Forming a Strategic Alliance With the HLB Letter of Credit
By Maureen Kalena
Liquidity is a key strategic issue for financial institutions. Having available collateral is a crucial element for tapping potential liquidity. Often, securities in your investment portfolio are used to collateralize state and municipal deposits. While this may be a valid method of managing your balance sheet, it has a downside – it may curtail your liquidity position and create operational headaches. There is an alternative solution: the Letter of Credit program from the Federal Home Loan Bank of New York (HLB).
AN ALTERNATIVE OPTION
As a key partner in financing, the HLB issues triple-A rated Letters of Credit (L/Cs) on behalf of its members to support liquidity, asset management, housing and economic development activities. An HLB L/C is a promise, made at the request of a member, to make payments to a third-party beneficiary in the event of a default of a performance. In particular, the HLB’s L/C program can provide an efficient and low-cost way to collateralize state and municipal deposits.
Thanks to the HLB’s New Jersey members, who worked with the HLB to obtain approval on this program, New Jersey members can now enjoy the benefits L/Cs have to offer. In May 2004, the New Jersey Department of Banking and Insurance promulgated a new rule allowing New Jersey financial lenders the ability to pledge HLB L/Cs as collateral for various municipal deposits.
The new rule states: “In addition to obligations otherwise authorized in N.J.S.A. 17:9-41, eligible collateral shall also include irrevocable stand-by letters of credit issued by the Federal Home Loan Bank of New York. The Commissioner shall review and approve the form of all such letters of credit proposed by a public depository as eligible collateral under this section. Further, the original letter of credit shall be held by the Commissioner.”
As your institution’s assets grow faster than its deposits, evaluating and managing liquidity becomes increasingly more important. Since liquidity is all about having sufficient funds to meet deposit withdrawals and other financial commitments when due, the HLB’s L/Cs make managing liquidity risk a little easier.
Using the HLB’s L/Cs allows your institution to keep its securities free for other uses. This now includes municipal deposit assets, which would otherwise be considered illiquid assets. L/Cs can help improve the earnings on your institution’s securities portfolios by reinvesting those low-yielding securities into higher-yielding investments.
Another advantage of using this competitively priced instrument is the reduction of transaction costs. Since the HLB takes on the liquidity risk, your institution can reduce the operational expenses associated with monitoring specific securities pledged for deposits. HLB L/Cs also eliminate the need to match securities and monitor margin calls. Your institution’s alliance with the HLB, being a congressionally chartered government-sponsored enterprise, allows your institution to take advantage of the HLB’s credit standing and capital market access.
Furthermore, the HLB L/C can also be a valuable tool for everyday banking purposes, other than the collateralization of deposits. L/Cs can be used to support transactions promoting home financing, housing activity or economic development through tax-exempt bonds or note transactions. L/Cs also facilitate interest rate swap transactions with third parties, beneficiaries’ draws of interest payments from bond issues, and the purchase of or the commitment to purchase mortgage loans. Other benefits include the provision of credit enhancements for collateral subordinated obligations or other MBS securities, as well as credit support in the sale of whole mortgage loan portfolios.
There are two types of L/Cs to choose from – the Irrevocable Standby L/C and the Irrevocable Direct Pay L/C. The Irrevocable Standby L/C provides that the HLB will pay a draw request to the beneficiary when the beneficiary certifies that there has been nonperformance with respect to an underlying transaction. The Irrevocable Direct Pay L/C permits the beneficiary to look directly to the HLB for satisfaction of the member’s obligation. Whichever L/C is chosen, both are low-cost and easy to use, with no capital stock purchase required.
Maureen Kalena is vice president of banking services for the Federal Home Loan Bank of New York. She can be contacted via e-mail at firstname.lastname@example.org.