Disciplined Investment Strategy Necessary in Soft Economy, NCUA Advises

ALEXNDRIA, Va. - Net interest margins will shrink for credit unions if they're not willing to take on higher risks that may not be commensurate with returns. In its June 2005 newsletter, NCUA advised CUs to consider laddering purchases out from three to five years as part of their "disciplined" investment strategy, which "is the most likely means to safely manage for the future." "Once, it was easy to assume that when the Fed decided the economy had gained the needed boost from a loose money policy and both long and short rates had renormalized, the world would return to a familiar environment where old strategies could once again be applied," NCUA said. "Instead, credit unions have moved from being confronted by one set of complex risks created by excess liquidity to another set equally fraught with dynamic, inter-related risk based on yield-curve uncertainties. In such a setting, discipline, and a willingness to sacrifice some return, may well be the watchwords for some time to come." Long-term callable bonds present risk when it appears that long-term rates may have fallen close to the minimum, NCUA said. Collateralized mortgage obligations especially contain extension risk in support tranches that are structured to be particularly sensitive to rate changes when prepayments dramatically lengthen with relatively small rate increases. "These "turbo" structures are designed to shift the extension risk out of shorter maturity PAC tranches," NCUA said. Because the bond market has disagreed with inflation, CUs should consider targeting lower returns on assets to avoid excessive interest rate risk exposure, in long term real estate loans and investments, the agency said. NCUA has also advised CUs to be careful to obtain the extension characteristics of any mortgage related security and ensure "they are not left holding the riskiest segments."