Low Rate EAR

As the prime rate dropped further and further, cutting into spreads and reducing profitability, some credit unions made the unilateral decision to freeze their prime rate. The moment they made that decision, their Earnings at Risk (EAR) exposure immediately became zero. Why? Most credit unions have a lot of variable assets and too few variable liabilities to offset them. That's why they are exposed to falling interest rates and that's why their income was getting decimated as the Bank of Canada kept on cutting rates. By freezing their asset rates, the problem was solved - most variable asset rates would no drop, so the exposure was eliminated.

Let's be careful with our terms here. What is an exposure to interest rates? If your organization has an exposure to interest rates, that means it will lose something (earnings or economic value) when interest rates change. Of course, interest rate changes could also mean that you gain something (earnings or economic value), but that is not an exposure. Exposures only concern themselves with the downside, favourable results are not a concern - so favourable results are not an exposure.

For the credit unions that froze their prime rates, interest rates rising to higher levels was not an exposure. And rates falling was not an exposure either, after prime was frozen. But their EAR was not zero. They would make more income (or economic value) when rates rose and, somewhat surprisingly, some credit unions would make more income when rates fell - substantially more.

To see why, we have to take a closer look at a very popular demand account - the premium savings account. The simple fact is that the rate on premium savings accounts is too high. In normal market conditions, no deposit rate should be higher than the swap curve, which is the same as the BA curve for terms under one year. Why? Because the swap curve is roughly where the major banks can borrow (or invest) as much money as they desire. Why pay a retail investor more for their $1,000 deposit than the rate where you can borrow millions, even billions of dollars? That should mean the rate for this account should be under 0.50%. And yet the rate persists as a full percent higher. Even the major banks offer premium savings account deposit rates higher than 1.00%.

So why is the rate on premium savings accounts so high? Most likely it is competition - everyone is offering high savings account rates, so not doing so likely means losing market share. But why is anyone paying such high rates? The premium savings account was practically invented by ING. They raised tons of money with this account and used those funds to finance loans - mostly mortgages. So they tend to watch the spread between 5 year mortgages and this savings account rate. So, this rate tends to change with 5 year mortgage rates rather than prime. Mortgage rates remained stubbornly high, as prime rates fell. And so did the rate on the premium savings account remain stubbornly high.

The chart to the left shows the Bank prime rate and ING's savings and 5 year mortgage rates. It may not be obvious (you get a clear picture by clicking the graphic), but prime rates fell 4% while mortgages rate only fell 2.15% and the prmium savings rate only fell 2.25%. That was very bad news for many credit unions. Many credit unions finance their variable rate assets with variable rate deposits, like the premium savings account. While their variable rate returns on prime-based assets fell off a cliff, the savings account rate only fell half as much. In fact, the chart shows how the savings rate was almost touched the prime rate at one point - for almost a month there was only 30 basis points difference between prime and the savings account rate, as compared to the more normal 2 or 3 percent. (You can see that the relationship between mortgage and savings account rates stayed relatively in synch for the entire period.) It was only when mortgage rates started to crack, that there was any relief on the savings account rates. That's the reason for the high savings account rate - it is tracking the 5 year mortgage rate rather than short term rates like BAs or prime.

No wonder, many credit unions took the unusual step of freezing prime to preserve income. Let's say the credit union froze their prime at 3.50%. Since then, the prime rate has fallen 1.25% and the premium savings account rate has fallen 1.20%. That represented a gain in income for these credit unions. The variable asset rates were stuck, but the variable liability rates continued to fall. That created interest rate risk. Now when prime rises, the variable asset rates will stay constant as they did on the way down. But chances are the savings account rates will also rise. And, in many cases, there is nothing to hedge this expense that is due to interest rates changing. That is a rising rate EAR exposure.

And this is a very unusual interest rate risk.

1. The magnitude of this EAR will vary as prime rates rise, such that this EAR will be zero again when bank prime equals the credit union's prime. The magnitude of normal EAR does not change significantly with interest rates.
2. This EAR is an exposure to rising rates, whereas credit unions are normally exposed to falling rates. The falling rate exposure still exists, but is currently hidden by the low rate environment. Eventually, rates will rise again and the falling rate exposure will be there again.
3. This new EAR is pretty tricky to hedge.

So we now have two types of EAR. We need to give this new form of EAR a name to avoid confusion with the completely different normal EAR. As this EAR will only occur when rates are low, we'll call it Low Rate EAR. So we have normal EAR and, now, Low Rate EAR.

What to do about Low Rate EAR next.