Credit Union 'A' Vs. 'B' Vs. 'C'

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Your credit union starts each morning with a pile of cash. How much larger is that pile of cash at the end of the day?

That question is determined in large part by an individual CU's investment strategy, but the answer can't be provided until the credit union asks itself several critical questions first, according to two experts.

Equally important, suggested Ron Araujo, managing principal with WesCorp Investment Sources, is how often the credit union asks itself those key questions. Araujo was joined in remarks before WesCorp's CU Outlook Conference here by Irving Yu, portfolio manager, who walked the audience through sample case studies to demonstrate what different strategies can do.

"You start with a pile of cash, and you end with a bigger pile of cash," he told the audience. "Many of the credit unions we see have a lot of liquidity."

When determining what types of investments to make, Araujo noted the options available to portfolio managers, ranging from floating rate vehicles to fixed-rate coupons, callables, mortgage-backed securities and more. The first two options carry low to moderate liquidity and interest rate risk, while the latter two have higher danger in those categories, as well as the possibility of prepayment or extension risk.

"Make the transaction consistent with what you want to do with your balance sheet," he advised. "Have a very active, integrated dialogue regarding investment activity and deposit activity at the credit union, because, at the end of the day, there is only one balance sheet."

It's what occurs during the day, of course, that determines that balance sheet. When it comes to information sources, credit unions have plenty of options-including security analyses from Bloomberg, detailed portfolio examinations by BondEdge, market intelligence from broker/dealers and other external investment advisory services, etc. Araujo reminded that credit unions must first consider the net economic value (NEV) impact of their investment portfolio on the balance sheet, policy considerations and possible regulatory impact. Moreover, every credit union must make a hard call on determining whether it has sufficient investment expertise.

Making sure the investment strategy is consistent with overall strategy is something that is "a little overlooked" in the CU movement, Araujo said. "Credit unions focus on member service, which is good, but they too often opt for very low risk (in investments). When you are talking about alignment, ask: 'Is my portfolio optimally constructed to serve my members?' Credit unions have a lot of options," he said.

Yu presented three case studies, representing fictional $500-million credit unions "A," "B" and "C." Each has investment portfolios of $200 million, or 40% of assets, with the following characteristics and goals:

* "Credit Union A" has low risk, ROA below peer average and high liquidity. Its goal is to improve financial performance to bring about greater member service.

* "Credit Union B" is in the moderate risk category, with ROA slightly below peer average and moderate liquidity. It would like to increase portfolio yield if risks can be controlled.

* "Credit Union C" carries high interest rate risk of -30% to -50%, and its ROA is above peer average. Its goal is to rebalance the risk with no effect on members and no change in asset size.

The balance sheet for Credit Union A showed 70% of its investments in fixed-rate bullets and 30% in cash overnight funds. Yu said its portfolio is "pretty good sized" in terms of percentage of assets, but it carries very little risk due to no investments in callables.

"Quite simply, the goal is to make more money," he said. "But, if the credit union takes more risk, how much return should it get? If it takes more risk, it should get more return."

The "what if" scenario called for CU A's investments to shift to 50% in fixed-rate bullets, 15% in callables and the remaining 35% in mortgage-related securities. According to WesCorp's analysis, this should improve ROA by 10 basis points.

Credit Union B is not underperforming as much as CU A because it is taking moderate risk, Yu said. Credit Union B's allocations are 30% in fixed-rate bullets, 25% each in callables and mortgage-related, and 20% in cash overnight funds. It is looking to maintain a balanced portfolio while allocating more funds to option-embedded assets.

"The key for Credit Union B is not all of its money is in cash, there is a mixture including some callables," Yu assessed.

CU B's "what if" scenario moved 40% to fixed-rate bullets, 40% to callables and 10% each to floating-rate bullets and mortgage-related investments. WesCorp's projections show a five basis point improvement in return.

Credit Union C's "before" allocation was 30% in callables, 30% in mortgage-related, 28% in fixed-rate bullets and 12% in cash overnight funds. Yu said one way to rebalance the portfolio would be to allow items to run off-"But that takes time."

As a second option, the "what if" scenario calls for reinvestment into short-term instruments. From the overall $200-million investment portfolio, CU C took a total of $50 million-$30 million from sale of callables and mortgage-related securities and $20 million cash-and put the money into 50% fixed-rate bullets and 50% floating-rate bullets.

As a result, interest-rate risk was reduced, and with only a five basis point reduction in ROA.

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