Moody's Analytics Senior Director - Credit Acceptance Industry Practice Lead Chris Stanley.
Rising interest rates impact demand for fixed-rate financing, and the value of your institution’s fixed-rate loan and debt securities positions (bond prices fall as rates rise). More problematic for executive teams, the accounting for these valuation adjustments adversely impacts key performance metrics scrutinized by investors, even when the underlying portfolio performs as contracted.
After a long period of historically low interest rates, concerns over inflation have moderated the Federal Reserve’s accommodative monetary stance, and rates have risen in response. Increasing interest rates provide unique challenges to institutions managing the risk of fixed-rate assets, especially instruments backed by residential and commercial real estate that are characterized by dynamic prepayment and default risk. To navigate this environment successfully, institutions will need to develop a deep understanding of how these assets may behave in different market environments and consider hedging away unwanted risks.
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Updated accounting for hedges
In 2017, the Financial Accounting Standings Board (FASB) released updates (ASU 2017-12) that introduced the “last-of-layer” method, which enabled fair value hedges to be recognized for prepayable financial assets. Under this method, entities designate a stated amount of the asset or assets that is not expected to prepay, default, or experience other events affecting the timing and amount of cash flows, as the hedged item in a fair value hedge of interest rate risk.
The Accounting Standards Update 2022-01 expands the last-of-layer model to allow designation of multiple layers in a single portfolio as individual hedged items. By allowing multiple hedging relationships with a single closed portfolio, the update enables entities to hedge a larger portion of the interest rate risk associated with a portfolio and allows more flexibility in the derivative structures available to hedge interest rate risk. The update includes provisions for new hedges to be designated, or existing hedges to be dedesignated at any time—allowing accounting to better reflect changes in an entity’s risk management activities in a dynamic interest rate environment. If a breach is anticipated (or occurs), a multi-layer strategy provides additional flexibility in determining which hedge or hedges to dedesignate.
How CECL tools help
CECL provided the incentive to advance institutions’ tools for understanding two key factors that impact hedge effectiveness: default and prepayments. Various disciplines throughout financial institutions had some insight available to evaluate these outcomes, but CECL prompted more rigorous consideration by bringing their lifetime effects to bear on income statements at the inception of each loan. This financial impact enhanced the importance of understanding the interaction of macroeconomic and loan-specific information on the competition between default and prepayment risks (in a multi-period setting, raising the conditional probability of prepayment will reduce the overall or cumulative probability of default and vice versa). The resulting models integrate consideration of:
Economic stress on loan performance
Layers of risk
A multiperiod view
These models create a richer representation of borrower behavior than was previously available to most middle market and community financial institutions. Modeling default and prepayment processes at the loan level (as opposed to the pool-level analysis prevalent pre-CECL) significantly improves accuracy in estimating losses, particularly for portfolios with heterogenous credit characteristics. Importantly, these models allow nuanced analysis of portfolio performance with one or multiple macroeconomic scenarios. This forward-looking, multi-scenario view enables credit teams to provide deeper insights on default and prepayment with the same scenarios used by asset and liability management (ALM) and treasury teams to plan liquidity, investment, and hedging strategies (or provide CECL model outputs directly to ALM and capital planning tools). With these additional capabilities, hedging strategies can be optimized for resilience across a range of interest rate, default, and prepayment scenarios.
For institutions that implemented a robust CECL methodology, the insight needed to create hedge relationships is already in place.
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