The NCUA has been requesting comments on a proposal to permitcredit unions to engage in certain derivative activities. Now thatthe agency has closed the comment period and is reviewing thoseletters, it's important to keep a few key points in mind whenasking, should credit unions be able to invest in derivatives afterthe losses of the past few years?

Hedging is insurance. Insurance can be costly and should beunderstood as such–not as losses. It's critical for credit unionsto manage their balance sheets to generate income, ensuringfinancial stability. Generally, this can be performed by durationmismatch and convexity risks within the balance sheet, which cangenerate short-term increases in income. But it certainly comeswith a higher likelihood of future loss. On the other hand, theconservative practice of selling mortgage loans and avoiding otherlonger duration asset classes can be equally devastating if ratesremain low for an extended time.

The proposed solution that the NCUA is considering is whether ornot to grant natural person credit unions hedging powers toactively and safely manage interest rate risk. With certainrestrictions, ALM First believes derivative authority should begranted to individual credit unions that have the infrastructure tosupport such activity and to third-party providers with numerousrestrictions.

Interest rate hedging should not be confused with derivativesthat did lose significant market value, such as credit defaultswaps, which are agreements where counterparties transfer creditrisk. (A counterparty agrees to insure a third-party credit risk inexchange of regular payments, or an insurance policy.) Derivativesthat hedge interest rate risk are fairly straightforward and theyperformed extremely well during the credit crisis.

The huge mistakes made should not broad-brush regulation so thatall “out of the norm” activity is bad. While credit default swapstructures and mezzanine nonconforming securities had huge losses,interest rate swaps didn't. As an example, all interest rate swapsof the failed Lehman Brothers cleared with no losses. Of course,there is a lot of work necessary to prepare for the use ofderivatives. We believe education is vital and speculation can bedangerous. As always, education is the key.

Emily M. Hollis
Principal
ALMFirst 
Financial AdvisorsLLC
Dallas