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Mar 20 2018

Calculated Shifts in Investment Strategies Can Yield Big Changes To Income and ROA

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Written by webmaster

4 min read

Credit unions in the asset range of 10 million to 250 million have seen their loan to total asset ratios increase in the last 5 years from a low of 49% to a ratio of 55% as of December 2017.

Mark H. Smith, Inc. Peer Analysis Balance Sheet Module

While this is a very nice improvement, it still leaves a sizable portion of the balance sheet residing in investments and other assets. Maximizing earnings while balancing interest rate risk is the essence of asset liability management and the investment portfolio continues to be an important component in a credit union’s overall profitability.

I would like to share the success one credit union had as they made some significant shifts in their investment strategies. To start, here are a few stats about this credit union: over $100 million in total assets, net worth ratio 10% plus, loan to asset ratio 64%, overnight liquidity ratio 19%, and 1-year liquidity ratio 22%. Their ROA for 12 months ending March 2015 was a modest 19 bps.

Early in 2015, this credit union made a conscious decision to restructure their investment portfolio and move assets that were in overnight accounts and a few investment CDs into longer-term investments with better yields. They also shifted their term investments from exclusively investment CDs into a mix of CDs, government agencies bonds, and muni bonds. With this shift, the credit union’s interest rate risk increased but remained well within acceptable risk limits. The overall benefit to income was worth the increased risk.

Before the transition, which took up to 15 months, the credit union’s interest on investments represented 21 basis points. At the end of the 15 months, their interest on investments grew to 39 basis points and set them on the path for continued improvement in investment interest income. From June of 2016 to June of 2017, investment income increased to 45 basis points. A 24 basis points increase equates to $240,000 annually for a credit union with total assets of $100 million. With assets of $50 million it would be $120,000 annually. If nothing else changed in income or expenses, the ROA would improve from 19 basis points to 43 basis points. For many credit unions in the asset range less than $150 million, additional income of this amount is not trivial.

Now the questions are, how long did they invest and what did this do to their interest rate risk? During this analysis period, it should be noted the credit union’s investment portfolio stayed consistent and continued to be very close to 30% of total assets. The investment terms did not exceed 72 months and the majority were in instruments with maturities of 60 months or less. They also appropriately laddered the maturities for liquidity. The improved earnings resulted in the net worth ratio increasing.

Before these changes, the credit union’s NII at risk in the up-rate shock of 300 bps was a positive 27.5% for the three-year cumulative and a positive 9.5% in year one. Their very low level of interest rate risk can be attributed to a one-year liquidity ratio of over 20% combined with 37% of their funding in lower rate sensitive regular shares and share draft accounts. The NEV analysis produced similar results with strong positive numbers and indicated little to no interest rate risk.

Mark H. Smith, Inc. Peer Analysis Balance Sheet Module

At the end of 2017, the interest rate risk profile in the up 300 basis point scenario estimated the NII at risk at a positive 4.1% in the three-year cumulative and forecasted a decrease in NII of 9.7% in the first year. The base case net interest margin in 2017 was stronger than it was in 2015 and easily absorbed the forecasted decline in the first year. The subsequent years indicated positive increases in NII over the base case scenario. Again, the NEV analysis yielded similar results with net worth at risk of a positive 8.6% and a strong market adjusted net worth ratio. The NCUA supervisory test results remained well within the low-risk range.

How does this case study help you as the reader? It is intended to promote questions and cause the reader to take a moment to reflect on your credit union’s balance sheet composition and investment strategies. Even during this time when fed fund rates are projected to increase 75 basis points in the next 9 to 12 months, there may be options for improving the performance of the investment portion of your balance sheet. Evaluate the benefits of investing now versus sitting on the sidelines until the up rate cycle ends. Review your interest rate risk profile and determine if there is an opportunity to improve earnings now, even as rates are increasing, and still keep your interest rate risk within policy limits and at a level your credit union management and board are comfortable with.

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Jan 14 2021

Five Top Credit Union Topics For 2021

As we move into 2021, the following topics might be worth discussing and considering with your management team.

Earnings

During the first half of 2020, net interest margins came under substantial pressure as market interest rates were shocked dramatically downward. Net interest margins are expected to remain under downward pressure throughout 2021 as investment portfolios continue to reprice lower and share growth continues.

One of the easiest and quickest responses to declining interest income is to address the cost of funds. Many credit unions still have room to decrease their cost of funds, as shown in the September 2020 ending period graph below.

Source: NCUA

Delinquency

Based on the September 2020 call report data, loan delinquencies and net charge-offs remained low and were below September 2019 delinquencies. Loan forbearance and other assistance programs in place through the entirety of 2020 may have helped delinquencies. Also, certain sectors of the economy are not as impacted as others. The unemployment rate is expected to continue drifting lower in 2021. However, as the assistance programs are lifted, delinquencies and charge-offs are expected to increase as unemployment remains substantially above the years leading up to the pandemic.

Source: MHSI Online Peer Analysis Module through September 2020

Credit Union Philosophy

Serving the underserved has always been a hallmark of credit unions, and now more than ever, there is an opportunity to do this for many credit union members. As these times have been challenging, credit unions can continue to evaluate and prioritize how to best serve members in the coming year, especially those under financial stress. Exploring how to provide service to those that are underbanked might be an opportunity. One option may include evaluating risk-based lending policies and programs, especially given the robust liquidity on most credit union balance sheets. New and alternative avenues to bolster income should continue to be explored.

Digital and Technology

As the pandemic shifts and prolongs, credit unions should evaluate if their electronic delivery channels meet members and potential members’ needs. Moving to or improving digital delivery channels should be accelerated and prioritized. Digital delivery should include evaluating loan origination and servicing channels to maximize new loan volumes. Online and remote financial services will continue to grow and may be the preferred way members access and manage their financial activities.

Balance Sheet Growth

Before the pandemic, many experts anticipated credit union loan growth to taper off but remain positive. After the first quarter of 2021, loan production became unpredictable, however, by the end of the third quarter, annualized loan growth was 6.34%. Real estate lending, driven by the abruptly lower interest rate environment, helped with the growth. Experts anticipate loan growth to be around 6.0% to 6.5% over the next 12 months as the economy recovers.

The first few months of 2021 may see strong share growth as the second round of government assistance and stimulus takes hold, and households remain reluctant to spend until signs of COVID easing and warmer weather occur. Share growth last year increased at an annualized rate of over 18% and is expected to be approximately 8.0% to 10.0% in the coming year. If double-digit growth continues, earnings sufficient enough to sustain capital will be critical. If economic conditions improve and overall consumer activity increases, loan growth and increasing long-term interest rates could counter some of the anticipated income pressures. Fortunately, the credit union industry is very well capitalized and able to ride out the adverse conditions and absorb some more growth, even if earnings are reduced.

Nov 04 2020

The Bottom of the Frog Market

Several years back, I went to Mexico for a vacation. While there, I found a ceramic hand-painted frog-shaped planter that I wanted. My husband loves the hunt, and his quest began. Every time we saw a frog-planter, he would start negotiating with the vendor to get the lowest possible price. We searched for several days and would stop in different towns and check the markets while enjoying our vacation and exploring. When we found a frog, he would inquire about the price and negotiate for further discounts. After a few days and no success at getting the cost of the frog below a certain point, my husband declared, “we have hit the bottom of the frog market.”

…

The Bottom of the Frog MarketRead More »

Sep 30 2020

Economic Uncertainties and Interest Rate Certainties – Asset Allocation Assessments and Considerations

Future GDP Projections

In September, the Federal Reserve Chairman spoke publicly on several occasions and reiterated that the central bank is committed to helping the economy “for as long as it takes.” He noted continued improvements in the economy, but also acknowledged a highly uncertain path ahead. The September FOMC (Federal Open Market Committee) projections are now projecting a full-year GDP decline of 3.7%. This is substantially better than their previous expectation of a 6.5% decline. However, they lowered their 2021 outlook from 5.0% to 4.0% and their 2022 outlook from 3.5% to 3.0%. Their 2023 outlook is at 2.50%.

Interest Rates and Economic Uncertainties

The FOMC also indicated that they would allow inflation to run above 2.0% on a sustained basis before any federal funds rate increases. As such, most individual members of the Committee indicated that the federal funds rate could remain close to zero through 2023. Some economists and analysts even think that we may not see an increase in the federal funds rate until 2024 or 2025. They believe that it will take up to five years for the global economy to fully recover to pre-pandemic levels.

The risks to the FOMC economic growth projections are high. Even the Chairman of the FOMC acknowledged the economic uncertainty of the path ahead. Following the sharp rebound in many economic data measures and drop in the unemployment rate, some recent measures have disappointed compared to expectations and some are indicating a recovery that is stalling. At the current time of this article, the nature of further fiscal stimulus continues to be negotiated in congress and some are not expecting a resolution until after the presidential election. Of course this only adds to the current economic uncertainty.

What is highly certain over the short to medium term timeframe is that interest rates will not likely be increasing more than just relatively minor fluctuations in the medium to long end of the U.S. Treasury yield curve. It is more likely that potential risks on the horizon could drive medium and longer-term U.S. Treasury yields even lower.

Reassessing Balance Sheet Strategy

Given the above outlook, it would certainly seem that some credit union balance sheet strategies of recent years should be reevaluated for the foreseeable future. Reassessing asset allocation strategies is possibly more relevant at the current time than at any time in the past several years. For example, the credit union may want to ask itself how much should we be redeploying assets into two to three year investment CDs given current interest rates on those maturities. If the answer is less than previous years, then what are the alternatives we can explore.

Priorities Going Forward

In exploring alternatives, the first priority for credit unions is of course serving members. Assessments and considerations could include expanding the types of loans offered, reevaluating risk based lending allocations, increasing real estate concentrations, debt consolidation programs, and loan payment support alternatives to name just a few. Secondary to the first priority are considerations such as allocations to loan participations and alternative investments. For example, should the credit union assess CUSO or similar investment possibilities. What are all of the possibilities for these type of investments that may be available to the credit union? After all, an alternative of earning five basis points at the corporate credit union with too much of assets is not likely to accomplish any priorities or goals for the credit union.

The present time and foreseeable future is a great time for credit unions to really show how they can serve and support members during these challenging times. Being there for your members is for sure the highest purpose for the credit union and always assessing ways to provide service and assistance to them will always be the credit union’s first priority. In addition and secondarily, now more than any time in recent years it may make sense to really take a deep dive into the above asset allocation assessments, considerations, and possibilities. Ideally, the best answers going forward would combine the first priority with the second to optimize balance sheet performance while best serving members.