For those credit unions that need to grow capital, and are doing it with a high amount of interest rate risk, they now have the tools to manage that risk. 

By Emily Hollis

Time and time again in our industry we hear the saying “Risk should not be avoided but should be managed.” However, is this advice really complete? I believe this statement should be expanded to: “Risk should not be avoided, but managed after educating yourself on what risk you are taking. ” Warren Buffett summed it up when he said, “Risk comes from not knowing what you are doing.”

Credit unions have different risk tolerances, strategies and capital, so, what works for one might not work for another. But for those credit unions that need to grow capital, and are doing it with a high amount of interest rate risk, they now have the tools to manage that risk.

The NCUA is offering these tools with the use of derivatives. Credit unions should take advantage of this, but don’t abuse it. If you do, the powers will be taken away and those that use it correctly will lose their competitive advantage. Sound familiar?

In June 2011, the NCUA came out with its first Advanced Notice of Proposed Ruling (ANPR) for credit union derivative authority. In late January 2012, the NCUA issued its second ANPR for derivative authority.

Without the regulatory authority to raise capital through secondary markets, generating income by managing balance sheet risk and financial intermediation are the only options to enhance capital. Generally, institutions generate income by exposing their balance sheets to different types of risks (interest rate, convexity, liquidity) and through financial intermediation (gathering a portfolio of member deposits and building a portfolio of member loans). Understanding and applying strategies for managing these risks and strategies for balance sheet construction can enhance returns, but also present risks if interest rates rise or liquidity spreads widen. On the other hand, the often-used conservative practice of selling member issued mortgage loans can negatively impact earnings. In this strategy, the interest rate risk is removed, but so is the asset’s yield spread that institutions would rather retain. The use of derivatives, when used properly, can allow financial institutions to enhance earnings by retaining longer-term mortgage loans and offsetting their interest rate risk. And as competition grows, the use of derivatives will allow credit unions to compete.

“Risk should not be avoided, but managed after educating yourself on what risk you are taking.” Warren Buffett summed it up when he said, “R isk comes from not knowing what you are doing.”

Understanding the concepts of hedging is not difficult. In fact, it is a lot easier than understanding some of the other product strategies on CEOs’ plates today. It just takes focus and a lot of ground work to get it going.

Simply put, hedging is insurance. Insurance can be costly, but it shouldn’t be considered as losses. As an example, take institutions that hedged 7.0-percent mortgages in 2001. Institutions entered into swap agreements to pay 6.0-percent for 10 years and receive three-month LIBOR (which was 5.50 percent at the time), in essence turning their fixed assets into floaters.  In 2003, three-month LIBOR dropped to 1.0 percent and the 7.0-percent mortgages prepaid dramatically.  Those who entered into these swaps found themselves paying 6.0 percent, receiving 1.0 percent and watching their asset that they hedged disappear. The hedge worked as it should; it was the asset that didn’t work as planned. 

Interest-rate hedging should not be confused with derivatives that did lose significant market value, such as credit default swaps[1]. Some believe the demise of the failed corporate credit unions was due to their derivatives power, but that simply is not true.  Their failure was caused by credit losses on non-conforming securities. Derivatives that hedge interest rate risk are fairly straightforward, and they performed extremely well during the credit crisis.

An alternative to hedging is long-term borrowings. But the downside of borrowing is that it decreases the credit union’s capital-to-asset ratio and is expensive. Compare a 10-year swap with a 10-year borrowing position. In a 10-year swap, the credit union would be paying 1.95 percent[2] in today’s market, while a borrowing rate is 2.55 percent. In the swap transaction, the credit union would pay 1.95 percent and receive three-month LIBOR, or 0.53 percent. To have the same effect of reducing interest rate risk, the credit union would have to take the funds that it borrowed and invest in three-month funds, probably not getting three-month LIBOR, but something less. But assuming it does, this 60 basis point difference is costly. Specifically, it will cost the credit union $60,000 every year for a $10-million trade, or $600,000 throughout the 10-year period.

The following describes more differences between borrowing and hedging.

• Hedging does not decrease the capital-to-asset ratio for transactions that are off balance sheet.
• Borrowings are not liquid and if a credit union needs to liquidate a position, it can be extremely costly. Swaps and caps are extremely liquid, especially when they commence trading on an exchange.
• Hedging does not directly create costs. Costs are embedded in the asset’s yield.
• Borrowing from the FHLB brings hedging benefits to the balance sheet, but also comes with the risks of investing or deploying the funds. An institution that invests the borrowings in longer-duration assets may have accomplished nothing except a simple leveraged trade; however, interest rate risk is not reduced at all. And, if credit risky assets are added, credit risk would be increasing, also. Interest rate swaps simply do not have these leverage and investment issues to contemplate, they simply reduce interest rate risk.
• When entering into a derivative contract with a dealer, risk can be mitigated by bilateral agreements, which require the dealer to post collateral on a daily basis in the amount of an unrealized gain in the transaction, and vice versa. The credit union would have to post collateral in the event of an unrealized loss. If the dealer defaults, the credit union would be made whole, so credit risk is minimal and contained to daily market value movements.
• Just as becoming a member of the FHLB is laborious and takes a good amount of time, setting up a line at a dealer is no different. Credit will need to be reviewed and authorized, and this can take months.
• It is easier to obtain a line for borrowing at the FHLBs than a line from the few counterparties that are currently authorized by the NCUA so most credit unions won’t be able to use derivatives unless they work with a third party provider.
• Borrowings do not need regulatory approval. A credit union can borrow up to 50 percent of its shares and undivided earnings. Hedging will require regulatory approval from a third-party provider (i.e. ALM First) or approval to go directly to the dealers.

Among the challenges facing credit unions today are enhanced regulatory scrutiny. Advanced analytics can scare most credit union officials into simply avoiding risk, which can be costly.  The careful use of hedging tools or the ability to buy insurance against interest rate risk is a viable option.  Credit unions that qualify should take the time to look into these options.

Emily Hollis, CFA, is a partner with ALM First Financial Advisors, LLC.

[1] Credit default swaps are agreements where counterparties transfer credit risk. A counterparty agrees to insure a third-party credit risk in exchange of regular payments, or an insurance premium.  If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset or at times, pay the market value loss of the insured asset.