C. Myblog

Evaluating Investment Proposals With Enhanced Due Diligence

September 6, 2012
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.

Start typing and press Enter to search