CU Investment Advisors Applaud NCUA's Proposed Derivative Changes

Editor’s note: This opinion piece was written in response to an opinion piece published by CU Times on Jan. 22 titled, “Government Regulators Should Not Expand Derivatives Trading at Credit Unions.”

Throughout our 25 years as advisors to credit unions, we are continually impressed by their true community-oriented strategies. The service and care that they provide to their members is inspiring.

At their core, credit unions are in the business of making consumer loans, primarily auto and mortgage loans. However, shrinking margins, tighter spreads, lower loan demand and higher deposit inflows are creating a challenging environment. More credit unions need simple, modern access to the same balance sheet management tools banks have used effectively for decades to hedge interest rate risk.

An Opportunity to Manage Risk, Do More for Members

The NCUA’s Proposed Rule on Derivative Use is an opportunity for federally-chartered credit unions to gain greater flexibility in managing interest rate risk and offering more products to benefit their members.

Like all financial institutions, capital must be built to ensure the safety of the depositors. The reason banks and credit unions use simple interest rate swaps (not to be confused with other types of derivatives) is to hedge interest rate risk.

Taking on more interest rate risk doesn’t add to performance over the long haul, but it sure can interfere with it. Credit unions generally focus on the things they do well (underwriting loans, diversifying them into a portfolio, gathering deposits, etc.) and remove items that are out of their control and may interfere with loan performance, specifically the level and direction of interest rates.

Credit unions will go to great lengths to serve their members. This includes issuing loans that might not conform to GSE standards and are, therefore, not agency deliverable. If asset duration becomes too long, senior leaders are faced with the dilemma of either having too much interest rate risk or turning down a member who truly needs a loan. Should rates rise, certain derivatives will gain in value. Simply put, credit unions are at risk of asset duration extension should rates rise, and the use of derivatives is to mitigate this risk.

Preparing Now for Down the Fairway Risk Management

The best run savings and loan organizations (many of which operated as cooperatives) hedged their interest rate risk with simple rates-related derivatives. Hedging interest rate risk allows credit unions to better serve their members. If you originate a non-conforming mortgage for a member that will be funded and capitalized on your balance sheet, we believe prudent risk management practices would include interest rate hedging in an asset liability management framework. Not the other way around.

The proposed rule is not about increasing credit union “investments” in derivatives, it’s about opening the door to sound risk management practices that may protect an institution’s capital in the future.

Natural person credit unions were first introduced to these tools in 2002 through a pilot program created by the NCUA. Regulators have taken time to understand derivative instruments and see their potential benefits. Now, it’s time to modernize regulations and provide greater flexibility for highly-rated (CAMEL 1 and 2) credit unions.

Safety and soundness is a core focus for any financial regulator. The value of interest rate swaps and other simple interest rate derivatives are priced daily. Credit risk is mitigated via bilateral agreements requiring daily margin maintenance or via tri-party custody or via clearing.

Modern interest rate risk management techniques were in their infant stages during the savings and loan crisis in the 1980s and surely weren’t around in the “It’s a Wonderful Life” era. Today, tried and true interest rate risk hedging strategies are at the heart of many risk management programs at both banks and credit unions.

A word of caution: Hedging mortgages can be complex, and so can modeling mortgages and accounting for derivatives. Some of the greatest minds in the financial services industry do mortgage research all day and still struggle. However, successful hedging programs are all about understanding the risks you’re hedging, and that includes understanding the assets you’re hedging and their complexities.

This has been a challenging time for balance sheet managers, but it’s certainly no time to ignore or restrict down the fairway risk management practices that banks may already use at will and more credit unions could utilize to potentially improve their safety and soundness. When rates rise, assets will likely decrease in value. As industry veterans and credit union advocates, we are concerned about what could happen to the industry if these tools are not used.

Emily Hollis, CFA is CEO of the Dallas-based ALM First Financial Advisors.

Robert Perry is Principal of ALM First Financial Advisors.