Higher Yielding Assets

Yields higher than US Treasuries Pension plans, hedge funds, and insurance companies are increasingly seeking alternative products that provide yields higher than US Treasuries to optimize their hedging strategies. With Archelyon, they can create leveraged positions in mortgage securities offering yields above Treasury rates (on a leveraged basis), as well as up to 300 basis points higher than AA-rated mortgage securities. These leveraged positions deliver returns without exposure to: - Subprime or high-risk mortgage defaults, - Rising interest rates (no yield loss when funding costs rise), - Idiosyncratic prepayment risk (no loss from increased prepayments absent rate changes). Current assets on Wall Street cannot achieve these yields without exposing investors to one or more of the aforementioned risks. These assets carry the interest rate and prepayment risks inherent in all mortgage instruments (e.g., cash flows must be reinvested at lower rates in falling rate environments, and maturity extends in rising rate environments). However, by eliminating idiosyncratic prepayment risk, insurance companies can use a portion of the coupon income to purchase exchange-traded options, protecting against return losses in both rising and falling rate environments. In fact, they can even use part of the coupon income to buy options across various markets (e.g., equities, foreign exchange, commodities). For example, an insurance company can transform a mortgage instrument with a 300 basis point yield premium over AA mortgages into an asset that: - Provides 100 basis points above AA mortgages, - Generates significant positive cash flow in falling rate environments, - Enables exiting positions in rising rate environments with minimal or no market loss, - Generates returns if equity markets decline by more than 10% or rise by more than 15%. Monetize Access to Federal Home Loan Bank Board (FHLB) In the U.S., the creation of high-yielding structures with customized risk/return profiles is made possible by a hedge fund or insurance company's ability to obtain funding from an FHLB bank. This access to FHLB funding addresses a key limitation that has persisted since the 2008 financial crisis. During that time, liquidity for non-bank providers vanished as investors feared losses in instruments like Asset-Backed Commercial Paper (ABCP) or repo transactions. The inability to obtain funding through commercial paper and repo markets led to the collapse of established non-bank entities like Bear Stearns and Lehman Brothers. Banks survived the crisis due to their ability to borrow from the Fed discount window and the FHLB system. Goldman Sachs and Morgan Stanley quickly acquired FDIC-insured commercial bank status, though this came with significant regulatory burdens, such as complying with Basel III capital rules. Insurance companies, however, can access FHLB membership without assuming the regulatory requirements of an FDIC-insured bank. This membership provides liquidity even in adverse market conditions, allowing insurance companies to offer products that banks (due to capital requirements) and non-bank originators cannot. Using FHLB funding to finance traditional mortgage products exposes insurance companies to risks like interest rate, prepayment, and credit risk. For instance, using short-term FHLB funding to buy 30-year fixed-rate mortgages exposes the insurer to potential losses if short-term interest rates rise, making funding costs exceed coupon income. Funding the purchase of prepayment derivatives (such as Interest Only Strips) also exposes the insurer to idiosyncratic prepayment risk. Furthermore, the FHLB would likely not fund purchases of mortgages with significant credit risk. Monetizing FHLB funding to create high-yielding AA assets can be done transparently and at no additional cost to the insurance company. Creating Custom Assets The key to the structuring process is transferring the funding risk on fixed-rate mortgages, which is achieved through the Archelyon technology. The mortgage owner pays a fixed rate and receives 1M SOFR, with all payments based on the remaining notional balance of the swap. This effectively locks in the funding cost for the mortgages at the fixed rate over their life, eliminating the need for dynamic adjustments in adverse market conditions, as is required with standard interest rate swaps. Our algorithm outlines the specific steps for a credit REIT to execute this strategy.

Hedge Fund Accounting

Archelyon has spent several years refining our product with valuable input from major financial institutions and specialists within the Big Four. Throughout this process, we have conducted numerous regression tests across a wide range of strategies, ensuring consistent results under various scenarios. Based on this analysis, we have been instructed by one of the Big Four firms that bank hedges constructed using instruments based on our proprietary Archelyon technology qualify for both cash flow and fair value hedge accounting. It was also later determined In subsequent discussions (after the FASB rule modifications), that Archelyon hedges qualify for fair value hedge accounting under the ‘last layer’ method. In our discussions with banks, they seek hedges that simultaneously qualify for cash flow hedge accounting and limit the economic consequences in adverse economic environments. Archelyon creates interest rate caps in addition to interest rate swaps. The notional balance on the cap will always track the remaining principal balance on the underlying MBS. Thus, these caps can provide the limits on risk sought by banks. Scenario Consider a scenario where a bank seeks to lock in funding costs for an existing pool of whole loans or mortgage-backed securities (MBS). To protect against potential economic losses from unexpected prepayment changes, the bank uses a mortgage cap. In this case, the appropriate accounting treatment is cash flow hedge accounting for the position in the mortgage cap. The risk being hedged involves funding costs for a pool of whole loans and MBS, projected to prepay at 150% PSA over the next five years, with the bank hedging at a static 150% PSA. The bank is mitigating the risk that funding costs will exceed a specified trigger level, such as 3.00%. The underlying asset is short-term deposits funded at SOFR, while the hedge instrument is the Archelyon mortgage cap. Cash flow hedge accounting will apply to the mortgage cap, with unrealized gains and losses recorded in Accumulated Other Comprehensive Income (AOCI). Unique Benefit Banks that execute this strategy using only standard interest rate swaps still face significant convexity (prepayment) risk. Typically, these strategies are based on projected run-offs from existing MBS or whole loan portfolios. If prepayments are slower than expected, the bank will be under-hedged, meaning it won't have enough low-cost deposits to fund the mortgages. Conversely, if prepayments are higher than projected, the bank will be over-hedged, holding expensive deposits with no corresponding assets. Managing these risks requires active, dynamic hedging, and as a result, few banks are likely to pursue this strategy. As an alternative, the bank can purchase an Archelyon mortgage cap to mitigate the convexity risk inherent in the strategy. Prospective Analysis The bank compares the present value of changes in funding costs with changes in the market value of the mortgage cap. Deposit balances amortize at a constant rate of 150 PSA, with the amortization of the cap tracking the principal balance of the MBS pool held by the bank. The hypothetical derivative represents the increase in funding costs if SOFR exceeds the trigger level. Accounting Entries: Gains/losses on the mortgage swap flow into AOCI. Premium payments on the swap flow into income. The Archelyon Benefit The cash flow hedge treatment on the deposit swap transaction can obscure potential economic losses for the bank. The deposit hedge itself exhibits extreme ‘negative convexity,’ meaning the position exposes the bank to economic losses if prepayments deviate significantly from expected levels, either increasing or decreasing. For example, if interest rates fall and prepayments on the MBS increase, the bank would need to replace these MBS with lower-yielding ones. In this case, the bank would face a substantial market-to-market loss on the swap (though the losses would be reflected in AOCI). Additionally, the bank would experience negative carry on the swap for an extended period. To hedge this convexity risk, the bank can use Archelyon interest rate caps. By purchasing a mortgage interest rate cap with a premium of, for example, 0.40% (40 basis points), the bank ensures that the notional balance of the cap tracks the principal balance of the MBS. Both the premium paid for the cap and any mark-to-market gains or losses on the cap will flow into income. If prepayments slow and interest rates rise, the cap can provide the bank with additional income (e.g., 1%) to offset any convexity losses from the deposit hedge transaction. Since the cap is an option, its mark-to-market losses are limited in scenarios with falling rates or slowing prepayments. This enables the bank to enhance returns in rising-rate/slowing-prepayment environments while avoiding losses in falling-rate/rising-prepayment scenarios. In essence, the interest rate cap mitigates the negative convexity of the deposit hedge position.