The Ups & The Downs

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Where's the risk: when interest rates rise, or when interest rates fall? The fact is, both environments carry their share of risk for credit unions, according to two experts.

"Traditionally, most people think that when rates go up, that's where the risk is," said NAFCU's Dr. Tun Wai. "And that is true, because when interest rates go up, the value of your asset can be affected negatively. Even with a whole portfolio, if you had to see it in a rising rate environment, obviously you would have to sell at a loss."

But the good-news scenario of declining interest rates brings with it its own unique set of risks, too.

"When rates fall, values go up, and that's supposed to be a good thing, but these are book-value things. You're really looking at the portfolio you have," Wai said. "It's great for borrowers when rates fall, but it's bad for savers. Credit unions have both."

The Federal Reserve has raised rates nine times in its last nine meetings, so credit unions have been dealing with a rising rate environment for some time, now.

"When rates rise, typically your savings rise, so you're flush with liquidity," Wai observed. "But then the question is, what are you going to do with it? You can get into an earnings crunch."

And it's more complicated than just the direction rates are moving, noted CUNA's Bill Hampel. "On average, more credit unions are hurt by rising rates than by falling rates, but the reverse can be true. In either case, you must be aware of your own credit union's situation and do asset-liability modeling to know," he offered.

"It's not so much if rates go up or down but which ones are up or down," he suggested, noting the different ways movement in the short-term rates can have an impact compared with the ways movement in medium- and long-term rates can have an impact. "What's really the culprit is the flattened yield curve. Market forces tend to pushing down credit union net income."

And just like with so many other gambles in life, timing is everything.

"When rates go up, loan rates have to adjust, and there's a timing issue involved. It's not instantaneous. Credit unions don't adjust their rates as quickly as banks do, and this is partly because of the way we operate," Wai noted. "Boards don't meet every week. Managers do have a lot of autonomy to set rates, but it still takes time."

And there's the added factor of how a credit union's balance sheet is structured, Hampel added.

"For most credit unions, rising rates puts downward pressure on net income," he noted. "But if the credit union particularly high penetration in home equity loans, then rising rates can actually be a good thing, because typically home equity loans are tied to an index, and as the index rises, the rates adjust nearly automatically. So as rates rise, those home equity loans are going to be bringing in a better interest rate for the credit union, and rather quickly. While on the other side of the balance sheet, credit unions have been able to put off raising their rates on deposits because banks haven't been raising theirs, either."

In the short term, then, most credit unions are well-positioned to deal with the current rate environment, as they are able to continue putting off raising their deposit rates. "But that will only last so long," Hampel cautioned.

But if the Fed's streak of rate hikes are trying the patience of credit union managers everywhere, then there is something to be learned from this. "This is the ninth time the Fed has raised interest rates," Wai observed. "How many times can you meet on this before you revisit your policy?"

If credit unions are at all nervous about throwing the dice on interest rates, then regulators are all the more so.

"Regulators can get nervous in times like these," he offered. "And you can see this in terms of the alerts that they put out. The NCUA put out an interest rate alert for the first time. Clearly, they are worried about interest-only loans. And they are also concerned about third-party vendor relationships (see related story, page 1)."

But sometimes the greatest risk of all doesn't come from which way interest rates are going. Sometimes the biggest risk is a whole lot closer to home.

"Whenever you talk about asset liability management, the member options are always a concern," Wai commented. "Member options are a concern because they can really throw you off when you think you had a members' CD for six more months, and then they come in and demand their money right now. Or with hybrid-type lending, a member option that can throw you off is when they can skip a payment, for example."

Economists often are loathe to make predictions, even though they are called on to do so on a regular basis, but if there is one sure thing bet out there right now it's this: interest rates are going to continue to rise.

"Obviously, we all expect rates will continue to rise, and we are currently in what they are calling a neutral economy," he noted. "But even so, it all depends on a number of factors: inflation, the global economy, terrorist activities. When you start talking about interest rate exposure, you have to think about how well that portfolio can withstand the shock. Well, nine rate hikes later, I think most managers have done the shock test, and they're pretty well prepared for the rising rate environment."

Which is all fine and good, so long as that is what actually happens, but Wai said credit unions do have an ace up their collective sleeve.

"According to our recent Flash report, 60% of members keep their direct deposit at their credit unions. That's a huge number," he said. "That's a rather significant amount of core deposits, by which we mean money that sticks around. This certainly gives credit unions the advantage in the way they set rates, because they know have that money that isn't walking out the door."

Even so, Wai offered the following advice, "be careful where you put your money and think of contingencies and make sure they are there. Things like lines of credit, the ability to sell on the secondary market, they need to be in place well in advance of your members coming in and clamoring for their money."

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