What effect will the inevitable rise in interest rates have on credit union balance sheets?
As would be expected, that was a hot topic when chief financial officers meet here last week for the CUNA CFO Council's annul meeting. The answer, according to a number of analysts: it depends on the individual credit union. What the analysts did agree on is that interest rate risk is being underplayed by many credit unions, and that credit unions must be prepared to replace the earnings they have enjoyed from a strong mortgage market.
Frank Farone, managing director of Newburyport, Mass.-based Darling Consulting Group, said every CU could pursue a different strategy, because the path taken depends on each credit union's balance sheet.
"Everybody knows where we are with interest rates, but no one knows where we're going," Farone said. "Credit unions must be prepared ahead of time, not reactive. Understand the alternatives to eliminate risk, and know the costs of these alternatives."
What is complicating asset/liability management for credit unions, said Farone, is that inflows of cash are not likely to reach the relatively high levels of summer 2003. "Margins are past their peak, which implies earning-asset growth is key for 2004 earnings," he said.
If CUs have a big hole in their earnings, the earlier they address it, the better, Farone advised. And they're going to have to do so, he acknowledged, despite intense competition for loans due to what he termed "irrational pricing" on the market.
"Interest rate risk is a bigger problem then most people realize. Meaningful risk modeling is critically important. Credit unions must examine risk versus reward for every strategy they are considering using."
Farone recommended several potential actions. First, CUs should determine the embedded risk to a flat, or stable, interest rate environment. Second, they should determine their exposure to rising rates. Third, determine the risk in their 2004 budgets for loan growth.
One of the best strategies for a rising rate environment-echoed by other presenters at the meeting-is developing a 10- or 12-year home equity loan product. "Deposit pricing is critically important," he said. "Whatever products credit unions decide to offer-CDs or money market-they should have them ready to go, now. As rates go up, they should let their best members have the best rates and let the others lag."
He urged credit unions to quantify their growth requirements, assess the feasibility of those requirements, and develop numerous contingency plans. Important items for the contingency plans include deposit rate reductions, mortgage loan strategies, and aggressive loan pricing including adjustable rate mortgages.
"Don't look for a home run," he counseled. "If credit unions do a little bit in every area, cumulatively, it will make a big difference."
The Spread To Watch
Brian Turner, manager of advisory services at Southwest Corporate FCU in Dallas, Texas, told attendees at his breakout session on "improving return on investment portfolio" that many people incorrectly believe the net demands of short- and long-term bonds are a predictor of future interest rates. He said there have been three false bottoms in mortgage rates in the past three years, most recently in June 2003, because when rates began to rise, people assumed the long-awaited bottom had passed.
"What is the Fed going to do going forward, and what will be the impact?" he asked. "The major interest rate cycles are five to 10 years, while the minor cycles are two to four years. Credit unions should focus on the minor cycles."
Turner recommended watching carefully the spread between the two-year U.S. Treasury note and the six-month Treasury bill because it will affect what CUs do and when they do it.
"Credit unions are in the risk business-that's the bad news. The good news is, it is manageable risk," he said.
According to Turner, an investment portfolio has a three-part mission. First, it is a place where a CU can prudently "park" surplus liquidity until it can be redeployed into loans. Second, it is an earning asset whose yield and duration ensures long-term return and liquidity to support core operations. Third, it can be structured to offset adverse interest rate risk or liquidity exposure from core operations.
By the end of 2004, or certainly in 2005, there will be an interest rate increase by the Fed, he predicted. "Its effect on credit unions depends on how quickly they respond. There's a lot of junk out there, a lot of volatility."
Turner said credit unions should shorten the average duration, decrease long-term loans, increase bonds, increase surplus liquidity as the yield curve flattens and increase allocation of variable rate assets. Specific pricing strategies depend on the cash flow structure at each CU.
"Those with adequate cash flow will be able to reinvest the money and get higher rates. For those without adequate cash flow, that opportunity isn't going to exist. But keep in mind, rising rates imply a strengthening economy, which creates additional loan demand."
Jay Johnson, EVP with Callahan & Associates, also offered his opinion on the effect rising rates will have on CUs. Johnson, who led a breakout session on "measuring value returned to members," told The Credit Union Journal the most pressing issue is to find a replacement for mortgage lending-which has generated substantial income from both interest and fees in recent years.
"There will be fewer loans and less service revenue as rates rise, and that will put pressure on margins. A good response would be to offer adjustable rate mortgages," he said. "On the investment side, credit unions stayed short in the first quarter and are waiting for rates to rise. Credit unions are developing different sources of revenue; products that will be good performers."
