What’s Included

INTEREST RATES

Rate Scenarios

No one can accurately forecast future rate conditions.  Therefore, instead of relying solely on rate forecasts or a limited range of rates, our simulations automatically place your entire financial structure (assets, liabilities, operating expenses, non-interest income) against the backdrop of history-based rate environments that have occurred since the 1950s.  Our thought is that if it has happened, it is reasonable to ask the question, What if similar rate environments happen again?  Therefore, our model is able to simulate combinations of:

• Short-term rates ranging from 0% to 16%
• Long-term rates ranging from 0% to 14%
• Yield curve ranges from positive 400 basis points (bps) to negative 200 bps

Automatically simulating results under these history-based scenarios provides a reliable Early Warning System for management and board.  You can see, in advance, the market conditions that could trigger negative earnings and/or result in an undesired capitalization classification.  To communicate results, we use scenario codes to represent potential external market interest rates.  The first two digits represent short-term rates (3-month Treasury), and the second two digits represent long-term rates (10-year Treasury).  For example, in rate scenario “0507,” “05” represents short-term rates of 5% and “07” represents long-term rates of 7%.  The yield curve in this case is 200 bps positive.

Although the level of short- and long-term rates are used to communicate potential external rate environments, behind the scenes in the simulation a large number of interest rates are used, including Prime, Fed Funds, LIBOR, and your credit union’s actual driver rates.  For example, if loans are tied to Prime they reprice based on Prime.

Rate Change Speed

In the simulation, market interest rate conditions are assumed to change over 12 months, and then remain at new levels for 36 months (or 48 months; select 5-year reports are available in the Reference Database (RDB, Book 2 of 2)).  Simulations can be easily conducted using an instantaneous rate change or a 24-month rate change.  It must be noted that instantaneous rate changes are unrealistic and we don’t recommend using them in decision-making.

CREDIT RISKS

The simulations we have conducted for you typically include two views of credit risk:

• Expected levels of loan losses, which are typically equivalent to your allowance for loan loss
• Your management’s assumption regarding worst-case credit risk conditions

Provision for loan loss (PLL) is based on assumptions from your credit union.  Recent experiences with widely varying credit losses have led to large changes in PLL in many credit unions.  We recommend every credit union run “what-if” scenarios on PLL.

HIGHLIGHTS OF OTHER MAJOR ASSUMPTIONS

Our senior consultants worked with your credit union to learn about your membership and the philosophy of management and board.  During this process, assumptions were developed to represent the credit union’s pricing strategy and potential changes in your members’ behavior.

Pricing assumptions were developed for each unique deposit category to represent the credit union’s likely reaction to changes in market interest rates.  For loan rates that are adjustable at the credit union’s discretion, likely reactions to changes in market conditions are also represented.

Levels of rate sensitivity were established for each deposit category.  Within each deposit category, different levels of potential member rate sensitivity are represented.  For example, typically higher balance accounts are assumed to be more rate sensitive than lower balance accounts.  Additionally, as the financial advantage for your members to move to higher rate products increases, higher rate sensitivity is assumed.

Since no amount of research can tell you exactly what your deposits will do if rates change, we encourage you to test and see what could happen if rate sensitivity was materially higher than assumed.

Prepayment speeds are customized for each loan category.  These prepayment speeds automatically adjust as rates change to represent modifications in member behavior in different rate environments.  For example, as rates go down, often members will pay off their mortgage loans faster.  Conversely, as rates go up, often prepayments will slow down.  Mortgage prepayments are based on data provided by the Mortgage Industry Advisory Corporation (MIAC) and Intercontinental Exchange.  If appropriate, this data is adjusted for membership and/or geographical location.  MIAC’s Mortgage Prepayment Projection Tables provide “street consensus” long-term prepayment projections, based upon a survey of financial institutions, including Credit Suisse First Boston, JP Morgan Chase, and Morgan Stanley.  Intercontinental Exchange is a leading provider of analytical data to financial institutions.

The credit union has provided ratios for operating expense, provision for loan loss and non-interest income.

EMBEDDED OPTIONS

In addition to prepayment speeds, embedded options (such as caps, floors, calls, lags, etc.) are automatically factored into the simulation for both loans and investments.

COMPLEX INSTRUMENTS

For credit unions with more complex instruments, such as derivatives or CMOs, values and/or cash flows may be provided by The Yield Book^® Software, Intercontinental Exchange, or the credit union.