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Jun 20 2018

Minding the Margin

Article

Written by Matthew Jacobsen

4 min read

The Federal Funds rate has now been increasing since December of 2015. The current Federal Funds target rate is 1.75% at the time of this writing. The U.S. Treasury curve three-month to five-year terms have also been increasing during this time period. The two-year U.S. Treasury Yield has gone from 1.08% at the end of 2015 to 2.44% as of this writing. However, during this time period, many consumer loan rates have lagged these increases as competitive pressures remained in lending markets and liquidity was still plentiful. Nonetheless, 2017 and the first quarter of 2018 did see new origination loan rates begin to move higher, and some expect this pace to quicken. In addition, most member deposit balances also did not see much pressure to increase rates since December of 2015, but this also began to change for member CDs in 2017 and also may be accelerating.

As can be seen with the new and used auto loan rates graphs below, new origination auto loan rates began increasing in 2017 and have continued upwards in the first quarter of 2018. As the Federal Funds target rate and short-end of the U.S. Treasury yield curve is currently expected to continue rising, many expect the trends seen in these graphs to continue and possibly even accelerate as they catch up to the Federal Funds target rate and U.S. Treasury yield curve. Credit unions need to consider this possibility when setting loan rates and particularly when setting rates for fixed-rate loans where these rates may be in two to three years. This becomes the case even more so for longer fixed-rate loan types as the credit union needs to consider the margin impact not just today, but over the next several years. Where should you be setting rates today, for your net interest margin objectives over the next several years?

Median New Auto Loan Rates

MHSI Interactive Peer Analysis

Median Used Auto Loan Rates

MHSI Interactive Peer Analysis

Since December of 2015, member non-maturity share rates have still not seen much pressure to increase for many credit unions. Some have argued that notable increases to member non-maturity share rates are still off in the distance. This may or may not be the case, but some credit unions have started to see pressure from larger balance member deposits, particularly in higher balance money market tiers. In terms of non-maturity share rates, this is where we would expect to see the initial pressure upwards (i.e. the larger, more rate sensitive balances). Member CD rates definitely began to increase in 2017 and at least based on the recent quarter, may be accelerating (see the Member CD Rates graph below).

Median Member CD Rates

MHSI Interactive Peer Analysis

Given the rising interest rate environment and an assessment of current and potential future movements on both the interest-bearing asset and interest-bearing liability sides of the balance sheet, now is the time to sharpen your focus on the credit union’s net interest margin objectives and risks. More specifically, this should include an assessment of where these rates may be within the next few years relative to the credit union’s net interest margin objectives. What if non-maturity member deposit rates start seeing greater upward pressures within the next year? Is the credit union considering this possibility when setting interest rates for five to seven-year fixed rate auto terms? In addition to the above, the credit union should also be considering potential increases to loan loss provisioning if the credit cycle turns as well as the impact of CECL for net interest margin planning and monitoring over the next several years.

As described above, the current bias is for higher benchmark interest rates, loan rates, and certain member deposit rates. It certainly makes sense to have a bias towards this outlook in managing the credit union’s current and forecasted net interest margin. However, as we often like to do at Mark H. Smith, Inc., “what-if” the current bias upwards in rates does not get much higher and even reverses course? Is there really any likelihood of this scenario on the horizon? Maybe or maybe not, but we continue to monitor the flattening of the U.S. Treasury yield curve as the spread between 2s and 10s is still at its tightest since the 2008 recession. If the economy is so strong and with inflation at 2.5% and potentially rising, why are 10-year bonds only yielding about .50% above inflation? Is the longer end of the U.S. Treasury bond market telling a different story than solid economic growth and increasing inflation, or is this still the remnants of quantitative easing across the globe holding longer-term rates down? A planning bias for higher interest rates is certainly a good base case in the current environment, but as risk managers, we are always on the lookout for potential market tells that may oppose the consensus. Either way, the current interest rate environment certainly demands a sharp focus on current and future loan and deposit rates and minding the margin.

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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.”

…

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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.