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Observations from ALM Model Validations: NEV – Loans Devalue in Rate Shocks – or Do They?

When considering valuation as a measure of interest rate risk, and value volatility as an indicator of changes in interest rate risk, many institutions perform net economic value (NEV) analysis. When working with credit unions, or performing model validations, a concern many have is ensuring the models have the “right” assumptions. What is the “right” discount rate? Should credit risk spreads be incorporated? What effective discount rate or what yield curve should be used to discount cash flows – which method is “more right”?

All of the above may be questions to consider but they are distractions from simple analyses credit union management teams can perform when determining if answers are reasonable. For example, take an auto loan portfolio in which the valuation methodology derives a value of $210M in the base rate environment. This same portfolio devalues to $200M in a +300 bp shock. Said differently, the value volatility in a +300 bp shock is -5.00%. From a quick reasonableness test, this is within a 4-6% devaluation range in a +300 bp shock – very reasonable for an auto loan portfolio.

However, does it change the reasonableness answer if the current book value of the auto loans is $199M? While the devaluation of the loan portfolio is certainly reasonable, the resulting answer implies that the loan portfolio could be sold at a 0.50% gain if rates increased 300 bps instantly. That answer is certainly less reasonable. It is important to remember, in Chapter 13 of NCUA’s Examiner’s Guide, NEV is defined as the fair value of assets less the fair value of liabilities. Would it be reasonable to assume a fair value gain on an auto loan portfolio if rates increased 300 bps?

When measuring NEV volatility, the starting value still matters. High starting values can be driven by low starting discount rates. It is good to evaluate both the effective discount rate and the difference between value and book in the current environment. Some models are unable to calculate an effective discount rate. We have found that sometimes in this situation the effective discount rate does not match what the user intended. If you are in the situation of the model not being able to show the current discount rate, extra attention should be given to the value versus book and how the value compares to book in different environments. Optimistically high starting and shocked values can hide risk and volatility; this connects with the cautions brought out in our blog regarding high starting NEV ratios posted on September 25, 2015.

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Net Economic Value and Business Decisions: Do You Understand the Trade-Offs?

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As a result of running a net economic value shares at par analysis, it appears that some examiners are trying to force credit union CEOs and CFOs to reduce interest rate risk in a rising rate environment by selling assets.

While we won’t argue that some credit unions should consider reducing interest rate risk, using net economic value to make this decision does not give decision-makers and examiners appropriate decision information.

The net economic value analysis will not show the hurt of replacing the asset sold with a lower-yielding, shorter-term asset. It will also not show the hit to earnings and net worth should the assets need to be sold at a loss. Additionally, no one involved in this type of decision will understand the breakeven point of this decision. In other words, decision-makers and examiners should gain an understanding of how high rates would need to go in order to be glad that the credit union took a guaranteed loss and reduced earnings today.

As we said above, it may be a good decision for some credit unions to restructure their interest rate risk profile while rates are still low. However, before taking any action, we encourage decision-makers to work very hard to ensure that they, and their examiners, thoroughly understand the impact of the direct hit to earnings and net worth of selling assets. It would be unfortunate for a credit union to take action based on net economic value analyses and have decision-makers and examiners be surprised by the hit to earnings and net worth.