NCUA: "The Empirical's New Clothes"... Derivatives: Part III - "Just Plain Vanilla"

"Can You Mitigate This Risk ?"

Here's the key idea underlying the NCUA Board's proposal to permit large credit unions to trade in derivatives (NCUA Board Action Bulletin - 5/13/2013):

"Credit unions applying for the authority must demonstrate how derivatives will be part of an overall interest-rate risk mitigation plan."

So, let's parse that a bit; the sentence has three basic assumptions:

1) Too much interest rate risk (IRR) can be bad for a credit union.
2) Credit unions with too much IRR should try to reduce ("to mitigate") excessive interest rate risk.
3) Derivatives are the answer... at least for some credit unions; but only if they are large, and only if they are.... and are... and also are... and, and, and...

A severe problem arises with the third general assumption that derivatives are a safe, empirical ("'ya just can't miss"),  "answer-to-all-prayers" solution to the issue of CU interest rate risk.  It just ain't true !!

A Capital Markets Group?

But, the worst problem is that "The Deciders" at NCUA have evidently been sprinkled with analytical pixie dust and agreed to drink the derivatives Kool-Aid - as we say in the South - "Whole Hawg"! And,"The Deciders" are reassuring in their assertion that these are simple, no-risk derivative transactions.

But let's look at the actual record to see how deep NCUA's self-assurance really is... you'll see some real-world, bureaucratic "hedging", kind of an "accountability cap", a "responsibility swap"... 

The following are all from NCUA's advance notice of proposed rule making (ANPR) published in the Federal Register on 2/3/2013:

1) [NCUA would have 3 requirements for derivatives authority - sound CU, need to mitigate IRR, experienced staff]... "The Board considers the requirements to be appropriate given the complexity of, and inherent risk in, derivatives transactions."
2) "... given the complexity of even the most straightforward derivatives instruments, the Board believes that an FCU should independently engage in derivatives transactions only if  FCU management and staff can demonstrate adequate derivatives experience."
3) "The Board believes that what constitutes "adequate derivatives experience" will vary depending on the nature and complexity of an FCU's balance sheet."
4) "There are numerous risks inherent in any derivatives activity, including market risk and counterparty risk."
5)"The Board is considering whether to establish exposure limits as a way to guard against such volatility in the value of a derivatives portfolio."
6) "Another significant risk in derivatives activity is counterparty risk, also known as "default risk" and "credit risk"."
7) ".. an FCU should , on an ongoing basis, monitor counterparties and their creditworthiness, as well as the credit risk mitigation features inherent in the derivatives transaction (e.g., margin requirements, daily valuations of collateral, and performance of third parties.)"

To quote NCUA Board Chair Debbie Matz :

 (CUTIMES 5/17/2013)

"The rule would only permit derivative swaps and caps, which are "plain vanilla"." 

A Free Lunch !!
Really?

(If this is "plain vanilla", don't you need to start asking some questions about whether NCUA is "tutti fruitti"?)