Where Asset Liability Management and Transactions Meet
The Model addresses these questions by determining the return on investment when purchasing or
originating loans. The return consists of the lending and funding contributions to profit, whereby the funding
is provided by retained earnings, deposits or borrowings. The return takes into account market realities,
including the yield curve shape, option cost, expected and unexpected losses, capital allocation and the
allocation of fixed and variable costs. The Model has comprehensive factors to specify loan profitability and
the valuation method is consistent with capital market pricing.
A federal bank regulator, Federal Housing Finance Agency (FHFA), has offered a guideline in Acquired Member
Asset Price Risk Governance, Advisory Bulletin AB 2017 – 03:
1. Should adopt an Option Adjusted Spread (“OAS”) approach to measure profitability when purchasing loans.
Using the “OAS” approach is not because FHLBs have different loan types but because the “OAS” approach,
as opposed to a static approach, is an appropriate methodology for the purpose of measuring profitability.
2. The “OAS” can be determined as a spread off a “liquid curve, such as LIBOR or Treasury, and then adjust the
underlying curve for the differences between the CO* curve and the curve used.”
3. “Minimum Expected Spreads for Pricing Guidance … acquisition prices to ensure the resulting expected
spread to funding covers its costs and provides adequate compensation for the risks assumed, eg option,
interest rate, credit, and model risks.”
The Model follows the three salient features recommended by FHFA guidelines when analyzing loan purchase
profitability: (1) use of Option Adjusted Spread (“OAS”) approach; (2) use Treasury or LIBOR as the Fund
Transfer Pricing (“FTP”) curve to separate Lending Contribution and Funding Contribution in profitability; and
(3) include expenses and adequate compensation for risks.
By way of contrast, some of the commonly used methodologies, such as Net Interest Margin (“NIM”) and the
Static Cash Flow Model, are inadequate to determine loan profitability under current competitive market
conditions. NIM is defined as the spread between the loan rate and funding rate; however, NIM fails to
include many items related to profitability, such as option cost sold to customers and credit risk premiums
across loan types. These items vary significantly across loan types and must be modeled to ensure accuracy.
The Static Cash Flow Model is another means of measuring profitability. The Static Cash Flow Model extends
from an accounting approach by considering one proforma scenario to estimate NIM, as explained above,
and then identifies the profits from the decomposition. The model does not incorporate the prevailing
market conditions, market-determined credit risk premium, model-based prepayments or customers’
behaviors. For example, this method cannot compare the profitability of a 5-1 Adjustable Rate Mortgage
(“ARM”) with caps and floors and a 15-year Fixed Rate Mortgage, as the complex cashflow characteristics of
the ARM defies the use of a standard discount cashflow model. As a result, the estimated values of the
components tend to depend significantly on the ALCO inputs and would not be consistent with the interest
rate and credit models of the asset-liability management process in general.