Proactive Risk Management

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A steadily improving economic outlook should bode well for increased loan production activity at credit unions next year, although a sharp slowdown in refinancing will remove the "easy-pickings" in the residential mortgage loan market.

More than $3 trillion in new mortgage loans will have been originated in 2003. However, a return to a more normal $1 trillion to $1.5 trillion annual pace in 2004 will still leave significant business on the table for those credit unions that have established a competitive position in their local real estate market.

While sales of new automobiles are also likely to moderate in 2004, the amount of subsidized financing available from manufacturers should also decline. Opportunities in the new car market have been few and far between in recent years, and any improvement would be a boost. The used car market should remain robust and serve as the prime source of new loans for most credit unions. There is also room for many credit unions to improve their position in the indirect market as long as they understand the unique challenges of working with dealer finance managers and ensure that underwriting standards are maintained. The incredibly strong growth that we have experienced in regular and money market shares will also moderate as the stock market begins to look more attractive and long-term interest rates continue to drift upwards. There may be some new opportunities in the certificate market as members seek to lock in a reasonable return.

Second quarter 2003 reflected a dramatic turnaround in recent balance sheet trends ationally, loans grew more than 11% on an annualized basis, compared to fewer than 3% in the first quarter. Second quarter share growth declined dramatically to an annualized rate of just below 10%, less than half the pace recorded in the first quarter. Slower growth in shares, share drafts, and money markets were partially offset by larger increases in share certificates and IRA-Keogh accounts. However, total share balances still grew $12 billion in the second quarter of 2003, while loan portfolios only increased $10 billion. Still, the trend is moving the right way. Auto loans grew $4.5 billion in the second quarter, while first mortgages, fixed-rate and hybrid ARM's grew $3.9 billion. Reserves grew at a faster rate, however, and the downward trend in net interest margins remains intact. Loan rates are moving up slowly and investment returns are still on a downward track.

Interest rate risk-management remains a major focus for many. While secondary market sales of mortgage originations continue at a record pace, fixed-rate mortgages are the only ready source of incremental loan assets for many credit unions. Secondary market sales have accounted for nearly 15% of all loan originations recorded in 2003. Borrowings have also increased sharply, $1.5 billion (20%) so far this year, as credit unions seek to mitigate some of the interest rate risk that they undertook by booking mortgage loans in their portfolio. Many CUs are also looking more seriously at the derivatives markets to synthetically lock in current forward-rates on their liabilities. Derivatives are particularly valuable to CUs that have ample liquidity and wish to avoid ballooning the balance sheet with borrowings that are only needed for interest rate risk-management purposes. Restructuring the investment portfolio in a rising rate environment will also be a major challenge for credit unions in 2004. The structure of many portfolios has disintegrated over the last 30 months.

With rates coming off 45-year lows, credit unions are right to be concerned about their interest-rate sensitivity. Liquidity, clearly not an issue for the last 30 months, may also start to become a concern as loan production picks up and members re-think their long-term investment strategy. Consequently, we are seeing a growing interest in reviewing modeling assumptions and ALM practices. This is certainly the prudent way to go even though most credit unions have plenty of capital and still have relatively low exposure to rising rates.

When modeling the balance sheet, predicting how we will price shares in the future is a key issue. Today, many CUs are paying rates on share accounts that are far above wholesale market rates. It is likely that they will bring pricing back in line as rates rise over the next year or two. But competition and liquidity issues also drive pricing behavior, so it is hard to model this phenomenon with a high degree of accuracy. It is highly likely that the structure and pricing characteristics of share products will continue to evolve, but more rapidly than in the past, as the influence of the internet, particularly the availability of alternative savings opportunities, continues to increase. Administered rate accounts make up as much as 60% of the liability side of the balance sheet for many CUs. Getting this right is critical in establishing a meaningful risk profile.

The second key modeling issue is forecasting prepayment rates, particularly on residential mortgage loans and mortgage-related securities. Regularly monitoring the performance of our own loan portfolios and how that behavior changes over time can provide valuable insights into how the balance sheet might perform in the future. Static pool analysis, where loans are segmented and analyzed by origination period or some other demographic, can be a very valuable balance sheet management tool.

This is a great time for credit unions. It's presenting us with enormous opportunities to increase membership, the range of the products, and share of the member's "wallet." Having strong relationships with members and enjoying their trust, we now need to find new ways to build on those relationships. We also need to adapt to the changing requirements and preferences of future generations of credit union members. A sound ALM framework can provide a valuable tool to evaluate alternative product strategies and optimize resource allocations. Proactive risk management will be a key element in taking control of the future and finding success in the financial services industry of 2004 and beyond.

Bob Burrell is EVP and Chief Investment Officer with WesCorp, San Dimas, Calif. For more info:

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