Deciphering Long-Term Assets
Is it a disaster? To quote ESPN sports broadcaster Lee Corso: “Not so fast, my friend.”
We have noticed a lot of recent discussions about the exposure credit unions have had to long-term assets and wanted to point out that it may not be as bad as some folks think.
According to a June 5, 2014, article from The Wall Street Journal, “Credit unions’ net holdings of long-term assets, a measure of exposure to rising interest rates, rose to an all-time high at the end of 2013 to 35.85% of total assets, according to the NCUA. The increase comes as some credit unions are adopting lax standards for mortgage and home-equity loans and lines of credit reminiscent of those leading up to the financial crisis, according to interviews. Credit unions also are extending the duration on investments like mortgage bonds, regulatory data show.”
The article implied that a higher net long-term assets ratio results in an increased asset-side interest rate risk.
The definition of long-term assets in the NCUA's FPR User's Guide is “Net Long-Term Assets/Total Assets Ratio: The sum of real estate loans which will not refinance, re-price or mature within five years, member business loans, investments with remaining maturities of more than three years, NCUSIF deposit, land and building, and other fixed assets divided by total assets.”
Surprisingly enough, variable rate investments are considered net long-term assets while variable rate real estate loans are not. Credit unions can buy variable rate investments to mitigate the risks associated with rising interest rates, yet see their net long-term asset ratio worsen.
In essence, a credit union could have longer-term investments whose rates change in 36 to 60 months (think 5/1 ARMS), yet have their net long-term assets ratio imply that an increased interest rate risk exists, when that risk does not.
With loan-to-asset ratios nearing an all-time low, investments are becoming an increasingly larger factor in net interest income and that is what ultimately pays the bills. Historically, boards of directors have properly focused on lending while treating investments as the leftovers.
Currently, with investments making up approximately one-third of credit unions’ balance sheets, it is of the utmost importance to ensure that the second biggest asset class does not present an inordinate amount of interest rate risk going forward.
Yet, the net long-term assets ratio does not take variable rate investments into account. Therefore, the ratio is a flawed measurement of interest rate risk and WSJ, if they had conducted more research, would have noted that point.
We could be poised for higher short-term interest rates in the near future and the cost of funds of many credit unions is tied to short-term rates as opposed to long-term rates. The net long-term assets ratio does not adequately measure the interest rate risk in investment portfolios. Instead, credit unions should use their own ALM models to determine exposure to rising rates and to ensure that the variable rate component of their investment portfolio is sufficient to offset the fixed rate component of the loan portfolio.
Thomas Bonds is owner of Bonds Capital Group and a SVP at Investments Professionals Inc. He can be reached at 205-383-8980 or firstname.lastname@example.org.