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Observations from ALM Model Validations: Prepayment Speeds

This blog is a continuation of our series to share observations from A/LM model validations that we’ve performed.

Prepayment speed assumptions impact earnings, net worth, and NEV within an A/LM simulation. Too often, though, people may simply expect that their assumptions have been input correctly and are operating as intended. Some of the issues to look for are:

  • Prepayment speeds stay the same in all rate environments. This should not be the case for mortgages. For other types of loans, if prepayment speeds don’t change as interest rates change, ensure that assumption seems reasonable for the particular account
  • A loan or investment account that may be tied to the wrong prepayment speed table. Specific account details are often on a separate page from prepayment tables, so linking the two can identify if there are inconsistencies between the two
  • Prepayment speeds may be difficult to locate or interpret within the simulation reports
  • Modelers may accidentally flip-flop prepayment speeds. When market rates go up, expect prepayment speeds to go down as borrowers become more reluctant to refinance
  • Newly added accounts may be assigned to the wrong prepayment table, or may not be set up with any prepayment speeds (it is always good to pay special attention to new accounts)
  • Prepayment speed assumptions in the income simulation are different than those used in the NEV simulation when they should be consistent. These different assumptions occur because some modelers use different systems to produce their income simulation and NEV
  • Prepayment assumptions provided/expected are not those in the model

Once you have verified that the intended assumptions are being modeled, you may then also want to understand how the results could change if the assumptions were different. For example, what if prepayment speeds actually experienced were 50% more sensitive than those modeled? Conducting stress tests over a range of different rate environments can demonstrate the sensitivity of the results to the assumptions, which may make you, and your examiner, more comfortable with the assumptions being modeled.

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Project Management Tip #20: Time

Time focuses on how much time is allotted to complete a project. Time is a resource that project teams can wield in their favor by building out a timeline as part of their project plan. The time it takes to complete tasks in a project should be reasonable, and can best be estimated by seeking feedback from stakeholders and subject matter experts.

Key events that are often missed when building a plan include project team vacations, vendor liaison vacations (if applicable), holidays, and other credit union projects. Effective project teams consider non project-related events when providing time estimates, and schedule these vacations and holidays into their project timeline. They also get time scheduled for the project onto the team’s work calendars, so that the appropriate time is reserved for the project and not usurped by other meetings and duties.

If there is a heavy reliance on IT resources for the project, their available time commitment must be understood and agreed to in advance. If third-party tasks are required, time should be scheduled to inspect the work provided.

In addition, if there are process changes required as a result of the project, appropriate time will need to be set aside for training, and communicated in advance to trainers so that they can prepare for their role in the project. If time is not appropriately controlled, an increase in costs and decrease in quality, or non-compliance could result. Creating, communicating, and achieving stakeholder buy-in to a timeline is critical, as is making sure each stakeholder understands the threats to cost and quality if the timeline is compromised.

For more project management tips like this, please click here to read our c. notes article, Project Management Tips from A to Z.

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Observations From ALM Model Validations: High Starting NEV Ratios

When performing model validations, it is common to see a net economic value (NEV) ratio that is considerably higher than the credit union’s current net worth ratio. Understanding NEV and net worth are two completely different concepts; there are reasons why starting with a high NEV ratio in the base environment may not be reasonable.

First, let’s discuss some of the reasons why this can occur:

  1. Non-maturity deposits are assumed to have long average lives. Given the positive slope of the yield curve, this assumption results in higher discount rates and optimistic market value premiums
  2. The credit union does not incorporate transaction spread costs when valuing deposits, which overstates the value to the credit union
  3. Optimistic loan discount rates, that ignore credit and other market risks, results in overly optimistic loan market values

Consider that NEV is intended to show the fair value of a credit union. Therefore, mergers can be used as a reasonableness check of this critical component of modeling. Mergers over the last several years do not support the assertion that an acquiring institution would pay a significant premium to the net worth.

It is important to understand that optimistic base NEV results also impact volatility ratios in various rate shocks. To keep the math simple, consider a $100 credit union performing NEV with two different sets of assumptions. For example purposes, the dollar volatility in a +300 basis point (bp) shock is assumed to be the same while, in reality, the more optimistic assumptions in Assumption B would result in a lower dollar volatility.

Model validations with high NEV ratios inaccurately predict volatility

Many have said that the reasonableness of the starting NEV doesn’t matter; it is the volatility that should be the focus. Notice that while the two sets of assumptions in this example have the same dollars of volatility in a +300 bp shock, the percent volatility and NEV ratio in a +300 bp shock are dramatically different. The NEV in Assumption A may be considered high risk, while the NEV in Assumption B may be considered low to moderate risk.

If using NEV, credit unions should focus not only on NEV volatility but should also understand what their base NEV ratio is showing and if it is reasonable. If the starting NEV ratio is considerably higher than the net worth ratio, the credit union needs to understand why. If it is not defendable, credit union management should consider making adjustments to assumptions.

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Planning for Successful Execution

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Most organizations are juggling multiple projects at any given time. A critical element for successful project execution is having an understanding of how those projects affect one another in terms of resource requirements and timing. Without that understanding, resource bottlenecks will inadvertently be created.

For more successful project execution, be sure to consider the following during the planning phase:

  • Existing projects that are still in progress
  • Predictable resource reductions due to major software updates, seasonally busy times, heavy staff vacation times, etc.
  • IT’s capacity since IT is required for almost every project
  • Spreading projects out – trying to start all projects in January will put pressure on resources as will making all projects due in December

To understand whether resources are over-allocated, start with the big project milestones and assign resources and timeframes. Do this for each project. Viewing milestones for all projects in progress at any given time throughout the year, along with the resources required, will provide a high-level view of resource usage and will make resource over-allocation more visible. Further refinements to the milestones as they evolve into project plans will provide an even clearer picture.

After going through these exercises, teams typically find that project schedules need to be adjusted and some projects may even be postponed indefinitely. Changing the timing can be disappointing, but is far better than putting unnecessary stress on the organization later and/or failing to meet project timelines. Good project planning not only requires planning for individual projects, but also planning how all projects affect each other and available resources.

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Best Laid Plans

Over the next few months, credit unions will be going through their strategic planning process to discuss the direction and goals for the credit union going forward. Often, we see actionable game plans with the best intentions to stay focused on implementation, which is when the real tough work begins.

Following are just a few tips to not allow the whirlwind of operations (or of life) to get in the way of strategic implementation (and the best laid plans):

  • Agree on how often progress will be reviewed
  • Keep the plan top of mind and connect it with day-to-day activities
  • Facilitate access to the right people who can make decisions on priorities

Each organization should set working agreements on how to maintain focus that suits the culture and ensures the success of the strategic plan. Ultimately, the key is to make sure the working agreements don’t let the whirlwind of real life take priority over strategic implementation.