The Danger That Could Lie Just Around the Yield Curve

Since May 1 rates have been rising, but John Worth is advising credit unions not to be "fooled" into inaction against interest rate risk.

For credit unions, the development is a long-awaited positive, with Worth, NCUA's chief economist, noted a steepening curve is "good for credit unions."

"A steepening curve is likely what we will see over the next year as loan rates go up, but the short end remains low due to Fed policy," he said, noting the Fed has made very clear that should the unemployment rate hit 6.5% it will make changes to the "extraordinary" monetary policy currently in place.

An increase in short-term interest rates could lead to a flattening yield curve, along with some "real problems" for CUs as spreads become compressed, observed Worth.

"Do not be fooled by the steepening period, because it is very predictable that the flattening period will follow," he warned. "Rates are rising in a particular manner right now, but that is not necessarily the manner in which they will be rising in 12 months or 18 months."

The interest rate risk management rule NCUA finalized last year is "really valuable" in times such as these, Worth said. That rule requires CUs to establish and follow an IRR management process that addresses levels of risk on balance sheets depending on the size and complexity of the credit unions.

"Hopefully, that has created an atmosphere where credit unions that have interest rate risk are planning how to manage it," he said. "It is a complex rate environment, but this is a well-timed topic because the recent moves are harbingers of moving toward a more normal rate environment."

Worth said those credit unions most at risk in a rising-rate environment are those with large amounts of fixed rate assets and risk-sensitive deposits. Another risky scenario involves CUs whose bottom lines have become dependent on fees, particularly fees based on mortgage refis as that boom cools off.

"If you look at credit union lending over time, the proportion of real estate has grown, and within that the proportion of fixed-rate loans has grown," he appraised. "More fixed-rate loans on the books is a concern when rates start to rise. It can be manageable, but it is a concern."

The other side, funding, also is something that creates risk in a rising-rate environment, Worth continued. He said in the last five years CUs have seen a transition to deposits that are more interest rate-sensitive.

"When rates rise, consumers are going to have a reasonable expectation the amount the credit union pays on money market accounts will rise," he warned. "Assets have become less interest rate-sensitive, but what a credit union is paying on deposits is moving. This is the crux of interest rate risk-a movement in interest rates where assets do not respond, such as a fixed-rate, 30-year mortgage, but funded with deposits that do vary with interest rates. It is important that credit unions do not put themselves in this position."

While the cost of funds has gone almost to zero, average yield, which Worth noted is highly correlated to the 10-year Treasury rate, has come down. The culmination, he said, is net interest margin has declined.

"Over last five years, the major basis for calculating earnings has fallen 100 basis points," he said. "Cost of funds is near zero, but it is not zero, and the amount a credit union is earning on loans has fallen more than cost of funds has fallen."

Consumers remain very interested in 30-year mortgages as that market has rebounded, and credit unions have moved longer on investments to get yield, Worth noted. The two-year Treasury rate has hardly moved at all, despite the fact other rates have risen.

Asked what he would counsel CUs to do, Worth said NCUA tries not to put out a "cookbook," because every credit union has to put together its own strategy.

"But one principle is, if you are in a hole, stop digging," he said. "If you have a lot of fixed-rate loans, stop approving those types of loans."

Other advice: Worth said CUs should look into diversifying lending, meaning more variable-rate loans that pose less risk, along with changes to funding. He suggested moving deposits out of the rate-sensitive category, and locking up long-term funding by offering CDs He said derivative authority is a tool that may eventually be useful for large, sophisticated CUs against IRR.

"You can look at summary statistics from Call Reports, but it really takes looking at data that is more granular to really get a handle on a particular credit union's situation," he said. "It is a matter of degree, and best done at an institution-specific level. Options such as CDs are credit union-specific because they depend on the members' preferences for savings instruments."

The problem with interest rate risk is, often by the time a CU realizes it is time to hit the panic button, it is are out of strategic options, Worth said.

"It hits the entire financial system at once, and becomes hard to back your way out of it. The parachute that pops out when you push the panic button is very small. Now is the time to be watchful. Plan now, put together management strategy now while there are options."