The Hidden Cost of DQs: Impact of Credit Spread on Your Credit Union's NEV

The Hidden Cost of Delinquencies: How Credit Spreads Impact Your Credit Union's NEV

As a credit union leader, you're keenly aware of the ebb and flow of credit risk, charge-offs, delinquencies, and interest rate risk metrics. But do you see how these pieces connect? Credit risk has a direct and measurable impact on your Net Economic Value (NEV) within your Asset and Liability Management (ALM) model through a mechanism called the credit spread.

Let's break down this crucial connection.

Unpacking Net Economic Value (NEV)

First, a quick refresher on NEV. NEV is a long-term, market-value snapshot of your credit union's net worth.

It's calculated by taking the present value of all your expected future cash inflows (primarily from loans and investments) and subtracting the present value of your expected future cash outflows (from deposits and borrowings).

Within your ALM model, different rate scenarios are applied to forecast the impact of changing interest rate environments on the value of all future asset and liability cash flows.

To arrive at this present value for your loan portfolio, your ALM model performs two key steps:

1. Projecting Cash Flows: For every loan in your portfolio, the model estimates all future principal and interest payments you expect to receive. This is done by capturing the loan portfolio at the quarter-end, applying prepayment and average life assumptions as determined by the characteristics of your loan portfolio, and amortizing those cash flows over the life of the loans.
2. Applying a Discount Rate: Once those future cash flows are projected, they're brought back to their present value using a "discount rate." This rate represents the required rate of return or the opportunity cost of capital, reflecting both the time value of money and the various risks associated with those future cash flows.

Learn more about NEV here: https://accoladeadvisory.com/articles/general/february-2021/measuring-interest-rate-risk-nev

The Credit Spread: Your Loan Portfolio's Risk Thermometer

The overall discount rate is typically a composite number, starting with a risk-free rate (like a U.S. Treasury yield of similar maturity) and adding various risk premiums, one of which is credit spread.

Credit spread is the specific component of the discount rate that compensates for the risk that a borrower might default, and you won't receive all expected payments. A higher credit spread signals a higher perceived risk of default within that loan portfolio.

The Chain Reaction: From Delinquencies to a Lower NEV

Now, let's connect the dots to recent trends. When your credit union experiences an uptick in delinquencies (loans that are past due) and charge-offs (loans deemed uncollectible), it's a direct and undeniable signal that the credit quality within your loan portfolio is deteriorating.

Here's the domino effect that this triggers within your ALM model and on your NEV:

1. Increased Delinquencies & Charge-Offs Signal Higher Risk: As your loan portfolio shows more signs of stress, your ALM model, which is designed to reflect current risk conditions, takes notice.
2. The Credit Spread Expands: The credit spread component of the discount rate is increased to reflect the heightened risk. Why? Because the market (or your model's internal logic) demands a higher return to compensate for the increased likelihood of losses from these riskier assets.
3. The Overall Discount Rate Jumps: Since the credit spread is a part of your total discount rate, an increase in the credit spread leads to a higher overall discount rate being applied to the projected cash flows of your loan portfolio.
4. NEV Takes a Hit: This is where the impact becomes tangible. It's a fundamental principle of present value calculations: the higher the discount rate, the lower the present value of future cash flows. For example, for a loan to be worth $100 five years from now, a higher discount rate means that you would have to start with a lower initial investment today to reach that $100 than if the discount rate was lower. In other words, a higher discount rate means that future money is worth less today; while a lower discount rate means that future money is worth more today.

Therefore, as the discount rate (driven by that increased credit spread) rises, the present value of your credit union's loan assets decreases. Since NEV is essentially the present value of assets minus the present value of liabilities, a decrease in the value of your assets directly leads to a lower modeled NEV for your credit union.

In essence, rising credit issues make the future cash flows from your loans less certain and riskier. Your ALM model captures this increased risk by widening the credit spread, which in turn elevates the discount rate, ultimately reducing the calculated economic value of your loan portfolio and, consequently, your credit union's overall NEV. This chain reaction underscores the value of proper interest rate analysis and a robust ALM model.

Why It Matters

Delinquencies and charge-offs don’t just affect reserves and earnings today; they cascade into your ALM results and erode long-term value. Recognizing this link is critical because it ensures your leadership team isn’t just managing credit risk and interest rate risk in silos, but seeing how they intersect to shape your credit union’s true economic strength.