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Understanding Interest Rate Movements, Basis Risk & ALM May 15 th, 2015 Presented by Understanding Interest Rate Movements, Basis Risk & ALM May 15 th, 2015 Presented by John R. Brick, Ph. D, CFA Copyright 2015 Brick & Associates, Inc. All Rights Reserved. This material is for the sole and exclusive use of conference participants. Any other use or copying of this material is strictly prohibited. Brick & Associates is located at 1400 Abbott Road Ste. 105 www. brickinc. com © Brick & ssociates, Inc. East Lansing, MI 48823 Phone: (517) 332 -7700 A staff@brickinc. com www@brickinc. com

Introduction & Comments A. Our Objective—to prepare for a changing rate environment by addressing Introduction & Comments A. Our Objective—to prepare for a changing rate environment by addressing key questions & issues 1. Which rates directly drive a credit union’s business? 2. How are changing interest rates related? 3. Should we attempt to anticipate (forecast) rate changes? What are the risks of doing this? 4. What is the financial impact of a changing rate environment? B. Graphical perspective on the key interest rates 1. Exhibit 1, PRIME RATE, FED FUNDS TARGET & 10 YR TREASURY RATE 2. Exhibit 2, SHORT-TERM INTEREST RATES May 2015 © Brick & Associates, Inc. 2 www. brickinc. com

Exhibit 1 May 2015 © Brick & Associates, Inc. 3 www. brickinc. com Exhibit 1 May 2015 © Brick & Associates, Inc. 3 www. brickinc. com

Exhibit 2 May 2015 © Brick & Associates, Inc. 4 www. brickinc. com Exhibit 2 May 2015 © Brick & Associates, Inc. 4 www. brickinc. com

C. Focus on three interest rate series 1. Fed Funds target (FFT) is currently C. Focus on three interest rate series 1. Fed Funds target (FFT) is currently 0. 0% to 0. 25% a. An overnight or very short-term lending and borrowing rate among financial institutions b. Set by the Federal Reserve as part of its monetary policy 1. An administered rate, i. e. , it is not determined by market forces 2. FFT is used by the Fed to control the money supply, inflation and other rates 3. What influences the FFT? Inflation, unemployment rate, wage growth and other measures of economic health May 2015 © Brick & Associates, Inc. 5 www. brickinc. com

4. When FFT is changed, it is global news 5. FFT is the benchmark 4. When FFT is changed, it is global news 5. FFT is the benchmark rate that drives all other rates in the short-term sector and influences competitors’ loan & deposit rates c. The impact of FFT rate changes on Treasuries and other bonds diminishes the longer the maturity of the bonds d. FFT rising would make borrowing more expensive. Money supply decreases, increasing short rates, keeping inflation in line e. Money Market Mutual Fund (MMMF) rates are closely linked to Fed Funds—this is a competitive issue 1. National average MMMF rate today? 2. Net asset value (NAV) pegged at $1. 00 May 2015 © Brick & Associates, Inc. 6 www. brickinc. com

3. How are MMMF invested? (1 -day to 1 -year maturities typically in Treasuries, 3. How are MMMF invested? (1 -day to 1 -year maturities typically in Treasuries, CDs, commercial paper and Repos; they have short average maturities, typically 30 -50 days. ) 4. What happens to the average MMMF rate when FFT increases? 5. What does this mean for your COF? 2. Prime Rate = FFT + 3 percentage points = 3. 25% a. WSJ defines Prime Rate as the base rate on corporate loans posted by at least 7 of the 10 largest US bank immediately after change in FFT b. Affects short-term bank loans, HELOCs, VR credit cards, other indexed loans, and investments such as VR SBAs 3. Exhibit 3, 30 -YR & 15 -YR MORTGAGE LOAN RATES vs 10 -YR TREASURY RATE May 2015 © Brick & Associates, Inc. 7 www. brickinc. com

Exhibit 3 May 2015 © Brick & Associates, Inc. 8 www. brickinc. com Exhibit 3 May 2015 © Brick & Associates, Inc. 8 www. brickinc. com

4. 10 -Yr Treasury Rate a. Drives pricing in long end of bond market 4. 10 -Yr Treasury Rate a. Drives pricing in long end of bond market 1. Fixed-rate 15 - and 30 -year mortgage loan rates 2. Fixed-rate passthroughs, commercial mortgage loans and long-term CMOs (Note: ARMs are priced off the 1 -year Treasury or 1 -year LIBOR at the reset dates. These market rates are influenced by FFT) b. What influences the 10 -year Treasury rate? 1. Fed Funds have indirect impact, i. e. , timing & magnitude of changes are different from that of 10 -year Treasury—A form of basis risk, i. e. , differential movement in rates May 2015 © Brick & Associates, Inc. 9 www. brickinc. com

2. Domestic economic statistics a. Favorable statistics higher rates; weak statistics lower rates b. 2. Domestic economic statistics a. Favorable statistics higher rates; weak statistics lower rates b. Employment-related (job creation, unemployment rate, wage growth, participation rate) c. Inflation outlook or the lack thereof, i. e. , potential deflation (falling prices) 3. 10 -yr Treasury rate is very responsive to inflation and inflation expectations May 2015 © Brick & Associates, Inc. 10 www. brickinc. com

4. Historically, the 10 -year Treasury rate moves by about 50% of the major 4. Historically, the 10 -year Treasury rate moves by about 50% of the major moves in FFT, i. e. , yield curve flattens. (It is not a parallel shift. ) a. What does a “bear flattening” yield curve shift mean? b. Why do CUs have to run a +300 BP shock test in NEV and reflect all discount rates increasing 300 BPs? 5. What were QE 1, QE 2, and QE 3 about? May 2015 © Brick & Associates, Inc. 11 www. brickinc. com

6. A new wild card—foreign interest rates a. Consider the following recent yields on 6. A new wild card—foreign interest rates a. Consider the following recent yields on 10 -year sovereign bonds 1. 2. 3. 4. US 2. 20% Italy 1. 77% Canada 1. 78% Spain 1. 74% 5. 6. 7. 8. France Netherlands Germany Japan . 85%. 72%. 55%. 37% b. It gets worse—negative yields on short-term foreign bonds! c. Why would investors invest in bonds that have negative interest rates? 1. If a bond is bought with a negative yield it is possible to make money if market yields ↓ even more & price of the bond increases 2. Some investors have no choice May 2015 © Brick & Associates, Inc. 12 www. brickinc. com

E. The Question—What does this mean for rates in the US? 1. In the E. The Question—What does this mean for rates in the US? 1. In the global bond market, low or negative interest rates abroad are likely to hold down US rates since they are clearly the best relative value in the global market 2. “Safe haven” status and strong US $ augments this process i. e. , higher US bond prices and lower yields than would otherwise occur 3. The key is that this scenario is not a short-term phenomenon—when you look at the causes, it could go on for years! May 2015 © Brick & Associates, Inc. 13 www. brickinc. com

F. What is causing the foreign interest rate situation? 1. Weak European & Japanese F. What is causing the foreign interest rate situation? 1. Weak European & Japanese economies, lack of growth, insufficient consumption, stagnant wages, aging population 2. Falling prices increasing risk of deflation abroad If you have deflation and you buy a bond at a negative yield and the general price level declines, you could have a positive real rate of return 3. Why is deflation such a concern? a. Deflation is extremely difficult to fix. Negative interest rates are a result of European monetary policy and weak economies. Negative rates are a European version of US’s QE b. Deflation tends to feed on itself May 2015 © Brick & Associates, Inc. 14 www. brickinc. com

c. Makes it far more difficult for politicians to service their debt, i. e. c. Makes it far more difficult for politicians to service their debt, i. e. , they have to pay interest and repay principal in a more expensive currency (opposite of inflation’s effect) 4. European Central Bank is buying 60 B Euros/month ($65 B) in sovereign bonds (QE American style!) a. Attempting to drive rates even lower; this policy is expected to last through 2016 b. Force people to spend and not save in order to stimulate the economy c. Central bankers are trying to create inflation (to counter deflation) 5. These are not short-term problems with proven solutions 6. Exhibit 4, LONG-TERM BOND YIELDS & FINANCIAL CRISIS May 2015 © Brick & Associates, Inc. 15 www. brickinc. com

Exhibit 4 Source: Seeking Alpha 2/10/15 May 2015 © Brick & Associates, Inc. 16 Exhibit 4 Source: Seeking Alpha 2/10/15 May 2015 © Brick & Associates, Inc. 16 www. brickinc. com

G. Forecasting interest rates 1. Elements of a forecast a. Direction of rate changes G. Forecasting interest rates 1. Elements of a forecast a. Direction of rate changes b. Magnitude of any change c. Timing of the change d. Relationship to other rates 2. What can go wrong with a forecast? a. any one or more of items a-d b. the Fed doing (or saying) something unexpected (remember the “taper tantrum” in May 2013? ) c. international tension May 2015 © Brick & Associates, Inc. 17 www. brickinc. com

3. Forecasting is more common than we think a. Explicit forecast—an overt attempt to 3. Forecasting is more common than we think a. Explicit forecast—an overt attempt to forecast the direction, timing and magnitude of rate changes and positioning the balance sheet accordingly b. Implicit forecast—a passive, approach resulting in a balance sheet with the same risk as one that is deliberately structured to benefit from an explicit forecast (this can result in foregone income) c. The Fed’s forecasting track record d. The best strategy—don’t bet the house on rate changes 4. Attempts to forecast increases may actually increase risk May 2015 © Brick & Associates, Inc. 18 www. brickinc. com

H. ALM Implications 1. The Fed wants to raise rates and restore a more H. ALM Implications 1. The Fed wants to raise rates and restore a more “normal” rate structure 2. Such moves will be constrained by a. The threat of deflation in the US & Europe b. Global interest rates & economic conditions c. A strong US $ will be stronger if rates increase 3. Rate increases are likely to be gradual 4. Yield curve may flatten, i. e. , 10 -year Treasury rate may not increase commensurate with FFT 5. Manage your institution on a basis that is consistent with your IRR limits May 2015 © Brick & Associates, Inc. 19 www. brickinc. com

6. The concept of Basis Risk can help explain a Financial Institution’s pricing strategy 6. The concept of Basis Risk can help explain a Financial Institution’s pricing strategy for liability rates as external rates rise a. When FFT increases it may not be affordable to raise Regular Share Rate much but MMA & certificate rates will need to be raised to retain deposits b. Low Rate Sensitivity Factors may be applied to Regular Shares but high RSFs should be applied to MMAs & certificates in ALM analyses 7. What about the impact of rising rates on mortgage origination income—A big surprise? I. Conclusion Remaining 2015 FOMC meetings are June 16 & 17; July 28 & 29; Sept 16 & 17; Oct 27 & 28; and Dec 15 & 16 May 2015 © Brick & Associates, Inc. 20 www. brickinc. com