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Interest Rate Risk Management: Timing of Earnings Matters

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Would it surprise you that some interest rate risk mitigation strategies actually add risk for a period of time?  In the end, these strategies may be effective at mitigating interest rate risk but it may take years for the effectiveness to be felt.  The challenge is that many methods used to test mitigation options, like NEV, don’t show decision-makers the full picture.  The reality is that earnings and the timing of earnings matter when understanding the impact of different decisions.

Take for example, a credit union that decides to sell $90.0 million of its 30-year fixed rate mortgages earning 3.61% and reinvest in auto participations earning 1.90% to mitigate interest rate risk.  No surprise that such a move hurts earnings today.  In fact, it would hurt earnings by 23 bps.

What is not obvious, though, is that in a +300 bp interest rate environment they would give up more cumulative revenue with a strategy to hold auto participations than with a strategy to hold fixed-rate mortgages over a four-year time horizon.  Year-by-year and cumulative revenues for both strategies are summarized below:

The credit union would earn more revenue holding fixed-rate mortgages than holding auto participations for each of the next three years.  It is not until Year 4 that the strategy change pays off and they earn more holding auto participations.  Over the four-year period, the credit union would earn a cumulative $15.0 million with mortgages versus $13.5 million with auto participations in the +300 bp increase.  Timing of earnings matters.

Using only NEV to evaluate this strategy might lead the credit union to pull the trigger on it.  In this case, the credit union is using NCUA’s NMS values from the NEV Supervisory Test.  When comparing the proposed strategy to the base, the NEV in the current rate environment is unchanged at 10.75% – meaning the restructure neither helps nor hurts the current NEV.

However, after selling the mortgages, the volatility decreased in the +300 bp environment leaving a higher NEV ratio (see example above).  An added benefit is that the credit union would now be considered low risk under NCUA’s NEV Supervisory Test thresholds.  Said differently, the NEV results show decision-makers would not have to sacrifice a thing in the current rate environment while significantly reducing risk in a +300 bp interest rate change.

Earnings (see Beginning ROA), on the other hand, show there is sacrifice in the current rate environment and more risk to earnings and net worth in a +300 bp rate environment over a four-year time frame.

The moral of this story is not that all credit unions should always hold mortgages because they will earn more than other alternatives.  Certainly, not.  It should be clear, though, that NEV provides credit union decision-makers with a limited picture.  Earnings and the timing of earnings matter.  In this particular example, the credit union may decide to execute the strategy, but decision-makers understand, in advance, that even if interest rates rise quickly, it could take about four years before the alternative strategy will contribute positive earnings and start to reduce interest rate risk.

For more in-depth ways to use ALM as actionable business intelligence, please click here for our c. notes.

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NCUA – Rethinking NEV

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It’s no secret that the NCUA is planning to implement new guidance for net economic value (NEV) testing this year.

From NCUA’s recent open meeting, some key elements of the new guidance include:

  • Non-maturity deposit (NMD) values will be capped at a premium, not to exceed 1% in the current rate environment.
  • NMD benefit will not exceed 4% in a +300 bp rate environment.
  • NMD guidelines may need to be re-calibrated over time.
  • Risk thresholds:

NEV Supervisory Test - Risk Thresholds Source: NCUA Board Briefing

The new test is being designed to support the NCUA’s responsibility with respect to understanding risks to the insurance fund, and is intended to create greater comparability between credit unions. Credit unions will still be expected to run their own A/LM analyses, to understand risks to earnings and net worth, and support their internal risk management and decision-making.

Having modeled thousands of NEV simulations, NMD values are arguably the most significant wildcard.  For most of our clients, we already model at least two views of NEV: one using their base case assumptions for NMDs and another showing shares at par. Historically, NEV with shares at par was used by examiners to get the same comparability concept, and to limit the variety of deposit assumptions.

Shares at par ascribes no market value to the shares, thereby removing any benefit of low cost deposits from the analysis. The new guidance then, at least with respect to shares at par, would be some improvement. Keep in mind, though, that any standardization of deposit values would hide any material differences in deposit pricing between credit unions.

However, no matter how much rethinking of NEV occurs…

…NEV, even with standardized assumptions, is still not going to address fundamental business issues. For example:

  • NEV doesn’t recognize the different earnings contributions and the risk/return trade-offs that exist between assets.
    • Overnight investments earning 0.50% devalue less and perform better in NEV than a fixed-rate loan yielding 4.00%. It’s important to note that the loan contributes greater revenue in the current rate environment, as well as in a +300 bp rate environment.
    • A $10 million purchase of a new headquarters would not show any hurt to NEV results because the asset would not devalue as rates increase, but it would have an impact on earnings over a very long-term horizon.
    • Moving from mortgages to autos would reduce NEV volatility in a rising rate environment, but NEV would not show you the possible reduction in earnings power.
  • The standardized assumptions still do not distinguish between pricing for share drafts, regular shares, and money markets. Therefore, a credit union could pay 1 bp on all NMDs or 100 bps, and the NEV results would not be different. But of course, the earnings would be drastically different.
  • NEV won’t tell you if you’re making or losing money. The previous bullet is a great example of this fact. For this reason and many more, NEV won’t show you risks to profitability and if the decisions you’ve made, or are considering will cause your net worth to fall below Well Capitalized.

To sum it up, NCUA has a new test. Passing NCUA’s test does not replace the need to understand short- and long-term profitability, risks to profitability, and risks to net worth. Understanding and managing these risks are directly related to creating a relevant and sustainable business model.