Credit unions: extending asset duration and managing rate risk

ALM challenge

As the rate environment remains at historical lows and deposit balances continue to grow, many credit unions have fewer lending opportunities and are looking for productive ways to utilize their excess liquidity. Some of these institutions have increased their investment portfolios and/or retained more of their mortgage originations. Both these strategies can provide more attractive yields and enhance net interest margin, but they can also increase interest rate risk. Hedging tools like swaps may provide credit unions with the flexibility to utilize excess liquidity, earn higher yields, and efficiently manage rate risk.

NCUA proposed changes

The NCUA Board recently met and proposed to modernize and simplify the agency’s derivative rules. The proposed changes would make it easier for federal credit unions (FCUs) to use common hedging tools to manage their interest rate risk especially during these uncertain times. More specifically, the NCUA would eliminate the pre-approval process for FCUs that are complex with a Management CAMEL component rating of 1 or 2, broaden the type of hedging instruments and structures, and remove the regulatory limits on the amount of derivatives usage.

Hedging strategies

A basic interest rate swap can be used under the NCUA’s current derivative rules to manage the rate risk of an individual investment security or a mortgage held in the loan portfolio. Moreover, a pooled hedging approach using a similar swap structure may create even more efficiencies from a pricing and accounting perspective especially if the underlying fixed rate assets are prepayable. A credit union would simply create a closed pool of fixed rate, prepayable securities or mortgages and hedge a portion of the pool based on a prepayment analysis. This approach is commonly referred to as a “last of layer” strategy and has become very popular given more flexible accounting rules.

A current or forward-starting swap could be used to achieve the financial institution’s preferred mix of fixed and floating rate exposures. Today the NCUA limits the forward-starting period to 90 days. However, that restriction would be lifted as part of the proposed changes to the existing derivative rules. A longer forward-starting period would allow credit unions to recognize the fixed rate coupons on a pool of securities or mortgages until the swap would become effective on the future start date. At that time, the institution would have protection in place to help mitigate the potential impact of a rising rate environment.

Conclusion

The pandemic has created a challenging operating environment for financial institutions. As many consumers and companies increased their cash holdings to buffer the uncertain market conditions, the credit union industry experienced rapid deposit growth and ultimately excess liquidity which has depressed margins. Institutions are evaluating alternatives and implementing strategies to enhance yields in the securities and mortgage portfolios. Hedging tools such as interest rate swaps can be effective in managing the rate risk associated with an increase in asset duration.

About Chatham

Founded in 1991, Chatham Financial is the world’s largest independent derivatives advisory firm, executing over $750 billion in transaction volume annually and helping clients across industries maximize their value in the capital markets. Chatham partners with credit unions throughout the U.S. to support their interest rate hedging activities. As an external service provider, we are equipped to deliver training, trade structuring, pricing execution, hedge accounting, and regulatory advisory support among other services. Having an independent and transparent approach allows us to bring a partnership mentality to every client engagement.