Margins have remained tight again in 2007. There will be pressure on the cost of funds, and it will be a challenge for credit unions to increase spread significantly in the next six months.
Though increasing slightly, overall cost of funds in the credit union movement has remained relatively low, thus supporting net margins in 2006. This also sets some limitations by which CUs might have regarding non-term share rates if market rates were to decline, which is a significant factor to net margins in a declining rate environment. Generally, CUs' liquidity profiles have improved in the first half of 2007 but could tighten this summer due to a mismatch between loan and share growth. If credit unions are faced with growing shares by raising rates, their outlook for the future might change quickly as it could contribute to higher cost of funds and possibly adversely impact net margins.
One way a credit union could hurt its net margin is if it tries to attract new members or new deposits with higher paying Money Market Accounts. At this point in the interest rate cycle, credit unions will not reach the 5% yields offered by Money Market Mutual Funds (2-3% offered by most credit unions) and attempting to creep up on them may not be a smart strategy. If competition is stable among the banks and credit unions in your area, it may not be necessary to raise your money market rates. You may not really draw in that many new accounts, but you certainly will increase your cost of funds. If the Fed remains "on hold" and the competition in your marketplace is non-aggressive on its Money Market Accounts, it may be best to leave your Money Market rates where they are.
Increasing ROA will require small, diligent steps. The measure of success may be determined by how well little things are done each and every day.
CUs can help their loan portfolio yield by applying some focus to attracting B-grade loan paper and for some credit unions, C-grade loan paper-that typically bring a higher rate of return. There is not a set formula on how much "B" and "C" paper that a credit union can take on. It is a case-by-case basis. You have to determine you are going to "test the waters" taking on loans that have higher credit risks. However, if your credit union's delinquency rate is very low and your capital ratio is above 10%, you may be able to loosen your loan portfolio a bit. "A" paper has been the most competitive asset and rates are very low for these auto loans. Your definition of "A" paper may be different from your competitors so an evaluation of what you are classifying as "A," "B" and "C" paper can be useful and possibly profitable. Adding some emphasis to attracting used car loans has reaped some success in the last year for many CUs.
Another way to enhance the yield on the loan portfolio is to search for loan participations with other credit unions that are active in underwriting and funding member business loans. By purchasing smaller participations in the larger loans, credit unions can take advantage of attractive yields while maintaining diversification in this fairly new loan arena. Of course, your credit union would have to be comfortable with the underwriting and analysis of the member business loan.
One overlooked area is unsecured loans. The perception is that unsecured loans have higher delinquencies rates. However, we've looked at historical data that actually reflects that the delinquencies on unsecured loans within the credit union movement perform in line with other loan sectors, such as those composed of auto loans and mortgage loans.
One way to start increasing your unsecured loan portfolio is to promote that type of loan through mail-outs to a select target of members who have better-than-average credit scores. Pre-approved lines are offered to these members in the package.
Keeping abreast of yields and specifically spreads in the investment products is another key to maintaining spreads in 2007.
For some, investing is a habit-one that needs a little change. Out of expediency or perhaps comfort, some credit unions keep buying the same investments regardless of its spread over the curve. But throughout the fixed-income investment sectors, spreads do change. It is necessary to monitor spreads carefully. An attentive investor may find one sector is paying a premium over another at any given time or the cash flow structure of a particular sector makes more sense given the current interest cycle. Unless you are monitoring these spreads, you may be losing out on a considerable amount of yield on your investments. Be more proactive in defined cash flow structures to enhance current and reinvestment yields. Simply said: avoid a rut. Pay attention to cash flow structure of investment. Monitor the market.
Finally, one other option that seems to be gaining some popularity-borrow money to make money.
If you have double-digit capital-and many credit unions do-your credit union may want to borrow liquidity that can, in turn, be lent to members or reinvested at a higher rate. Leveraged transactions can be structured with a group of borrowings and another group of investments to achieve a spread on the entire transaction. The incremental income to the credit union increases the return on equity, but will decrease the capital ratio for the term of the loan due to the increase in assets.
If liquidity is tight, there are also times when it makes sense to fund a term borrowing rather than increase your share certificate rate 50 to 75 basis points in order to attract new funds. For some fields of membership, the increase in share certificate rates results in deposits simply shifting from regular shares to certificates without any new funds being attracted and thereby increasing the cost of funds. Analyze other sources of funds before making the decision to significantly increase term rates when liquidity is needed. If loan demand remains strong, and after a careful financial review of your credit union's position, you may see that you can afford to take on some debt if you can easily turn it around to meet the demands of members or reinvest at a positive spread to increase your return on equity.
Zane Wilson is Director of Investment Services for Southwest Corporate.
