Two Roads Crossing

Credit unions are increasing their holdings in securities available-for-sale while banks are increasing their holdings in securities held-to-maturity. How do these different strategies relate to price risk?

 
 

Markets are focused on when the Federal Reserve will raise interest rates for the first time since July 2007. The Fed removed the key word “patient” from its March Federal Open Market Committee (FOMC) statement, signaling it might raise interest rates as early as June; however, the minutes from the April FOMC meeting suggest the Fed might further delay the increase until at least September because of slowing GDP growth in the first quarter of 2015 and stubbornly low inflation coupled with unstable oil prices and stagnant wage growth.

If interest rates rise, the value of credit unions’ debt securities will decline because the yields on their existing bonds are lower than compatible yields on new securities in the market. This interest rate-driven change in the market value of investment portfolios is called price risk.

There are three major classifications where credit unions place their securities: held-to-maturity (HTM); available-for-sale (AFS); and trading securities. HTM securities and AFS securities are the two classifications credit unions use most often, with AFS being the predominant one.

A credit union holds HTM securities on its books until maturity with returns locked-in at the time of initial purchase; therefore, HTM securities are not exposed to mark-to-market risk. The risk lies in having too many securities in HTM when a credit union needs liquidity. If a credit union sells one HTM security, it has to move all HTM securities into the AFS bucket and risks tainting the entire portfolio.  

Security Classifications Characteristics
Held-To-Maturity Securities
  • Acquired with the intent to hold until maturity.
  • Reported on the balance sheet at amortized cost.
Available-For-Sale Securities
  • Not expected to be held to maturity but can be held to maturity. Intent is to hold them but retain flexibility.
  • Reported on the balance sheet at fair value.
  • Marked-to-market monthly.
  • Unrealized gains and losses are not recognized in the income statement (for banks and credit unions) but are reported in the other comprehensive income section as a part of stockholders’ equity (for banks).
Trading Securities
  • Acquired with the intent to profit from near-term price changes/trading.
  • Reported on the balance sheet at fair value.
  • Unrealized gains and losses are recognized in the income statement.

 

In anticipation of rate increases, banks are rapidly shifting a bulk of their securities to the HTM bucket because the temporary loss of value for HTM securities does not show up on the balance sheet, which helps banks shield capital levels from higher interest rates. Additionally, many of the nation’s largest banks are moving their securities into HTM to minimize the realization of the losses from the decline in value of the securities containing credit risk, such as corporate bonds related to oil businesses and Greek bonds. This helps them protect themselves from a decline in equity valuations.

According to The Wall Street Journal, banks have moved $293 billion to the HTM bucket in the past 18 months ended Dec. 31, 2014, bringing the total to $640 billion. This represents an 84% increase since June 30, 2013. Held-to-maturity as a percentage of total investment securities at banks increased from 11.8% in June 30, 2013 to 20.0% in Dec. 31, 2014.

HTM AS A % OF TOTAL INVESTMENTS
Data as of Dec. 31 for all U.S. credit unions and banks
© Callahan & Associates | www.creditunions.com

HTM_as_a___of_Total_Invts

Source: Callahan & Associates’ Peer-to-Peer Analytics & FDIC

In contrast, the ratio of HTM securities as a percentage of total investments for credit unions has remained relatively stable. Contrary to banks that have increased HTM securities holdings considerably over the past year, investments in AFS have risen at credit unions as total investments have grown.

According to data from Callahan & Associates, the percentage of the industry’s AFS securities to total investment securities has consistently increased since 2005. As of Dec. 31, 2014, AFS securities accounted for 59.9% of credit unions’ total investment securities, up from 59.3% one year ago and up from 46.0% five years ago. This upward trend shows credit unions can more easily reposition their portfolios by selling these securities, thus providing more flexibility and balance sheet liquidity in asset-liability management.

AFS AS A % OF TOTAL INVESTMENTS
Data as of Dec. 31 for all U.S. credit unions
© Callahan & Associates | www.creditunions.com

AFS_as_a___of_Total_Invts

Source: Callahan & Associates’ Peer-to-Peer Analytics

Meanwhile, AFS securities are susceptible to market price fluctuations as they must be marked-to-market monthly. Credit unions report gains or losses in the securities in the FASB 115 account in the equity section of the 5300 Call Report. In other words, credit unions can estimate the portfolio’s market value by tracking monthly gains or losses. Today, the book value of the industry’s total AFS securities on balance sheets stands at $167.3 billion. The current market value of total AFS securities exceeds the book value by $213.8 million, signifying that credit unions will post gains if they need to sell these securities.

 UNREALIZED GAINS OR LOSSES ON AFS
Data as of Dec. 31 for all U.S. credit unions
© Callahan & Associates | www.creditunions.com

Unrealized_Gains_Or_Losses_On_AFS

Source: Callahan & Associates’ Peer-to-Peer Analytics

The total price risk ratio measures the change in the market value of all investments — both AFS and HTM securities — as a percentage of total investments. If unrealized losses from the value of investments are a higher percentage of the investment portfolio, it suggests a potentially greater price risks for credit unions if they need to sell the securities prior to maturity.

For the past 10 years, the industry’s total price risk has been minimal, with the largest unrealized losses representing just 1.1% of the value of total investment losses in 2005. As of December 2014, the industry’s investment portfolio (including cash) has a weighted average life of 2.2 years. Based on the duration calculation, if the 2-year US Treasury rate were to increase by 1%, the value of the industry’s total investments should hypothetically decline by 2%. Although historical performance is not an indicator of future performance, the consistent record of posting gains since 2007 — except for the bear market for bonds in 2013 — still demonstrates the stability and resilience of the credit union industry’s investment risk management practices.

TOTAL PRICE RISK AS A % OF TOTAL INVESTMENTS
Data as of Dec. 31 for all U.S. credit unions
© Callahan & Associates | www.creditunions.com

Total_Price_Risk_as_a___of_Total_Invts

Source: Callahan & Associates’ Peer-to-Peer Analytics

 

 

 

 

May 4, 2015


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