This is part two of our look at Strip Funding vs. WAL. In part one we explained the differences in the two methods. Today we’ll look at why (and when) these methods can produce significantly different cost of funds calculations – and why that matters.

## Why Strip Funding Is Superior to WAL

When it comes to choosing a method for pricing loans, we know that WAL (Weighted Average Value) is often considered easier to calculate. It has been used successfully in pricing models for many years. But we believe Strip funding (sometimes known as Match funding) yields a better-priced loan -- one that keeps you competitive in the market and allows you to maximize profits.

One of the most significant issues with WAL is that to get the projected COF, all the funds would need to be borrowed at the calculated term. In the example we showed in part one of this blog post, for a 60-month term (120-month amortizing loan with 0% CPR), you must obtain all the funds within a 48-month term. What happens after 48 months becomes a problem, since approximately two-thirds of the balances are still outstanding at that point.

In theory, you would need to obtain new funds for another 12 months. Unfortunately, predicting the level of the FTP curve 48 months from now is difficult to determine. Up through the 48th month, about a third of the funds are scheduled to be paid back. You would need to make assumptions about where these funds would be invested and what rate could be obtained. The most important issue is that these methods imply different COF and as a result, require a different lending rate to reach certain target RORAC (ROEs).

Also, the WAL method, by its nature, is not a reasonable procedure to use with adjustable rate loans. So any model using WAL cannot include these types of loans, while the strip funding method will provide an accurate cost of funds.

Clearly WAL is less accurate than Strip funding. But should banks be willing to trade off less accuracy for greater ease in calculation? That depends on how much the COF calculations of Strip Funding and WAL vary.

We looked at some historical data to make that determination. Spoiler: The variance matters. Read on to find out how much.

## Looking at the Historical Results

Many US community banks use the FHLB fixed-rate advance curve as the basis of their FTP curve. These fixed-rate advances reflect changes in the marketplace and have a close correlation to movement of their “all-in” cost of funds. We tested the results of Strip compared to WAL funding using the FHLB of Des Moine, Iowa historical fixed advance rate of data from January 2000 to February 2016. The data includes 4,163 observations.

One of the best aspects of this information set is that it looks at 16 years of data that encompass at least two economic cycles. We tested two major categories of fixed-rate loans, those with a 120-month and a 240-month amortization. In both cases, we examined 36, 60 and 120-month term loans. For the 240-month option, we also added a fully amortizing loan. We initially assumed no prepayments.

The model discussed in the previous post was used to determine the cost of funds (COF) for each of the FHLB observations using the Strip and WAL funding methods. Let's take a look at the tables below to outline the differences that result from these calculations.

*Note: that the numbers here represent the result of taking the Strip COF for each observation and subtracting the WAL COF. So positive numbers reflect a higher COF for Strip, while negative numbers indicate a higher WAL COF. *

##### Strip Versus WAL Funding Differences (No Prepayments)

- The longer the duration of a loan the greater difference on average between the two methods.
- The closer a loan is to being fully amortizing the greater is the difference. In other words, the more a loan has interest-only characteristics, the less likely there will be differences.
- The shape of the FTP curve matters a great deal. The steeper the curve, the more likely there will be differences.

The first table shows the results for a loan with an amortization of 120 months. The average difference is 6.5 basis points (bps) when the loan term is 36 months and 24.6 bps for a fully amortizing loan (term of 120 months). For a loan of 36 months, the maximum difference was 17.5 bps, and the minimum was -1.4 bps. The last category was the percentage of time that the difference was within 1 bps (plus or minus). For the 36-month loan about 15% of the time there was a minimal difference, yet in the fully amortizing scenario this hardly ever happened (.74% of the times). We see a similar pattern with the 240-month amortizing loans.

We also noticed that the steeper the FTP curve, the greater the difference between the two methods. Using the FHLB data we looked at the difference between the Strip and WAL, and how that correlates over a 120-month amortization with steepness. At 36 months, it correlates 90%, 84% at 60 months and 77% at 120 months. We used the difference between the one-year and 10-year maturity as a measure of steepness. The greater the difference between the one-to-10-year spread, the greater the difference between the two methods.

The following chart plots the differences for the loans with 120-month amortization by business day over the 16-year period, as well as the one-to-10 year spread. In most cases, this illustrates a close correlation between the movement of the change in the one-to-10 year spread and the various term loans.

## Running the Numbers With Prepayment

We also examined the output to see if the results would change if a prepayment assumption is included. In the next set of examples, we assume a 120-month amortizing loan with terms of 60 and 120 months, but we add a 5% per annum constant prepayment rate (CPR). We also assumed that all prepayment represents partial repayments. Having early repayments will shorten the WAL.

An upward sloping yield curve has dominated the rate environment since the beginning of the 21st century. As a result, the COF using either method will be lower than when the CPR is set to 0%, since more of the funding will occur in earlier periods. Using the Libor/Swap yield curve from late August 2017 and adding a 5% CPR to the example shown previously in part one results in a WAL decline for the 60-month and 120-month amortizing loan from the prior 32 and 48 months respectively, to 27 and 41 months.

Although both the WAL and Strip funding COF fall under the 5% CPR, the latter declines by a greater amount. For the 60-month term of the 120- month amortizing loan, the difference between the Strip funding and WAL moves from positive 4 bps (with 0% CPR) to negative 12 bps (with 5% CPR). Much of this difference is because the 0% CPR loan had about 57% of its balance remaining at the end of the balloon term, while the 5% CPR only had 37% of its balance left. Since the final payment almost always has the highest rate associated with it, the strip funding COF declines more significantly than the WAL funding example.

The table above has the the results for the FHLB of Des Moines FTP curves for loans with 120-month amortization. It is identical to the one shown earlier in this post, except this table incorporates a 5% CPR.

The Strip funding COF fell, on average, more significantly in most cases than the WAL COF. On average the WAL had a higher COFs, which is the opposite of what was observed in the no CPR scenario. However, more importantly, the differences between the 90% Percentile and 10% Percentile is much larger. Also, except for the 120-month term, the minimal difference (1 bps) fell relative to the scenario with no assumed CPR.

In the two tables below, we can see the shift to the left, or WAL COF having a higher rate than Strip in the 5% CPR case.

## Charting the Differences for Floating Rate Loans

For most floating or variable rate loans, the short end of the FTP curve is used as the basis for the cost of funds. However, many banks incorporate a Liquidity Premium (LP) curve, so that a three-year floating rate loan will have a somewhat higher COF than a one-year, but also lower than a five-year. These differences are generally not as significant as when they are calculated for a fixed-rate loan since there is limited interest rate risk. Regardless, you must consider that the floating rate loans still carry basis and funding risk when you make pricing decisions.

The table below shows a Liquidity Premium curve as of late August 2017.

We have found that there are several methods used to determine appropriate LP to add to the short end of the FTP to determine the COF. Both Strip and WAL are commonly used, but some banks treat the loan as interest only, despite being amortized. They will use the final maturity as the WAL. The table below shows the difference between the WAL and Strip funding methods using the LP for a floating rate loan:

The above table shows the difference between the WAL and Strip funding methods on a floating rate loan using the LP for a floating rate loan

Based on this analysis, there are some differences in the COF for the floating rate loan depending on the method used. While the difference may be less as compared to the fixed-rate scenarios, due to the generally lower level of rates used in LP, you would still see a difference in loan rate required to reach a stated RAROC(ROE) target.

## When the Variance Gets Significant

The results clearly show that there are often differences in determining COF when using Strip compared to WAL methods. In some cases, the differences are immaterial (less than 1 bps), while in others the variability is more significant.

We think this final table below is particularly illustrative. It shows the absolute difference between the two methods for a 120-month fixed rate amortizing loan. This table shows results using prepayment assumptions of 0% and 5%, respectively. It demonstrates the absolute difference between the two methods for 75% and 50% of the time when using the FHLB of Des Moines FTP curve.

The 36-month term the difference is at least 3 bps in 75% of the cases and 7 or 10 bps for the 0% and 5 % CPR, respectively, 50% of the time. For the 120-month term loan, for both the 0% and 5% CPR, the difference was one-eighth a percent 75% of the time and one-quarter percent in about 50% of the times.

In some cases, the difference is immaterial, but as the information from the 120-month amortization table shows -- the difference 50% of the times is at least 7 bps and for a fully amortizing loan it is 25 bps.

We have also found that there have been periods in time where the that difference can be over 50 bps. This means that a loan could be badly mispriced. While that might satisfy the customer, if underpriced, it ultimately reduces profitability. Or the loan could be over-priced, which is ideal for profitability but could also encourage the borrower to engage with a competitor that uses a more accurate pricing solution.

## Conclusion

Our careful analysis has convinced us that the Strip method is the better way to calculate the cost of funds. We use it in our solution because we believe it provides a more accurate method to convert an FTP curve to cost of funds for the loan. If your current model uses something other than Strip funding it might be best to review the results.

## What's Next ...

We also recently took a deeper look at another popular pricing question: "Should I price using Libor or Prime?"