Should Derivatives Be Allowed?
The NCUA has been requesting comments on a proposal to permit credit unions to engage in certain derivative activities. Now that the agency has closed the comment period and is reviewing those letters, it’s important to keep a few key points in mind when asking, should credit unions be able to invest in derivatives after the losses of the past few years?
Hedging is insurance. Insurance can be costly and should be understood as such–not as losses. It’s critical for credit unions to manage their balance sheets to generate income, ensuring financial stability. Generally, this can be performed by duration mismatch and convexity risks within the balance sheet, which can generate short-term increases in income. But it certainly comes with a higher likelihood of future loss. On the other hand, the conservative practice of selling mortgage loans and avoiding other longer duration asset classes can be equally devastating if rates remain low for an extended time.
The proposed solution that the NCUA is considering is whether or not to grant natural person credit unions hedging powers to actively and safely manage interest rate risk. With certain restrictions, ALM First believes derivative authority should be granted to individual credit unions that have the infrastructure to support such activity and to third-party providers with numerous restrictions.
Interest rate hedging should not be confused with derivatives that did lose significant market value, such as credit default swaps, which are agreements where counterparties transfer credit risk. (A counterparty agrees to insure a third-party credit risk in exchange of regular payments, or an insurance policy.) Derivatives that hedge interest rate risk are fairly straightforward and they performed extremely well during the credit crisis.
The huge mistakes made should not broad-brush regulation so that all “out of the norm” activity is bad. While credit default swap structures and mezzanine nonconforming securities had huge losses, interest rate swaps didn’t. As an example, all interest rate swaps of the failed Lehman Brothers cleared with no losses. Of course, there is a lot of work necessary to prepare for the use of derivatives. We believe education is vital and speculation can be dangerous. As always, education is the key.
Emily M. Hollis
Financial Advisors LLC