Pub 8 2020 Issue 4


Questions to Answers: Net interest margin in jeopardy? Here are some solutions

To start the year, I’d like to both properly memorialize the late, great Alex Trebek and provide some helpful suggestions for investment management in this challenging rate environment in which we find ourselves. And I’d like to do it in the space of this column, so let’s pick up our signaling devices and see what answers we have in front of us.

Answer: Community banks are embracing this segment of the municipal bond market after being shunned for the last three decades.

Question: What are general market munis?
General market munis are differentiated from bank qualified (BQ) munis in two ways. First, there is no limit on the size of the issue (BQs are limited to $10 million per issuer per year). Secondly, the uses of the proceeds in general market munis are virtually limitless; BQs must be for essential services. As to why BQ issues have been favorites of community banks since 1986, they qualify for beneficial tax treatment related to an institution’s cost of funds. This TEFRA application normally creates higher tax-equivalent yields for bank-qualified issues. However, this advantage begins to shrink when tax rates and the cost of deposits decline, and both of these conditions have been in play since 2017. The result? Community banks have been buying roughly twice the volume of general market issues vis-à-vis BQs lately. We’ll see if that trend continues if cost-of-funds levels — or marginal tax rates — ever rise again.

Answer: Community bank bond strategies have recently begun including these types of mortgage-backed securities (MBS).

Question: What are multifamily MBS?
All three of the major housing agencies, GNMA, FNMA and FHLMC, have stepped up their issuance of multifamily MBS in the past five years. The main reason for the growth is that more of us live in 5+ family dwellings than ever before. Another is that they can offer some structural advantages over generic pass-throughs. For example, many multifamily pools have short state final maturities of seven to 10 years. Another is that they almost all have some prepayment penalty baked into the structure. While penalties (or “yield maintenance” provisions) are common in commercial real estate lending, they’re almost non-existent for single-family loans. The prepayment protection they afford is especially attractive in yield environments like we have at present.

Answer: These three factors can each help limit prepayment risk on amortizing securities.

Question: What are the borrowers’ rate, loan size and geography?
At the end of the day, only a few criteria can provide tangible protection against wholesale refinancing (read: prepayment risk) in generic MBS. The most causal relationship is the borrowers’ rate (in bond speak, the “gross WAC”). The lower the current rate, the harder it is for a homeowner to economically benefit from refinancing. There is a high correlation between note rate and prepayment speeds. Similarly, the more a borrower owes on their dwelling, the more likely the math works in favor of a refinancing. What isn’t quite as universally known is that certain states (e.g., New York and Florida) have punitive taxes and fees that make the prospects of cutting the debt service costs much more difficult. As an investor, you can ask for “prepayment friction” pools containing some specific collateral that can significantly reduce prepayment risk.

Answer: This is by far the most popular month for municipal bond maturities and calls.

Question: What is January?
Given that we’re embarking on a new calendar year, and, generally speaking, community banks have more cash and liquidity than they prefer, it’s worthwhile to mention in the near term, there will be a lot of money being turned over in muni land. It’s possible that the “January effect” could play out in all its glory this year.

That is the outcome of a lot of money chasing a limited supply of bonds. Many municipal borrowers, including BQ issuers, don’t tap the market until later in the year. So, it’s entirely plausible that combining the wave of redemptions coupled with scant early-year supply will put a heavy lid on yields. Many community banks forward purchase in January and February once they identify which bonds in their portfolio will be maturing or will be called away.

Answer: This financial services sector punched above its weight in extending credit to small businesses at the height of the COVID-19 pandemic.

Question: What are community banks?

Jim Reber

Jim Reber ( is president and CEO of ICBA Securities, ICBA’s institutional, fixed-income broker-dealer for community banks.

This story appears in Issue 4 2020 of the Community Banker Magazine.