In May the Federal Reserve Board discussed reducing itspurchases of Treasury and mortgage bonds as signs pointed to animproving economy. The “tapering” comment, as the press reportedit, led to a spike in Treasury rates and decline in bond marketvalues. The backup in rates provided a sneak preview of thepotential damage to credit union balance sheets, underscoring theimportance of preparing for the inevitable collapse of the bondbubble.

The yield on the 5-year U.S. Treasury doubled to 1.49% in thequarter ending June 30. According to Sandler O'Neill research donein collaboration with R.P. Financial utilizing Call Report datafrom SNL, the rate increase led to significant market value declinein the available for sale (AFS) investment portfolio for manycredit unions in the group with assets greater than $250 million(Group).

Should interest rates move up 300 bps from the June 30 levels,the market value decline for the Group would be more than $16billion (assumes three-year duration for the AFS portfolio). Forperspective, the average yield of the 5-year Treasury from January1990 to December 2007 was 5.396%, and the total capital of theGroup is $88 billion.

To assess their readiness for higher market interest rates,credit unions should ask themselves several questions. Whatwill be the credit union's capacity to meet member demand forhigher share rates as market rates move up? Will earnings betweennow and then result in margin that enables competitive rates?

If not, will the credit union have enough liquidity on thebalance sheet to meet member demand for withdrawal? If investmentsmust be sold, will their diminished market value create a loss thatcapital can withstand, and will there be enough capital to supportborrowing to meet withdrawals?

If the credit union is adequately prepared, the market valuedecline would be an unrealized loss that remains mostly just that,UNrealized.

Preparing for higher market interest rates requires CUs toconsider the following, in conjunction with other factors such asloan to share:

Liquidity management – Sufficient liquidity isa critical factor in successfully managing rate shocks, and we seeopportunity for improved readiness. Of the 783 credit unions in theGroup, 658 have designated 77% of total security balances as AFS.These credit unions, if necessary, will be able to sell securitieswith a phone call to meet a liquidity event.

The other 125 credit unions are severely limited in theirability to deal with the bond bubble collapse and should take thesneak preview as a wakeup call. The perceived benefit of avoidingmark to market is not worth the reduced flexibility in managing theportfolio for income and liquidity caused by designating allinvestments held to maturity. Members don't pay attention to“unrealized” losses, but they will notice if you can't meet theirdemand for rates or withdrawals.

Some 59% (464) of the Group does not have access to the FederalReserve discount window for borrowing purposes. A liquidity eventcould become a liquidity crisis for these credit unions.

Capital – Higher levels of capital improve aninstitution's ability to cushion the blow that comes from bothcredit losses and the loss on sale of assets when rates rise, bothof which remain a distinct possibility for many credit unions.Generating incremental income is critical, yet difficult, given theprevailing low-rate environment, increased compliance costs, and apotentially dramatic reduction in fee income.

The investment portfolio represents opportunity for increasedincome and readiness, in part because management can influence itsperformance more easily than member behavior. Higher levels ofcapital also increase the amount that can be borrowed to meetwithdrawals and therefore avoid selling assets, while remainingabove minimum capital requirements.

Next Page: Capital Reasons for SecondOpinion

Investment portfolio structure – The investmentportfolio's results in generating both increased income andadequate cash flow contributes to two of the more criticalcomponents of fortifying against rising rates: higher capitaland sufficient liquidity. In many cases, we see opportunity forimprovement.

Federal credit unions in the Group aggregately hold 25% ofinvestments in callable securities and bullet securities withmaturities greater than three years. These portfolios typicallyfeature deeper market value declines and less monthly cash flow,while generating yield that is only on a par with (or even lessthan) portfolios with higher levels of appropriate mortgage backedsecurities.

Some credit unions are holding far too much in cash andshort-term securities. The income loss from excessive cashpositions is imprudent considering both the ease of meeting cashneeds in other ways and the cash generated from a properlyconstructed investment portfolio. What's more, the incrementalincome from deploying cash in more constructive ways can boostcapital levels.

Get a second opinion – Next month will markfive years of Fed Funds ranging between 0 and 25 bps. This is anhistoric run of low rates and requires a closer look. The peerinvestment yield of the Group is 1.03%, and the average decline inmarket value from Q1 to Q2 is 1.44% of AFS holdings. If acredit union's investment yield and market value decline are nobetter than peer levels, it's a red flag that mandatesanalysis.

The sneak preview prompts us to analyze what improvements can bemade, and there is no time to waste. If the Federal Reserve'sdecision not to taper (and other factors) leads to bond pricesmoving up again before the bond bubble collapses, an institutioncan make material improvement in readiness, in part by selling lessdesirable securities and replacing them with better bonds. Forsome, this can also mean more income and capital.

Since equity capital and derivative hedging tools areunavailable, credit unions must leave no stone unturned inpreparing themselves for the inevitable, and possibly epic,collapse of the bond bubble.

Peter F. Duffyis managing director with Sandler O'Neill & Partners LP in NewYork City.