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Article

Credit unions: extending asset duration and managing rate risk

Date:
December 3, 2020
  • matthew tevis headshot

    Authors

    Matthew Tevis

    Managing Director
    Head of Sales

    Financial Institutions | Kennett Square, PA

  • todd cuppia headshot

    Authors

    Todd Cuppia

    Managing Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

Credit unions have experienced a significant increase in member deposits during the pandemic which has led to excess liquidity and low-yielding cash balances. Hedging tools may help these institutions extend asset duration and improve margins while also managing their incremental 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.


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About the authors

  • Matthew Tevis

    Managing Director
    Head of Sales

    Financial Institutions | Kennett Square, PA

    Matt Tevis is a Managing Director and the Global Head of Sales for Chatham’s Financial Institutions business. He advises clients on a variety of interest rate risk management topics with a focus on hedging solutions.
  • Todd Cuppia

    Managing Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

    Todd Cuppia is a Managing Director and leads Chatham Financial's Balance Sheet Risk Management practice. Todd works with financial institution clients on developing and executing strategies to manage complex economic risks.

Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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