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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.

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More Certainty Over The Direction Of Interest Rates?

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Following the January 25th meeting, the Fed released a forward-looking rate forecast.  This forecast shows the range of predictions made by Fed officials about the level of short-term interest rates in the fourth quarter of 2012, 2013 and 2014.  The forecast also estimates when the Fed expects to begin raising short-term rates, and describes what the Fed plans to do with their investment portfolio.

The rationale for this change in policy is to provide more clarity for businesses and consumers as to the direction and level of short-term rates.  The hope is that it will spur additional borrowing and economic growth (though it is possible this will not have any material impact on businesses or consumers, as most already expect rates to remain low for a while).

However, this shift in policy raises several questions that decision-makers should consider:

  • How might other financial institutions respond? Now that the Fed announced rates are likely to remain low into 2014, do financial institutions further adjust loan pricing—dropping rates even further?
  • Will financial institutions take additional risk in their loan and investment portfolios by extending maturities?
  • Will there be additional market demand for short- and medium-term investments, further driving down yields?
  • Does this push decisions to “hedge” balance sheet risk further down the road, at which time hedging could become too expensive?
  • Why is the “risk management” function in place? To inform decision-makers about how the institution could fare in the face of unlikely events.  Institutions that put too much reliance on Fed forecasts might spend less time preparing for the unexpected
  • Is the Fed always right? Consider Fed Chairmen Ben Bernanke’s quote from his July 2007 testimony to Congress when he said, “Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.”  Unfortunately, the economy worsened materially in 2008

The Fed is a group of people, each with their own opinions.  They also do not have total control over all of the factors that would impact the level of rates.  Therefore, the Fed forecasts could be wrong.  However, the forecasts might lead to overconfidence, causing institutions to make decisions they might not have made otherwise.

Sources:
Fed Expects Low Rates Through 2014, WSJ, 1/26/12
Semi-Annual Monetary Report to the Congress, Federal Reserve Board, 7/18/07

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Record Low 10-Year Treasury Rates and Net Interest Margin

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On September 22nd, the 10-year Treasury Rate touched another historic low with a yield close to 1.7%.  This is a critical measure, as many credit union assets are priced off of the longer end of the yield curve.  There are many factors contributing to the low yield, including:

  • The Fed’s decision to sell some shorter-term debt and buy longer-term debt
  • The weak economy
  • The continued flight to safety (American debt looks relatively safe on a global scale)
  • The Fed’s stated intention to keep short-term rates low into the middle of 2013

So what does this all mean to a credit union’s net interest margin? All else being equal, credit union loan and investment yields will continue to decline while rates are low and the economy flounders.  Additionally, the ability to maintain the net interest margin becomes increasingly unlikely the longer we are in this low rate environment.  Deposit rates will hit a “floor” at some point.  Even if a credit union has room to lower deposit rates—and thus minimize the loss of asset yield today—that credit union will, by default, still be adding interest rate risk to the balance sheet.  Additionally, most credit union assets are fixed rate, and these low-yielding, fixed-rate assets will likely stay on the books for a while.  As a result of all these factors, credit union margins will be further squeezed and the potential for interest rate risk will increase.

Does your credit union have the ability to absorb more interest rate risk going forward?  Can your institution remain profitable 12 months from now if current trends continue? Now is a good time to try and figure this out, and take mitigating actions if deemed necessary.

Source: US 10-yr Treasury yield falls to lowest on record, The Associated Press, 9/9/11

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U.S. Debt Downgrade?

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Six days before the deadline to raise the national debt limit, 30 of 53 economists surveyed by Reuters news service believed the United States will lose its AAA debt rating in the near future.  Some would argue that kind of action is overdue with the national debt standing at about $14.5 trillion and growing.  However, many experts contend that the financial markets have already built in the possibility of a debt downgrade.  As such, any material impact on the interest rate environment would likely be muted in the near term but the long-term effect would be to put upward pressure on interest rates.

There are conflicting signals out there on rates, though.  The continued weak economy is likely to keep downward pressure on rates, at least for the near term.  The Fed has said as much in recent weeks.  This remains a very challenging environment for financial institutions.  Successful credit unions are continuing to update and create long-term financial forecasts and develop contingency plans.  What if loan demand remains weak?  What if rates rise; remain low?  Keying in on the performance of new business is a critical component in this as well.  In addition, credit unions should continue to evaluate their levels of interest rate risk and make determinations as to whether those levels are acceptable.  Now, more than ever, effective planning and risk management will be critical to credit union success in the coming years.

Source:  Reuters

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Recent Rise in Rates…

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Many thought that the recent Fed actions would drive rates lower, or at least help keep them at their extraordinarily low levels.  However, in the roughly seven weeks since the Fed announced the second round of easing, the 10-year Treasury rate has actually increased about 100 bps, from 2.5% to about 3.5%.  Thirty-year fixed mortgage rates have increased a similar amount over that period of time.  Shorter and medium-term rates have increased as well.

The increase in rates may impact recently completed 2011 budgets, with some positive effects, some negative.  If your credit union plans to originate and sell mortgages, you may consider testing a possible negative impact on volume and on associated non-interest income, if you have not done so already.  On the bright side, if your credit union is planning to book and hold mortgages, the increase in rates could make that decision look more attractive.

With the rise in investment yields across most points on the yield curve, credit unions might be able to top their projected investment income for 2011.  Others may see the rise in rates as an opportunity to shorten the planned duration of new investments while still hitting budgeted investment income targets.  Of course, long-term rates could drop in the next few weeks.  However, if rates stay where they are or move higher, credit unions should be discussing the likely impacts on their balance sheet management strategies heading into 2011.