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Managing interest rate risk in a rising rate environment
Many credit unions are now looking at loan portfolios heavily populated with fixed-rate loans originated during a (fairly lengthy) period of historically low-term interest rates. As a result, a rising interest-rate environment may pose a real challenge in coming months. Unmanaged, interest rate risk can quickly erode both the net interest margin (NII) and the net equity value (NEV) of a credit union. Fluctuations in interest rates can cause earnings volatility, which may limit a credit union’s ability to forecast, manage and plan for growth. The Fed’s most recent cut in the fed funds rate to two percent is being perceived as the “last” cut. While that may or may not be the case, it is highly likely that current market rates are at or near the current cyclical lows.
While the Fed is unlikely to begin tightening until well into 2009, market rates will be under upward pressure far in advance of the Fed’s first action. This is the typical pattern for cyclical interest rate movements as market participants are always trying to anticipate future changes in monetary policy. Interest rate risk results from differences in the maturities, re-pricing cycles or spreads of a credit union’s assets and liabilities. Typically, credit unions fund longer-term, fixed-rate loans with member deposits and similar short-term liabilities that are prone to frequent periodic repricings. In a rising rate environment, as the rates paid on money market accounts, CDs and member deposits increase, the profit earned on an underlying fixed-rate loan portfolio, known as the net interest margin, decreases.
To address the asset/liability mismatch described above, credit unions must either lengthen the duration of their liabilities or shorten the duration of their assets. Shortening the asset side of the balance sheet is often difficult since it reflects the demands of the credit union’s membership (fixed-rate mortgage loans) and the credit union’s desire to hold the longer term assets they generate. It’s usually much easier for credit unions to alter the asset/liability mix by lengthening the duration of the liability side of the balance sheet.
There are several tools in the risk management toolbox to increase the duration of the liability side of the balance sheet: 1) long term, fixed-rate borrowings; 2) interest rate derivatives; and 3) long term CD issuance. Since long term CD issuance is tied to member demand for longer maturity investments, it can often be difficult and costly to accomplish, especially in a rising rate environment. Members may be reluctant to purchase long term, fixed-rate investments in a rising rate environment. The decision to use long term borrownings and interest rate derivatives, however, is driven by the credit union’s own preferences and the cost of each option. Each of these tools can increase liability duration by fixing liability costs for a longer term, thereby protecting against interest margin compression. It is important to compare and contrast the two approaches to determine which choice may be more effective and cost efficient. Most credit unions have more experience with long term borrowing than they do with interest rate derivatives, so let’s take a moment to review interest rate derivatives. The two most common forms of interest rate derivatives used to hedge against rising rates are the “pay fixed” swap and the purchased interest rate cap.
The “pay fixed” swap
A pay fixed swap is a contractual agreement in which a credit union agrees to pay a fixed rate of interest (driven by current market rates) and in return receives a floating rate index, usually LIBOR, for a pre-determined period of time (three years, five years, etc.). The swap is an exchange of net interest payments, without an exchange of principle. The maturity of the swap, the principal amount for interest calculations, the interest rate basis for the calculations (actual/360, actual 365, etc.), and the frequency of the payments are all determined in advance by the two parties. The basic idea in using a “pay fixed” swap is that a credit union can synthetically convert the floating rate liabilities that it pays to its membership (money market account, CDs, etc.) to a fixed rate, through the use of a properly structured swap.
The maturity and the principal size of the swap can be structured to meet the desired effect the credit union wishes to accomplish with respect to the asset/liability mix on its balance sheet.
The interest rate cap
An interest rate cap is an option that protects the buyer from a rise in short term interest rates by compensating the holder when the underlying interest rate index exceeds the pre-determined protection level of the cap, known as the strike price. In short, the buyer purchases an option that acts as insurance against rising rates. The length of the cap (three years, five years, etc.), the principal amount for interest calculations, the interest rate basis for the calculations (actual/360, actual 365, etc.), and the frequency of the payments are all determined in advance by the two parties.
The interest rate cap allows the buyer to hedge against rising rates (buy insurance) for a known fixed cost upfront, because the hedging expense when using a cap is limited to the premium paid to purchase the cap.
Long term borrow vs. “pay fixed” swap
As mentioned above, rising interest rates may lead to a compression of net interest margins for credit unions. In order to protect against this compression or erosion of income, credit unions can take advantage of the current low-rate environment to lock in longer term, fixed liability costs. Both a long term, fixed rate borrow and a “pay fixed” interest rate swap can accomplish this task, but in different ways.
The borrowing adds a new long term, fixed rate liability to the balance sheet, while the swap converts existing short term liabilities into longer term liabilities (see figure 2). The important distinction is the effect the two methods have on the balance sheet. In a borrowing, the full principal amount of the borrow is recorded on the balance sheet. In a swap, only the fair market value of the swap is recorded on the balance sheet. Since the fair market value of the swap is the present value of the net cash flows based on the principal amount, the fair market value of the swap will always be significantly smaller than the principal amount on which it’s based. For instance, if we were to compare a $25 million, five-year borrowing to a $25 million, five-year swap, the long term borrow will increase the size of the balance sheet by $25 million, while the increase related to the swap will be almost zero at inception (the fair market value). Even with substantial changes in interest rates over time (which lead to changes in the fair market value of the swap), the long term borrow will always result in a much larger increase in the size of the balance sheet relative to the swap.
The difference in how the two strategies affect the size of the balance sheet becomes more important when you look at return on assets (ROA) calculations. The long term borrow, because of its significantly larger balance sheet effect, will have a larger adverse impact on a ROA calculation relative to the swap. While the borrowing and the swap have very similar effects on the numerator (Net Income), the borrowing increases the denominator (Average Assets over the period) a great deal more than the swap, resulting in a lower ROA.
The accounting learning curve
Using interest rate derivatives adds one complexity not found in long term, fixed-rate borrowing—accounting. Derivative accounting guidelines focus on the use of swaps and caps as “hedges,” and require users to demonstrate the effectiveness of their chosen strategies. A cash flow hedge attempts to hedge the exposure to a variability in expected future cash flows, while a fair value hedge attempts to offset changes in the fair market value of a designated item. Most credit unions will opt for cash flow hedging by converting a variable stream of future cash flows (a money market account or the future issuance of CDs) into a known fixed stream of cash flows.
Accounting guidelines require the measurement of the effectiveness of a hedge (i.e., how closely the change in value of the hedge matchs the hedged item). If a hedge falls within the appropriate guidelines, only the ineffective portion is recorded as income/loss, whereas in a non-qualifying, ineffective hedge, the entire change in the value of the hedge (the mark to market) is recorded as income/loss. Since most financial institutions seek to minimize the amount of income variability they experience, a properly structured, highly effective hedge is recommended. While dealing with accounting for derivatives is new to most credit unions, it is not a insurmountable task.
The easiest and most efficient way to manage this process is to hire outside accounting help. There are a number of firms specifically equipped to handle the accounting requirements and are often a cost-effective means to do so. In most cases, the cost of using “pay fixed” swaps, including the cost of outsourcing the accounting, is cheaper than doing a long term, fixed-rate borrow. Before avoiding the use of derivatives due to a fear of accounting, speak with a WesCorp representative, as the process may be easier than you think.
Vince Herman is WesCorp’s Director of Hedging Services. You can reach Vince at (312) 238-9618, or by e-mail here. You can see his complete article in WesCorp’s InsideRISK magazine (Vol 8, No 2, 2008).