Analysis Shows Asset Size Big Driver In Portfolio Performance

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In looking to identify the relationship between balance sheet riskiness versus investment portfolio riskiness, our recent analysis of 5300 data shows an interesting factor in investment performance. Rather than the capital ratio, or the amount of real estate lending, or even the amount of core deposits being the determining factor in investment performance, it's the size of the credit union that plays a critical part.

In short, the larger the credit union, the greater the willingness to take risk in the investment portfolio, and the higher the investment yield. At first glance, this would appear intuitive. Larger credit unions tend to have proportionately larger staffs, tend to buy more securities (proportionately), and so on. Larger credit unions, however, also tend to have lower capital ratios, lower core deposits (to assets), and higher first real estate lending (to assets)-all of which are indicators of a lower risk appetite. In other words, smaller credit unions, armed with more capital, more liquidity, and more core deposits, choose to play it safe in their investment portfolios.

Risk Analysis

There are some significant differences between different sized credit unions, especially in the areas that generally determine IRR levels, i.e., first real estate lending, core deposits, and capital levels.

* First Real Estate (1RE) Lending-Because most first real estate lending is fixed rate, its presence on the balance sheet usually increases IRR. Large credit unions hold 23% of their assets in 1RE, while the smallest credit unions in our analysis commit just 14% of their assets to 1RE. By its very nature, 1RE is also a high-yielding asset, and this difference could be a contributing factor to larger credit unions having higher ROAs (1.00% versus 0.68%).

* Core Deposits-Longer average life assumptions for this liability indicate that a large concentration of core deposits generally reduces IRR. Small credit unions fund 61% of their total assets with core deposits, while large credit unions fund with just 55% core deposits. As is the case with 1RE, larger credit unions should have less of a risk appetite in their investment portfolio for a given comparable overall IRR target vis-?-vis smaller credit unions.

In combination, the above mentioned two pieces of data, are even more striking. For small credit unions, the 1RE to core deposit ratio is just 25%. Contrast this with a ratio of more than 45% for large credit unions, and a picture begins to develop: without looking at the investment portfolio, small credit unions are much less risky than their larger counterparts.

* Capital Ratio- Smaller credit unions enjoy a capital to asset advantage over their larger counterparts (12.43% versus 11.09%). All things being equal, this should increase the risk appetite for small credit unions and, ultimately, their investment and lending yields.

Portfolio Implications

All of the key risk data point to just one conclusion: small credit unions have the ability to take on much greater risk (and reward) in their investment portfolio than large credit unions. And yet, the exact opposite is actually occurring. Small credit unions are taking much less investment risk than large credit unions, which is exaggerating the yield differences in the various groups. In other words, large credit unions, that already have more non-investment risk and return than small credit unions, continue the pattern of increased risk and return in the investment portfolio, thus furthering their yield advantage over small credit unions.

All of the key risk indicators point to smaller credit unions having the advantage when it comes to investment portfolio risk and return levels. Now, there could be some valid reasons for small credit unions carrying much less interest rate risk, (e.g., lack of exposure to complex products, lack of adequate support systems), but this question goes beyond the scope of this analysis. Our main point here is that balance sheet IRR levels seem to be associated with the total assets of the credit union. These differences are, in part, due to a lack of risk taking in the investment portfolio by smaller credit unions, which reduces the return opportunities for this group.

Two of the primary areas where credit unions can invest are mortgage-backed securities and longer-term investments. In most cases, these investments provide higher relative yields, albeit with an increased level of risk. As the data suggest, in spite of the presence of greater relative IRR on the balance sheet, larger credit unions are more likely to invest in both of these areas. While the difference appears to be small in long-term investing, the difference in IRR indicates that small credit unions should have much more risk in their investment portfolio.

With respect to higher-yielding mortgage-backed securities, larger credit unions are nearly three times as likely to invest in this area (75% to 27%). Hence, one of the relatively safe (in the sense of no credit risk and controllable IRR) ways that small credit unions can close the yield gap (by using more of their already greater risk capacity in the investment portfolio) is going largely ignored.

What Smaller CUs Can Do

While the size of a credit union does afford it the opportunity to explore investment alternatives that smaller credit unions could not, smaller credit unions do not appear to be fully utilizing the risk capacity advantage that they enjoy over larger credit unions. This has contributed to the lower ROAs that smaller credit unions have incurred recently.

In the process of developing a superior comprehensive investment and balance sheet strategy, by including more investment products, smaller credit unions (and some large ones) can begin to level the playing field with their larger counterparts.

Ron Araujo is Managing Principal, WesCorp Investment Services, San Dimas, Calif.

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