2010: No Time for Complacency - The Satisfaction of Proaction

Tom Slefinger
February 3, 2010 | COMMENTS

Last year, the world focused on massive credit losses and a deleveraging of the financial system that, in turn, created a global recession throughout the economy. Unprecedented monetary and fiscal stimulus was unleashed to cushion the blow and has, up to now, succeeded in stabilizing the financial system. This has led to a sharp rebound in equity, fixed income and commodity markets. Most major industrialized and developing economies started to post positive growth in the latter half of 2009.

So while 2009 was the year of massive governmental stimulus, the upcoming year is likely to be a transition to more normal times, as stimulus is withdrawn. In addition to navigating this shift, credit union decision makers will need to factor in the potential end of quantitative easing and regulatory changes. Who will buy U.S. Treasuries, Agency debt and mortgage-backed securities (MBS) once the Fed exits the stage? Moreover, how will increased capital requirements impact the lending-versus-investment decision within the banking system? And, will fears of deflation be replaced with heightened inflationary expectations? In other words, while 2010 should be less exciting (hopefully) than 2009, it will undoubtedly bring its own set of challenges. Bottom line: this is not the time to become complacent.

To that point, on January 8, 2010, financial regulators of credit unions and banks jointly issued a timely and important advisory (online here) pertaining to interest rate risk management for banks and credit unions, excerpted below.

“The financial regulators* are issuing this advisory to remind institutions of supervisory expectations regarding sound practices for managing interest rate risk (IRR). In the current environment of historically low short-term interest rates, it is important for institutions to have robust processes for measuring and, where necessary, mitigating their exposure to potential increases in interest rates.”

*The financial regulators consist of the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the FFIEC State Liaison Committee.

Note: this is not a form of monetary policy but an extension of regulatory supervision. In reading the communiqué, the subliminal message is that just as banks and credit unions errantly thought they were properly hedged for credit and subprime prior to the credit crunch, regulators may have reason to be concerned once again. The unease is that many financial institutions may have become complacent regarding interest rate risk. As such, they may not be amply prepared for a changing interest rate cycle.

At the time of this writing, with the Fed Funds rate on hold at 0.00%-0.25%, and with the gap between short-term and long-term rates at record-wide levels, many banks and credit unions have borrowed short and are investing in long-term assets to enhance income and replenish capital. This is the same trick that was used in the 1990s after the S&L crisis. While Balance Sheet Solutions has advocated moving out the curve within a well defined ALM risk control framework, the regulators have become increasingly concerned that many institutions may have become intoxicated by today's easy-money paradigm. These institutions may have accepted undue interest rate risk relative to their balance sheet, and are not hedged properly. Hence, they could be subject to potentially negative ramifications should the Federal Reserve move toward tightening its monetary policy. In other words, regulators are rightly concerned that credit risk has mutated into interest rate risk.

If one were to believe in mean reversion, history would indicate that the yield curve will flatten in coming months or years. A yield curve can flatten (the spread becomes smaller) due to a fall in the long end, or due to a rise in the front end.

Some Fed officials have expressed concerns over the historically low Fed Funds rate. Early this year, Kansas City Federal Reserve Bank President, Thomas Hoenig, challenged what should be the fair level of funds once the economy is fully functional. He signaled that he will be an advocate of relatively early monetary tightening as a voter on the Federal Open Market Committee in the coming year. Hoenig warned that keeping the Fed Funds rate near zero for “an extended period” not only risks inflation and resource misallocation, but also actually impedes economic and financial recovery. He remarked that the Fed should instead raise the Fed Funds rate back up to a “more normal” 3.5% to 4.5%. He did not give a timeframe, but said he favors getting monetary policy back to a “more balanced” level “sooner rather than later.”

Mr. Hoenig also stated that the Fed “must curtail its emergency credit and financial market support programs…and restore its balance sheet to pre-crisis size and configuration.” As shown below, reducing the Fed's balance sheet could lead to dislocations in the market and apply pressure to rates.

Federal Reserve's Balance Sheet

Hoenig also had some stern warnings about the need to tighten fiscal policy, asserting, “The ballooning federal deficit must be controlled and reduced. If not, the federal debt will soon exceed national income.” and, “The dire consequences of such action are well documented in history,” as well as, “In its worst cases, it is a recipe for hyperinflation.”

Mr. Hoenig is one person and one vote on the FOMC, and undoubtedly others possess an opposite perspective. That said, in 2009 as crisis management moved front and center, the FOMC was unified in its response and approach. As the economy begins to normalize, dissenters of the zero interest rate policy within the FOMC are likely to emerge in 2010. Hoenig also brings to light three future events that will be adding negative pressures to valuations: 1) when the Fed stops buying MBS and Treasuries, 2) when the Fed starts selling MBS and Treasuries to return the balance sheet back to normal and 3) when the Fed starts tightening.

It is important to note that we are not forecasting higher rates – forecasting is best left to speculators and fortune tellers. Yet, we do believe that given where we are in the current interest rate cycle, it is more critical than ever for credit union decision makers to take a proactive stance. That means quantifying the risk in their portfolios and overall balance sheet under a changing interest rate environment. In addition, to assess the impact of higher short-term interest rates, credit union executives need to analyze their yield curve exposure (key rate durations) and how a bear- or bull-flattening of the yield curve could impact funding and investment returns. Also, given that spreads have collapsed in most sectors, portfolio managers should quantify spread duration across the portfolio. In other words, ask: “If spreads widen, what is the risk to my portfolio and balance sheet?”

Tom Slefinger is Senior Director of Trading at Balance Sheet Solutions, LLC. Contact the author at tom.slefinger@balancesheetsolutions.org.

*The securities listed in this article are intended to be representative securities. The article does not consider the particular investment objectives, financial situation or particular needs of any specific credit union.