A Fuller Array of Financial Risk Management Tools

The National Credit Union Administration’s proposed changes that would allow credit unions to use derivatives for hedging is a welcome event. Credit unions are complex financial institutions that should be allowed to use these tools to mitigate interest rate risk if they have staff with the right expertise. With a more complete toolkit for managing risk, credit unions would be able to focus on what they do best—serving members by taking deposits and making loans (or buying appropriate investments when necessary) without taking undue market interest rate risk.  

Buying Derivatives Has Gotten Easier

Since the Dodd-Frank act was enacted in 2010, entering into an interest rate derivative relationship with a derivative dealer has become a lot less onerous, especially as it relates to interest rate and basis swaps. Negotiating the standard document regularly used to govern over-the-counter derivatives transactions, a master agreement put forth by the International Derivatives and Swaps Association, can take time and drain resources. Under the proposal, credit unions would be able to trade on an individual dealer swap execution facility, which according to the Dodd-Frank act is a facility, trading system or platform in which multiple participants can execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system. Most large global investment banks now have their own SEF.

When initiating a relationship with an individual derivative dealer, a credit union must enter into a cleared derivative execution agreement. This is a standard form that allows for seamless derivatives trading. A standardized CDEA allows market participants to execute trades on an SEF. Unlike traditional ISDA swap agreements, the CDEA is a standard, market-accepted template and thus eliminates the costs of lawyers negotiating swap agreements between two parties. Generally, any standardized swap is available on an SEF. However, any option or tailored trade will require an ISDA agreement between the credit union and the derivative counterparty.

On a practical note, to get access to a CDEA and hence an SEF, a credit union usually needs to get sponsorship from its contact at the institution’s SEF, as the institution will evaluate the overall relationship it has with the credit union. For example, if the credit union buys and sells investments with a few potential SEF sponsors, it will be easier to get the CDEA agreed upon with those institutions compared to others. Additionally, interest rate caps and floors may be more difficult to negotiate, as credit unions will continue to need a separate ISDA master agreement with derivative dealer counterparties.

The Impact of LIBOR

Another issue to keep in mind is the state of LIBOR, the London Interbank Offered Rate. Since the benchmark is the building block for most interest rate derivatives and is now scheduled to be phased out in 2023 (originally it was to be terminated this year, but replacement problems have plagued the effort), credit unions must evaluate the “fallback” or LIBOR replacement documentation in any derivative transaction. Plus, they’ll need to budget for potential operational and legal expenses.

Addressing Secondary Loan Pipeline Management

NCUA’s proposal also addresses the use of derivatives for secondary loan pipeline management.

The Board is proposing to remove paragraph (i) from § 701.21 to consolidate it with related provisions without intending any substantive change. This section currently allows FCUs to purchase put options to manage increased IRR for real estate loans produced for sale on the secondary market. A put option is a financial options contract which entitles the holder to sell, entirely at the holder's option, a specific quantity of a security at the specified price at or before the stated expiration date of the contract. Using put options in the manner permitted by § 701.21(i) is a form of loan pipeline management. 

While credit unions will appreciate the freedom to use derivatives to control risk with regard to hedging pipeline exposure, utilization of put options (including options on swaps or “swaptions”) can be an especially tricky business. First, there is correlation risk between swaps and mortgages and Treasury futures and mortgages. Second, when selling mortgages forward to Fannie Mae or Freddie Mac, the government-sponsored enterprises provide built-in optionality by allowing for both mandatory delivery, under which the credit union must deliver the exact amount agreed upon, and best-efforts delivery, which provides the option not to deliver. The best-efforts portion will be an expense (just like buying an option, but perhaps less expensive) but is much better correlated to a credit union’s mortgage exposure.   

We applaud NCUA’s proposed changes on the use of derivatives. We see them as a vital risk management tool that the credit union community needs to protect itself, its members and the industry from the risk that will eventually occur in a rising rate environment. Interest rate swaps and LIBOR caps and floors are sound risk management tools. Derivatives, used properly, are no longer dark magic.

Eric Salzman is a founding partner of Blanton Research LLP, with offices in New York and San Antonio, Texas.