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Investment Decisions

It is important for decision-makers to understand the impact assumptions can have on the risk-return trade-offs presented in investment proposals.  One of the key assumptions that can have a material impact on the decision information being presented is prepayment speeds.

Our focus in this blog is on investments with high yields and high premiums.

If the credit union pays more than the current face value for the investment, the additional payment is treated as an expense recognized over the life of the investment.  Of course, the life of the investment is not only influenced by contractual maturities but also by prepayments.

The upside of the type of investment is if prepayments are slow, the higher coupon can help generate additional revenue.  On the other hand, if prepayment speeds are faster than assumed, the investment will pay down faster than assumed—decreasing the investment yield by shortening the time the credit union has to recognize that premium.

In some instances, this may even create a situation in which the credit union has a negative yield, which is the result of earning less interest income over the life of the investment than what the credit union paid in premium.

When evaluating investments with high yields and high premiums, be sure to ask your investment advisor to explain the rationale of the prepayment assumptions being used and always insist on a stress test of the prepayment speeds, especially in the current rate environment.  Prepayment assumptions used for the current rate environment typically include average CPRs over the last 1-, 3- or 12-months which can be a fair starting point, but the analysis should not stop there.

It is also prudent to gain a better understanding of the underlying collateral.  For example, is the underlying collateral a pool of interest-only loans that are on the cusp of converting to principal and interest?  How might borrower behavior change when principal and interest payments are due?  Is it a pool of newly issued mortgages?  As these mortgages become more seasoned, how might prepayments change?  These are just a couple of examples of how prepayments in the future may be materially different than history.

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Callables and Low Rate Environments

Trying to get any kind of yield on investments is tough when rates are this low. Some credit unions are reaching for yield by purchasing longer-term callables with the justification that “we don’t have to worry much about the risk because they are going to get called.” But consider this, if rates move up even a little bit, most callable bonds will not get called, and the credit union could be stuck with material losses. The example table below demonstrates this potential risk.

The example assumes that a $1M 1/5 callable (callable in 1 year, final maturity in 5 years) is purchased today at 80bp. It shows that, compared to Overnights earning 25bp, this investment would yield an additional $6K in revenue over the course of 1 year, at which point it would be called. However, when you layer on industry-average cost of funds, operating expense and fee income, it reveals that from an ROA perspective this investment loses $19K in year 1. If rates go up at all, the bond will stick around for the full 5 years, and in a +300bp rate environment the bond would lose about $147K over its lifetime when the credit union cost of funds, operating expense and fee income are factored in. If rates returned to levels seen in 2007 (5%), this bond would lose $190K over its lifetime.

Note that for simplicity sake it is assumed that rates move immediately.

Some credit unions can afford to take this risk, some cannot. In any case, the decision to buy longer-term callables should NOT be based solely on the expectation that they will be called; the consequences of being wrong could have a very negative impact on a credit union’s risk profile and future earnings.

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Have You Reviewed Your Policies Recently?

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Historically, credit unions may have been wary of making material changes to their policies, whether an A/LM policy, Liquidity policy, Investment policy or broader Financial Management policy – for fear of raising regulatory “red flags.”  However, with the adoption of the final rule on interest rate risk (§741.3(b)(5)(i)), and the effective implementation date of September 30, 2012, many credit unions are finding this a great time to revisit their policies.  While reviewing policy, some key questions must be asked:

  • How does the policy help promote safety and soundness, while also reflecting the risk appetite of the credit union’s board and senior management?
  • Have there been situations in recent history where policy limits or guidelines have “tied hands” with respect to making sound business decisions?
  • Conversely, are there limits or guidelines in policy that have aided in the decision-making process, potentially saving the credit union from less than favorable outcomes?
  • How can we effectively construct policy limits and/or guidelines to both satisfy regulatory requirements and aid in the decision-making process of the board and senior management?

With heightened industry awareness surrounding interest rate risk, and increasing regulatory pressure to mitigate the risk being taken by some credit unions today, would it possibly raise more regulatory “red flags” if a credit union did not revisit relevant policies prior to the September 30 implementation date?  A good policy has limits and guidelines intended to promote risk management and safety and soundness.  A great policy has limits and guidelines intended to promote risk management and safety and soundness, but most importantly, provisions that drive dialogue to aid in the decision-making process.  While revisiting policy this year, the above questions will help take your existing policy from “good” to great.

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Evaluating Investments

This post is a continuation of Investing At “Record” Low Rates… published February 10, 2012.

Investments with complex optionality are increasingly being added to credit union investment portfolios.  As such, it is critical that credit unions have a solid understanding of what they may be purchasing, before the transaction is executed.

First, make sure your broker is providing you with a complete picture of the characteristics of the investment in question.  In general, most brokers provide market value, and cash flow information for the current environment and a +300 basis point (bp) rate change.  However, some investments (in particular some CMOs) may look “okay” if rates go up 300bp, but have the potential for extreme extension risk if market rates go up 400 or 500bp.  Credit unions should ask their broker for cash flow and market value shock data for the +400 and/or +500bp rate change, particularly for investments with optionality.  Remember that short-term market rates were 500bp higher than they are today as recently as 2007.

In addition to cash flows, other optionality features can be very important as well.  For example, if the investment is variable rate, make sure that all of the repricing parameters are clearly understood: repricing frequency, margin, caps, floors, etc.  When the first repricing can occur is particularly important, especially with rates being so low.  For callables and step ups, consider call dates and potential repricing dates.  For step up investments consider if the future step protection warrants the lower starting coupon rate compared to a bullet or callable with the same final maturity.

Working with a trustworthy broker certainly helps in this process, but that does not absolve decision-makers of completing their own due diligence and ensuring an investment fits within their overall strategic objectives.  Keep asking questions until there is clarity on the investment and its structure, consider the other pertinent decision drivers (for example, policy, impacts to aggregate risk position, etc.) and consider the unexpected in the decision-making process.

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Investing At “Record” Low Rates…

The Fed’s first 3-year “forecast” revealed that almost half of the Fed Governors believe the Fed will keep short-term rates very low through 2014.  Coupled with continued weak loan demand, many credit unions feel like they are forced to do more with investments.  These two factors may cause more credit unions to extend investments moving forward into 2014.  Here are a couple of things to consider:

  1. Ask yourself, does that make sense? Regardless of what your broker tells you, it is always a good idea to apply the “reasonableness test” to any new investments that your credit union is evaluating.  Honest mistakes can be made.  A recent example is a broker showing a credit union a 13% market devaluation in a +300 basis point (bp) rate change on a 15-year final maturity callable.  The mistake was made because the market value model that was used showed the callable being called at the 5-year point, even in a 300bp rate increase.  In reality, a 15-year final maturity callable should devalue by roughly 30% in a 300bp rate change.  Callables will NOT get called if rates rise.   Make sure your credit union is evaluating the risk to final maturity if you consider investments with optionality, like callables, or mortgage-related products.  Buying long maturity callables with the expectation that they will be called can be a risky strategy
  2. How does this fit within policy? All investment decisions of relevance should be examined from an overall risk perspective, to ensure the new purchases still fit within policy limits.  Not just investment concentration limits, but overall aggregate risk policy limits (calculating impact on overall financial results)

There are many other areas that could be considered, such as overall credit union strategy and how new investments fit within this strategy.  Is the credit union positioned for long-term success if rates stay low and loan demand remains weak?  Lengthening investments can provide some revenue relief in the short-term, but will not provide relief from the long-term structural and operational challenges that many institutions are facing in this environment.