The NCUA is hyper-focused on interest rate risk (IRR). They go so far as to include an “Interest Rate Risk Resources” button on their main webpage that includes, among other items, a video featuring NCUA Chief Economist John Worth highlighting the agency’s concerns using numerous charts depicting industry data and trends. Chairman Matz has also addressed IRR in numerous speeches and videos. Given that the ten-year Treasury yield is actually more than 80 basis points (bp) lower than at the start of the year, and the two-year is down about 5 bp, what is the agency’s concern? In a nutshell, it’s this:
- The Fed funds target rate has remained at a record low: 0-25 bp for nearly six years. There’s nowhere for rates to go but up.
- The economy is finally picking up on its own, so the Fed’s next move is likely a rate hike.
- The Fed has been withdrawing Quantitative Easing (QE), with the program slated to end in December.
- The Fed will likely begin raising rates sometime in 2015. Fed members’ projections indicate that will happen in Q2, while Fed funds futures traders are betting on early Q3. Both indicators forecast a total increase of 50 bp next year.
- The Fed is worried about a repeat of the S&L crisis.
Regarding the last point, S&Ls faced crippling IRR in the 1980’s. Their balance sheets consisted of long-term, low fixed-rate first mortgages funded by daily deposits. After interest rates were deregulated in 1980, then-Fed Chairman Volcker began aggressively raising rates to combat rampant inflation. His actions resulted in a Fed funds target as high as 20%. This dramatically increased S&Ls’ cost of funds, while the long-term mortgage loans on its books repriced even more slowly as refi demand disappeared. A subsequent series of regulatory and legislative miscues only exacerbated the problem, which ultimately cost taxpayers more than $130 billion.
While the impetus for the S&L crisis (runaway inflation and interest rate deregulation) was vastly different from the present situation, the outcome could be similar if rates were to rise rapidly and dramatically. Clearly, the NCUA doesn’t want that kind of legacy on its watch.
Countering NCUA’s heightened focus are arguments made by several industry experts.
- While the Fed is likely to begin tightening next year, economic growth probably won’t accelerate such that we see the kind of run-up in rates we saw in the 1980’s.
- Should we see a marked increase in short-term rates, it’s likely to be sufficiently gradual to allow credit unions time to make adjustments to mitigate IRR.
- While credit unions’ balance sheet durations have extended in recent years, the mismatch between asset and liability durations isn’t nearly as severe as that of S&Ls in the early 1980’s.
- Credit unions are far better-capitalized than the S&Ls were, and their ability to lag deposit rate increases in a rising rate environment is illustrated by the very charts that Dr. Worth uses in his video.
Several of those points are valid; that notwithstanding, we foresee a scenario in which the NCUA’s concerns could be realized. In 1994, the Greenspan Fed had maintained the funds target at 3.00% – a then unheard of low – for over a year. The economy began to improve in late 1993, and the bond market began to anticipate a round of monetary tightening. The Fed, indeed, began tightening in February of 1994, with a 25 bp hike. The market had anticipated a more aggressive move, given economic performance. The day before the first hike, the spread between the two-year Treasury and the Fed funds target was 128 bp.
After that first hike, the spread widened as the market became concerned that the Fed was getting behind the curve with respect to firming monetary policy. Indeed, the Fed’s next two moves were also 25 bp hikes, when the market expected more, leading many observers to refer to the Fed’s gradual tightening strategy as “Chinese water torture.” The fear was that the Fed would have to increase rates longer, and by more, than it otherwise would if it took a more aggressive stance. (Note that market yields anticipate future Fed actions.)
By the time the Fed was finished tightening in early 2005, it had increased the funds target by 300 bp, while the two-year yield was up by about 350 bp during that time. The spread between the two rates had increased to as much as 224 bp – nearly 100 bp more than just before the round of tightening began. (The ten-year yield from which mortgages are priced saw a similar run up.) In short, the market feared that the Fed had gotten behind the curve, and thus the market got ahead of the Fed.
The result was that mortgage rates rose sharply, prepayments slowed dramatically, mortgage-backed securities and collateralized mortgages got hammered in terms of market values, and margins got squeezed. Credit unions with significant exposures to those assets fell under increased regulatory scrutiny, and cost of fund increased which resulted in a significant margin squeeze.
That’s the scenario that could unfold next year. The economy has finally found its legs without having to rely on the crutch of stimulus, but the Yellen Fed is the most dovish in modern history. It has indicated that it will postpone tightening as long as possible. We suspect that this Fed will also approach less accommodative monetary policy very gradually, which will likely result in the markets getting ahead of it, unless those markets have become so addicted to the crack of stimulus that they’ve disconnected from their traditional responses to monetary policy. It is not lost on us that the bloated federal debt needs to be re-funded, and while the Fed is technically politically independent, the impact on a rising cost of funds to the government’s own balance sheet may well be a factor in Fed policy going forward. We should note that today, credit unions have considerably more direct balance sheet mortgage exposure than in 1994.
So who’s right? It doesn’t matter – as we all know, if the NCUA is concerned about something, they’re going to focus on it and ask questions accordingly. In fact, Dr. Worth’s presentation on the NCUA website sets forth a list of questions that credit unions should be asking themselves, questions that examiners will surely be asking on their next visit:
- What kind of interest costs would your credit union face if short-term interest rates rise by 300 basis points?
- How will your members react if your credit union’s deposit rates don’t keep pace with short-term market rates?
- How will rising rates affect loan demand?
- What strategies have you considered to find new avenues for loan growth?
- What share of your credit union’s loan portfolio is in loans whose rates are not scheduled to change in the next three to five years?
- What share of your investments have rates that are locked in for more than three years?
- Have those shares increased sharply in the past year, and why?
- Are your non-interest costs per dollar of assets in line with your peers?
- Is your credit union operating at high efficiency?
To this list, we would add an additional question: What strategies have we considered to increase non-interest income?
The Rochdale Group has developed a simple tool that can help you address these questions. They use the NCUA’s industry data and your credit union’s own data to compare your IRR preparedness relative to the industry’s. The report includes a customized presentation that can be delivered to your board, including basic education on IRR and the NCUA’s concerns, and a comparison of your credit union’s data to the NCUA’s industry data. In addition, we provide a written summary that addresses the above questions, based on the data presented.
This IRR response package is available to your credit union at a nominal cost for presentation to your board, or The Rochdale Group’s professionals can deliver the presentation via webinar or in person. The result is education and peace of mind for your board and a tailored response to the NCUA’s questions, at a cost savings vs. doing the analysis necessary to respond internally.
For more information regarding The Rochdale Group’s IRR Response Toolkit, contact The Rochdale Group at (800) 424-4951.