In May the Federal Reserve Board discussed reducing its purchases of Treasury and mortgage bonds as signs pointed to an improving economy. The “tapering” comment, as the press reported it, led to a spike in Treasury rates and decline in bond market values. The backup in rates provided a sneak preview of the potential damage to credit union balance sheets, underscoring the importance of preparing for the inevitable collapse of the bond bubble. 

The yield on the 5-year U.S. Treasury doubled to 1.49% in the quarter ending June 30. According to Sandler O'Neill research done in collaboration with R.P. Financial utilizing Call Report data from SNL, the rate increase led to significant market value decline in the available for sale (AFS) investment portfolio for many credit 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 $16 billion (assumes three-year duration for the AFS portfolio). For perspective, the average yield of the 5-year Treasury from January 1990 to December 2007 was 5.396%, and the total capital of the Group is $88 billion.

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

If not, will the credit union have enough liquidity on the balance sheet to meet member demand for withdrawal? If investments must be sold, will their diminished market value create a loss that capital can withstand, and will there be enough capital to support borrowing to meet withdrawals?

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

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

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

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

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

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

The investment portfolio represents opportunity for increased income and readiness, in part because management can influence its performance more easily than member behavior. Higher levels of capital also increase the amount that can be borrowed to meet withdrawals and therefore avoid selling assets, while remaining above minimum capital requirements.

Next Page: Capital Reasons for Second Opinion

Investment portfolio structure – The investment portfolio's results in generating both increased income and adequate cash flow contributes to two of the more critical components of fortifying against rising rates:  higher capital and sufficient liquidity. In many cases, we see opportunity for improvement.

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

Some credit unions are holding far too much in cash and short-term securities. The income loss from excessive cash positions is imprudent considering both the ease of meeting cash needs in other ways and the cash generated from a properly constructed investment portfolio. What's more, the incremental income from deploying cash in more constructive ways can boost capital levels.

Get a second opinion – Next month will mark five years of Fed Funds ranging between 0 and 25 bps. This is an historic run of low rates and requires a closer look. The peer investment yield of the Group is 1.03%, and the average decline in market value from Q1 to Q2 is 1.44% of AFS holdings.  If a credit union's investment yield and market value decline are no better than peer levels, it's a red flag that mandates analysis.

The sneak preview prompts us to analyze what improvements can be made, and there is no time to waste. If the Federal Reserve's decision not to taper (and other factors) leads to bond prices moving up again before the bond bubble collapses, an institution can make material improvement in readiness, in part by selling less desirable securities and replacing them with better bonds. For some, this can also mean more income and capital.

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

Peter F. Duffy is managing director with Sandler O'Neill & Partners LP in New York City.