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If My Investment Strategy Hasn’t Changed, Then My Interest Rate Risk Hasn’t Changed—Right?

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We often are asked “If I keep my investment strategy the same through various rate cycles, won’t my interest rate risk be the same?’’
The answer is no.
Let’s take a simple example of a 5-year bullet purchased in June of 2013 compared to a 5-year bullet purchased in June of 2007.
As of June 2013, a 5-year bullet would yield approximately 0.80%, while the average cost of funds for the industry was 0.59%.  This provides a margin of 0.21%.  A 5-year bullet purchased in June 2007 would yield approximately 5.40%, while the average cost of funds for the industry was 2.70%.  This provides a margin of 2.70%, going a lot further to covering the operating expense structure over the long run.
So it’s evident that the earnings potential is dramatically different, but what about the interest rate risk?
From an interest rate risk perspective, at first glance, there doesn’t appear to be much difference in the change in value between the June 2007 and June 2013 5-year bullets in a +300 environment. Please see below:

Question: How many years of earnings would it take to offset the potential risk of the 5-year bullet purchased in 2007 versus the 5-year bullet purchased in 2013?

Answer: For the bullet purchased in 2007, a little over 2 years (How do you figure?  Just take the loss/the yield:  -12%./5.4% = 2.2 Years).

For the bullet purchased in 2013, a little over 17 years (14%/0.80% = 17.5 years).

So yes, even if you have not changed your investment strategy, your interest rate risk and risk/return trade-offs have materially changed, making business decisions based on asset/liability management more important.

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Do A/LM Modeling Results Match What’s Intended?

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Is your A/LM model producing the intended results?  During the course of validating other A/LM models, sometimes we see inputs that appear reasonable on the surface but are not producing the intended results.

When conducting a recent credit union model validation, we were asked why the model showed a loss on 30-year mortgages when the credit union intended to show a market value gain.  The account was discounted to the yield curve plus a spread with the intention of having the discount rate equal to current offering rates.  Given that the yield on the account was materially higher than the discount rate, a market value gain would have reasonably been expected.  Digging further into the details revealed the cause of this issue:  slower-than-average assumed prepayment assumptions.

The credit union’s decision to slow down prepayment assumptions pushed more maturing cash flows further out on the yield curve, to a point on the curve where the discount rate was actually higher than the portfolio yield.  The cash flows further out on the curve were at a sizable loss, enough of a loss to wipe out all of the gains on the maturing cash flows at the shorter end of the curve.  In the end, the credit union made adjustments to deliver a result more in line with its expectations of the portfolio’s value.

While this example represents an unusual situation, the takeaway here is simply to stay on the lookout for unexpected results. Always ensure that your modeling results make sense to you. Understand and verify the accuracy of any unexpected results, or make adjustments as appropriate to correct the problem.

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Test Your Budget As Part Of Your A/LM Process

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Wouldn’t it be nice to know if that “light at the end of the tunnel” is actually a fully loaded freight train coming straight at you?  Back in August, we wrote a blog with some tips on budgeting heading into 2013:  Budgeting Tips For 2013.  One of the points suggested evaluating the budget from an A/LM perspective.  This kind of analysis also falls within the guidance outlined in the NCUA Interest Rate Risk Policy and Program Requirements, where it emphasizes the importance of testing the interest rate risk impact of all business initiatives, new products, etc.

Testing the interest rate risk of a forecast will also connect the budget to any risk limits you might have.  Understanding the potential risks in advance can allow decision-makers to adjust budgeted objectives if necessary.  This is especially critical if results suggest that successful execution of the budget could result in the credit union being close to, or outside of, board approved risk limits.

This extra bit of due diligence is particularly important now given the continued low rate environment.  Remember:  the longer rates stay low, the more interest rate risk credit unions are likely to face.

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Examiner FAQs

We frequently hear about examiner inquiries regarding non-maturity deposit assumptions in credit union A/LM models.  The question is usually along the lines of, “what are the non-maturity deposit assumptions used in the A/LM modeling and how were they determined?”

Non-maturity deposit assumptions include pricing sensitivity and withdrawal sensitivity.  When it comes to pricing sensitivity the modeling needs to have assumptions about what the credit union thinks it will pay on its non-maturity deposits in different rate environments.  While there are many things to consider when it comes to pricing, one approach is to look at how the credit union has priced deposits in the recent past.  Short-term rates, which influence deposit pricing, were around 1% in 2003-2004 then rose steadily to about 5% in the 2006-2007 timeframe before dropping to the historically-low rate environment of the last few years.  A good starting point is to base your pricing assumptions on how you actually priced during this rate cycle.

Withdrawal sensitivity models the behavior of members who move their funds from lower-paying deposits (like regular shares) to higher-paying ones (like CDs) when presented with an opportunity to do so.  This behavior is much more difficult to observe than how deposits were priced in different rate environments.  In fact, in the IRR Questionnaire, NCUA says, “The uncertain timing of NMS account cash inflows and outflows can make treatment challenging.  It is not possible to predict with certainty what future balances in non-maturity accounts will be, how long they will remain open, or what future rates will be paid to members on these accounts.  Even when CUs study member behavior, or contract with vendors to perform such a study, substantial uncertainty remains.”

Similar to the approach with pricing, it is possible, however, to observe how your credit union’s deposit balances responded during the last rate cycle.  Reviewing balance changes, especially during the period of 2004-2006 (when short-term rates were increasing), can provide a basis for withdrawal sensitivity assumptions.  Still, there is nothing in recent history that replicates this extremely low-rate environment and there are valid concerns that member behavior in the future may be very different than in the past. Movement of funds to higher-paying deposits, or having to replace funds that are leaving with higher-paying deposits, can dramatically increase a credit union’s cost of funds.  As with the pricing assumptions, it is a good practice to stress test these assumptions by asking, “what if our member withdrawal is X% (for example 50%) greater than assumed?”

One last consideration:  the type of analysis you are doing. Deposit pricing assumptions are needed for static and dynamic balance sheet income simulations, NEV and long-term risk to earnings and net worth simulations.  Withdrawal assumptions are needed for NEV and long-term risk to earnings and net worth simulations.  While dynamic simulations wouldn’t necessarily employ withdrawal assumptions, it is possible to model changes in the deposit mix. Static balance sheet income simulations, by definition, ignore this threat by assuming that deposits never leave and that members never act in their best interest by moving to higher-paying deposits.

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Evaluating Investment Proposals With Enhanced Due Diligence

Understanding the impact that new business decisions can have on a credit union’s risk profile is central to effective asset/liability management, and is even addressed in NCUA’s recently issued Interest Rate Risk Questionnaire.  This is especially appropriate when evaluating proposals from investment brokers seeking to “rebalance” or “strategically realign” a credit union’s investment portfolio.
Many of our clients have received proposals from their brokers to sell investments they currently own for a gain and replace those sold with comparable investments (albeit at lower yields).  Accompanying these proposals are broker-provided due diligence information packets that show the current portfolio price risk compared to the proposed portfolio price risk in a +300, WAM for the current portfolio and proposed portfolio in a +300 and other industry-standard measures of risk.  While many of these proposals can offer an acceptable balance between risk and return given an individual credit union’s unique circumstances and appetite for risk, some proposals can be downright disastrous, resulting in significant interest rate risk with even the slightest change in interest rate environment.
To appropriately safeguard against making a decision that is inconsistent with a credit union’s normal practice, or board-directed appetite for risk, a certain measure of independent due diligence is highly recommended.  For example, ask your broker to provide the same reports with a shock higher than the traditional +300 (+500 is recommended—before rates plummeted to today’s low levels, short-term rates were roughly 5% for a sustained period).  You should also ask your broker to twist the yield curve (non-parallel shock).
Nearly every broker-provided proposal generates an increase in net worth dollars, and a corresponding increase in net worth ratio.  The key in realizing the potential risks of executing on a proposal is understanding how the amount of net worth not at risk changes, and in what interest rate environments this becomes a negative change.  Understanding margin changes today, as well as changes in price risk in a +300, can be valuable tools.  However, testing the potential impact on net worth is critical when evaluating the risk in a business decision, and this level of testing is typically not included with any standard broker-provided due diligence.
Remember, in NCUA’s Final Rule on Interest Rate Risk Management, NCUA states “net worth is the reserve of funds available to absorb the risks of a credit union, and it is therefore the best measure against which to gauge the credit union’s risk exposure.”  Ensuring that decision-makers have the appropriate information to drive effective decision-making is an integral part of ensuring that an interest rate risk program is effective, and is incorporated in the risk management process of high-performing credit unions.