Over the past year, US Treasury rates have climbed at a meteoric pace in anticipation of the Federal Reserve’s move to hike short-term interest rates. For example, the 2-year Treasury is currently hovering near 2.7%, up from just 0.15% one year ago. Higher interest rates are broadly beneficial to the credit union industry, allowing for more flexibility in interest margins. However, the pace of the rate increases is on par with a real-world ALM shock scenario (+250 bps on average, ramped over 12 months), therefore causing many of the metrics we use to understand financial risk to become stressed. This memo will look to discuss one such metric, the Unrealized Gain/Loss on Securities Available-for-Sale, and how management should consider it for the purposes of strategy and risk mitigation.
Credit unions can hold securities in one of three accounting categories, Available-for-sale (AFS), Held-to-maturing (HTM), or Held-for-trading. Trading securities is uncommon in the industry, so we will focus on the designation between AFS and HTM today.
When a CU holds a security as available-for-sale, it is done so for liquidity purposes. AFS investments are reported at fair market value, and changes in their market values are reported in Other Comprehensive Income, a supplementary section of the CU’s financials that covers material changes to the valuation of strategic assets that are not reflected in net income. The CU will report the potential market loss from the sale of these investments on an ongoing basis in part to strategically evaluate the cost of liquidating investments should it need to do so. On the other hand, securities held-to-maturity are very simple to understand from an accounting perspective. The acquisition cost of the investment is simply amortized over the expected life of the investment, and fluctuations in market value assessments do not appear in the CU’s financials.
In our experience working with credit unions, we have found very few examples where the accounting staff can remember the origins of why they classify certain investments as AFS vs. HTM. That is not a criticism, but rather demonstrative of how different interest rate and regulatory environments can shape how financials are reported over time. With the rapid expansion of CU balance sheets over the last two years, paired with a rapidly evolving interest rate environment, it may be time to reconsider how you classify securities in your portfolio.
Why is my Unrealized Loss on Available-for-sale Securities so large?
Fair market values for investments can be understood as a pricing assessment of the relative attractiveness of an investment’s yield compared to similar alternatives in today’s market. For example, the 2-year Treasury purchased one year ago at 0.15% is significantly less attractive today when a 1-year Treasury is available for over 2%. If the holder of the investment wanted to sell it, a market price at a discount would be expected to make the effective yield for the new holder to be comparable to today’s better rates. When an investment is sold at a discount, a loss of principal would be recognized. Using this definition, the Unrealized Loss on AFS Securities is the cumulative expected market loss if the CU were to liquidate every single investment under this accounting treatment.
Unrealized losses are accumulating to very high levels for a few reasons: 1) Interest rates moved up a lot in the last year, causing market values on current investments to plummet, 2) investment portfolios are a larger portion of overall assets than normal, and 3) there is a broad precedent to hold most CU investments as AFS in the industry. Why? Our theory is that in pursuit of risk management, many credit unions have opted to maximize their liquidity options without fully evaluating the cost. More liquidity should come at a cost (thus why in a normal rate environment, a longer maturity merits a higher yield). Too much liquidity comes at an opportunity cost, thus highlighting the fundamental goal of credit union investment strategy: to balance the credit union’s liquidity needs with its need to generate earnings.
In evaluating different liquidity options, we find that the sale of investments is often a last resort. When a security is sold, the CU will be giving up the future income from an earning asset along with paying a transactional cost. In practice, we frequently see that the small investment block sizes that credit unions use to construct a diversified portfolio also carry a liquidity premium (in other words, brokers will often bid lower than fair value because a smaller investment is harder to resell). It almost always makes more sense to bridge a funding gap with short-term borrowings and to utilize the natural liquidity from paydowns to respond to changes in the credit union’s liquidity.
We can consider the Unrealized Loss on AFS securities to be a relative measure of how attractive it is for the investment portfolio to be utilized for short-term liquidity needs. When the loss is high, it’s not a good time to sell investments. Moreover, a large Unrealized Loss should not be reason alone to sell investments and realize the loss. Breakeven analysis will consistently show that the credit union is better off to hold the lower-yielding investments to maturity and reinvesting the proceeds into the higher rate environment. The only exception we see to this is occasionally in the direct placement CD sector, where early redemption fees are not based on a market adjustment, but rather a time-based fee (e.g., give up 3 months interest). Such instances are rare as the financial institutions continue to become more efficient.
The various regulatory agencies have differing perspectives on the treatment of the Unrealized Loss. Other Comprehensive Income is an equity account which means an examiner may elect to include the Unrealized Loss when evaluating your capital adequacy. While we understand the Unrealized Loss to be most relevant to a liquidation scenario, management will need to demonstrate the continued soundness of its risk management program. Context may be helpful here: nearly every financial institution that has made investments over the past two years should have a larger than normal Unrealized Loss if they hold AFS securities. The biggest driver of the change is the prevailing rate environment rather than the individual investment decisions made by credit unions. With those higher interest rates, it should also be easier for credit unions to generate earnings.
While we have described the Unrealized Loss as a symptom of a changing rate environment, we can also expect it to normalize over time. Market value assessments of investments on the books “roll down the curve,” as they approach a maturity. As long as the yield curve remains steep, the value of investments will be discounted against lower current rates (at shorter terms). In tandem, investments that mature can be reinvested at higher rates which will naturally decrease exposure to the previous low-rate environment. You can get an idea of the expected pace of reinvestment exposure by evaluating the average life profile of your investment portfolio.
How to avoid a large Unrealized Loss in the future
Now that we have discussed the implications of the Unrealized Loss, we will acknowledge that there may be cases in which management may want to avoid a large Unrealized Loss in the future. As always, we recommend discussing any accounting changes with your CPAs. Management may consider a revised accounting policy to classify future investment purchases as AFS or HTM to better reflect their intentions of holding the investments to maturity or to utilize them as a back-up liquidity source. This should be integrated into the credit union’s broader liquidity strategy, including seasonal cash flows, expected loan and deposit growth, as well as liquidity stress testing. It may make sense to think of the investment portfolio has having sub-portfolios: one for liquidity that’s held AFS and another portfolio that serves other ALM purposes such as income stabilization that’s held HTM.
Within the individual asset classes, it may be appropriate to align AFS classification for investments that are the most liquid or that are less volatile to market pricing changes. For example, floating-rate agency CMOs or debentures that are purchased near par typically do not see a lot of market price fluctuation, as the associated yield reprices according to the bond’s structure. We also see a wider degree of demand for these investment types in the fixed income space, making these investment types one of the easiest to sell at a minimal loss. Therefore, these investment types may be some of the most beneficial investments to hold AFS without seeing significant impacts to Other Comprehensive Income.
On the other end of the spectrum, longer term investments with a fixed rate carry a greater risk that market pricing will look unattractive at some point in the future. Such investments can have very beneficial impacts to the credit union’s ALM strategy, whether it be a low degree of credit risk, a steady amortizing cash flow, or stabilization of expected future income. These investment types can also be structured in such a way to support ongoing liquidity needs through laddering and cash flow structure. It may make sense to hold these bonds as HTM for some institutions.
As credit union leaders evaluate ongoing strategy, we encourage you to think of the different tools in your toolbox. In times of rapid balance sheet expansion, it takes multiple years for loan demand to work through excess deposits. Therefore, credit unions are likely to continue holding larger-than-average investment portfolios for some time. Because the Unrealized Loss is reported on your financial statements, it’s likely to continue to be a discussion and focus point for management and regulators. Larger investment portfolios offer the opportunity to deploy nuanced strategies that serve different purposes. While the Unrealized Loss may look a bit intimidating again, it’s important to remember that the largest driver of the cause is that interest rates are higher today, ultimately offering your institution the opportunity the opportunity to improve earnings as you continue to pursue your mission of driving value to your members.