Q&A with Emily Hollis

Emily Hollis
December 21, 2009 | COMMENTS

Question: If you fall in the “low” risk category for both the net interest income (NII) simulation and net economic value (NEV) analysis, do you have to worry about interest rate risk.

Being complacent with interest rate risk because you fall in the “low” risk category is one of the most dangerous assumptions one can make. In the current environment rates are extremely low and longer-term mortgage loans show economic gains in the base scenario which is caused by fast projected prepayment speeds. Rates are so low that mortgage loans with coupons greater than 5.875 percent continue to have gains even in the up 100 basis point (bps) scenario. However, a word of caution: as rates move up, the duration of these cash flows will extend. If overnight rates move up to 2.25 percent and 30-year mortgage rates rise to 6.875 percent, all of a sudden you might find a dramatically different interest rate risk profile.

Typically the higher the amount of capital an institution has the more risk it can take. However, remember that with the corporate write-offs, negative earnings, and deposit growth, you can quickly find yourself in a position with greater interest rate risk and much lower capital without doing anything to your balance sheet.

As an example, the following diagram shows a $100-million credit union with 10 percent capital. In the current interest rate environment the credit union's NEV percent change in the up 300 is negative 27 percent with an NEV ratio of 7.05 percent. Should rates move up 200 (bps), the new up 300 results (indicated as up 500) would be an NEV percent change of negative 39 percent and an NEV ratio of 4.91 percent. And the credit union would maintain its moderate interest rate risk.

On the other hand, a credit union with the same balance sheet that starts with lower capital of 8 percent, (or loses $2 million in capital due to write offs and losses), realizes a dramatically worse risk position in the up 300 bps scenario. The institution moves to a negative 52 percent NEV change and a 2.91 percent NEV ratio, which is well into the high risk category.

You should move rates up to double-digit figures to really test your inherent interest rate risk.

Although we do believe at some point that rates will rise, modeling your balance sheet given double-digit scenarios is probably not warranted, unless it is a forward NEV ( A forward NEV is an analysis where the balance sheet is projected using an income simulation analysis). There is a balance between building strategies that are based upon unlikely scenarios and being aware of how risk can be mitigated should indications point to such environments.

Credit unions with a good amount of mortgage loans should model their results in a variety of scenarios, but most importantly rising rate environments. Rates are at historical lows and building strategies that are based upon rates staying this low for a long period of time could be very dangerous.