Investments mix and balance are held constant throughout the 5 year analysis period for both shock scenarios.

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1 Assumptions and Operations to Accompany CostPro ALM Reports The TCT ALM Model provides two Base Case reports that reflect the impact of two distinct shock simulations. The first is the Stair-Stepped Shock which has occurred repeatedly in the economy showing the sustained impact of periodic increases in interest rates as they occur. The second is an immediate parallel shock similar to the one that occurred in 1981 leading to the demise of the Savings & Loan industry due to the impact the 300BP increase in interest rate had on the S&L industry and changes to the rates they had to pay. The model is run to simulate the effects of Interest Rate Risk (IRR) effectively illustrated through changes in interest rates as the impact the present balance sheet. General Balance Sheet Assumptions The purpose of this tool is to measure the level of Interest Rate Risk in the current balance sheet. In order to measure the existing risk, the current configuration of the balance sheet is held constant for both Base Case scenarios (Base Case Immediate Shock and Base Case Stepped Shock). Loan balance and mix are held constant throughout the 5 year analysis period for both shock scenarios. Investments mix and balance are held constant throughout the 5 year analysis period for both shock scenarios. Deposit mix and balances are held constant throughout the 5 year analysis period for both shock scenarios. If the credit union is experiencing a trend of either contraction or expansion of the Weighted Average Maturity (WAM) the projection of that trend can be addressed in the Simulations. In the TCT ALM method, all assets and liabilities on the balance sheet are held constant so as to measure the actual IRR in the current balance sheet. If any of the assets or liabilities were changed, we would not be measuring the IRR in this balance sheet, but rather in one with varying inputs. These changes threaten the validity of the output and cloud the results. For example, a run off of deposits would also reduce assets and artificially increase the resulting equity ratio. Hence the threat to the validity of the output. Modeling Changes to the Balance Sheet Assumptions TCT ALM Model offers credit unions the ability to create additional simulations to model proposed changes to the balance sheet. More detail on the application and use of these simulations is shown at the end of these assumptions. Amortization of Loans Loans are grouped into pools with similar amortization patterns for application of the amortization calculation.

2 The WAM of loans in each pool is applied to calculate the rate at which loan balances will amortize, returning principal balances to the credit union. A unique amortization rate is calculated for each pool. For fixed rate loans the amount of principal amortized back to the credit union is assumed to be returned into the loan pool at the shocked interest rate. For variable rate loan the adjustment period is applied to determine the re-pricing schedule of that pool. Amortization percentages and maturity schedules are presented on input schedule of each report. Maturity/Amortization of Investments Investments are re-priced based on the maturity of each instrument. All investment are assumed to be held to maturity. Re-pricing of investments is based on cash-flow and maturity. For fixed rate investments the amount of principal amortized back to the credit union is assumed to be returned into the investment pool at the shocked interest rate. For variable rate investments, such as step up CDs, the adjustment period is applied to determine the re-pricing schedule of that investment pool. Prepayment Speeds Pre-payments speeds for both loans and investments are assumed to slow in rising rate environments associated with shocks and accelerate in declining rate environments. A statistical algorithm is applied to the base cash flow to simulate the reduction in prepayments for both loans and investments. The base maturity schedules are presented on the input schedule of each report. Maturity/ Balances of Deposits Deposits are partitioned into the balances by type with the month end balance shown on the balance sheet. The total balance and mix of deposits are held constant in both base case reports. Loans and Investments The TCT ALM Model uses the WAM of loans to create an anticipated amortization schedule for the principle balances of loans. Loans with common amortization patterns, as determined by WAM are input into the model. Using the WAM a straight-line calculation of amortization is derived. The amount of amortization is then applied to each quarter and year as a baseline for repricing. A statically derived algorithm is then applied to the amortization schedule in shocks to allow for anticipated changes in prepayment speed resulting from shocks of increasing magnitudes. This adjustment allows credit union managers to choose different shocks in simulations to test the outer limits of IRR on their balance sheets.

3 Fixed interest rate loans are re-priced to the market level as they mature or are amortized. The weighted average payoff rate for each type of loan is employed to simulate the maturity performance of each segment of the loan portfolio. The new rate on maturing loans is then blended with the existing rate to calculate a weighted average interest rate for the loan portfolio. Portions of loans that amortize at greater than 5 years maintain their existing rate throughout the simulation. Investments held by the credit union are re-priced to the market level as they mature. The actual maturity date for investments is employed to simulate the maturity performance of each segment of the investment portfolio. The new rate on maturing investments is blended with the existing portfolio rate to calculate a weighted average interest rate for the investment portfolio. Investments with maturities greater than 5 years maintain their existing rate throughout the simulation. Deposits Each share type will exhibit a unique pattern of repricing in response to interest rate shocks associated with the Immediate Shock or the Stepped Shock. Stepped Shock In the Stepped shock non-maturity deposits experience an increase spread over a period up to 12 months. The amount of the shock and the period of time is calculated using an econometric model employing the price elasticity of demand. In the Stepped shock maturity deposits experience an increase at maturity. The amount of the shock and the period of time is calculated using an econometric model employing the price elasticity of demand. The TCT ALM Model employs an application of the Price Elasticity of Demand in the Stepped Shock, to determine the percent of shock that must be applied to each deposit type in order to maintain the current balance of deposits. The Price Elasticity measure employs a regression model to predict runoff at distinct interest rate increases. This algorithm informs the model on the magnitude of cost of funds increases that are required to continue to fund loans and investments to maturity, based on the current balance sheet configuration. Down-shocks on deposits are limited by the spread between current rates and a zero interest rate. In other words, if the rate currently offered on a share type is 0.05% then the maximum reduction in interest rate is the current rate or 0.05%. This same restriction applies to all deposit types, both maturity and non-maturity. This means that the effect of a down-shock with rates below the shock amount will result in a compression of Net Interest Income.

4 Immediate Shock In the Immediate shock non-maturity deposits experience an increase equal to 100% of the shock within 3 months in order to emulate the 1981 shock associated with the Saving & Loan crisis, even though this event is unlikely. In the Stepped shock maturity deposits experience an increase at maturity. The amount of the shock and the period of time is calculated using an econometric model employing the price elasticity of demand. The TCT ALM Model employs an application of the Price Elasticity of Demand in the Stepped Shock, to determine the percent of shock that must be applied to each deposit type in order to maintain the current balance of deposits. The Price Elasticity measure employs a regression model to predict runoff at distinct interest rate increases. This algorithm informs the model on the magnitude of cost of funds increases that are required to continue to fund loans and investments to maturity, based on the current balance sheet configuration. Down-shocks on deposits are limited by the spread between current rates and a zero interest rate. In other words, if the rate currently offered on a share type is 0.05% then the maximum reduction in interest rate is the current rate or 0.05%. This same restriction applies to all deposit types, both maturity and non-maturity. This means that the effect of a down-shock with rates below the shock amount will result in a compression of Net Interest Income. Income/Expense Interest rates and balances from the end of quarter, or the last month of the study period, are used to calculate the base level of interest income and interest expense for each of the five shock scenarios. Operating expenses for the previous month are annualized and used as the base period for comparison each of the five shock scenarios. Provision for loan loss from the previous month are annualized and used as the base comparison each of the five shock scenarios. Interest expense is subtracted from interest income for the base year to calculate the base level of net interest income in that year. Interest expense is subtracted from interest income for each year of the study is used to calculate the adjusted net income and identify the total effect of the interest rate shock. Other income and operating expenses (adjusted as mentioned above) are then added to the calculation of operating income for each period. Operating income from each year is subtracted from operating income for the base period to identify the dollar amount of change resulting from the shock. The dollar amount of change is divided by the base income to determine the percent of income lost or gained as a result of the shock.

5 If the difference between the two years is negative (a loss) the amount of loss, (not the total variance) is subtracted from current equity to identify the resulting amount of equity. The new equity balance is then divided by assets to determine the equity ratio resulting from the shock. Simulations The TCT ALM Model provides for multiple, additional simulations where management may vary the inputs and examine the impact of those changes on IRR, equity and income. For example once base IRR is established, simulations may be generated that includes the following modifications: Operating expenses for the previous month are annualized and used as the base period for comparison each of the five shock scenarios. Increasing loans Increasing deposits (with specific types or generally applied) Decreasing deposits (with specific types or generally applied) Changing mix of deposits Changing mix of loans By using the additional Simulations to examine changes to the balance sheet, the report maintains the validity of the original balance sheet IRR measure and may be used to compare the impacts of designated balance sheet adjustments. Simulations provide an easily applied solution to comply with NCUA regulations regarding IRR measurement and monitoring.

6 Supplement to Assumptions Distinct Shock Applications The table below shows a history of the benchmark US interest rate from 1974 through 2013 uses a surrogate for overall interest rate movement in the US economy. It can be noted for the table that rates have been volatile over most of that 39 year period. From this overview, one can see that regulatory concern regarding IRR appears well founded. Indeed, shocks of all types and directions are displayed. Because of the very fact that different shocks are shown it is important to discuss two distinct types and their impact on the measurement of IRR. First a quick review of the table s output. The period from 1974 to 1976 was characterized by unstable economic conditions principally influenced by OPEC and the oil embargo. During this period President Nixon experimented with price controls to combat inflation resulting from the crisis. From 1976 through 1980 inflation was a serious problem within the economy. Interest rates were out of control and President Carter returned to price controls and austerity in attempt to stabilize the economy. The period from 1980 through 1988 included years of adjustment as President Reagan initiated deregulation in multiple industries, including the financial industry. These actions led to more stable and prosperous years from 1988 through 2004 with rates decreasing substantially from 2000 through Then in 2004 rates began a steady climb as Fed Chairman Greenspan tightened monetary policy in an effort to cool down the economy. This led to a sustained multi-year pattern of increasing rates. With these facts in place, we examine two principle types of shocks that have exerted influenced in the economy. The two types are: 1. Sustained/Stepped Shock 2. Immediate Shock

7 To cover both possibilities, CostPro ALM provides reports addressing both types of shocks. The Sustained/Stepped shock is shown in a report called Base Case Stepped Shock. The immediate shock is shown in a report called Base Case Immediate Shock. Base Case Immediate Shock is presented for reference and review, however, since the most likely shock scenario is the Sustained/Stepped shock, Base Case Stepped Shock is employed for policy and management of the balance sheet. Providing both reports gives credit union officials a comprehensive, broad-based view of interest rate risk and its impact on the earnings and equity. Sustained/Stepped shock The typical type of Shock is the Sustained or Stepped Shock. The history of interest rates in the US provides multiple examples of this type of shock. The example in the table below is the most recent example. From the mid-1990s the government had been intervening heavily in the housing market with the goal of expanding home ownership. Credit was easily obtained with low rates, and loans such as stated income and negative amortization were available, making home purchases cheap and easy for almost all Americans. Cheap and easy credit led to high appreciation of values in the housing market. The housing boom also accelerated the demand for consumer credit and the rapid appreciation of home values also resulted in expanded consumer deposits. The combination of these two effects resulted in inflationary pressures and increased cost of funds for credit unions. With inflation increasing the Fed initiated an ongoing response to slow its effect. Under the direction of Chairman Greenspan the Fed began increasing rates. These increases were done in multiple adjustments to ratchet down demand and cool inflation. The stepped approach was intended to control inflation while taking care not to kill the economy. This scenario seems much more consistent with the current status of the economy. And is a much more probable scenario for examining IRR in credit unions today.

8 Immediate Shock Two examples of an immediate, or sometimes called Overnight Shock, are displayed below. This type occurred in 1980 and The 1981 occurrence was related to the Savings & Loan crisis that led to their collapse. To understand this type of shock we need to a brief review of economic policy and history. In 1933 attempting to resuscitate the financial industry Congress implemented Regulation Q as part of Section 11 of the Banking Act of This regulation included a number of stipulations directly affecting credit unions. Among those stipulations in Reg. Q: Assigned deposit types to institutions (savings only for credit unions) Set Maximum rates on deposits Prohibited interest on checking One of the primary objectives of Reg. Q was to promote mortgage lending by assuring ongoing sources of dependable, low cost funds. The ceiling on deposit rates created a situation of minimal IRR in which S&Ls could comfortably extend maturities of 20 years and then 30 years on mortgages. This condition remained stable for almost 50 years. As mentioned before the period from was characterized by high inflation, instability in the economy and interest rate tension in the financial markets. The prime rate rose to over 16% with mortgage rates starting at 18% and consumer loans starting at 21%. In spite of these high rates the interest ceiling imposed by Reg. Q stayed in place. In the midst of this tension between low deposit rates and high loan rates, two distinct events occurred both of which would directly affect the resulting interest rate shock.

9 First, Merrill Lynch, seeking to capitalize on the Reg. Q ceilings, introduced a new Overnight Investment Account. Called Money Market account which offered interest rates well above the Req. Q controlled rates with overnight availability of funds. The new account was a direct competitor to regular savings accounts which were the primary source of funds for all financial institutions but especially Credit Unions and Savings & Loans. The difference between the savings rates and Money Market rates rose to 3% over this period and resulted in what was called disintermediation as money moved from the traditional financial institutions into Money Market accounts. The second event was the initiative toward deregulation which began in 1980 when President Carter signed the Financial Deregulation Act. The goal appeared to be to create a more market driven interest rate environment. Phased in over time, it resulted in the elimination of Req. Q rate ceilings in With the elimination of the ceilings, savings rates at banks, Credit Unions and Saving & Loans increased immediately to match Money Market rates, hence the immediate shock The results proved disastrous for S&Ls. The increased interest rates drove the cost of funds above the yield on loans which created an unsustainable negative margin. The key was the long-term nature of earning assets which allowed for minimal amortization of principal balances and extreme IRR. The outcome of this immediate shock is well referenced in the literature and provides a warning to lenders to avoid excessive exposure to long-term maturities. However in looking at historical events, which of the factors that led to the 1981 immediate shock are present in our current economic condition? Do we have regulated interest rates? No, we do not. Are we currently experiencing high inflation? No, we are not. Do we have limited access to multiple types of deposits such as checking and CDs? No, we can offer them all. Since the answer to each questions is no, then what is the likelihood that we will experience an Immediate Shock under the current economic conditions? The answer is much less than probable. If it is unlikely, then why would we use an immediate shock as our primary analysis of IRR?