The biggest question in many observers mind regarding the upcoming interest rate from the Federal Reserve is when it will actually happen. But many questions linger beyond that, including what the impact of a rate increase will be on financial institutions that operated for an unprecedented eight years of near-zero rates until the Fed finally edged up the benchmark rate last December.
Curt Long, chief economist and director of research at National Association of Federal Credit Unions (NAFCU), noted that a slight hike in rates would have very small impact on the mortgage businesses at credit unions at least in the near term. "Long-term rates are still at historic lows and that is not likely to change overnight," he said.
Dwight Johnston, chief economist at the California and Nevada Credit Union Leagues, also concurs that a modest rate hike would have little impact on credit unions. "What matters is what the bond market does in the weeks after the [presumed] overnight rate hike," he noted. "After the December 2015 hike, all rates other than the overnight rate actually fell after the Fed move. This means that interest rates on most loans, especially autos and mortgages, fell. Even today those rates are roughly 50 basis points below where they were before that first Fed rate increase."
G. Michael Moebs, economist & CEO at Moebs Services in Lake Forest, Ill, said he doesn't believe the Fed should raise rates this year. But, he said, even if the central bank boosted rates by 25 or even 50 basis points, it would not have much of an impact on credit union finances. "Both deposits and loans would be affected and some arbitrage would go on, but not much," he said
According to Joe Newberry, president and CEO of Redstone Federal Credit Union, a $4 billion institution based in Huntsville, Ala., a modest rate hike could equate to a "win" for savers, but less so for investors.
"However, it's important to remember that an interest rate change can take up to 18 months to fully impact the economy," he explained. "In addition, credit unions generally do a good job of keeping a close eye on their balance sheet. Many have ways to 'stress test' their balance sheet using various interest rate scenarios. Credit unions should be well prepared for rates to rise, so a rate hike this year should not be an issue."
Complex Relationships
Interest rates have a very complex relationship with the performance of financial institutions.
For example, Brian Turner, president of Meridian Economics LLC in Plano, Texas, explained that every rate hike increases the rate of return on a credit union's surplus cash during a time when liquidity in the industry has never been stronger. For instance, for a $100 million credit union with $12 million in cash, a 50 basis point increase in the fed funds rate would immediately add 6 basis points to their return on assets.
"It also would mean that this same credit union would benefit more from the rate hike than a 10 percent annualized increase in vehicle loans," he said. "Of course, for those credit unions who have chosen to re-invest most of their surplus liquidity to pick up only a couple of basis points or earnings — but which have to commit to a three- to three-and-a-half-year investment — would not fare as well. In fact, their total return profiles will become narrower to cash returns."
A higher rate would not impact small business lending at credit unions either, since such businesses are less impacted by shifts in interest rates than in the fundamental strength of the economy.
"Higher consumer rates, greater price inflation or stagnant wage growth reduce consumers' disposable income, which tempers their discretionary spending behavior," Turner explained. "If any of those variables put downward pressure on the economic recovery, a complete shift in the business cycle is not only assured, but the depth of that reversal could be catastrophic. The first to be impacted would be small businesses who would be unable to adjust prices, lower costs or reduce inventories sufficiently to avoid significant losses."
Newberry also said that a rate hike could mean a slowdown of the double-digit loan growth many credit unions have seen. "But, you are not going to see a mortgage rate jump immediately after the feds take action," he cautioned. "Longer term obligations — like mortgages — are not directly tied to the short end of the curve."
As for small business lending, Newberry advises small and medium sized businesses is to "continue taking advantage of these historically low rates, fund their businesses and position themselves for the year ahead."
Ralph Monaco, chief economist at the National Credit Union Administration noted that in general, a rise in short-term interest rates usually translates into slightly higher long-term rates. "So it is possible that mortgage rates would increase a little if short-term rates were to increase by 25 basis points," he said. "However, lately, some concerns about financial developments abroad, especially in Europe and China, have been pushing down longer-term U.S. Treasury rates — relative to shorter rates — as investors seek the safety of U.S. Treasury bonds. This has helped to keep longer-term interest rates, like mortgages, at relatively low levels." Monaco emphasized that mortgage lending at credit unions has been strong over the first half of the year — consumers looking to purchase a house are influenced by a variety of factors, like employment prospects, income growth, as well as interest rates.
"If the economy remains relatively solid, mortgage business is likely to remain solid, even if mortgage rates rise slightly," he added.
Monaco further said that small businesses thrive when the overall economy is doing well. "If the economy is growing and inflation is picking up, small business lending is likely to be picking up as well," he noted. "A modest increase in interest rates is not likely to derail small business lending."
Monaco suggested that credit unions need to understand what can happen to their income statements and balance sheets under a variety of interest rate scenarios, including one in which short-term interest rates are rising at the end of the year.
Sell off Long-Term Investments?
In anticipation of higher rates, some observers would recommend that credit unions should unload more of its long-term investments. However, it's not quite that simple. Other factors are at play.
"Some people believe we are in a bond bubble, much like the tech bubble of 2000, and the bubble will burst soon," warned Johnston of the California and Nevada leagues. "Other people, including most of the world's biggest bond fund managers, believe that the global economy will slow further and drag down the U.S. They see dis-inflation or deflation for years to come, and interest rates that will remain low or go lower for years to come."
Thus, Johnston characterizes this scenario as a "coin flip."
"Most credit unions do a very good job of managing interest rate risk," he observed. "Even if rates rise and the value of longer-term investments fall, they have the ability to ride out the storm. Additionally, if they sell all of their long-term investments now, they will lose income from not having those investments."
Turner said for those credit unions who invested in longer-term fixed income securities to garner higher returns, particularly greater than five years in duration, it could be practical to either sell of swap those securities to improve their total return profile in the event of higher interest rates.
Regardless of fed moves, Turner offered, credit unions should be more concerned about the credit quality of each loan portfolio over the next six to nine months rather than thinking about any reallocation or marketable shift in originations. Earlier this year, he noted, as oil prices neared their lowest level in years, the financial market experienced measurable increases in loan delinquency.
"Now that oil prices have recovered nearly 60% of that decline, delinquencies have stabilized and earnings profile have become stronger," he noted. "A credit union's earning profile always is more adversely exposed by credit quality than from interest rate risk exposure. That certainly was the case in the 2008-09 recession. I would suggest that institutions forsake the urge to attract yield by seeking lower quality paper and accept the lower yield by long-term safety of prime or 'A'-quality loan paper."
In any scenario, Newberry added, credit unions should review their balance sheets and find a steady balance between savings and loan rates. "Small adjustments to pricing of both will likely have to be made," he recommended. "The most immediate impact from higher interest rates will be on credit union's adjustable rate products, such as HELOCS, overdraft line of credit and credit cards because these automatically adjust with the fed rate increases. Credit unions tend to be conservative and have already planned out a higher rate scenario."
