If loan growth is up, why is profitability down?
While the U.S. economy has rebounded, the returns generated by loans issued by credit unions, banks and thrifts remain stagnant, according to a report from economic research firm Moebs Services, Lake Forest, Ill., which analyzed data from than 12,600 financial institutions.
NCUA Chief Economist Ralph Monaco said credit union loan volume has generally fared better than banks — loans at the end of the second quarter of 2015 were up 10.6$ over the year ending in the second quarter of 2015, and the loan-to-share ratio has risen from about 68% at the end of 2012 to 75.5% in the middle of this year — but the thing is, volume isn't everything.
"Rising loan volume is not the only factor in determining the contribution [that] lending makes to credit union net income," Monaco explained. "The rates that credit unions can charge on their loans are also a critical factor."
Mike Schenk, CUNA vice president of economics & statistics said that with market interest rates near zero, there has been a compression in credit union net interest margin. Funding costs are pretty close to zero and can't fall much further while loan yields can (and have) fallen more dramatically.
Another issue, suggested G. Michael Moebs, CEO of Moebs Services, is the reliance on indirect loans. "Profitability is almost non-existent on indirect loans," he said. "Dealer reserve is way too high — and this is because credit unions allow the dealers to get away with the high reserve."
Also, many credit unions do not account for the "full cost" of the loans they make, Moebs added. "Most only have interest revenue and interest cost and an estimate of potential loan losses," he said. "Few credit unions have the direct and indirect non-interest cost [associated with] doing a loan."
Brian Turner, president and executive director at Meridian Alliance LLC in Plano, Texas, observed that while loans provide a central part of a credit union's revenue stream, they don't unilaterally dictate its profitability. Moreover, most of the loan growth — and the return on those loans — is being seen at the larger credit unions.
Turner notes that whereas the industry's loan growth has reached close to 9% and return-on-assets (ROA) remains steady at 0.81%, most of the loan growth is coming from the largest credit unions.
"Collectively, credit unions with more than $500 million in assets represent 71% of industry assets, but account for only 8% of the [actual] number of credit unions," he noted. "[As] this group has experienced a 13% annualized growth in loans in 2015, this suggests that the remaining 92% of the industry [all credit unions with less than $500 million in assets] collectively experienced a 0.1% decline in loans."
What Can Credit Unions Do?
Moebs proposes that credit unions need to make more direct loans, in order to generate more profits. "Adapting to relationship service and price designs would help this immensely," he suggested. "Having a member with a checking account who knows they can get a better deal on a vehicle loan is a way to develop the direct business." Also, credit unions need to develop better sales compensation approaches instead of just being an 'order taker. '"
Turner believes the credit union industry should enjoy a more broad-based increase in loan demand in 2016. "Much of the lackluster loan growth for the '92 percenters' [that is, the smaller credit unions] has been [related to] their hesitation over retaining mortgage loan originations — something that has been either a self-inflicted injury or a result of misguided regional examiners placing a greater focus on risk exposure metrics than total return analysis."
Another key metric related to profitability: the expected delinquency/net charge-off ratio. "Ideally, the loan quality of new originations should surpass prevailing experience which should help to remedy future dilution of asset yields," Turner said. "There is only a 22 basis point difference between the delinquency rate at large credit unions and the remaining '92 percenters.'"
What if the Fed Hikes Interest Rates?
There is no doubt that having higher interest rates would provide greater flexibility in rate pricing, Moebs said. "However, the real question is not if the Fed will hike rates in December [2015] or the first quarter of 2016, but how many times will the Fed hike rates in the next 12 to 24 months," he suggested. "If the Fed moves at only a 25 basis point move each time it will take eight [such] moves [just] to get to good interest rate pricing flexibility. [And] how many economists will say the Fed will move eight times in the next two years?"
Turner anticipated that any rate hike in December will not have any impact on the market rate for most credit union consumer loan rates nor will they immediately impact share rates. "Market demand for vehicles and home financing will continue to dictate rate spreads for each," he explained. "Already, benchmark short-term treasury rates have valued in the next rate hike yet the average financing rate for autos is unchanged — in essence, reducing the spread between market and benchmark rates. This will most likely continue in the short-term, but gradually increase as we venture further into 2016 and 2017."
Turner also said cash yields will experience the greatest increase on each potential rate hike. For some credit unions, a 50 basis point increase in the Fed Funds rate could positively impact ROA by as much as 15 basis points alone. "The overall result will be positive to industry net interest income as asset yields will begin to increase at a faster pace than cost of funds," he indicated.
NCUA's Monaco cautions that it's hard to generalize about how all credit unions will be affected by rising rates, if that happens. "That's because there is a whole ecology of credit unions with different characteristics. For example, there are some credit unions, mostly smaller, that have few loans but a high percentage of safe investments," he said. "As rates rise, net income at these credit unions could rise. Naturally, that's a plus for them and their members. But there are other credit unions where the effects won't be so benign. The group of credit unions we have been most concerned about when we think about interest rate risk are those who have a lot of deposits that pay market rates and have, at the same time, locked in low rates on long-term loans and investments."
Nathan Stovall, senior editor and New York bureau chief for SNL Financial, a financial information firm, noted that interest rates have been so low for so long that depositors are "hungry for yield."
What If The Fed Holds Tight?
"There really is no danger in leaving interest rates unchanged," Moebs assured. "However, this does require credit unions to get a full-cost approach… and for the credit unions to cut their expenses."
Turner concurs that a postponement by the Federal Open Market Committee (FOMC) in raising rates in December, but deferring until early 2016 will have little adverse impact on credit union finances. "There is no question that credit union financial performance has been more a function of the protractedly long low-rate environment than most any other factor," he cautioned. "The challenge for the Federal Reserve is to be cautious not to raise rates too soon, too fast, too high as to stymie the already relatively weak increase in consumer spending."
Turner further noted that instead of experiencing traditional 5% to 8% growth in spending, the prevailing growth rate is barely above 3%. "To have short-term [interest] rates accelerate too fast could further threaten spending behavior that would send the economy spiraling downward into another recession — possibly more damaging than in 2008," he warned.
Schenk of CUNA explained that the recovery has itself been rather modest, suggesting there is still a lot of pent-up demand for big-ticket items, like automobiles — a scenario that could be a boon for credit unions. "The average age of cars on the road now is at or near an all-time high," he said, predicting continued loan growth.
But the key is what rate CUs charge on those loans.
For example, the median rate on first mortgages in the credit union system at the end of 2011 was around 5%, said NCUA's Monaco. At the end of the second quarter of 2015, the rate was just over 4%. Meanwhile, rates on auto loans, credit cards, and other loans have also come down. "For every old loan that rolls off the books, it is being replaced [by] a loan that likely has a lower interest rate," he explained. "Now credit unions are adding loans, but… with lower loan rates, you need to add a lot more loans to generate the same income you would get with fewer loans but higher rates. So there is not a clear one-to-one match between loan growth and rising net income."
Finally, since credit unions are not-for-profit, a discussion of their "profitability" differs greatly from banks. "Credit unions continue to pay higher deposit rates than other institutions on average and tend to have lower rates on consumer and auto loans than other institutions, which is a way to serve members that definitely affects credit union net income," Monaco said. "It's a deliberate choice by credit unions. Second, with respect to net income, there are lots of other factors that affect net income beyond loans. For example, rising provisions for loan losses reduced net income through 2010. As the economy has improved, provisions have come down, which helped to push up net income through 2014. Since about mid-2014, provisions have been about flat. But the general point is that provisions, expenses, pricing decisions and a host of other factors beyond loan growth help to determine credit union net income."
Jay Johnson, executive vice president and partner at Callahan & Associates, pointed out that even though loan yields for credit unions are down — due largely to the long-term environment of near-zero interest rates — credit unions are still in a strong position.
"Loan yields have fallen about 200 basis points since 2008, but credit unions are enjoying such high capital levels, that they don't really need high 'earnings' to prosper," he said. "In addition, credit unions currently have the highest loan-to-share ratio since 2009, which means they are effectively converting their deposits into loans."
