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3 Ways Rising Rates Affect Your Balance Sheet

BY MICHAEL ORAVETZ

Michael Oravetz

Since the turn of the calendar year, financial markets have experienced significant change. After severe flattening at the end of 2017, swap and treasury securities have sold off in anticipation of a rate hike by the Federal Reserve in March, and potentially two to three more throughout 2018. The 2/10-year treasury spread has rebounded to 61 bps following a decade-long low of 50 bps in early January. As of March 12th, the 2- and 10-year yields sit at 2.26% and 2.87%, respectively. Economic sentiments remain largely optimistic as higher growth and inflationary expectations persist, commonly associated with higher interest rates and steepening yield curves.

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The rise in long-end yields has pushed mortgage rates higher. At December month-end, the national average offering rate for a 30-year fixed mortgage was 4.08%; as of March 9th, that rate had increased to 4.41%. Despite the rise in rates,2017 was the strongest year in credit union history for mortgage volume. Over $174 billion in 1st mortgages were granted (originated) in 2017, on the heels of a then-record $172 billion in 2016.

Figure 2illustrates the changes that the CU industry has experienced. First, the composition of the typical credit union balance sheet is evolving. No question, credit unions play a large role in consumer lending.Short duration assets such as auto loans are a flagship credit union product; indirect auto lending, for example, has grown in popularity, even as relatively high credit costs and punitive dealer fees plague marginal return. However, focusing exclusively on consumer lending can often hamstring an institution from meeting the ever-evolving needs of the member. The recent low-rate environment has catered to mortgage borrowers, and credit unions have been happy to oblige, opting to fund an increasing number of more profitable, longer duration assets.

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As rates rise, though, every institution should remain cognizant of the potential effects to the balance sheet, particularly for those with high concentrations of mortgage loans.Compared to consumer loans, mortgages have significantly more interest rate risk. Let’s examine three metrics that help demonstrate these differences: economic value sensitivity,economic capital ratio, and earnings-at-risk.

First, mortgage loans have “optionality” – cash flows that strongly rely on the path of interest rates.A mortgage prepayment option is not unlike a call option on a bond; when interest rates decrease, the borrower has the right to “call” the note(payoff the outstanding balance of the loan). This allows the borrower to “buy” the mortgage from the lender at par, even if the economic value of the loan is substantially above par. For the lender, this will reduce their economic value sensitivity exposure as cash flows contract and average lives shorten; practitioners refer to this as the convexity effect.Contrarily, as rates increase, prepayments will slow, since the borrower does not face an economic incentive to prepay. This will cause cash flow and duration extension, longer average loan lives, and shorter deposit average lives, creating increased sensitivity to interest rate changes. In comparison, auto loans face little interest rate risk as short duration assets with no optionality. In fact, auto prepayments have been observed to be tied more strongly to loan age, rather than changes in interest rates.

Second, economic capital, measured as net economic value (NEV), will also be affected by changes in interest rates. The magnitude and direction of the change will be determined by the construction of the balance sheet. This can be measured by the duration gap, which demonstrates whether the depository is asset-sensitive or liability-sensitive. Many institutions are liability-sensitive, meaning that relative to liabilities, assets will reprice over a longer time frame. As we touched on earlier, under periods of economic growth, yield curves generally steepen aslong-end rates increase more rapidly than short-end rates.This will not only exacerbate liability-sensitivity, but will also lead to reduced mortgage valuations, all else equal. However, rising rates also can offer a benefit to the institution, derived from the depository franchise. Ultimately, the impact to the value of the firm will depend on the interaction between the asset and liability base.

Lastly, rising interest rates also affect profitability and earnings volatility.As average lives extend for mortgage loans, this means cash flows extend to a longer horizon. Thus, institutions already displaying a liability-sensitive earnings-at-risk profile should expect increased income volatility.Asset-sensitive institutions will experience an increase to income volatility, as well, but will put them closer to an interest rate-neutral profile.

As credit unions continue to expand products to meet member demands, it is important to ensure balance sheet risk is managed. A rising rate environment should not deter an institution from meeting the demands of the marketplace.Whether it be through various hedging strategies, secondary marketing efforts, or even whole loan trades, every institution can succeed as rates rise. Opportunities lie along the entire yield curve,and credit unions must have the capabilities to pursue them.

michael OravetzMichael Oravetz Associate, ALM Strategy Group
ALM First Financial Advisors, LLC

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