NCUA IRR POLICY

Presented By

NCUA IRR POLICYAugust 14, 2012

Cullen Coxe

Financial Advisor

Agenda

• Interest rate risk policy• Assumptions• Net interest income• Net economic value• Non-maturing deposit analysis• Prepayment sensitivity analysis• Spread / basis risk• Twisted yield curve

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New IRR Policy

• NCUA passed a final ruling requiring federal credit unions to develop and adopt a written policy on interest rate risk management

• Effective date - 09/30/2012

• Required for CUs that meet one of the below criteria– More the $50mm in assets– Assets between $10-50mm only if “Supervisory Interest Rate

Risk Threshold Ratio” (SIRRT) is above 100%

Total Net Worth

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SIRRT Ratio

Total first mortgages held + total investments with maturities greater than 5 years

IRR Policy Elements

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IRR Policy Highlights

• Document responsible parties

• Set content and frequency of reporting

• Set IRR policy limits

• Test IRR impact on new business activities

• Document and regularly evaluate assumption and methodologies

• Separation of controls

• Action plan

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ALCO

• Examining the impact of changing interest rates and economic conditions– Net economic value– Net interest income– Net income

• Monitoring the liquidity position

• Monitoring key ratios and statistics

• Reviewing and monitoring the credit union’s competitive position

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Internal Guidelines

• The credit union is responsible for setting internal policy guidelines that best secure the stated goals and objectives of the institution

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NCUA Risk Measurement

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NCUA Risk Measurement

Low Moderate High

Cumulative gap

1 Year +/- 10% +/- 10% to -20% +/- 20%

Earnings at risk

Percent change in NII > -20% -20% to -30% < -30%

Percent change in NII > -40% -40% to -75% < -75%

Net economic value

NEV ratio < 6% 4% to 6% < 4%

Percent change in NEV < -25% -25% to -50% < -50%

NEV

• NEV ratio: must be above 4.00% in all environments between the shock down 300 scenario and the shock up 300 scenario

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Interest Rate Shock

Status -300 Base 300

In Policy > 6% > 6% > 6%

In Policy, Approaching Limit 4% to 6% 4% to 6% 4% to 6%

Over Limit < 4% < 4% < 4%

NEV

• NEV Percent Change: must be within negative 40.00% in all environments between the shock down 300 scenario and the shock up 300 scenario

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Interest Rate Shock

Status -300 Base 300

In Policy > -30% 0% > -30%

In Policy, Approaching Limit -30% to -40% 0% -30% to -40%

Over Limit -40% 0% -40%

NII

• NII Percent Change: must be within negative 20.00% in each of the four tested scenarios

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Interest Rate Change

Status Declining Base Rising Shock 300

In Policy > -15% 0% > -15% > -15%

In Policy, Approaching Limit -15% to -20% 0% -15% to -20% -15% to -20%

Over Limit -20% 0% -20% -20%

IRR Measuring and Monitoring

• Model Sufficiency– The model used to assess the risks of the credit union must

employ sufficient techniques, analytical capabilities, and fundamental functionalities that properly capture the complexities of the balance sheet at hand

• Model Maintenance– A sufficient chart of accounts– An appropriate level of data aggregation– Inclusion and use of account level data

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Assumptions

• Play an important role in classifying the risk of the balance sheet

• BOD must understand these assumptions and their impact on the model

• The credit union is responsible for:– Documenting all assumptions that have a substantial impact on

the credit union’s risk position and ensure that these assumptions are appropriate

– Monitoring these assumptions regularly– Ensuring any assumption changes are properly recorded and

fully disclosed in a transparent way

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Different Types of Rates

• Weighted average book rate– Aggregate note rate as of a specific period of time

• Reinvestment rate– Used in earnings simulation to depict the current rate at

which cash flows will be reinvested

• Discount rate– Used in value simulation to determine the present value

of future cash flows

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NII Assumptions

• Reinvestment rates should be product and term specific

• Reinvestment rates– Loans: offering rates– Investments: market yields– Non-maturity deposits & certificates: offering rates– Borrowings: FHLB fixed-rate term advance rates

• Reinvestment rates will be adjusted depending on the interest rate scenario – Base, rising, declining and shock up 300

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NEV Assumptions

• Determine appropriate discount rate– Present value of projected future cash flows

• Primary versus secondary market rates– Primary: current offering rate– Secondary: observable market rate

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NEV Assumptions

Sources for discount rates•Offering rates for accounts without an actively traded secondary market

– Unique loan types– Signature loans

•Secondary market spread over an index for accounts with an actively traded secondary market

– Auto loans– Credit card loans

•Observable market rates – Home equity loans: closed-end second liens and HELOCs– Mortgage loans: fixed and adjustable

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Spread Relationships

• Asset-backed securities (ABS)– Auto loans– Credit card loans

• LIBOR / swap curve plus additional spread– Servicing – New versus used auto loans– Liquidity

• Final spread is based on the average spread of observable ABS as published by multiple brokers

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Spread Relationships

• Home equity– Bankrate represents comprehensive and objective

average rate obtained in the primary market for home equity loans

• Rate specific based on fixed versus floating• Example: 1/31/12 discount rates

– Fixed 6.00%– Floating 4.71%

– Discounting over a curve

• 1st lien residential mortgage– FHLMC servicing retained, 30-day mandatory delivery

price– Post-settlement delivery fees (loan-level pricing

adjustments)

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NEV Assumptions - Investments

• Obtain base prices from third-party pricing source– IDC, Reuters

• Collect all security information– Bloomberg

• Retrieve structured product cash flows– Moody’s, Intex

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Assumptions

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Reinvestment Discount Prepayment SpeedsRate Source Rate Index Source

AssetsConsumer Loans

Visa 7.20 7.20 Offer 7.34 1M LIBOR + 7.12 Broker Avg.

MasterCard 7.09 7.09 Offer 7.34 1M LIBOR + 7.12 Broker Avg.

Direct Auto Loans 5.15 4.58 - 5.27 Offer 2.18 - 4.13 Swaps + 1.94 to 2.40 Broker Avg.

Indirect Auto Loans 5.30 4.03 - 4.31 Offer 2.18 - 4.13 Swaps + 1.94 to 2.40 Broker Avg.

HELOCs 4.16 3.06 - 6.00 Offer 4.60 National Average Bankrate

Wtd. Avg. Book Rate


Business Loans

Business Loans Fixed 4.73 4.25 - 6.25 Offer 4.94 - 6.43 Swaps + 4.70 Broker Avg./Offer

Business Loans Adjustable 5.49 6.75 - 9.81 Offer 7.74 - 9.23 Swaps + 7.50 Broker Avg./Offer

Wtd. Avg. Book Rate

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Assumptions

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Mortgage Loans

15-Year Fixed Rate Mortgages 4.22 2.88 Offer 30-Day Price Table FHLMC

15-Year Fixed Rate Mortgages, Jumbo 4.06 2.88 Offer 30-Day Price + Spread FHLMC

30-Year Fixed Rate Mortgages 5.00 3.63 Offer 30-Day Price Table FHLMC

30-Year Fixed Rate Mortgages, Jumbo 5.26 3.63 Offer 30-Day Price + Spread FHLMC

1-Year ARMs 2.87 1.38 Offer 30-Day Price Table FHLMC



5 Year ARM Jumbo 5.13 2.38 Offer 30-Day Price + Spread FHLMC

Wtd. Avg. Book Rate


Total Investments Agency Notes, Fixed 1.80 0.55 IDC 0.55 NA IDC Agency Notes, Callable 1.40 0.59 IDC 0.59 NA IDC MBSs, Fixed 2.87 0.87 IDC 0.87 NA IDC MBSs, Variable 2.72 2.03 IDC 2.03 NA IDC CMOs Fixed 2.31 1.48 IDC 1.48 NA IDC

Wtd. Avg. Book Rate

NEV Assumptions - Liabilities

• Share certificates– Federal Home Loan Bank fixed-rate term advance curve– Early redemption

• Borrowings– Federal Home Loan Bank fixed-rate term advance curve– Call / put features modeled in ZMdesk

• Non-maturity deposits– Federal Home Loan Bank fixed-rate term advance curve– X-coefficient, effective maturity, decay rate– Net non-interest costs

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Assumptions

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Funding

Regular Shares 0.25 0.25 Offer 0.26 - 2.54 Term Advances FHLB Atlanta

Share Drafts 0.25 0.25 Offer 0.26 - 2.54 Term Advances FHLB Atlanta

IRA Shares 0.35 0.35 Offer 0.26 - 2.54 Term Advances FHLB Atlanta

Money Market 0.37 0.37 Offer 0.26 - 2.54 Term Advances FHLB Atlanta

Regular Certificates 1.09 0.40 - 1.44 Offer 0.26 - 2.54 Term Advances FHLB Atlanta

Jumbo Certificates 1.52 0.40 - 1.44 Offer 0.26 - 2.54 Term Advances FHLB Atlanta

IRA Certificates 2.39 0.60 - 1.44 Offer 0.26 - 2.54 Term Advances FHLB Atlanta

FHLB Borrowing 3.61 0.26 - 2.54 FHLB Atlanta 0.26 - 2.54 Term Advances FHLB Atlanta

Wtd. Avg. Book Rate

Net Interest Income Analysis

• It is important to remember the purpose of any analysis

• In the case of NII, the purpose is not budgetary– That is, the primary goal is not to determine the projected

income for the institution over a given time period• To do so would require balance and rate projections

• The goal is to project the volatility of earnings in changing (rising / declining) interest rate environments– NII is then compared in alternative scenarios in order to evaluate

interest rate risk

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NII Assumptions

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NII Scenarios

• Possible scenarios include:– Base scenario - rates are held constant– Declining scenario - rates decrease 25 basis points per month

for 12 months (resulting in a down 300 over 1 year)– Rising scenario - rates increase 25 basis points per month for 12

months (resulting in an up 300 over 1 year)– Shock up 300 scenario - rates shock immediately 300 basis

points and hold at that level indefinitely– A non-parallel shift in rates (a “twisted yield curve”)

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Reinvestment Rates

• Should be product and term specific• Reinvestment rates

– Loans: offering rates– Investments: market yields– Non-maturity deposits & certificates: offering rates– Borrowings: FHLB fixed-rate term advance rates

• Reinvestment rates will be adjusted depending on the interest rate scenario – Base, rising, declining and shock up 300

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NII Projected Outputs

• Projected interest income

• Projected interest expense

• Projected NII and net income

• Percent change from base model

• Asset yields and costs of funding

• Net interest spread

• Net interest margin

• Return on assets

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Reinvestment of Cashflows – ExampleCurrent Offering Rate = 3.00%

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Month 1 Month 2 Month 3

$600K Principal

$400K Principal

$375K Principal

Net Interest Income Output – Nominal Values

Declining Base Rising Shock Up 300

Total Consumer Loans 11,688 12,129 12,790 13,878

Total Real Estate Loans 19,275 21,229 23,248 24,950

Total Business Loans 4,585 4,890 5,091 5,606

Total Investments 3,171 4,283 6,634 8,439

Total Interest Income 38,719 42,531 47,763 52,873

Total Interest Expense 7,026 8,242 13,844 19,895

Net Interest Income 31,693 34,289 33,919 32,978

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NII Output – Interpreting Interest Rate Risk

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Declining Base RisingShock

Up 300

Interest Income $ 39,719 $ 42,532 $ 47,764 $ 52,873 % Change from Base -6.61% 0.00% 12.30% 24.31%

Interest Expense $ 5,026 $ 8,242 $ 13,844 $ 19,895 % Change from Base -39.02% 0.00% 67.97% 141.38% Net Interest Income $ 34,693 $ 34,289 $ 33,919 $ 32,978 % Change from Base 1.18% 0.00% -1.08% -3.83% Provision for loan losses $ 3,000 $ 3,000 $ 3,000 $ 3,000 Other Income $ 13,000 $ 13,000 $ 13,000 $ 13,000 Other Expense $ 35,000 $ 35,000 $ 35,000 $ 35,000 Net Income $ 9,693 $ 9,289 $ 8,919 $ 7,978

% Change from Base 4.34% 0.00% -3.98% -14.12% Yield on Earning Assets 3.28% 3.60% 4.04% 4.48% Cost of Paying Liabilities 0.65% 0.77% 1.29% 1.85% Net Interest Spread 2.62% 2.83% 2.75% 2.62% Net Interest Margin 2.68% 2.90% 2.87% 2.79%

Return on Assets 0.35% 0.32% 0.29% 0.25%

What do NII Results Provide?

• Breakdown of interest income and interest expense by category type

• Projected earnings on a static balance sheet

• Earnings at risk due to constant, rising or declining interest rates

• Potential balance sheet problems prior to interest rate shifts

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What is NEV?

• Evaluate interest rate risk from a value perspective

• Economic value is calculated at a single point in time

• Net economic value– The present value (PV) of the balance sheet

Economic Value of Assets

- Economic Value of Liabilities

= NEV

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Purposes of NEV

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Why Calculate NEV?

• Superior to cost accounting information

• Captures interest and principal cash flows

• Provides an analysis of options risk

• Allows for comparisons between different scenarios

• More complete than the income simulation

• Properly managing NEV can reduce the volatility of earnings and net worth

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NEV Measurements

• NEV percent change– The projected net gain or loss of net economic value assuming

changes in interest rates, relative to the starting value– The sensitivity of capital to changes in interest rates

• NEV ratio– A measurement of capital adequacy from an IRR perspective– Calculated as the NEV of equity / NEV of total assets

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Price Examples

• There is an asset and it has a fixed rate of 3%, with a maturity of 5 years

Current Market Rate3%



PricePar100

PricePremium

>100

PriceDiscount

<100

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Calculating Prices

• Example 30-year mortgage portfolio– Book value $30,000,000– Book rate 4.55%– Market (discount) rate 3.96%– Market value $31,102,800– Gain / (loss) $1,102,800– Price 103.68

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Net Economic Value (Micro)

Selected asset prices:Interest Rate Scenario

Assets Book Value (200) (100) Base 100 200 300 400

Visa Platinum $22,526 97.63 97.59 96.48 95.11 93.77 92.46 91.17

New Auto $65,000 103.17 103.12 102.64 101.05 99.78 98.63 97.51

Used Auto $44,269 102.70 102.65 101.64 100.32 99.10 97.81 96.59

Share Secured $11,229 104.16 101.97 99.86 97.83 95.87 93.98 92.16

Signature Loans $14,801 100.00 100.00 99.74 98.70 97.68 96.67 95.68

Home Equity LOC $32,405 99.90 99.88 99.85 99.83 99.81 99.78 99.76

First Mortgage Loans $30,000 104.91 104.67 103.68 99.85 94.90 90.16 85.51

Second Mortgage Loans $26,457 100.99 100.03 97.32 94.58 91.98 89.50 87.14

Agency Fixed $2,000 100.03 100.03 100.02 98.84 97.32 95.78 94.26

Agency Callables $9,994 100.31 100.31 100.03 98.56 96.76 94.93 93.14

Bank CDs $5,475 101.24 101.05 99.93 98.47 97.04 95.64 94.27

Corporate CDs $1,000 100.01 100.01 100.01 100.00 99.98 99.96 99.95

CMO Fixed $15,996 100.05 100.34 100.08 98.88 97.04 94.83 92.47

CMO Variable $3,870 100.32 100.21 99.81 98.99 97.65 95.84 93.63

ARMs $2,688 105.85 106.09 105.64 104.36 102.58 100.38 97.87

MBS Fixed $36,588 102.83 102.89 101.07 97.57 93.31 88.92 84.68

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Interest Rate Scenario

Assets Book Value (200) (100) Base 100 200 300 400

Visa Platinum $22,526 (534) (542) (793) (1,102) (1,403) (1,699) (1,989)

New Auto $65,000 2,063 2,026 1,719 683 (145) (893) (1,621)

Used Auto $44,269 1,195 1,172 724 143 (398) (969) (1,509)

Share Secured $11,229 467 221 (16) (244) (464) (676) (880)

Signature Loans $14,801 (0) (0) (38) (192) (344) (493) (639)

Home Equity LOC $32,405 (31) (39) (47) (55) (63) (71) (79)

First Mortgage Loans $30,000 1,473 1,401 1,103 (45) (1,530) (2,951) (4,347)

Second Mortgage Loans $26,457 261 7 (709) (1,434) (2,123) (2,778) (3,402)

Agency Fixed $2,000 1 1 0 (23) (54) (84) (115)

Agency Callables $9,994 31 31 3 (144) (324) (507) (686)

Bank CDs $5,475 68 57 (4) (84) (162) (239) (314)

Corporate CDs $1,000 0 0 0 (0) (0) (0) (1)

CMO Fixed $15,996 9 54 12 (180) (474) (827) (1,204)

CMO Variable $3,870 12 8 (7) (39) (91) (161) (247)

ARMs $2,688 157 164 152 117 69 10 (57)

MBS Fixed $36,588 1,034 1,058 393 (887) (2,446) (4,055) (5,604)


Selected asset gains / (losses):

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Liabilities Book Value (200) (100) Base 100 200 300 400

Regular Shares $93,296 107.56 103.90 100.93 98.21 95.71 93.41 91.51

Share Draft $71,794 107.85 103.44 99.46 95.81 92.53 89.60 86.96

Money Market $82,567 104.71 102.42 100.33 98.44 96.84 95.67 94.74

IRA Shares $12,376 108.21 104.78 101.77 99.01 96.48 94.16 92.21

Share Certificates $52,666 102.53 102.36 101.34 100.09 98.87 97.69 96.53

IRA Certificates $24,083 103.22 103.05 101.96 100.61 99.28 97.99 96.74

Total Other Liabilities $11,206 100.00 100.00 100.00 100.00 100.00 100.00 100.00


Selected liability prices:

We can see that the regular shares are priced above par in the base case (which is a detriment to the credit union as it reduces capital), whereas the share drafts are priced below par in the base case (which benefits the credit union by increasing capital)

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Liabilities Book Value (200) (100) Base 100 200 300 400

Regular Shares $93,296 7,055 3,639 867 (1,674) (4,005) (6,144) (7,921)

Share Draft $71,794 5,635 2,472 (389) (3,010) (5,360) (7,469) (9,363)

Money Market $82,567 3,887 2,001 276 (1,289) (2,611) (3,577) (4,341)

IRA Shares $12,376 1,016 592 219 (122) (435) (723) (964)

Share Certificates $52,666 1,334 1,243 704 46 (595) (1,218) (1,825)

IRA Certificates $24,083 776 734 473 146 (173) (483) (786)

Total Other Liabilities $11,206 - - - - - - -


Selected liability gains / (losses):

The gains and losses, based on the prices, are shown

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NEV- Macro

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($,000 omitted)(200) (100) Base 100 200 300 400

Change in Economic Value of Assets 7,560 7,479 3,002 -3,686 -10,553 -17,251 -23,853

Minus Change in Economic Value of Liabilities 7,235 3,932 -271 -4,785 -9,208 -13,542 -17,789

Equals Cumulative Change in Economic Value 325 3,547 3,273 1,099 -1,345 -3,710 -6,064

Plus Book Capital 31,267 31,267 31,267 31,267 31,267 31,267 31,267

Equals Economic Values of Book Capital 31,592 34,814 34,540 32,366 29,922 27,557 25,203

NEV Dollar Change (2,948) 274 - (2,174) (4,618) (6,983) (9,337)

NEV Percent Change -8.54% 0.79% 0.00% -6.30% -13.37% -20.22% -27.03%

NEV Ratio 7.79% 8.59% 8.62% 8.21% 7.72% 7.24% 6.74%


Purpose of an NEV Analysis

• Measure interest rate risk

• Understand trade-offs between long term risk and short term return

• Conduct “what-ifs”

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Break

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Non-Maturity Deposit Analysis

Consists of two regression analyses• Financial institution’s dividend rate sensitivity

– How does the financial institution’s dividend rate change with a given change in market rates

– X-coefficient

• Membership sensitivity– Calculate an effective final maturity for each deposit

account– 10-year maximum maturity

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• Should be updated every year

• Regression analysis for final maturities

• Regression analysis for dividend payments

• Non-interest costs

• Run sensitivity analysis

• Discussion with ALCO on reasonableness of rate movements

• These scenarios test maturity and sensitivity assumptions

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Regular Shares– Dividend rate 0.50%– Coefficient 0.27%– Non-interest cost 1.39%

Down 100 Base Up 100Non-interest cost 1.39% 1.39% 1.39%Dividend rate 0.23% 0.50% 0.77%Total cost 1.62% 1.89% 2.16%

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Coefficient Materiality

Coefficient Model A Model BRegular Shares 0.27% 0.41% 0.54%Share Drafts 0.15% 0.23% 0.30%Money Market 0.45% 0.68% 0.90%

Initial Model A Model BNEV Ratio - Base 11.26% 10.92% 10.58%NEV Ratio - Up 300 9.03% 8.20% 7.37%NEV % Change Up 300 -23.04% -29.78% -34.82%Asset Duration - Up 300 2.77% 2.77% 2.77%Liability Duration - Up 300 1.16% 1.04% 0.91%

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Maturity Materiality

Maturity Model ARegular Shares 8 4Share Drafts 10 5Money Market 6 3

Initial Model ANEV Ratio - Base 11.26% 9.84%NEV Ratio - Up 300 9.03% 7.14%NEV % Change Up 300 -23.04% -32.13%Asset Duration - Up 300 2.77% 2.77%Liability Duration - Up 300 1.16% 1.14%

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NMD Price Materiality

Initial NMD @ parNEV Ratio - Base 11.26% 9.67%NEV Ratio - Up 300 9.03% 4.71%NEV % Change Up 300 -25.04% -54.45%Asset Duration - Up 300 2.77% 2.77%Liability Duration - Up 300 1.16% 0.44%

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Prepayment Speeds

• Prepayments are early repayments of a loan• Prepayment risk results when cash flows contract or

extend more than expected– Leads to reinvestment risk– Increased / decreased volatility in net economic value

• Generally, if rates rise, all else equal, prepayments will slow

• Generally, if rates fall, all else equal, prepayments will rise

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Prepayment Speeds

• Auto loans - based on historical prepayment speeds of

asset-backed securities• Residential mortgages - derived from prepayment

model which accounts for the following among many other factors:– Refinancing incentive– Seasoning– Burnout – Seasonality– Media effect

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Prepayment Sensitivity

• Impact of slower prepayment speeds

• Extend mortgage loans and mortgage investments

• Run annually or more frequently depending on rates

• Most important when projected prepay speeds are fast

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Prepayment Curve

Agency MBS prepayment “S” curve

Rates are ‘low’ relative to mortgage

coupon

Prepayment Incentive

Rates are ‘high’ relative to mortgage coupon

Low Prepayments

High Prepayments

CP

R

Rates

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Two Sample Financial Institutions

Financial institution - Mortgage• Total Assets = $740 million

– 37% Fixed-rate mortgages– 18% Adjustable mortgages– 5% Auto loans

• Total Liabilities = $673 million– 50% Share certificates– 10% Money market

• Total Capital = $67 million

Financial institution - Auto• Total Assets = $500

million– 55% Auto loans– 10% Fixed-rate

mortgages– 5% Adjustable mortgages

• Total Liabilities = $455 million– 50% Share certificates– 10% Money market


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Sample Economic Value Simulation

Financial Institution - Mortgage

(200) (100) Base 100 200 300 400 NEV Ratio 9.28% 10.45% 11.26% 11.29% 10.32% 9.03% 7.39%

NEV Percent Change -13.77% -6.49% 0.00% -1.26% -11.98% -23.04% -35.80%

Financial Institution - Auto

(200) (100) Base 100 200 300 400 NEV Ratio 7.65% 8.98% 9.25% 9.30% 9.36% 9.20% 8.87%

NEV Percent Change -15.39% -3.45% 0.00% -1.00% -5.21% -7.84% -10.66%

Net Economic Value AnalysisInterest Rate Scenario

Net Economic Value AnalysisInterest Rate Scenario

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Prepayment Materiality

-200 -100 Base 100 200 300 400Initial 15 year fixed 48 43 23 11 7 6 6

30 year fixed 52 47 21 9 6 6 53/1 ARM 44 39 39 39 37 34 31

-200 -100 Base 100 200 300 400Model A 15 year fixed 36 32 17 8 5 5 4

30 year fixed 27 25 18 13 7 6 53/1 ARM 39 35 16 7 4 4 4

-200 -100 Base 100 200 300 400Model B 15 year fixed 24 22 11 5 3 3 3

30 year fixed 18 17 12 8 4 4 33/1 ARM 26 23 11 5 3 3 3

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Prepayment Materiality

Financial Institution - Mortgage Initial Model A Model BNEV Ratio - Up 300 9.03% 8.21% 7.32%NEV % Change Up 300 -23.04% -32.76% -40.33%Asset Duration - Up 300 2.77% 2.94% 3.11%Liability Duration - Up 300 1.16% 1.16% 1.16%

Financial Institution - Auto Initial Model A Model BNEV Ratio - Up 300 9.25% 9.01% 8.67%NEV % Change Up 300 -7.84% -10.53% -17.22%Asset Duration - Up 300 1.55% 1.59% 1.63%Liability Duration - Up 300 1.01% 1.01% 1.01%

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Spread / Basis Risk

• Secondary market spreads widen due to economic or market conditions

• Mortgage spreads

• Auto spreads

• November 2008 spreads

• Discount spreads are used to determine the value of a holding. Higher spreads (i.e. a higher rate expected by the market) result in lower prices

• Capital drops, and capital volatility increases

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Spreads

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Spreads

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Rate Spreads

Primary vs. secondary rates comparison as of Dec 2008

• Primary - average offering rates– New auto 5.75% – Credit cards 10.00%– Home equity 4.30%

• Secondary market rates– New auto AA spread over LIBOR/Swap 10.40% -

12.10%– Credit cards 12.25%– Home equity AA spread over LIBOR/Swap 30.40% - 42.10%

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Two More Sample Financial Institutions

Financial institution - Mortgage• Total Assets = $900 million

– 48% Mortgages– 19% Investments– 4% Auto loans

• Total Liabilities = $784 million– 40% Share certificates– 16% Money market– 19% Savings


Financial institution - Auto• Total Assets = $900

million– 52% Auto loans– 18% Mortgages– 26% Investments

• Total Liabilities = $784 million– 40% Share certificates– 16% Money market – 19% Savings


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Spread / Basis Risk

Financial Institution - Mortgage Initial Spreads + 200NEV Ratio - Up 300 11.60% 7.59%NEV % Change Up 300 -23.30% -35.07%Asset Duration - Up 300 2.57% 2.75%Liability Duration - Up 300 1.64% 1.64%

Financial Institution - Auto Initial Spreads + 200NEV Ratio - Up 300 14.22% 13.99%NEV % Change Up 300 -2.89% -7.66%Asset Duration - Up 300 1.61% 1.66%Liability Duration - Up 300 1.64% 1.64%

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Twisted Yield Curve

• Interest rate shift with a change in the spread between two interest rates at different maturity points

• Non-parallel shifts and twists

• Change in shape and slope of yield curve

• Choose a curve that adequately stress your balance sheet

• These changes stress different parts of the balance sheet

• “Shocking” this new curve then measures the risk to the balance sheet (in other words, if the curve moved like this, what would the new ALM report look like at that time?)

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Twisted Yield Curve-Steepener

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Dec-11 TYC Change Dec-11 TYC Change Dec-11 TYC Change Fed Funds 0.25 0.25 0.00 Swap FHLB Dallas Prime 3.25 3.25 0.00 1 month 0.30 1.25 0.95 1 month 0.25 1.20 0.95 3 month 0.58 1.40 0.82 3 month 0.26 1.20 0.94 Treasury Curve 6 month 0.81 1.60 0.79 6 month 0.32 1.80 1.48 1 month 0.02 1.00 0.98 12 month 1.13 2.20 1.07 12 month 1.03 2.30 1.27 3 month 0.02 1.00 0.98 24 month 0.73 2.35 1.62 18 month 1.07 2.50 1.43 6 month 0.06 1.50 1.44 36 month 0.82 3.25 2.43 24 month 1.12 2.80 1.68 12 month 0.11 1.50 1.39 48 month 1.01 3.50 2.49 36 month 1.39 4.00 2.61 24 month 0.24 2.00 1.76 60 month 1.22 4.25 3.03 48 month 1.63 4.30 2.67 36 month 0.36 3.00 2.64 120 month 2.03 5.30 3.27 60 month 1.94 5.00 3.06 60 month 0.83 4.00 3.17 360 month 2.62 5.90 3.28 120 month 2.79 5.80 3.01 120 month 1.88 5.20 3.32 360 month 2.90 6.20 3.30

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Twisted Yield Curve

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Twisted Yield Curve- Flattener

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Dec-11 TYC Change Dec-11 TYC Change Dec-11 TYC Change

Fed Funds 0.25 0.25 0.00 Swap FHLB Dallas

Prime 3.25 3.25 0.00 1 month 0.30 2.24 1.94 1 month 0.25 2.20 1.95

3 month 0.58 2.32 1.74 3 month 0.26 2.25 1.99 Treasury Curve 6 month 0.81 2.55 1.74 6 month 0.32 2.30 1.98 1 month 0.02 2.02 2.00 12 month 1.13 2.81 1.68 12 month 1.03 2.85 1.82 3 month 0.02 2.02 2.00 24 month 0.73 2.58 1.85 18 month 1.07 3.00 1.93 6 month 0.06 2.20 2.14 36 month 0.82 2.75 1.93 24 month 1.12 3.00 1.88 12 month 0.11 2.40 2.29 48 month 1.01 3.00 1.99 36 month 1.39 3.40 2.01 24 month 0.24 2.60 2.36 60 month 1.22 3.00 1.78 48 month 1.63 3.70 2.07 36 month 0.36 2.80 2.44 120 month 2.03 3.40 1.37 60 month 1.94 3.70 1.76

60 month 0.83 2.80 1.97 360 month 2.62 4.00 1.38 120 month 2.79 4.20 1.41 120 month 1.88 3.25 1.37

360 month 2.90 3.35 0.45

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Twisted Yield Curve

Twisted Yield Curve Steepener

Financial Institution - Mortgage Initial Twisted YCNEV Ratio - Up 300 11.60% 4.51%NEV % Change Up 300 -23.30% -47.65%Asset Duration - Up 300 2.57% 2.79%Liability Duration - Up 300 1.64% 1.54%

Financial Institution - Auto Initial Twisted YCNEV Ratio - Up 300 14.22% 13.22%NEV % Change Up 300 -2.89% -8.33%Asset Duration - Up 300 1.61% 1.65%Liability Duration - Up 300 1.64% 1.54%

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Conclusion

• IRR Policy update

• What-ifs stress different aspects of the balance sheet. Understanding the impacts assumption changes have is important in helping monitor and manage interest-rate risk

• Assumptions

• Supplemental IRR test– NMD assumption sensitivity– Prepayment sensitivity– Basis risk– Twisted YC

• Testing IRR impact of strategy

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Date post:	11-Jan-2016
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