Catalyst News

Derivative Hedging Can Strengthen Interest Rate Risk Management

by Catalyst Corporate | Apr 27, 2021

A growing number of mortgage loans is good news for credit unions, but the low interest rates associated with those loans is causing concern for some. A high volume of long-term, low-yield loans spells rising interest rate risk.

Fortunately, derivative hedging can help.

The mortgage industry finished its best quarter since at least 2000, according to a recent report from ATTOM Data Solutions. Fueled by rates hovering around three percent, lenders originated $1.06 trillion in mortgages the fourth quarter of 2020 – the highest quarterly figure in at least 20 years.

Number of loans also reached the highest quarterly figure in nearly 14 years, with 3.51 million mortgages originated in the fourth quarter. Refinancing was a big driver of the record-breaking quarter, according to ATTOM’s report. Lenders refinanced 2.23 million mortgages for $666.8 billion in the fourth quarter.

Meanwhile, new homes sales, which represent signed contracts, jumped 20.7 percent in March to the highest sales pace in 15 years. Warmer weather is bringing buyers to the market, making up for the traditionally slower months of January and February. The strong demand for new homes has pushed the backlog of construction to the highest level seen since late 2006.

But the resulting high volumes of low-rate mortgage loans can create challenges. “Many credit union executives and board members are increasingly uncomfortable booking mortgage loans,” said Mark DeBree, Managing Principal at Catalyst Strategic Solutions, in a recent blog entitled: Take Another Look at Interest Rate Derivatives.

“Interest rate derivatives can help,” DeBree said. “A proper strategy can significantly reduce the interest rate risk added by the low-rate mortgages, while still enabling your credit union to enjoy most of the earnings stream.”

Credit unions have had access to interest rate derivatives as a risk management tool for years. Gaining the authority to use them, however, presented a challenge many credit unions simply did not want to tackle. If NCUA’s recently proposed rule goes into effect soon, this will make it easier for credit unions to incorporate derivatives into their balance sheet management practices, DeBree pointed out.

Although derivative usage within the industry remains low, a couple of key considerations may prompt credit unions to take a closer look at this useful tool. “And having more, rather than fewer, tools at your disposal is usually better,” DeBree said.  

Derivative hedging may be an appropriate alternative to the use of borrowings for credit unions looking to hedge interest rate risk on their balance sheet. Using borrowings to manage interest rate risk will tie up liquidity, and ample access to liquidity is critical during periods of uncertainty.

Also, “because interest rate derivatives are off balance sheet items, they can reduce risk without placing additional downward pressure on net worth. Proper application of a derivative strategy can help lower your interest rate risk position while maintaining full access to external liquidity,” DeBree said.  

For credit unions concerned about interest rate risk, looking to expand their presence in the real estate markets, or seeking to expand their risk management toolbox, it may be worthwhile to explore whether interest rate derivatives are an appropriate fit. If you need more information on interest rate derivatives, contact Catalyst Strategic Solutions today.