In December 2003 I wrote a piece on how consumer debt affects CUs that observed, “CUs will also want to be careful [to] resist ‘chasing’ loans with questionable credit, just as they should resist ‘chasing’ yield in the investment portfolio.”
In the four years since, indirect loans have grown from 7.1% of total CU loans to 13%, according to NCUA call report data. Considering the indirect lending numbers in the context of the overall economy brings new meaning to some very important topics we’ve discussed in the past, and perhaps calls for a refresher on why we still consider them important to your CU’s competitiveness.
Let’s consider the overall economy as a backdrop to CU indirect lending growth. What worries me is that the indirect growth came at a time when consumer credit totals were increasing 250% (from 1995-2007 according to Bloomberg LLP) and, according to NCUA data, the concentration of home equity line of credit totals more than tripled on the average CU balance sheet. As the typical household leveraged to such unprecedented levels, gas, food, healthcare and housing costs have soared, leaving many families vulnerable to economic calamity in the event corporations begin to downsize. Time will tell the extent to which credit unions chased loans of questionable credit (as of December, 2007, delinquent loans to total loans for all CUs was .93%), but this brings up familiar important topics.
First is the regulatory imbalance between banks and CUs. Banks and CUs between $100 million to $33 billion have grown differently in the past five years. According to NCUA and FDIC call report data, banks grew 61% faster than CUs while generating a 440 basis point advantage in Return on Average Equity (capital to asset ratios are similar with banks at 10.7% and CUs at 11.7%, so the ROAE difference is largely after tax income).
Boxed in by remaining field of membership restrictions and a consumer who is unsure what a CU is, many CUs turned to indirect and subprime lending for growth at a time when Americans were piling on debt. What’s more, asset growth for CUs is constrained by their inability to access the capital markets and a secondary capital imbalance compared to banks that the stalled Credit Union Regulatory Improvement Act would not address even if enacted.
Going forward, access to the capital markets could define the long-term future of a financial institution, because some institutions will need to raise capital for a variety of reasons. These include maintaining adequate capital levels as they grow, better meeting customer/member demand for service enhancements such as branches, and competitive rates and fees–not to mention enhanced marketing and funding compliance costs.
Meanwhile some industry “experts” are telling CUs everything is OK because “our capital levels can absorb the loan shock.” Everything would be OK if the competition is also absorbing a credit bump (community banks may not be), while held to the same capital requirements.
Second are the traditional performance measures of loan to share (versus market share) and ROAA (versus ROAE). Incentives tied to asset and loan growth proved in some CUs to be as nefarious as stock options were for many public companies, including some banks.
In many cases, indirect lending proved to be nothing more than temporary loans carrying possible credit risk and with costs that render them less profitable than government agency bonds. What was the benefit to some credit unions and their members of driving indirect loans up to 40% of the loan portfolio? Why was it necessary to grow via indirect lending anyway?
In the past five years, many CUs fell behind in the effort to increase awareness of their value and culture to the unsold household because the focus was on loan to share (via indirect loans) instead of market share (market share of US deposits held by CUs remains stuck at 6% since 1998). Meanwhile, focused on ROAA versus ROAE, CUs are only now realizing that courtesy pay (share draft protection) is not the cure for the intense margin erosion brought on by a consumer who is taking advantage of the fact that there exist more lenders than America needs.
Successful financial institutions will be focused on growth in customers (members) while becoming increasingly shrewd in capital management. CUs are only now realizing this, in part due to an over-reliance on peer analysis that simply is not good enough because it does not tell you what your competitor is doing to get more (i.e., your) members.
So what’s the “heads up” for today? It begins with the realization that once a CU leaves the “factory floor” of the original sponsor, maintaining the culture is critical while becoming more prudently aggressive in its campaign to acquire more households and increase household penetration.
In doing this, many credit unions need to evaluate the effectiveness of both the marketing and marketing advice that makes up the $900M in “Promotion and Education” expenses the industry reported at year-end 2007. As I understand it, this expense captures most but not all of the marketing/marketing consultant expenses of a CU.
For critical perspective, $900 million represents close to 10% of all US financial institution marketing expenses last year. That means CUs are spendng 10% of all financial institution marketing expenses to maintain a 6% share of all deposits. Food for thought–and action.
Peter Duffy is Associate Director with Sandler O’Neill + Partners, LLP, New York, and can be reached at pduffy
