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Evaluating Derivatives—Part I: Earnings

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While derivatives can be a good tool for mitigating interest rate risk, it is important for credit unions to understand the cost of the protection they are purchasing. This example uses an interest rate swap with the following terms to illustrate:

  • 7-year term
  • Notional amount: $100 million
  • Credit union pays fixed rate of 2.00%
  • Credit union receives 3-month LIBOR (~0.25%)

The basic workings of the swap are pretty straightforward. If rates do not change, the swap will be a hit to earnings because the credit union will pay a higher fixed rate than the variable rate it will receive; however, if rates increase, the credit union could benefit and this can help to mitigate interest rate risk. In evaluating the decision, it is critical that the credit union understand just how much the swap could cost over its life if rates do not change and how high rates would have to increase before the swap helps.

As shown in the table below, if interest rates do not change the credit union will pay out $1,760K per year, or $12,320K over the term of the swap. For some credit unions, this can be expensive insurance. Note that it takes rates increasing more than 300 bps – assuming an instantaneous rate change, which is an optimistic assumption when evaluating a derivative – before the net benefit to the credit union would offset the potential cost, if rates do not change.

Cumulative Swap Cash Flow table
Note: $s in 000s

Again, derivatives can be an effective tool for mitigating interest rate risk, but the credit union should do a thorough analysis of the financial impact and compare it to other risk-mitigating actions to determine the best route.

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Risk/Return Trade-Off—Part II

In last week’s blog, we discussed the need to understand risk/return trade-offs and the concern in relying solely on net economic value (NEV) for decision-making. If the objective is to decrease NEV volatility and your strategy under consideration is to A) Sell 30-year mortgages or B) Sell a 3-year bullet, does NEV fairly represent the downside of this sale? The answer is “no” and we will explain with an example.

To keep the math simple, assume we have $100M in both recently originated 30-year mortgages and 3-year bullets. In evaluating the decision using only NEV, it is clear the answer is to sell the 30-year mortgages because they devalue the most in a +300 basis point (bp) rate shock, as shown below:

However, the analysis should not stop there. Consider the potential impact to earnings of holding $100M in each product versus holding that same balance in overnight funds. Over 12 months, the credit union is giving up $4M in revenue by selling the 30-year mortgages compared to $550K by selling the 3-year bullet.

There are different ways to incorporate the return component when evaluating strategies. In this approach, divide the 12-month revenue difference by the market value loss in a +300 bp shock to get the trade-off ratio.

The trade-off ratio reflects the foregone revenue associated with mitigating the NEV volatility. The smaller the ratio, the lower the revenue sacrifice per dollar of shocked value reduction. In this example, selling mortgages gives up revenue that equals 20% of the risk, while the bullet gives up only 6% of the risk. Said differently, the credit union could get more “bang for its buck” by selling assets with a lower ratio.

The objective here is to demonstrate that seeing only the change in NEV without seeing the change in return can result in misleading decision information. A tool or model that shows the impact to earnings is a critical piece of the decision-making. If you take this one step further and incorporate longer-term risk to earnings, the decision information becomes even stronger.

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Risk/Return Trade-Off—Part I

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Cliché? Yes. Often overlooked in decision-making? Also yes. This current long-lasting low rate environment has lulled some credit unions into ignoring the risk of things changing, such as an increase in rates. The focus on return without proper respect for potential risk has led to a material increase in interest rate risk in some institutions, thereby inviting more scrutiny from regulators.

What about the other side of the equation? We see many examples where the evaluation of risk ignores the return. A primary example is using net economic value (NEV) for decision-making. NEV can do a fair job of evaluating the risk of certain assets, such as marketable investments, but it does a bad job at evaluating the risk of the whole credit union. While NEV may capture the risk of an investment, does it appropriately represent the return for the institution?

Consider this, if you decide to reduce risk, you may test selling MBS investments and put the funds in overnight investments. When selling MBS investments, the risk in higher rate environments will go down, and NEV will typically improve. But what about the risk/return trade-off? Does the NEV show a difference in the credit union’s current position? No. The MBS will be sold at today’s value and then the funds would be invested at today’s value, resulting in the same current value of the institution. For example, an MBS may yield 2.00% today, while the overnights earn 0.25% at most. Did the return go down? Absolutely. Does NEV fairly represent the downside of this sale? No.

Only seeing the change in risk without seeing the change in return can result in misleading decision information. Understanding the potential impact to earnings (short term and long term) and the long-term risk to net worth in a wide range of rate environments is critical to decision-making.

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Investment Decisions: Prepayment Assumptions Can Drive the Results

Yield tables provide a wealth of information to evaluate prospective investment purchases.  Take the example below.  The screen shows the coupon and the prices as well as possible prepayment speed, yield and average life depending on the rate environment.

Not unlike the IRR process, decision-makers should asses the reasonableness of the assumptions being presented in the table. The key assumption is the prepayment speed which affects the potential yield and average life of the investment.  Referring to the example, the assumed prepayment in the current rate environment is 460 PSA which causes the potential yield to be 0.825%.  You can observe that the prepayment speed over the life of this investment has been 610 PSA and has been increasing over the last 12 months (see historical prepayments box on the example).

Keep in mind the importance of the prepayment assumption when there are large premiums (as indicated by the 108-13 Price).  The calculated yield would be materially lower if any of the historic prepayment speeds were used.  For example, looking at the -100bp rate environment, the prepayment speed is 712 PSA which matches the 6-month experience of this investment.  The yield with the higher prepayment speed is now almost breakeven at 0.071% compared to the 0.825% with the 460 PSA.   The difference in yield is drastic and likely changes the decision a credit union would make.

The question is, why is a lower prepayment speed being used?  It could be an expectation that prepayments will slow in the future or it could be that the higher resulting yield makes the investment look more attractive.  Historical prepayment behavior may not be an accurate predictor of future prepayment behavior, so the prepayments could slow down.  However, using history is a reasonable starting point for understanding what the possible yield is.  From there, decision-makers should test a range of prepayment speeds in order to understand the yield impact and make sure they are comfortable with the possibilities.

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“My investment portfolio is not working for me!”

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This is a statement heard more frequently in the past couple of years.  For those thinking it, here are some questions worth considering.

Question 1:  Is my lending process working for me?

The economy shows glimmers of improvement, with home values up and consistent increases in new auto sales as some evidence.  Before turning to investments, make sure your core business is maximized.  It is important to count your business – every day; as noted in the article Thriving In A World Of Shrinking Margins, questions to consider include:

  • How many loan applications are we getting? How many are we approving? How many are we funding?
  • If our approvals are low (compared to the number of applications), are we attracting the wrong borrowers and, in the process, hurting our reputation?
  • If our funding rate is low (compared to the number of approvals), what can we do to improve it?

Question 2:  Is my business model working for me?

If you feel your loan department is doing the best it can, then a bigger question may need to be asked: Are we chasing the right target market? Consider that, at the end of 2000, the credit union industry had 20% of its loans in new autos and 20% of its loans in used autos.  Fast forward to 2007, as the recent recession was about to flex its muscles, the numbers had dropped to 16%, respectively.  As of September 2012, the percentages stood at 10% and 18%, respectively.  The numbers represent a declining market share in new autos.

Count your business and find other numbers that can tell a story:

  • How many branch transactions do you have today relative to just 3 years ago?
  • How many online banking and mobile transactions do you have today compared to 3 years ago?
  • Segment your borrowers by age and you may be surprised that your borrowers are not as young as you think.

The trends in auto loans, branch use, electronic transactions and the shifting demographic of borrowers are signs that a business model that was successful in 2000 may need some fine tuning for a sustainable future.

A fine-tuned business model may realign priorities and resources and you may not need to rely so much on your investment portfolio.

Question 3:  Is it a good thing that my investment portfolio is not working for me?

Some credit unions have a high loan-to-asset ratio and strong earnings and still feel like they’re leaving money on the table because their relatively small investment portfolio is earning little. Before focusing on the performance of one slice of your financial structure, understand how the whole structure is working together. It may be that a low-yielding investment portfolio may be providing you with interest rate risk protection you need from the longer-term loans you made for the benefit of your membership.