Interest Rate "Swaps" Are a New, Major Undertaking for Yankee Farm Credit

by Dean W. Moreau, president and CEO, Yankee Farm Credit

Yankee completed another successful year with 2002 net income considerably above budget. We had extraordinary income from a tax settlement with the State of Vermont, the sale of most of our acquired property and a reduction in nonaccrual loan volume. In addition, last year was the first full year of Yankee’s interest rate swap program, which added $621,958 to our bottom line. Our 2002 annual report will contain significant detail about interest rate swaps in the footnotes to our financial statements. Since this is a major new undertaking for us, I also wanted to take this opportunity to do a little more explaining.

"Over time, interest rate swaps will stabilize association net income, and, most likely, improve it."

Much of Yankee’s ongoing success is the result of business practices that are just common sense:

1. We work with excellent, loyal customers.
2. Employees are talented and productive. We have 35 employees today (the same number as 1995), while loan volume is up almost 30 percent.
3. Our building investments are functional, yet modest in cost.
4. We have top quality partners in FPI and CoBank.

One previously unmanageable factor that has a huge impact on our financial results is the general level of interest rates. All other things being equal, we are more profitable when interest rates are high, rather than low, because we have a substantial amount of accumulated earnings invested in member loans (about $45 million at December 31, 2002). For every 1 percent drop in interest rates, $450,000 evaporates from association net income.

I know nobody is shedding any tears over this, because your farm “Over time, interest rate swaps will stabilize association net income, and, most likely, improve it.’‘ operations are reverse interest rate sensitive. The lower the rates, the better you like it — expenses drop and net income grows.

This is a classic cooperative dilemma of “how to balance the needs of the membership with the association.” How, in a favorable low interest rate environment for members, do we make enough profit to meet our capital, loss reserve, patronage needs and so forth? Should we pray for higher rates? (Probably not a career enhancing move!) Instead, we bought interest rate “swaps.”

What is a “swap”?

The $40 million of swaps that we purchased are contractual agreements. Yankee pays a second, or “counter” party, the interest rate for 90-day money, while the second party pays us the rate for three-year money.

As rates drop, we pay less than is paid to us. As rates rise, we net less money, or, in some instances, even pay more than is paid to us. The key point is that, through a contract, we create the opposite result of what is occurring in the “real world.”

Basically, we’re creating a hedge. If rates go down, we make less money on the equity that we invested in your loans, and the interest rate swaps become more profitable. If rates go up, we realize more income on our loanable funds, but make less, or even lose money, on the swaps.

Over time, interest rate swaps will stabilize association net income, and, most likely, improve it.

This is a tough, but very important subject. Be sure to corner me at our upcoming annual meeting, or give me a call, if you want a further explanation.

This letter appeared in the spring 2003 issue of Financial Partner (F.P.) magazine, Yankee Farm Credit's customer publication. Click here if you would like to start receiving F.P. magazine in the mail.

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