The Past as Prologue & Interest Rate Cycles

Tomorrow the Federal Reserve will announce an increase in its overnight Fed Funds target rate by at least 50 basis points.   This will be the second in a series of raises  to “normalize” the yield curve.  The goal is to curb inflation by increasing rates so that the “real” cost of borrowing exceeds the rate of inflation.

Bond prices have anticipated some of this increase.  Headlines reported the “rout” in bonds as market values fell and yields rose in the first quarter.  Yesterday’s lead story in the WSJ was “Bond Yield Rise Steepest since ’09.”

Interest rate cycle increases are not new.  In 1994 Fed Chairman Greenspan raised overnight rates from 3% to 6% in six 50 basis point jumps to cool an Internet driven economy.

Even though interest rate cycles are an ever-present factor in a market economy, for some leaders of credit unions this will be their first time navigating a cycle.  Learning from past events, can help with this process.

“Never say Never”

In late 1978, the US economy was entering a period of increasing inflation with short term rates rising close to 10%.   This increase was leading to some disintermediation to the newly created money market mutual funds.  But another credit union concern was the 12% usury ceiling on loan rates which was incorporated in most enabling statues.

In our discussions at the Illinois Department of Financial Institutions, I told Ed Callahan that 12% was like a law of nature.  Rates would never get above that level as we had fifty years of precedent to prove my point.  Ed’s response was “never say never.”

Short term rates went above 14% in December of 1979, by which time the Illinois Credit Union Act had been re-codified to remove the 12% ceiling. “Never” had taken place.

A Visit to NCUA by the ICU Funds

Short term and long-term rates continued to spike into 1980.  Chairman Volcker was committed to stopping the double-digit inflation resulting in short term rates of nearly 20% in June of 1981.

In early 1982, I had a visit from two senior executives from Madison to discuss the circumstances this had created for the two ICU investment  funds managed by CUNA Mutual.  Examination and supervision policy fell under the Office of Programs which I held.

I can’t recall all the details. The two funds had investments from several thousand credit unions, many of whom were small.  The market value of the two funds had declined dramatically.   The question they asked, would NCUA force the credit unions take a loss by writing down their investments to the current  market value?

They had taken steps to minimize withdrawals and believed that the decline would prove temporary.

I discussed the request with Ed who was now chairman of NCUA and Bucky the General Counsel.   There were many issues confronting the agency and credit unions.  A number of large credit unions had invested in GNMA 8’s, that were far underwater.  Their solvency was in questions and 208 NCUSIF guarantees were keeping some of them operating.  Shares were leaving credit unions as members withdrew funds for the double-digit yields offered by mutual funds.

Federal credit union share rates had not been deregulated as we had been able to do for Illinois credit unions. Jim Williams President of CUNA told Ed before his February 1982 speech to CUNA’s Governmental Affairs Conference that credit unions had only one issue on their minds, “survival.”

As we looked at the situation I can remember Ed’s comment in response to whether NCUA would require a write down of the ICU investments.  His words: “Leave it alone.”  Credit unions and the agency had more than enough concerns without adding to the moment.  Interest rates will change and today’s circumstances will not be tomorrow’s.

The ICU funds did recover their value.  By then the corporate credit unions had evolved into an option where they could meet the investment needs of credit unions. The ICU funds were eventually closed later in the decade.

Bernanke’s Taper Tantrum


In 2013 Fed Chairman Ben Bernanke announced that the central bank would begin pulling back its stimulus efforts by reducing bond purchases.  As summarized in a CNBC article in June:

Mr. Bernanke continued the theme into his press conference, stating again that if economic conditions continue to improve, the Fed will begin tapering its bond purchases at the end of the year.

He did put a little more flesh on the bond tapering plan: “may gradually reduce purchases later this year…will continue to reduce purchases through next year…may end in the middle of next year…will end purchases when unemployment is near seven percent.”

But time and again he emphasized the pace was data dependent: if conditions improve faster than expected, reduction in bond purchases can accelerate. If conditions worsen, purchases could even increase.

Why is the bond market over-reacting? Because they believe diminished tapering means higher yields. I agree, but to what extent?

NCUA Reacts

The taper tantrum carried over into the broader market as yields rose, bond prices fell.  The NCUA took up the issue. It imposed its internal interest rate shock and NEV tests on credit unions believing that this event presaged an ever-increasing interest rate cycle.

NCUA examiners created DOR’s on credit unions from by their models.  They required the sale of longer-term fixed rate loans and investments at a loss and borrowings from the FHLB, when the cash was unneeded, in order to comply with the model’s forecasts.

Tomorrow I will share one credit union’s story of how these modeling-induced DOR’s resulted in a loss of over $10 million.   The model’s assumptions were wrong.

This precedent is important because, unlike 2013 and 2014, inflation is here and the Fed is committed to raising rates until the trend is reversed.

The issue is whether NCUA will allow credit unions to manage their transitions through this cycle using their experience and operational options, or impose their modeling judgments on them?







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