Using Costless Collars to Hedge Interest Rate Risk
The NCUA’s May 2021 updates to 12 CFR §703.103 have empowered credit unions to use costless collars as a tool for managing interest rate risk. These strategies are permissible under the NCUA’s updated derivatives regulation and comply with GAAP (ASC 815), incorporating updates from ASU 2017-12, which optimizes hedge accounting. Costless collars offer a flexible, cost-effective strategy for stabilizing cash flows while managing operational challenges
The following analysis examines the use of costless collars to hedge interest rate risk on two specific use cases:
1) on assets in the form of adjustable-rate mortgages (“ARMs”) and
2) on liabilities in the form of Federal Home Loan Bank (“FHLB”) borrowings.
General Regulatory Framework: NCUA’s May 2021 Derivatives Rule Update
The May 2021 revisions to 12 CFR §703.103 modernized how federally insured credit unions use derivatives to manage interest rate risk. Key considerations include:
A. Principles-Based Approach: The NCUA removed prescriptive limitations on specific derivative instruments, allowing credit unions to deploy strategies such as costless collars if consistent with their risk management practices and priorities.
B. Risk Management Requirements:
a. Credit unions must establish board-approved policies outlining the purpose, scope, and limits for derivative use.
b. Robust internal controls are required to monitor and mitigate risks from derivative transactions.
C. Competency and Expertise:
a. Credit unions must demonstrate expertise in derivatives through qualified staff or external advisors.
b. Ongoing training and audits are necessary to ensure compliance with the framework.
D. Alignment with NCUA Goals: Derivatives must be used to manage risk in a safe and sound manner that supports the credit union’s strategic objectives, and not for speculative purposes, which is strictly prohibited.
Use Case 1: Asset Side – Hedging Interest Rate Risk on Adjustable-Rate Mortgages (ARMs)
Example scenario: a credit union holds a portfolio of 5/6 ARMs. These mortgages have a fixed rate for the first five years, after which they reset every 6 months based on the 30-day average SOFR rate plus a margin, depending on the loan agreements. Declining interest rates post-reset could reduce interest income and negatively impact the credit union’s Net Interest Margin.
Hedging Strategy
The credit union uses a costless collar:
• Buys an Interest Rate Floor: Protects against declining rates by ensuring a minimum yield on the ARM portfolio after reset.
• Sells an Interest Rate Cap: Offsets the purchased floor’s premium by agreeing to cap income if rates rise beyond a specified level.
This structure stabilizes interest income without any upfront costs.
Hedge Accounting Application
Ideally the costless collar is designated as a cash flow hedge of forecasted interest income on the ARM portfolio post-reset.
1) Documentation: The hedged item is forecasted interest income, the hedging instrument is the costless collar, and the risk being hedged is the cash flow variability tied to the benchmark interest rate (SOFR).
2) Effectiveness Testing: Either quantitative or qualitative depending on alignment of the hedge relationship. Qualitative methods often suffice if the hedging relationship’s critical terms closely match and the relationship is highly effective by design.
3) Accounting Treatment: derivative fair value changes are recorded in Other Comprehensive Income and reclassified to earnings when the hedged cash flows occur.
|
Pros |
Cons |
|
Protects
against declining rates (floor) |
Caps upside potential if rates rise |
|
Stabilizes interest income |
Operational complexity in hedge
accounting documentation |
|
No upfront costs |
Basis risk from potential mismatches |
Use Case 2: Liability Side – Hedging Interest Rate Risk on FHLB Borrowings
Example scenario: a credit union frequently borrows from the FHLB on a 1-month rolling basis. These borrowings are reinitiated each month based on then applicable market conditions, which are closely aligned with then applicable SOFR or Fed Funds. Rising interest rates would increase borrowing costs, therefore negatively impacting Net Interest Margin.
Hedging Strategy
The credit union uses a costless collar:
• Buys an Interest Rate Cap: limits the borrowing costs by capping the interest rate.
• Sells an Interest Rate Floor: Offsets the purchased cap’s premium by agreeing to minimum rate if rates fall below a specified level.
This structure protects against rising borrowing costs while avoiding upfront costs.
Hedge Accounting Application
The costless collar is designated as a cash flow hedge of variable interest payments on FHLB borrowings.
1) Documentation: The hedged item is FHLB borrowing cash flows, the hedging instrument is the costless collar, and the risk being hedged is the cash flow variability tied to SOFR or Fed Funds resets.
2) Effectiveness Testing: Either quantitative or qualitative depending on alignment of the hedge relationship. Qualitative methods often suffice if the hedging relationship’s critical terms closely match and the relationship is highly effective by design.
3) Accounting Treatment: derivative fair value changes are recorded in Other Comprehensive Income and reclassified to earnings when the hedged cash flows occur.
|
Pros |
Cons |
|
Protects
against rising borrowing costs |
Limits benefit if rates fall
significantly |
|
Stabilizes interest expense |
Operational complexity in hedge
accounting documentation |
|
No upfront costs |
Basis risk from potential mismatches |
Regulatory Basis
Under 12 CFR §703.103, the NCUA permits the use of costless collars to manage interest rate risk on assets such as ARMs, provided the following requirements are met:
1) Board-Approved Policies: Policies must specify how derivatives mitigate cash flow risk for assets such as ARMs and explicitly allow the use of interest rate collars.
2) Risk Management Practices: The risk management framework should assess the sensitivity of the ARMs resets to interest rate declines and justify the use of costless collars to stabilize cash flows.
3) Internal Controls: Controls must ensure accurate tracking of hedge performance, alignment with risk tolerances, and compliance with regulatory requirements.
4) Demonstrated Expertise: Credit union staff must understand how ARM reset mechanisms interact with derivatives indexed to SOFR, and/or collaborate with external advisors as necessary.
Real-World Cost Considerations
While a costless collar involves no upfront premium, the term “costless” can be quite misleading due to other expenses and trade-offs. In hedging it is important to remain transparent about the real-world costs of deploying any strategy. The primary cost is the opportunity cost, as gains beyond the sold strike are forfeited, limiting the upside potential. Secondly, transaction costs, such as broker fees and bid-ask spreads, can add to the overall expenses and with over-the-counter derivatives there is counterparty risk. Additionally, many institutions lack the necessary expertise or pricing tools/models to accurately value options. While these strategies avoid premium costs, these factors highlight that this is not entirely free and requires careful evaluation.
Conclusion
The NCUA’s May 2021 updates to 12 CFR §703.103 have empowered credit unions to use costless collars as a tool for managing interest rate risk. A general regulatory framework ensures that derivatives are applied prudently and in alignment with credit union policies. Tailored regulatory considerations for assets and liabilities ensure compliance with governance, risk management, and expertise requirements. Combined with ASU 2017-12, which optimizes hedge accounting, costless collars offer a flexible, cost-effective strategy for stabilizing cash flows while managing operational challenges.