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NEV: Things to Remember

February 27, 2014

Net economic value (NEV) will not show you the effect on current earnings when testing risk-mitigating strategies.

To illustrate, assume a credit union concerned about its interest rate risk is considering selling all of its 30-year, fixed-rate, 1st mortgages. The credit union plans to put the proceeds into overnights to give themselves the best hedge against rising rates. As part of the credit union’s decision-making process, a “what if” is run off the most recent NEV analysis. After reviewing the results of the “what if,” the decision is made to sell the mortgages. Why?

As indicated in the table above, the “what if” shows that selling the mortgages today does not hurt the starting NEV, but it does help NEV if rates increase 300 basis points (bps). The decision was a “no-brainer” for the credit union.

The reason the results look like this is that NEV is the fair value of assets less the fair value of liabilities. In the current rate environment, the base case NEV results already included the small loss the credit union expected to take upon sale of the mortgages. That total sale price would be invested into overnights (at par). In a +300 bp rate change, the base case NEV results included the devaluation of the mortgages. However, in a +300 bp environment, overnights are still valued at par. So the “what if” results showed that there was no change to the current NEV, and in a +300 bp rate change, it showed less risk.

What about the earnings trade-off? Selling all of the credit union’s mortgages and putting the proceeds into overnights does help its risk in a rising rate environment, but at the cost of over 100 bps in ROA today. Using NEV as the primary decision-making tool did nothing to show the credit union the “risk-return trade-off.” NEV also will not help the credit union answer the question: “after selling the mortgages, how high would rates have to go before reaching a breakeven point from an earnings perspective?”

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