Are credit unions underestimating just how quickly rates might rise?
Two analysts who believe so are urging preparation for steeper increases than many credit union portfolio managers may be prepared for, with one person calling on CUs to shock test their portfolios for a five-percentage point increase, rather than the more common three percentage points.
"I think people are underestimating this year just how fast rates are going to rise," observed Dwight Johnston, managing principal with San Dimas, Calif.-based WesCorp. Johnson's observation came during NAFCU's Volunteers Conference.
Echoing that warning was Dr. Richard S. Lamothe, president of Summerville, S.C.-based Lamothe & Associates, which specializes in asset/liability management for credit unions.
"Look at the potential that history shows us," Lamothe stated. "Every time rates have gone back up it has been rapid and large. We have done a very good job of managing the decline in interest rates. That's not to say there hasn't been pressure on earnings. But we've kept average ROA at about 1%. The question to ask yourself is has your infrastructure, investment in the future, or quality of assets suffered as a result to maintain that 1% ROA."
Lamothe said that CFOs and portfolio managers who weren't in the same position at their credit unions in 1972 or 1976 or 1986 or even 1993 simply don't have the experience of working in a rapidly rising rate environment. (Before they got too smug, Lamothe asked, how many of the volunteers were directors at financial institutions at these same points? Few hands were raised.)
It was Lamothe who recommended credit unions exceed NCUA's requirements and shock-test their portfolios by five percentage points.
WesCorp's Johnston noted that while the Fed has said it will control "measured increases" in rates, credit unions should "take no comfort in that whatsoever. They're not lying, but they don't know where rates are going over the long term, either. What is measured? Pounds? Tons? Boatloads?"
The Cost of The Cost of Funds
Lamothe pointed out that the cost of funds for credit unions in recent years has been significantly less than the cost of distributing those funds. But a movement up in rates will have ramifications across the enterprise, he stated. "In the current low interest rate environment, credit unions have been required to reduce costs and take on slightly riskier products, such as mortgages and indirect programs. It has required credit unions to become wholesalers of funds."
He noted that wholesaling in the form of indirect loans means pushing the member out at the same time the credit union needs the member to come in for other loans.
"It's required a higher reliance on fee and non-interest income," he said. "If we didn't have fee income right now, we'd be in trouble. The philosophy has become if you use it, you pay for it."
Lamothe said he believes credit unions are currently poorly positioned for a rise in interest rates. He said that living with reduced costs over the past few years has meant more stress for credit unions in the form of less training, postponement of infrastructure investments, etc., a phenomenon he summed up as, "It requires one to become a lean, mean, fighting machine, or a lean, anemic, dying machine."
One interesting statistic, he noted, is that more businesses fail during an economic recovery, than during the trough. The reason: the businesses were unprepared to deal with good times.
"Many senior managers and most junior managers have never lived through an interest rate cycle, especially a rapid rise in rates," he said. "Many CEOs are about to retire. Their 'rate cycle' experience will be lost. Imagine someone in your mortgage department who has not been through a rate cycle, and rates are starting to go up and they have to make a decision about what to do."
He also noted that credit unions are paying significant attention to fees and non-interest income, and less attention to interest rate risk. "What happens is that as interest income increases, (competitors) cut their fees to get more of members' business and earn the interest income."
Most credit unions, noted Lamothe, have too much liquidity (a show of hands in the room showed just two with no liquidity). As the stock market rises, "How long before funds leave to chase these returns?" he asked. "Even with the recent market drop, how long will people stay with your quarter-point returns? How much will you be able to allow to leave before you need to 'bid' to keep it?"
A Mortality Outflow
One solution: Lamothe urged credit unions to create what he called a "Mortality Outflow." In short, it's a death predictor for the membership base. "If you look at your balance sheet, you'll find the old 80/20 rule applies, and often it's the 90/10 rule. A lot of them are older members. What happens when they die? The kids get it, and what are they going to do with it? A few may invest it, but most are going to spend it or pay off loans they have with you. None of it is too favorable to you."
So how does a credit union keep deposits? Lamothe called for a "gaming approach." The first step is to analyze what the credit union needs. "If you have excess, go below market by 10 to 15 basis points," he recommended. "You're not helping the member by keeping it in there. If this gets you to where you need, then go to market (on pricing). If not enough, bid above the market next week. If still too much, bid even lower. This has no overall effect on the member."
Lamothe reviewed four market scenarios:
Rates Fall. "Not a lot of room for rates to fall."
Rates Remain The Same: "This means a continued stress on earnings and a continued emphasis on higher 'risk' assets, a continued postponement of infrastructure, and a continued expansion of wholesale position."
Rates Rise Slowly: "I would say to you seriously, ask yourself, 'Do we need to be this big, asset wise?' Here you slowly work down liquidity, and slowly sell off higher interest rate-sensitive assets and replace with new assets of like kind. You can ride the yield curve up by converting assets to cash. This requires the CU to structure an asset ladder."
Lamothe recommended developing that ladder from cash flow reports, and include potential sales. "Use pricing and promotion to fill in the ladder of assets. Review the ladder constantly as rates move up."
Rates Rise Quickly: "This is our worst-case scenario. You need to know what you can afford to lose in deposits before it starts being a problem. You must be prepared to reprice interest-rate-sensitive assets quickly-hesitation is deadly. Perform your shock tests-the higher the impact on capital, the faster the reaction must be."
Lamothe cautioned that credit unions that have never sold a mortgage better recognize it will be six months before that sale takes place. And that will be occurring at a time when everyone else is selling, he added.
How should a credit union prepare for a rapid rise in rates? Lamothe called on CUs to create a "red team" that constantly tests the system. Its job is to "tear it to pieces to ensure no flaws." Hold a war game weekend using your team, a simulation and a fast clock. Observe how the management team responds to rate increases and the behaviors that result in losses. Watch the group psychology in action. And strengthen the team with training or replacement."
