Is Your Credit Union Leaving Money On The Table?
Going into 2006, credit union CFOs are faced with rising overnight rates, a flat yield curve and an ROA that is under pressure. As upward pressure on short term liability rates builds-potentially impacting the cost of funds-the net interest margin for credit unions will be squeezed, and CFOs could be searching for ways to increase asset yield. But, are some credit unions leaving money on the table?
As overnight rates have risen from 1.0% in 2004 to 4.50% in January 2006 and the two-year Treasury yields have risen from 2.0% to 4.60% during the same time period, staying in cash has been an attractive option. While liquidity was tighter-than-normal in 2005, staying in cash didn't hurt credit unions that were experiencing strong loan demand. However, keeping all of your investments in cash is not a viable alternative for the long term as it is generally the lowest yielding investment available.
Typically, during the first half of a year, credit unions' share growth outpaces loan growth causing liquidity to build. This is a blessing for credit unions with high loan demand. However, for credit unions with loan-to-share ratios in the 30% to 45% range, finding attractive yields on investments is necessary to keep ROA within policy limits.
If your credit union relies significantly on investments to maintain ROA, you may need to review your procedures and analyze your balance sheet to determine if you are leaving money on the table.
Manage Cash Flow
Managing your cash properly ensures that you are getting the most out of your balance sheet. Keeping track of the credit union's daily cash flow and balances takes only a few minutes a day and can lead to a more efficient use of liquidity. Examine liquidity levels, share activity and loan demand throughout the year and determine when there are high and low liquidity periods for your credit union. Typically, there are cash cycles during the calendar month that reveal fluctuations in overnight cash. Those should be analyzed to determine cash levels for each month and what time of the month cash is at its highest and lowest level.
Borrowing a small amount one or two days a month to cover the low liquidity periods is efficient cash management especially if your credit union experiences a large overnight cash fluctuation during the calendar month. (One side note-borrowing for a longer period such as one or two years instead of paying up for deposits in those terms is an attractive option during certain interest rate environments.)
Investing some of the excess cash to build a liquidity ladder can alleviate much of the pressure on having to maintain a large amount of overnight cash as insurance against higher loan demand or increased share outflow. The second and third quarter of 2006 could very well be a period of above average loan growth; therefore credit unions should be liquidity conscious by analyzing their cash flow needs regularly.
Measure IRR on Balance Sheet
Before undertaking strategies to increase asset yield, credit union management must measure and analyze the interest rate risk of the balance sheet and understand the components of risks. You can determine how much risk reallocating to term investments can add to your balance sheet and quantify your risk tolerance levels. Obviously, risk tolerance levels will be influenced by the level of experience the credit union management has in asset/liability management and investment management, the capital ratio of the credit union, and the amount of credit risk inherent in the balance sheet; risk parameters in the ALM policy should be set accordingly. Determination of appropriate terms relevant to reinvestment and liquidity risk can be discussed in ALCO Committee meetings-taking into account loan demand and share activity. Credit union management should always be working with a total balance sheet approach in managing interest rate risk and when managing ROA and net interest margin.
Evaluate Alternatives to Maintain ROA
As mentioned earlier, credit unions with a low loan-to-share ratio rely on their investment portfolio to maintain ROA within policy limits. Can you move beyond treasury notes and agency bullet securities to gain additional yield?
While treasury notes and non-callable agency securities are excellent investments and highly recommended, your credit union could be leaving 30 to 60 basis points on the table by not exploring other alternatives.
Share certificates at corporate credit unions such as Southwest Corporate Federal Credit Union can bring as much as 10 to 60 basis points over a comparable non-callable agency security depending on the structure. Share certificates can be structured as simple as a non-callable certificate or more complex, such as an amortizing certificate tied to the prepayment on a specified pool of mortgages. A key feature to the share certificates is that any agency structure can be replicated at a higher yield by the corporate credit union and a structure can be customized to fit into your credit union's unique ALM and balance sheet requirements.
Short-term mortgage-backed security structures have been around since the mid-1980s and offer credit unions an alternative to place an amortizing investment on the balance sheet at a yield from 50 to 90 basis points over the treasury yield curve. Planned Amortization Classes (PACs) are types of mortgage-backed security structures that offer some prepayment protection against changes in interest rates and normally carry much less prepayment risk than a callable agency security. Investing in a PAC near a par price will provide the credit union with an investment providing a steady stream of monthly cash flows and an attractive yield over a wide range of interest rate scenarios.
Some state-chartered credit unions have the ability to invest in Asset-Backed Securities (ABSs), which are very similar to the mortgage-backed structures discussed in the previous paragraph except that the collateral consists of various assets such as auto loans, credit card receivables, and home equity loans rather than single-family mortgages. There is some credit risk exposure since the securities are not backed by a government-sponsored agency and ongoing credit monitoring is required. Home equity-backed securities with a two-year average life can yield as much as 80 to 100 basis points over the treasury yield curve.
The Lesson To Be Learned
Whether your loan-to-share ratio is 80% or 30%, squeezing the most out of your balance sheet is important especially as short term rates approach long-term rates, impacting your cost of funds. Possessing a 30% loan-to-share ratio puts even more pressure to get everything you can out of your balance sheet. By managing your cash efficiently, understanding your risk tolerance and exploring alternatives to increase asset yield, credit union management can maximize ROA growth. Manage the entire balance sheet.
Zane Wilson is director of Investment Services with Southwest Corporate Investment Services, a CUSO of Southwest Corporate FCU, Dallas. For info: swcorpinvest.com.