Although interest rates appear to be stabilizing, two WesCorp representatives say credit unions have many issues to consider when pricing loans and deposits, and that there remain a number of strategies for improving net income.
Perhaps the most important factor in price setting, according to Jeff Hamilton, VP-portfolio management, and Dietmar Huesch, VP-treasury and funding, is each CU's marketplace.
"Be aware of where the market is in pricing," Huesch told attendees of WesCorp's Credit Union Outlook conference here. He noted the rise of Internet banks, such as ING Direct and HSBC Direct, and said: "There is competition out there. It used to be local competition; now it is national and international."
According to Hamilton, there are two approaches for pricing loans: liability-based and asset-based. He noted the liability-based pricing begins with cost of funds, then adds a spread for overhead and servicing for a "hurdle" rate. After adding 1% for required ROA, the loan can vary widely in price, depending on the borrower's credit.
The default rate for borrowers in the "prime" category-roughly 700 credit score or above-is just 1.2%, according to an NCUA Risk Alert. But sub-prime borrowers (approximately 620 or below) have an average default rate of 24.72%. In between, the "mid-prime" borrowers have a 7.06% default rate. "It is difficult to define where mid-prime ends and sub-prime begins," said Hamilton. "Those numbers are kind of fuzzy."
After accounting for the cost of defaults and recovery, Hamilton gave an example of three people getting widely different prices for the same loan under today's rates: "A" credit, 6.38%, "B" credit, 9.78%, and "C" or "D" credit, 23.2%.
The asset-based pricing approach looks for the ability to sell loans on the secondary market, Hamilton continued, and the key is stability.
"It looks to me, and the market expectations in general are, rates will be stable."
Similar to the framework for liability-based pricing, Hamilton said asset-based pricing's starting point is the price a CU would get on the secondary market when selling a loan (for example: 6.50% for a mortgage). From there, CUs can add a small amount for servicing if they plan to sell the loan for cash, or price in overhead, credit losses and ROA and retain the loan.
When it comes to raising funds, Heusch said both money market accounts and CDs have heavy competition. "Most credit unions intend to lag the Federal Funds rate; few have 5% money market rates."
In terms of wholesale borrowing, Heusch said corporates offer loans that are easy to set up with flexible terms and collateral, the FHLB is inexpensive, but requires membership and mortgage collateral, while repurchase agreements also offer short-term options. "If a credit union has immediate cash needs, all of these are ways to raise cash quickly," he said. "The problem is, rates must be right on the market."
There are four ways to improve net income, Huesch continued. The first is by increasing net interest margin, which takes time. Second, increasing fee income, which might be limited by the CU's market environment. Third, by reducing operating costs, which might be at the expense of quality member service. The fourth option, which he encouraged well-capitalized CUs to explore, is leveraging-or borrowing from wholesale funding sources and purchasing big ticket, high yield investments or loan participations. By using leverage, Huesch said $100-million Credit Union "X" could borrow $20 million for two years at 5.19% and invest in auto loan participations at 5.49%. Under this sample scenario, Credit Union "X" would see its net income rise to $660,000 from $600,000, and its ROE would jump to 6% from 5.45%.
