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WASHINGTON – In an environment where rates continue to rise, embedded options tend to need closer scrutiny. Embedded options are an asset or liability characteristic, such as coupon rate, coupon-rate formula, final maturity, or weighted-average life, that can change during the term of the asset or liability. The options include, among other things, call features, coupon-rate caps/floors, and prepayment features. All mortgage-backed securities have embedded options. The rise in longer term interest rates has had, and may continue to have, a particularly damaging effect on the values of assets with embedded options, some industry watchers contend. Asset values decline first because interest rates are rising. As the anticipated maturities of these assets with embedded options extend, values decline further because of the longer maturities. What generally happens is asset values decline first because interest rates are rising. As the anticipated maturities of these assets with embedded options extend, values decline further because of the longer maturities. The risk of embedded options in a rising rate environment became so crucial that the Office of the Comptroller of the Currency warned banks to tread carefully. “A number of banks have chased yields in their investment portfolios by acquiring assets with embedded options, hoping to keep their earnings growing during the recent period of low interest rates and weak loan demand,” said Kathryn Dick, OCC deputy comptroller for risk evaluation. She said, in an alert issued last summer, rate changes can impair bank assets to a point that additional capital may be required. Dick said the OCC is especially concerned that banks may fail to appreciate the risk because the initial effect of rising rates may be positive for their earnings. The OCC recommended that banks take certain precautions including identifying all assets and liabilities with embedded options; limiting exposure to these options according to the bank board’s tolerance; verifying that interest-rate risk metrics are sufficient; understanding the risk to earnings and capital from a rising rate environment; and asking board approval for any redesignation of securities held-to-maturity. For credit unions, the warnings are just as applicable but the scenario has some variations given the makeup of their investment portfolios and keeping the focus on short-term interest rates, said David Trinder, vice president of balance sheet management for WesCorp. “When credit unions are faced with a higher than desired exposure to rising interest rates, they are somewhat limited in their corrective actions,” Trinder said. “One option would be to sell longer-term, fixed-rate loans or investments to reduce this risk. If the sale of target loans or investments would generate capital losses, however, credit unions will typically refrain making that choice and seek an alternative solution.” WesCorp offers its “Super Floater” certificate as an alternative hedge instrument. The certificate is a combination of a simple term floating rate certificate and a fixed-pay interest rate swap. The embedded interest rate swap acts as the hedge against the potential increase in short-term funding costs. When short-term rates rise, credit unions might also turn to issuing fixed-rate certificates to members. The drawback is this usually requires the payment of a large rate premium and typically only generates limited volumes, Trinder said. “Other credit unions might turn to long-term, fixed-rate borrowings as a solution, but this also can be expensive and balloons the balance sheet for credit unions that do not need additional liquidity,” Trinder said. Financial derivatives are “the most efficient tools for hedging interest rate risk,” but they too have their drawbacks such as taking the time to set up a derivative hedging program, implement new policies and procedures and train staff and the board, Trinder said. According to NAFCU’s 2004 Report for the Board of Governors of the Federal Reserve System, federally-insured credit unions’ non-mortgage-backed investments with embedded options expanded from $18.7 billion to $19.5 billion during the first six months of 2004. Non-mortgage investments without embedded options were unchanged at $2.9 billion. Jonathan Hullick, newly-named president/CEO of $200 million First Florida Credit Union, was also a senior examiner with the FDIC for six years and wrote the guidelines for interest rate risk for the bank regulator. From the latter’s vantage point, he’s seen firsthand how banks have dealt with embedded options when rates rise but is concerned that the issue is not on the front burner for some credit unions. “The challenge is usually at the executive level, where some don’t come from the risk management side of the house,” Hullick said. “There is more of a focus on service delivery and not market risk.” Hullick said it is critical that credit unions pay more attention to long-term forecasts and net portfolio value changes to spot hidden risks. “Put stresses on the balance sheet such as interest rate shocks so you can see where the excessive risk rate exposure is,” he suggested. “Look at any characteristic on the asset or liability side that can change timing or cash flow.” Hullick said the FDIC and OCC “are becoming more aggressive” with embedded options and rising rate risk and NCUA “is doing it to some degree” and will do it more especially for smaller credit unions. “It’s not a crystal ball, it’s simply applying stresses,” Hullick explained. “It’s like changing the oil in your car. You can pay the $20 now or really pay later. It’s purely preventative maintenance.” Meanwhile, the Federal Reserve Board isn’t showing any signs of stopping with rate increases expected until at least the middle of 2006, said Jeff Taylor, NAFCU senior economist. Credit unions should also be ready for long-term rates to move higher, he added. The days of plus or minus 300 basis points as a shook test may be “old school.” “I would say go 500 basis points,” Taylor said. “If you do due diligence and understand the options and what you’re hedging against, you can shock up to 500 basis points and still be able to sleep at night.” [email protected]

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