For three consecutive years, the number of mergers receiving preliminary approval from the NCUA has declined to the lowest number of approvals in the decade with just 226 through November 2007. This trend, when coupled with the very low number of preliminary approvals granted by the NCUA in October and November (30), could indicate that merger activity will continue to slow in 2008. The first quarter of 2008 will likely be one of the slowest quarters for merger activity in the past five years. However, mergers are rarely a result of poor financial performance and short-term trends but rather a combination of negative long term sustainability trends, emotional concerns and external changes in the market.
Sustainability Trends
When looking at merger potential and probability, the trends and metrics need to be observed on a basis of individual CUs rather than in mass as most statistics are reported. A good example: membership growth. Through September 2007, total membership was up over 1.2 million, yet nearly 54% of all CUs and over 60% of credit unions under $50M in assets had a decline in membership over the previous four quarters. This is one of a number of key trends for any credit union considering its long term sustainability.
Loan Growth: Individual credit union loan growth declined during the four quarter period from Q3 2006 to Q3 2007 with nearly 40% of all credit unions having their loans outstanding decline. This is a 7% increase in the same metric from the four quarters prior to Q3 2006. Interest income through three quarters of 2007 was up over 11% from 2006. But the margin squeeze continued with interest expense up over 22% in the same period. For many credit unions, declining margins coupled with diminished loan receivables is a critical concern.
ROA: Over 69% of all credit unions posted a decline in annualized ROA in the four-quarter period from Q3 2006 to Q3 2007. This is up over 29% over the same time period the year before. Unless return on average assets improves significantly in the fourth quarter, 2007 will mark the fifth consecutive year of annual decline in ROAA.
Scale: The trend of the business environment in the U.S. over the last two decades has leaned heavily in favor of the big-box retailers. This has held true for financial institutions as well. In the banking community only 20% of the institutions are smaller than $50M in assets and 1% are under $10M. Whereas, over 75% of credit unions are under $50M in assets. Even with few small institutions, banks consolidated at a pace nearly 70% faster than credit unions. So with many small credit unions, a SEG environment that is diluting and moving toward community charters, shrinking margins and less brand loyalty, how is the small credit union to survive long term? Many credit unions are left to the unenviable task of trying to do more with less to compete and many feel it is best to merge now when there are many options to meet their needs.
Productivity: 2007 is the eighth consecutive year of a decline in members served per full time employee. Despite the increases in technology and the enhanced ability to service members remotely, credit unions are continuing to add expense by adding employees faster than members. The average shares per member has seen a reduction in growth rate for six years and the average loan balance growth rate per member has declined for the last five years. If these trends continue through the fourth quarter, then 2007 may mark the first year this decade that employee growth outpaces member, loan balance per member and average shares per member growth.
Merger Probability Modeling: Every quarter we model the trends and metrics of every active credit union against the same metrics of the past two years of merging credit unions. This modeling, made available to all acquiring credit unions, provides a breakdown of merger completion probability to enable a focus on the best merger opportunities. Credit unions that have an above average probability are 11 times more likely to complete a merger than those not on the report. The percentage of credit unions that have above average merger completion probability is up 18% from Q3 2006. This is the first time that our modeling has produced a rise in the highest probability grouping at the end of the year.
Emotional Concerns
This is the most critical area of concern in the merger process for many CEOs and board members. It is the emotional issues that the people involved in making a decision to merge that will ultimately decide if a merger is to be completed or fail. As some of these key emotional considerations are forced to be confronted, they will play a significant role in merger activity. One or more of the following concerns played a key roll for nearly all of the mergers we facilitated in 2007.
Retirement: Published statistics have stated as many as 70% of all current CEOs will retire in the next five to 10 years. Many CEOs that we work with are concerned about their credit union being in existence by the time they expect to retire. CEOs are offsetting these concerns with a review of their current options and opportunities in the merger process so that they have an understanding of their paths to meeting their career goals.
Succession Planning: This has been a task that many credit unions put off or simply do not have a plan in place for the inevitable replacement of their CEO and directors. This is especially difficult for small CUs with few options, limited interest in their positions and cannot afford to pay CEOs what they can earn as VPs with large credit unions. Board members can be even more difficult to replace as each year seems to bring fewer volunteers dedicated to making a difference at their credit union. For many CUs, a merger is their final succession plan.
Burnout: Repetition and stagnation are not terms considered in strategic planning sessions. Yet so many CEOs and volunteers endure year after year of effort, dedication and time spent to see no growth, declining membership, less support and greater competition from larger CUs and banks. These types of results can be an emotional rollercoaster and a merger could allow a fresh start with new opportunities for a CEO, the board, the staff and the members.
Legacy: For many CEOs and their board members, being a part of the credit union is really part of their life. For so many people, the credit union is their career or volunteer identity and do not want it change or merged out of existence. However, for some, a merger is a path to maintaining this legacy by finding the partnership and terms that best meet the needs of preservation. With the new trends of retained branding and interstate mergers, we are finding more opportunities for credit unions to keep some of their legacy, provide a better future for the members and increase the stability and strength of the CU community.
External Changes
Merger Accounting Change: Dec. 15, 2008 will mark the beginning of the purchase method of accounting for credit union mergers. Given that most merger timelines to completion are three to nine months, this effective date is right around the corner. It is still unknown as to how this will affect credit union mergers in the long term, but the short-term response is one of concern and priority. Given already declining earnings for many credit unions, how will the accounting of goodwill affect potential mergers? This new method, if difficult to manage, may reduce the interest large credit unions have in smaller opportunities and thus limit the options for a CEO and board in finding the best merger terms and partnership. The proposed account only affects earnings but to what extent this will impact is unclear. As we are seeing already in the market, some credit unions may not wait to see what happens and rather take advantage of the window of the next 11 months to complete a merger.
Camel/Risk Rating Revisions: With the NCUA change to the RFE model utilizing the seven risk categories for assessment, an immediate concern for many credit unions is how this change in evaluation may affect their sustainability. A focal point of concern is the determination of risk in any one credit union, especially a small credit union that could struggle meeting capital adjustments to offset its calculated risk. With delinquency in credit unions up over 20% through the third quarter and interest expense rising at nearly double the rate of interest income, the calculations of credit and interest rate risk may have a substantial impact on the evaluations of individual credit unions. For many credit unions with declines in margins, membership and loans outstanding, it is becoming more difficult to raise capital and be competitive. A small credit union that needs to raise its capital ratio 100 to 200 basis points may not be able to achieve the required goals and need to sell loans or assets that have been evaluated as a higher risk. In either case, the need to focus on raising capital or selling performing assets to reduce assumed risk levels may significantly hurt the sustainability of any given credit union. Credit unions are already looking into merger options with potential partners as a contingency plan to these changes. For most merging credit unions there are usually 20 to 60 credit unions that would be interested in being the continuing credit union.
Merger Outlook–2008
In reviewing the trends, market environment and sustainability metrics, we had anticipated a decline in consolidation activity in 2007. The observation of these same metrics are painting a different picture for 2008. We can see that in the past four quarters:
* The number of credit unions with downward trends of ROA, loans outstanding and membership are continuing to increase
* Our merger probability modeling for each active credit union indicates a greater number of credit unions that would likely consider and complete a merger
* We are seeing a significant increase in the number of credit unions evaluating their needs in a merger and all options available to meet their merger requirements
* Early retirement options, lack of succession planning and executive/board burnout will continue to build an emotional concern
* The change of merger accounting methods and audit procedures in 2008 may accelerate consolidation
The year should start slow for merger activity but we do anticipate increased merger activity and start to return to the five year average of 3.29% annual consolidation. As credit unions become increasingly focused on acquisitions as a growth strategy and the cumulative result of negative performance trends and emotional concerns continues to affect many small credit unions, the question of when a large scale consolidation in the industry may occur still remains a possibility.
David Bartoo is president of Merger Solutions Group. He can be reached at 888-637-4328 or j.david
