Wednesday, June 3, 2009

Low Rate EAR solutions

If you are a credit union that stopped lowering it's prime lending rate some time ago to preserve income, you likely have this Low Rate EAR that we have been talking about. That means, when rates start to rise again, your credit union will start to lose income as compared to what it is earning today. And we know that the next movement in prime rates will be to higher levels.

The first step is measuring how much income you will lose. Here's how:
  1. Add up all your variable liabilities - those deposits that have rates that changed as the bank prime rate fell. Chances are that these consist mostly of the premium savings account and perhaps the floating side of a receive the fixed swap.
  2. Now total all your variable assets. Chances are that these are pretty rare. One example would be the floating side of a pay the fixed swap. (By the way, the floating side of swap is normally considered fixed not floating, but if the swap's reset period is 3 months or less, then it is close enough to floating for our purposes.)
  3. Take the difference between the total variable liabilities and the total variable assets. That difference is the source of your Low Rate EAR exposure.
  4. Now calculate how much is at risk. That is how much bank prime has dropped from the level where you froze rates. That would be the difference between your credit union' s prime rate and bank prime rate (currently 2.25%). For instance, if your credit union froze prime at 3.50%, there is 1.25% at risk.
  5. Calculate the dollar amount at risk per annum. That is the difference calculated in #3 multiplied by the percentage at risk calculated in #4.

That's how much income you will lose as the prime rate rises again to the level where you froze rates. So what to do?

Well, one choice is to do nothing about this Low Rate EAR and just concentrate on lowering your falling rate EAR that is currently masked. Here's the logic - you froze prime to prevent losing income from further drops in prime and that worked very well. Then there was a bonus as prime dropped further and you actually made more income as the rate on your premium savings account fell. That was great - the last blog called it found money. This is the income now at risk and it really means you will be back where you were when you froze prime - so why worry about it? You're just losing income that you weren't expecting to have.

Besides, there is no guarantee that when the prime rate starts to rise that the premium savings account rate will be forced higher. We saw that when prime rates were falling, that the premium savings account rate wasn't always in synch. Prime rate fell 4% whereas these rate only fell 2.00% to 2.50%. Perhaps the savings account rate will not rise when prime rate rises. However, there was a pretty good relationship between premium savings account rates and prime for the last few drops. Also, I think there is a pretty good chance that these rates will rise before prime does - in response to the economy turning and mortgage rates rising. (We saw the majors raised mortgage rates yesterday.)

Yeah, but what about solutions? We need something that will pay more when rates rise, but that will not be a burden when the normal EAR exposure to falling rates returns. That is difficult because many solutions that reduce Low Rate EAR will increase the normal falling rate EAR. Fixing one often makes the other worse.

A natural solution is to use your liquidity investments. Keep them short. When rate rise, their rates will also rise. If you have enough short investments to cover the difference calculated in #3, then you problem is solved. The shorter the term the better the match to your exposure. It would even be a good idea to sell longer investments and buyer shorter ones. Also, when rates rise to the extent that your normal EAR returns, you can reduce that exposure by investing longer. This really is the easiest/best approach to the problem, but chances are it is not enough.

Here's a very common thought process I hear about as an interest rate risk consultant. There is a price to pay when you keep your investments short. Shorter terms have lower yields than longer terms. So there is an immediate income loss if you invest short. Why not invest long and get the higher rate when you are pretty sure that rates will be stable for a while? Here's the problem - there is no telling when rates will start to rise again. When they do your credit union will lose income. A short investment will be able to offset that loss with higher rates on rollover.

If you have a one year term investment though, and rates rise say 1.00%, then you have to wait a year with a very low rate investment before your income will return. And remember that rates will not likely increase by 25 basis point increments - they cam down much faster and they will probably go up very quickly - perhaps as much as 2% in a couple of months. If you feel you can predict when rates will start to rise - go ahead and invest longer for more yield, but this is not recommended. We suggest terms of 3 months or less and again, shorter is better.

Interest rate swaps are another possibility. If you pay the fixed on a swap, the floating side will be like a variable rate that will rise when prime rates ascend again. That will hedge Low Rate EAR exposures. And, fixed pay swaps are a great idea right now because they effectively lock in these low rates for the long term. A five year fixed pay swap is like a five year deposit in that it locks in the rate for five years. But, and its a big BUT, this will also increase you normal EAR exposure to falling rates. (And your falling rate EVR exposure too.) You will also find that the amount you are paying is higher than the amount you are receiving - a loss that starts the moment your swap starts. And there is some pretty ugly accounting for swaps these days. However, this is an effective hedge for Low Rate EAR and a great way to lock in long term rates, so it is a good approach provided that the effects on the normal falling rate EAR and EVR are manageable. Otherwise, a pay fixed swap is not recommended.

Is there a way to get BA (not prime) based loans on your books? These would work, but they also will impact your normal falling rate EAR adversely. Can you convince members to convert their premium savings deposits to longer term deposits (preferably longer than one year) in this environment? Probably a hard sell and again, it will add to your normal falling rate EAR So there really are not many good solutions For Low Rate EAR.

Here's one more approach. As prime rates start to rise, can you also increase the rates on your variable assets? That too is a tough sell to members, as these rates didn't fall when prime fell so how will you explain that to the members affected? Even increasing your prime a portion of the prime rate increase would help. If prime was to increase 1.00%, you could cut this Low Rate EAR in half if you could raise you prime rate by 50 basis points. One way to help sell this would be to promise to get credit union prime back to the levels of bank prime by increasing less than the banks after bank prime reaches the level where you froze rates. Of course that means you would still lose the full amount of annual income calculated in step #5 above, but you have spread the losses to a period where you have higher income.

Finally, you can increase margins the old fashioned way - by increasing spreads on variable loans. This too will offset losses from Low Rate EAR. That is what the banks have done and that is one way they are able to make money with a 2.25% prime rate.

So, the two best methods are to shorten investment terms and to increase loan spreads. Other methods impact member relations or add to the normal EAR that will return when rates rise. They should only be considered with that in mind.

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