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Understanding Liquidity Adjustments

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PrecisionLender allows you to enter Liquidity Adjustments to loan funding costs. This adjustment permits variance in the cost of funds (“COF”) based on duration. PrecisionLender believes it is important to use liquidity adjustments in pricing longer term loans due to liquidity risk. Clients should feel free to develop their own liquidity curves using appropriate methods; however, for our clients that would like to use liquidity adjustments but are uncertain how to develop them we provide a recommended curve. For more information, please see our Recommended Liquidity Curve article.

 

In this article:

 

What is a Liquidity Adjustment?

Liquidity Premiums compensate for uncertainty of funding availability in the future. The premium intends to cover the risk of funding uncertainty. The use of liquidity premiums mostly applies to organizations that do not execute matched funding at the loan level and therefore incur a liquidity risk on longer term loans.

A liquidity curve is meant to provide an additional COF for loans with maturities typically longer than 12 months, to address the issues associated with having additional risks to support longer maturity loans compared with those of a shorter term.

For example, a floating rate loan may have a 2.5% COF based on the one-month COF rate on the funding curve. In addition to this COF, a three-year term loan may have an added premium of 0.30% from the current liquidity premium curve. A floating rate ten-year term may have a premium of 1.0% from the same liquidity curve. Typically, liquidity premiums increase with duration. These funding cost adjustments are made on each loan’s cash flow through maturity.

 

“All-in” compared to “Raw” Funds Transfer Curves

All-in Funding Curve

An All-in curve, such as the Federal Home Loan Bank (FHLB) Composite curve, represents the cost to raise funds and by its nature includes premiums for longer maturity debt.

  • The FHLB curve likely includes a liquidity premium, as well as other premiums.
  • Loans with Floating and Swap rate types are considered to have a repricing frequency equal to one month. These types of loans will receive funded liquidity interest expense based on the loan maturity.
  • Amortizing loans will have the liquidity premium applied to each cash flow using a weighted average rate of the remaining principal repayments.
  • When a loan is assigned a liquidity premium, the interest expense field in the PrecisionLender Financial Statement will carry both the raw interest expense from the FHLB COF curve and the liquidity expense from the liquidity curve.
  • Organizations with FHLB COF and a separate liquidity curve will observe that most floating rate and swap loans with a 1-month repricing frequency carry additional interest expense in the form of funded liquidity premium, as shown on the Financial Statement.
  • Organizations with FHLB COF will not observe funded liquidity interest expense applied to any fixed rate loan or adjustable rate loan with a repricing frequency greater than 1 month, since the FHLB curve likely has liquidity cost built into the curve for maturities greater than 1 month.

 

Raw Funding Curve

A Raw curve, such as the Libor/Swap or Treasury curve, does not include premiums and therefore does not contain a built-in liquidity premium.

  • Liquidity Premiums are applied to all loan rate types: Floating, Adjustable, Fixed and Swap.
  • Clients using a Raw curve and a separate liquidity curve will see loans carry total interest expense presented that includes a funded liquidity premium in addition to the raw curve rate matching the same duration.
  • Amortizing loans will have the liquidity premium applied to each cash flow using a weighted average rate of the remaining principal repayments.
  • Organizations that utilize matched borrowed funding might not use liquidity premiums but should determine their own liquidity strategy.

Within PrecisionLender you can elect which type of funding curve you prefer and whether to include Liquidity Adjustments.

 

How does using a Liquidity Curve affect an Opportunity’s return?

All-in curve: In general, Liquidity Premiums are applied to floating, swap and adjustable rate loans with one-month repricing frequencies.

Raw curve: In general, Liquidity Premiums are applied to loans of all rate types.

 

Example:

  • Assuming:
    • 6 month Liquidity Premium = 0.00%
    • 1 Year Liquidity Premium = 0.10%
    • 3 Year Liquidity Premium = 0.40%
    • 10 Year Liquidity Premium = 0.75%
    • 1-month COF = 2.5%
  • Prior to Liquidity Adjustments, a one, three or ten-year floating rate loan will have the same COF of about 2.5% because floating rate loans have a 1-month repricing frequency as noted above.
  • After Liquidity Adjustments, the total COF will be:
    • 1 Year Floating rate Loan =2.60% or (2.50%+0.10%)
    • 3 Year Floating rate Loan =2.90% or (2.50%+0.40%)
    • 10 Year Floating rate Loan = 3.25% of (2.50%+0.75%)
  • If the interest rate charged to the borrower is the same for all three loans, the net income and ROE should be lower for the longer-term loan because interest expense increases with the floating rate loan maturity due to the liquidity adjustment.
  • Loans that convert to a more permanent loan type, such as construction loans, will see a higher COF the longer the permanent loan is.

 

Where Can I View Liquidity Adjustments in PrecisionLender?

Assumptions

Within the Opportunity screen, you are able to view any current liquidity adjustment assumptions applied to the funding package used in pricing by clicking "Assumptions" in the top right corner.

 

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In the Assumptions window, select the "Funding Packages" tab on the top left. Scroll down until you see the "Liquidity Adjustments" section.

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Financial Statements

The impact of liquidity adjustments on an Opportunity can be viewed within the Financial Statements tab, located in the top right portion of the Opportunity screen. From there, expand details for a specific loan by clicking the chevron next to "Loans". Click the Info icon (Shows the information icon) to view the Funded Liquidity Premium applied to the Opportunity.

 

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What Do I Need to Do?

If you do not wish to make any changes to your liquidity adjustments, no action is required on your part. If, however, you have questions about liquidity adjustments or want to use the PrecisionLender Recommended Liquidity Curve, please reach out to our Support team and we will be glad to help you.

 

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