Like everyone else, EagleCommunity Credit Union has weathered what CFO Scott Rains describedas several years of blustery economic conditions. What’s more, the$206 million institution, located in the Orange County, Calif.,community of Lake Forest, has prospered almost in spite of guidancegiven by its examiners.

Eagle Community, which serves 18,000 members including manyfederal employees, has few mortgages on its books and is primarilyfocused on short-term member loans. To help the credit union stayfinancially viable as the loan market softened in recent years,Rains rolled 50% of the credit union’s assets into investments. Butvolatile interest rates and a changing economic climate havestarted to threaten earnings even from that portfolio.

“We’ve had some pretty substantial unrealized losses [oninvestments] in the past nine months,” said Rains. “It’s about $2million on an $80 million portfolio, but we’re very comfortablewith that and I don’t have anything better to put my money intoright now.”

The losses occurred on the investment’s mark-to-market values,which measure lost revenue potential through rate changes ratherthan a declining principal value. Unfortunately, the NCUA examinersunder whose scrutiny Eagle Community falls were less comfortablethan the credit union with the losses.

“The NCUA comes at this from a very different perspective,”Rains said. “They’re all about safety and soundness, but we have tomake money.”

Cultivating earnings potential while staying within NCUA’sprescribed regulatory guidelines can be a risky business, admitexaminers and credit union executives alike. Managing interest raterisk is a challenge faced by all credit unions, and one that’slikely to be compounded when rates eventually begin to rise. Whenthat day finally comes, credit unions whose cash flow streams failto balance with their funding streams may find themselves veryuncomfortable indeed.

“We get concerned in a situation when a change in interest ratesstresses income or creates very large changes in asset valuation,”said John Worth, NCUA’s chief economist. A changing rateenvironment can weaken the value of fixed-rate assets at a timewhen depositors may demand higher rates just to keep money in theirmember accounts. The result, Worth explained, can be a compressednet margin that can wind up threatening a credit union’s financialstrength and stability.

“That’s really the crux of it,” Worth said. “A stress toearnings, a stress on asset values and a reduction in liquidity cancreate a significantly stressful environment for the credit union.That’s where we have concerns about interest rate risk.”

That’s also the point at which credit unions like EagleCommunity and others come to loggerheads with the NCUA. Walking thetightrope between safety and soundness and the need forprofitability has rarely been more challenging than over the pastfew years.

Neither aspect can be sacrificed in pursuit of the other, andboth parties have valid concerns, according to Brian Turner, chiefstrategist for Catalyst Strategic Solutions, part of CatalystCorporate Federal Credit Union in Plano, Texas.

“Most regulatory guidelines are not obstructive and arereasonable in their intent, but there needs to be a more balancedapproach in assessing risk exposure,” said Turner. “If you were toask most credit union managers, they’d say the challenge is dealingwith the unbalanced interpretation and intervention by certainfield examiners.”

Read more: Credit unions better positioned toweather rising rates than banks ...

Despite some examiners’ concerns to the contrary, however,credit unions are in a better position than banks and otherfor-profit financials because the average life of their earningassets are shorter than those of the competition. Even the growthof mortgage lending hasn’t significantly lengthened asset life,which across the industry remains between two and three years,according to Turner.

“Roughly 58% of credit union assets are in cash, short-terminvestments and vehicle loans,” said Turner. “The shorter assetduration creates less of an impact on cash flows from changes ininterest rates. Therefore, income streams are not as adverselyaffected in a rising-rate environment as they are in the for-profitsector.”

And how much of credit unions’ aggregate industry assetportfolio does the NCUA consider at risk? Citing the wide range ofspecifics involved in determining risk, Worth declined to disclosea specific number.

“When you look at a credit union, interest rate risk and assetliability management risk are determined by a lot of variables,”Worth said. “It’s done on a case-by-case basis and is not somethingwe have in a way that works well in the public space.”

In terms of funding durations, credit unions are comparable tobanks and thrifts. Yet, in a rising rate environment, credit unionshistorically have not had to increase their non-term shares rateparallel with the upward movement of the fed funds rate orshort-term treasury rates, Turner said. In fact, non-term sharerates do not change for the first 250 basis point movement in thefed funds rate.

“This suggests that as market rates increase, marginal assetyields will advance at a greater pace than funding rates,” saidTurner. “This will increase net margins, specifically during thefirst part of the new interest rate cycle.”

Both Turner and Worth believe that credit unions won’t see arise in rates during 2014 due to continued consumer anxiety overjob security and ongoing economic uncertainty. When rates do rise,they also won’t rise at the same rate for both short-tem andlong-term instruments.

“Most likely, short-term rates will see very little movementuntil mid-2015, but longer-term rates will remain very volatile asmarket forces battle against Fed monetary policy, specifically itsbond purchasing program,” Turner said. “This could bring shiftsbetween 25 to 50 basis points over the next year.”

The distinction between long-term and short-term rates iscritical to understanding interest rate risk, according to Worth.In terms of safety and soundness, one size does not fit both.

“People talk about rising and falling rates, but it matterswhether we’re talking about short-term or long-term rates,” Worthsaid.” Interest rates are not just an up-down discussion. It’s theshape of the yield curve that matters.”

When it comes to the spread between the asset yield and the costof funds, the rate matters less than the percentage of revenue thatresults, Turner explains. Failure to manage that spreadeffectively, more so than interest rates themselves, oftendetermine the degree of interest rate risk a credit union canface.

Greater examiner sensitivity to that spread and how well it’sbeing managed could go a long way in strengthening the relationshipbetween institution and regulator, he added.

“In some cases, over the past three years in particular,examiners have given explicit directives to credit unions againstreal estate lending and have tried to limit investment activitiesall in the name of protecting the credit union against risingrates,” Turner said. “This edict comes from a fundamental theorythat financial institutions should not put longer-term assets ontheir books when rates are about to increase.”

Read more: The credit union-examiner tug of war...

Some credit unions find themselves in a tug ofwar that once again pits profitability against safety as defined bythe regulator. Instead of booking, say, a seven-year asset at 4.5%,they are told it is better to book a three-year asset like a carloan at 1.9% or invest in a three-year security at 1.25%. But sinceconsumer demand has been soft, the credit unions end up investingin securities or certificates of deposit, according to Turner.

“Assessments seem to ignore the fact that balance sheets are notstatic,” Turner said. “Loans put on the books over the past threemonths may account for 10% of a portfolio today, but as ratesincrease and additional loans are booked at higher rates, those 10%additions drop to 5% of the total very quickly. In the meantime,the credit union’s earning profile has been enhanced during theduration. This seems to be lost in the examination review.”

At Eagle Community, the examination process has been a struggleover the past few years, said Rains, Continued dialogue, as well asthe examiner’s understanding of the credit union’s intent, itsrationale and its processes can go a long way in bridging gaps thatdevelop between the regulator and the regulated.

“With examiners, it’s all about the credit union having a plan,being able to explain that plan and then having the examiners buyinto that plan,” said Rains. “I don’t think their concerns areunwarranted, but my expectation is that my examiners should workwith me.”

Such was the case when Eagle Community invested in municipalsecurities, one of the first credit unions to do so and somethingthe examiner at first thought too risky. Once Rains showed them theplan, the duration of the investment and the anticipated yield, theexaminer saw the positive financial impact and did not downgradethe credit union for the investment.

“If the examiners see that you’re doing things right, theyshould trust that you know what you’re doing and cut you a littlemore slack,” said Rains. “For a time things were pretty touchyhere, but for the past 18 months I think things have gottenbetter.”