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Evaluating Investment Proposals With Enhanced Due Diligence

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.
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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.