out of our Atlanta office here, covers banks in Florida, and she’s going to have some great insight for us today. Patty, thanks for joining us today.

Patty: Thank you for having me, Eric.

Eric: And then we’ve got Parker Groves, Parker works in our Winston Salem office, Parker covers banks in the Carolinas. And I think all the way up to Washington DC. Parker, we’re glad to have you today as well. So thanks for being on.

Parker: Thanks for having me, Eric.

Tom: As Eric said this is an episode that I’m really excited about the last several months that we’ve had been on topics that were, I’m sure compelling to the listeners and informative. But it was sort of topics that I was kind of a fish out of water. So I kind of just tried to make my way through it. This on the investment portfolio side, this is kind of my expertise, I’m really glad to get Patty and Parker, just kind of go over where we are like Eric said, we did one of these about six to eight weeks ago. And so, we thought it would be a great time to kind of get back and revisit, you know, where we’ve transitioned into the summer, the re-openings and then some of the setbacks from the re-openings. And just kind of get a feel for what, you know, Patty and Parker are seeing from their customers, but they’re hearing what, you know, what’s working with them, maybe what’s not working with them. So I think with that Patty I’ll just kind of give you a chance to get started, kind of just tell us what you are hearing from your customers. How are those discussions going?

Patty: Well, I think, for the most part, I’m hearing that the majority of my customers have excess liquidity they need to invest. But when they look at the rate structure out there, it’s kind of deer in the headlights, it’s like what do I do? Can I really go out that long, because, you know, the yield curve is pretty spot funds is earning 10 basis points? So I think the hard thing to convey is the Fed has projected and I know you’ll talk about this in a minute, that they’re not going to get even think about raising rates until 2022. And recently, it’s even longer, maybe 2024. I think, more frustrating than that is we similar customers were in the same position two months ago, and we were, you know, 80 basis points on the 10 years, and then we made it all the way down to 50 basis points on the 10 years. So after a day like yesterday, where we get a little bit of a backup. I don’t customers can’t sit on the sidelines and not invest. I believe that this time that they’ve got to get all cylinders firing on the balance sheet right now. And as hard as it is to invest at these levels. I think I have to.

Tom: And that’s kind of you know, it’s difficult, obviously, with rates near zero to kind of jump up and down and say this is a great deal. Because it’s just not, you know, the market is just not giving us those kinds of deals that you want. But again, to your point, it’s not a case of just sitting on your Fed funds balance and just waiting because I think that wait is going to be fairly long. And there’s, I put together a spreadsheet and it kind of shows where we kind of project what the Fed fund rate is going to be for the next four or five years. And then compare just sitting in Fed funds versus an investment, in this case, I put together investment being a 15-year 2% coupon that was yielding 1%. Again, nothing to write home about as far as that yield. But over a five-year period, it out earns this just sitting in Fed Funds by $300,000. And this is under ten-million-dollar investment. So even that I kind of projected a few rates increases at the back end of that five-year period just to be a little bit more conservative. So, you know, we kind of put it in dollars and cents, you’re sitting there, you know, if you’re just going to sit in Fed funds, it’s probably going to be a costly decision in the long run for the bank. And everybody’s fighting, you know, net interest margin compression. And so, you know, sort of like every basis point is precious and you know, you don’t want to just give that up waiting for something that may not happen for a few years. So with that, I’ll kind of turn it over to Parker now. Parker, give us kind of that same feel for what you’re seeing what you’re hearing? what’s working, you know, from the sales side?

Parker: Sure. Thanks, Tom. Patty, I think you’re exactly right. Most of my customers are telling me they are very flush with funds, think they anticipated with PPP loans that excess funds will probably leave them. But in reality, the actual opposite has happened, and they have more funds than they were thought they were going to have. So kind of the deer in the headlights what to do, and what not to do. So. Tom, you mentioned 15-year twos. And what we have found is that a lot of folks are looking for a place to hide out without getting themselves into long-duration security or a lot of interest rate risk, but yet earning some type of spread to fed funds. So one of the pools that I’ve really been working and had great success with so far is 15 years two. It’s about $9 billion. Now in total part value. And when I started on the pool, it was 7 billion. So just this month, it’s increased by $2 billion. There are 20,000 loans in it. When it was at seven now it’s like 29,000 loans. And so it’s really grown. What’s really interesting about it is the underlying weighted average coupon, as we call whack is a 266. So all the loans average on a weighted basis of 2.66%. So, if we’re worried about prepayments, we’re going to have to see yields really fall somewhat significantly further, for these folks are in this particular pool to refi. This poll is yielding to your point, somewhere in the one-to-one quarter type yields depending on historical prepays. Bloomberg has two specific models that they are using called Beam Ed. and Bam and both of those Bloomberg models are being very aggressive in their prepay assumptions. In reality, what we’re seeing is, historically, they’re much slower, and obviously, with the premium in the one to four type level, is yielding that one to one a quarter type deal. And speaking of premium, a lot of my folks have said that they’re scared of premiums. And that is I agree with that. One of the advantages of a poll this size is $9 billion in paramount, 27 29,000 loans, you’ve got some protection there if there is a little bit of prepayment because it’s going to be spread over much larger loans.

Patty: I agree with you, Parker. And just like he said, you know, the large size of the loan prevents the prepayments but if you’re putting something on the books at this stage in the interest rate cycle, don’t you want the lowest dollar price that you can possibly invest in? Which is your 15 year two right now?

Parker: Yeah, I would agree with that Patty, and certainly, our head trader has shown us some one and a half percent coupons, but the liquidity is just not going to be there. We don’t believe long term and believe that the 15-year twos are a better, better spot to be in. I know, Tom, you are probably going to talk about this, but Penny and Freddy did Institute a 50-basis point fee for Refi’s, that’s going to take place now I believe in December. So again, rates are going to have to fall pretty significantly for these folks to be able to make it worth their while to Refi.

Tom: Yeah, you’re right, that program was slated to start September one. And it was just for Refi’s only. So not purchase applications. I think they got a lot of blowbacks, both from industry groups, as well as some, you know, some of the politicians and so they’ve pushed it, as you said to December 1, and it probably, it wouldn’t surprise me if they if it gets pushed back again if we’re still sort of struggling on the economic side. You know, you talk kind of going into another vein, you talked about obviously the number one risk for mortgages, keeping that dollar price levels, the prepayments that you were just saying, heavy prepayments, and one thing that’s probably going to drive that even more is that from the cares act, there were forbearance programs where they were struggling, you could basically hold off on your mortgage payments for a period of time, I think, up to a year. What’s interesting, though, in the Ginnie Mae program, once a loan gets to be 90 days or more delinquent, that loan can be bought out of the pool. And there’s some advantage to that, from the buyers perspective, you’ve got a pool that probably has a price of a 105 or 106, they can buy that loan out at par, so they can kind of lift that out of the pool at par. And then you know, kind of profit from that side of the transaction. But what happens to the investor is he sees a prepayment coming from that loan being bought out. So it’s just one more element of prepayment risk that we have to be aware of. And I think it’s one thing where, you know, I think you want to kind of scour your portfolio and I think Patty you’re going to talk to that too.

Patty: Yeah, I think now is very important to actively manage your mortgage back portfolio, the mortgage-backed security side of your portfolio, and look at a six-month historical CPR speed to determine what kind of prepayment trajectory you’re on. And the good news is, if you own general collateral, because of the drop-in interest rates, you probably got a game so you can go in there and come out of some of the faster-paying pools and invest in the 15 years two that Parker is talking about. I just wanted to just say one thing, Parker and I talked, and I couldn’t believe how much that 15-year pool grew over the last month $2 billion, that tells that speaks to you what is going on out there. So everyone is refinancing from a 30-year mortgage down to a 15-year mortgage. So it’s really important to stay on top of these CPR speeds. We can do that for you. We can run a historical speed analysis. And I really recommend that you take a look at that.

Tom: Kind of stepping away from the mortgage arena, kind of talk about some other products. And as we record this, we’re right after the Jackson whole symposium, the Kansas City fed holds every year. And the big news out of that was the Fed kind of rolling out this what they call their new monetary policy framework and the big item, and that was that they are going to now just sort of setting up targeting, you know, a hard 2% inflation target, they’re going to do more of an averaging approach where if we’re under 2%, for a period of time, they’ll let that rate drift over 2% by a similar period of time so that on average, it’ll, it’ll rest around 2% target rate, and so that’s caused the back end of the market to back up several basis points on the 10 years in the third year, with a thought that the feds going to let the economy run a little bit hotter and kind of engender a little more inflation. I guess my counter to that as they’ve been wanting to get to 2%. For the last decade, it’s been, it’s been a hard push. So now they’re wanting to get it even over 2%. It’s like, Okay, I’ll believe that when I see it. And I think Parker you want to add in on that.

Parker: Well, I also want to go back and hit on what Patty talked about a minute ago and looking at the portfolios and seeing over the last six months. Maybe what the CPR speeds might do. And one of the things that we look at when we make purchases, and then we talked about this really large pool, and that’s a little unusual. You just don’t see pools quite that big and 15-year land. But what we try to do is look at some of the origination and where it might be coming from and actually who the originators are. And we have found that these third-party originators such as Quicken, and Rocket Mortgage. Those mortgage backs have a heavy issuance by others. Those underwriters tend to prepay faster because once they get in their system, rates fall and all sudden the homeowners’ phones start ringing and saying hey, mortgage rates have dropped, and we need you to refi. Whereas some of the banks originated mortgages such as up IBMA are well Fargo or trust BB&T type origination those polls tend to be a little less speedy if you will. And so therefore we don’t see the prepays quite as much.

Tom: That’s a good point and that’s something that like you said, our traders really pay attention to that third-party originator level. And try to select pools that kind of We get that number as low as we can because of that element of prepayment risk there. Stepping back then to what you know what the Fed is changing their inflation targeting to. And it sort of dovetails with you know, we’ve been trying to do get people to buy more duration in this environment. Obviously, with low yields, that’s a sort of your kind of going down a tough road to get the transaction done. But we still believe it, I still think I’m going back to this discussion of the Fed wanting to get over 2%. Yeah, like I said, I believe that when I see it, so I think this backup right now is probably more of a buying opportunity than it is a kind of a reversal of the trend of lower rates. So and I just want to turn it back over to Patty Just to say again. What are you experiencing with your customers when you bring up that topic of let’s go get some longer duration, more positively convex type Securities.

Patty: That’s exactly right. That’s exactly what customers are looking for and it goes back to trying to add positive convexity with longer duration product. But also, it speaks to how we got our customers to manage the investment portfolio and set up somewhat of a barbell approach. So I hear from a lot of customers when we bring mortgage backs to them to invest, they say I don’t need cash flow I got more cash flow than I possibly can. But I think it sets up a process that if you know, we come out of this recovery quicker than we think we’ve got the cash flow from the mortgage backs securities yet, we can go a little bit longer with municipal securities to add duration, and yield, because what we’re selling a lot of right now is taxable meanings in that 10-to-12-year time period. We’re targeting anywhere from one and a half-rate to 160 rates on yield for those. It’s the intermediate part of the curve. We had a huge blowback and in our municipal market two-three months ago, so a lot of people added Long, long paper and I feel like this intermediate part of the curve is a great place to add the taxable securities along with the 15-year mortgages. Parker, I know you have been selling our tax-free units out on the long curve, which we like that trade as well.

Parker: Sure. And so, I would concur Patty that certainly on the taxable side we’ve seen a lot of new issuance due to the tax law changes in 2018 were some of the stipulations then there were municipalities can’t do advanced refunding, but they can do it with taxables. So that’s the reason why we’re seeing so much more issuance on taxable and then spreads and then wider which has allowed us to really have some interest in those taxables.

Patty: And when you compare it to everything else in that intermediate part of the curve, the last thing you want to do is buy a 10-year six month. So it’s cheaper than anything out there.

Parker: Right and then on the bank qualified in general market tax-free monies. We’ve seen a lot of interest as well. Of course, what’s happened on the bank qualified side kind of refers back to the tax law changes. The issuance is down, so we’re not we don’t see quite as much issuance in that realm as a result, bank qualifies have been a bit more expensive whereas general market tax freeze which obviously is larger than $10 million in issuance in any given year. Otherwise, it can be designated bank qualified we’re seeing a lot more issuance. Yield seems to have stabilized somewhat, there’s been quite a rally in meetings, but that we seem to have bottomed out and stopped falling if you will. Non-banks are qualified or getting as we believe cheaper, and we have many more banks buying non-bank qualified than bank qualifies at this point.

Patty: But they can also buy size there, right Parker?

Parker: Absolutely that’s a great point. Typically you don’t see a million-dollar-plus offering in specific maturity on bank qualifies, whereas a lot of times, they’re certainly much more size on the non-bank qualified sector.

Tom: And I’m just going to speak to what our bond accounting customers have been doing in the second quarter, we do kind of a quarterly review of what that what those portfolios look like from a yield and duration perspective, obviously the yields have fallen off from, you know, we were about 260 when the quarter began. And then as you know, as the Fed lowered all the rates down to close to zero, and then the 10 years dropped into the mid 60 levels at that time, we’ve seen, you know, the portfolio yields dropped to the latest was June month-end, was 239 was the yield. So, you know, pretty big drop, we’ll probably see that continue. Obviously, when we’re investing in one or 1 1/2%, we’re going to continue to see that those yields drift off. What was interesting, that kind of speaks back to the immunity and the mortgage back discussion. In the second quarter 2/3of our bank customers bought into mortgage backs sector. So they’re still very, very heavy and very prominent in the mortgage bank sector. But the second-largest sector was immunities with 19% of the purchases were in municipals. So yeah, that’s higher than it was before, I would say, the quarter before we were in that 10 to 12% of the investment. So, you know, people are coming back to the Muni just because that’s where the strongest yields are, from a typical bank investment perspective.

Patty: Well, and that’s right. And I don’t know if I made this point. But it seems like all the banks are on the same page. And I’ll speak to that in just a minute that everybody’s liquid and they’re looking for a long-duration product with positive convexity, Freddie Kay deal a CMBS deal that came a couple of weeks ago. And it was three times oversubscribed, and it was repriced down by six, seven basis points three times because everybody’s looking at duration.

Tom: And I just wanted to, talk about our bond accounting group and talk about our own portfolio, we’ve got a $3 billion portfolio that’s large, that’s obviously larger than most of our listeners, I would imagine. But it’s a very typical type of investment. If I’m investment standpoint, it would look very much like a lot of our customers and just want to kind of go over some of what they’re doing in the portfolio, because I know a lot of the listeners, we’re always interested in what center state doing. And right now, they’re kind of some of the bullet points, they’re buying bonds and have a little possibility of negative yield, selling bonds that do have a history of negative yield, reducing floaters, which that may seem counterintuitive, but they want to add duration. So you know, removing some of those floaters, obviously helps with the duration. And also, they want to kind of look at the pledging perspective, keep that in mind when they’re adding security. So kind of breaking it down. They’re looking at adding 40% of the bonds that will perform well and a stable rate environment. 40% that will perform well in a lower or stable rate environment. And 20%, that will do better at a higher rate environment. So obviously, the outlook is that rates are either going to be where we are or maybe even possibly lower versus a higher rate scenario.

Parker: Tom, you mentioned the Jackson whole symposium that the Fed put on. And one of the comments that Chairman Powell made was that the Fed funds rate is likely to be constrained by its effective lower bound more frequently than in the past. And that just tells me that rates are going to be downgraded closer to zero for a lot more often than we have been accustomed to seeing, you know, it took seven and a half years last time for the Fed to raise rates. So, when we talk about duration, I think that really plays into putting some duration on the books without worrying about a lot of interest rate risk and one of the bonds that our own portfolio has been purchasing is a 30-year 2% coupon and that Paddy is a $28 billion poll.

Tom: And it’s got 78,000 loans in it and the dollar prices in that 103 level. So again, trying to protect and if we’re worried about prepayments. That’s a pool that is like I said, our portfolios purchased I’ve sold a couple of pieces of it

Patty: I have as well.

Parker: The yield is in the 150-type range. So again, I know that doesn’t sound great, but when you can be Fed Funds by 140 basis points. It certainly makes a difference.

Tom: And I would say going back to your discussion of the Fed and again, this new policy framework, when you read through the entire speech that Powell gave, I think you know, they have a dual mandate right full employment and price. stability, I think for the next several years, they’re going to be more focused on that full employment mandate. And so, again, you know, with the idea of letting inflation kind of run a little bit more, the question is, is it even going to run a little bit more, you know? Given the global situation, we have with the pandemic and just kind of the whole globalization that we’ve been going through in this last generation. So again, I think that it’s a case of like you said Parker. You know this probably going to be the front end of the curve is going to be You don’t have to Zero lower bound for several years Login end It may rise a bit. But I still think the FED understands that they want to get to full employment so if they see the rate starting to rise more then they feel comfortable with it. So it would be, I think they would get back in very heavy in the quantitative easing part of the program. They have grown their balance sheets since March from $4 trillion to almost 7 trillion, so not quite the doubling and that’s just in the last several months. If they started seeing rates start to back up on the long end where it was threatening say the mortgage market, or some other of those vital parts of our economy? I would see them coming in pretty heavy with, you know with the quantitative easing program again.

Parker: I would agree with him. I often have many of my customers asked me what’s going to take rates higher and as I say I don’t see the catalyst right now and certainly the amount of debt that our treasury is issuing for the deficits that we’re spending. I just don’t know how much we could afford and how much higher rates could go before our own government come as a choking point? So I do think that rates stay lower for longer, really across the curve.

Tom: Patty do you feel the same on that?

Patty: I do, I agree, I just don’t see. I think there’s a huge unknown out there because I don’t think that we have seen the full economic impact of the pandemic and shutdown on the economy. Such as we have over the last three months. Numbers are surprisingly stronger than we expected. We got personal income today. And it was harder than we anticipated. But I just think there’s a lot of pain out there on the main street, and I’m not sure that we’ve seen that. You know, we’re hearing that from our banks also is they’re getting loan payoffs, and they’re really not being able to add to the lending portfolio at this time. So, and I was going to mention the broken CD side, and just saying they are obviously historically low rates. And the reason they’re at historically low rates is because the big banks aren’t in there raising money through brokered CD issuance, and it tells you what their balance sheets. So collectively, we’re all flush.

Tom: Right? That’s what we hear consistently.

Parker: You’re exactly right Patty and even the big banks and we also see a lot of credit card banks typically come in and issue a lot of brokered CDs to help fund those programs. And we heard this morning was Capital One came out and actually cut their credit lines, some of their customers because of the lack of the stimulus. It’s an impasse if you will. And to your point, what can happen down the road from a slowdown in the economy.

Tom: And you talked about the fading stimulus? And I think that’s a huge point because I know you were, I think one of the big items in the stimulus package was that $600 supplementary benefit per week, you know, to the unemployed. That was that’s basically expired. Now the President and Executive Order to, to kind of rule out a $300 per week supplement, and then have the states kick in another 100, I think only two or three states have said they’re going to do that. So you’re talking about a benefit that’s being cut in half, to a vulnerable part of the population. And so I think you’ll see this, the stimulus programs that were put in under the cares act start to roll off. And I think it really just has to affect the consumer and their behavior to a negative degree. So I think you add that in and then you get to the fall and then the cooler weather and then is there going to be another, you know, the second wave, as they call it. So it’s, you know, it certainly looks like to me we’re not out of the woods at all with this thing and it’s going to continue to be a drag on the economy and drag on, races as well both from the short end and the long end.

Patty: Couldn’t agree more.

Parker: I would say the same.

Tom: Well I want to thank you both for coming today. I think this is a lot of valuable information, I know our listeners always want to see what the other person is doing. So this kind of Intel that we’re getting from you is very valuable and I’m sure we will kind of circle back again in a month or two to kind of see how things have changed between now and then but again, Patty and Parker I want to you know thank you both for coming today and giving our listeners some valuable information.

Patty: Thanks again for having me.

Parker: Thanks Tom very much appreciate it.