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Is NEV Capturing The Risk Of Declining Asset Yields?

Short and long-term market rates have been at—or near—record lows for almost 3.5 years.  This has resulted in credit unions continually replacing higher-yielding assets with lower-yielding assets.  This is creating earnings challenges at many institutions, particularly as the cost of funds is nearing a “floor.”

So, is your NEV analysis reflecting this risk?  The answer for most credit unions is no.  Loan yields have decreased steadily, but offering rates (often used to discount loans in NEV) have decreased much faster.  In many cases this has resulted in loan valuations improving from an NEV perspective, even as the yields and revenue are decreasing.

Consider a credit union auto portfolio that yielded 6% in 2010.  Lower-yielding loans have been booked since then, and have taken the yield down to 5%.  If the NEV discount rate being used is 3.5%, an economic value gain today of ~3% would be produced (a different gain could be generated depending on principal cash flows, prepayment assumptions, etc.).  The credit union might be happy that they are holding autos at a gain, but since they don’t plan to sell them anyway, the reality of lower yields and less revenue is a very unappealing prospect.  NEV does an inadequate job of capturing the risk of declining asset yields (along with ignoring net operating expenses and earnings).  Credit unions should be cautious if NEV is used in the decision-making process, and make sure they are aware of the limitations of NEV.

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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.