It’s All in the Assumptions!

What are the key assumptions underlying Net Economic Value (NEV) and Net Interest Income (NII)? How do changes in member behavior affect your set assumptions?

 
 

With many credit unions in the strategic planning phase of calendar, the "art" of selecting which assumptions to incorporate into their plans takes on renewed importance – and scrutiny. While it is challenging enough to forecast how members will behave, trying to estimate external factors (e.g. interest rates, stock market returns, or the housing market) has humbled the brightest financial minds on Wall Street. Nonetheless, credit unions must incorporate these, and any other assumptions into their strategic planning to ensure the process is a meaningful one.

Key Assumptions Underlying Net Economic Value (NEV) and Net Interest Income (NII)

Within the framework of the strategic plan come projections for the economic value of the institution as well as net interest income. While the concept for Net Economic Value (NEV) is straightforward – basically the difference between net present value of credit unions assets and liabilities – the tricky part is selecting the appropriate market rate to discount the instruments. For example, in the case of an auto loan, should those future cash flows be discounted at the rate the loan was originated, or some secondary (external) rate?

Net interest income (NII) – the difference between interest income minus interest expense – requires its own set of assumptions. These include a simulation of future interest rates to compare the base case (where rates are held constant) to a "shocked" scenario or a reinvestment rate for maturing assets and funding rate for maturing liabilities! The point here is not to discount (no pun intended) the usefulness of NEV and NII, but to illustrate how dependent they are on assumptions.

Member Behavior and the Changing Balance Sheet

In 2009 credit unions have validated their charter, stepping into the tight credit markets and originating record loan volume. For the first six months of the year the industry recorded record loan originations of $144.2B. More surprisingly, first mortgage originations were up 36.3% over June 2008 levels.

In spite of the record loan originations, the liability side of the balance sheet actually outpaced the asset side: share balances grew $58.1b over the last 12 months, the largest increase in a decade!

A Dynamic Set of Assumptions

A dynamic set of modeling considerations relative to the planning/ALM process have manifested as a result of the opportunities presented to credit unions. For credit unions that are experiencing marginal (not existing refinancing) mortgage growth, and are electing to maintain those assets on the balance sheet, what type of assumptions are being incorporated as far as prepayment factors are concerned? Just this past year, Wall Street was predicting a huge refinance boom due to interest rates, yet that didn't happen. What factors should credit unions consider to forecast the behavior of these long-term assets?

 

 

 

Sept. 7, 2009


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