Tag: Article

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.

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.

Aug 12 2020

What We Can Learn from the Financial Crisis

With the dramatic changes in the economy due to the Coronavirus, credit unions are wondering what they should expect moving forward. Even though this recession is unlike any other, we can look at data from the financial crisis, or the great recession, to get some clues as to what might happen.

Increased Deposits or “Surge Shares”

Starting in 2008, deposits increased substantially at almost every credit union and were often referred to as “surge shares“. There was much debate as to whether the surge shares would eventually leave, but in the end, deposits did not decline but steadily increased for the next ten years. We have already seen a sizable increase in deposits at credit unions this time around, and we could see even more, especially as talks of another stimulus check are underway. Credit unions should plan for multiple scenarios, but a strategy to maximize profitability with the influx of deposits should remain a top priority. Unless additional deposits are needed for loan funding or the new deposits can be profitably reinvested, credit unions should employ strategies to minimize deposit growth and possibly even shrink deposits. Lowering deposit rates, including certificate rates, should strongly be considered if it has not already been done. Dropping deposit rates below competition rates may not be enough to discourage the inflow of deposits, but it is a critical component to maximizing the profit margin. If deposits leave due to low rates, then we know the money is rate sensitive and the credit union knows how to likely get it back when needed; just raise rates.

Change in Deposit Composition

During the financial crisis we saw deposits move from certificates to regular shares. We also saw members purchasing shorter term CDs as the yield of longer-term CDs was not worth the extended term. The potential changes in deposit mix, both by term and by type, and the impact on the cost of funds should be anticipated.

Share Certfiicate Average Weighted Maturity Graph 7 2020

Increase in Loan Charge Offs

As we get further into this financial crisis and as government intervention fades, we will begin to see loan charge offs increase. The unemployment rate at the end of May was 13.3%. In comparison, the unemployment rate peaked at 10.0% during the financial crisis and the total loan charge off rate for all credit unions went from 0.40% to 1.31%. If we use the historical relationship between the unemployment rate and the charge off rate, at an unemployment of 13.3% we could expect the charge off rate to jump to 1.57% from the current 0.57%. This recession is different, so the relationship between unemployment and charge off rates may also be different. We do not have the data yet to see how unemployment has affected delinquencies or charge offs for almost all types of loans. However, credit card delinquency and charge offs have been steadily increasing over the past few years and are almost to financial crisis levels.

Total Loan Charge Off & Recovery Graph 7 2020

Credit Card Charge Off & Recovery 7 2020

Changes in Loan Composition

The loan composition also saw a dramatic shift during and since the financial crisis. New vehicle loans as a percentage of the loan portfolio rose during the crisis and then fell as we recovered. Used vehicle loans did the opposite. Real estate loan composition shifted and 1^st liens became a much larger portion, but it appears to be offset by the decrease in home equities. It seems many people may have taken advantage of the increase in home values and refinanced or moved the Jr. lien debt into the 1^st lien. This move to longer-term fixed-rate products has caused the average weighted maturity of the loan portfolio to increase, and potential interest rate risk to be greater.

Real Estate Loan Composition Graph 7 2020

Loan Estimated Average Weighted Maturity Graph 7 2020

Lower Net Income

Historically, when rates are lower net income is also lower. Often, loan and investment rates drop farther than deposit rates. At the same time, many credit unions struggle to even make loans, and charge offs typically increase in a declining rate environment. The loans to assets ratio did not return to the pre-financial crisis number, and this recession may halt or erase what progress has been made. Compounding this issue is that investment rates are at or near historic lows, and all of the inflow of new deposits and reinvesting of maturing investments will be in lower-yielding instruments.

Conclusion

It is important to remember these charts and graphs represent the aggregate of the credit union industry, and many credit unions saw much more dramatic shifts in their balance sheet, charge off rates, and earnings than shown. We are presenting this information to help as credit unions explore options, anticipate changes, plan, and prepare to manage through this new crisis. Each credit union should evaluate how they performed during and since the last economic downturn and be ready for the potential for history to repeat itself. If credit unions properly prepare for this and future recessions, they can maintain healthy margins and help their members through their financial difficulties.

If you would like more information on the MHSI Peer Analysis tool and how it can be used to show your credit union and your specified peer’s historical data, please contact us at info@markhsmith.com or call us at 1-800-268-7795.

Jul 17 2020

Managing Risk – Interest Rates, Net Interest Margin, and Capital

Recent Economic Activity

At the end of the first quarter and throughout the second quarter, the U.S. economy experienced one of the largest, if not the largest, economic shocks in history. The Federal Reserve Bank reacted swiftly in lowering the Federal Funds rate to a near-zero target and implemented various additional asset purchase programs. In addition, the federal government initiated numerous fiscal stimulus programs to aide businesses and unemployed workers. Some have proclaimed that given how this was an event-driven economic shock coupled with large and immediate responses, that a quick, “V” shaped recovery could occur. But should you really plan for this when making decisions now and throughout the next 12 to 18 months?

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Managing Risk – Interest Rates, Net Interest Margin, and CapitalRead More »

Apr 21 2020

Net Economic Value (NEV) and The Current Environment

As interest rates increased from 2016 through 2018 so did concerns pertaining to interest rate risk in the up-rate scenarios. Many credit unions saw an increase in the net economic value (NEV) of capital when estimating potential rates up interest rate risk. In the up-rate scenarios, most of the improvement in economic value of capital was a result of the increased benefit received from member shares. In the up-rate scenarios, the increases in the economic value of non-maturity deposits exceeded the decrease in the economic value of assets. In the up-rate scenarios, it is expected that asset values will decline because the yield of the assets will be below-market rates. The increase in the economic value of non-maturity shares in the up-rate scenarios comes from the growing gap between rates paid on shares, including non-interest expenses, and market or wholesale funding rates. The market rates commonly used for non-maturity deposits are the wholesale funding rates or the cost to borrow from a Federal Home Loan Bank or a corporate credit union. One can look at the gap between the all-in cost of funds for deposits and the wholesale funding rates as the economic value of non-maturity shares. (See graph below)

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Net Economic Value (NEV) and The Current EnvironmentRead More »

Apr 21 2020

Economic Uncertainties and Scenario Risk Management

Prior to the Coronavirus expectations were for a gradual economic slowdown in 2020, but most economists were not expecting a full-blown recession. The abruptness and severity of the economic impact of the Coronavirus have been unprecedented, to say the least. First-quarter estimates of economic contraction are around a seasonally adjusted 5% annualized rate. Some second-quarter estimates range around a massive 20% contraction. Estimates of the unemployment peak in the near-term range widely from 15% to as high as 30%. However, a lot of uncertainties come in the months and quarters following the first half of 2020. Will the recovery be a “V”, “U”, or “L” shape is often the question asked? Some economists are expecting anywhere from an 8% to 12% annualized GDP growth rate bounce back in the second half of 2020 and some degree of bounce back is certainly likely. The very large uncertainty lies in how much that bounce back will be and how constant it will be in terms of the economy returning to positive growth on a sustained basis. For example, the unemployment rate will certainly come down substantially from its Coronavirus peak, but it is difficult to forecast to what level it will return. The days of sub 4.0% unemployment are gone and for the medium-term, the unemployment rate could settle in the high single digits. Unfortunately, many jobs and businesses will not be able to return and the pace that larger company job losses come back may be questionable for some industries. New jobs and areas of growth will certainly emerge, but it will take time. In considering the economic outlook, the credit union may want to contemplate several scenarios such as a quick bounce back in the second half of 2020, a more gradual and drawn out improvement after some initial bounce back, and a worst-case scenario where improvements happen slowly over a longer time period. Unfortunately, given the high degree of uncertainty at the current time, it may be prudent to plan for the latter two. From a risk management perspective, this means that credit unions should look hard at credit, liquidity, net interest income, and capital stress scenarios and plan accordingly.

Forecasting credit performance going forward will be challenging to say the least. As unemployment rates rise to unprecedented highs in the near term, recent legislation allows credit unions to enact forbearance programs for those members affected economically by the Coronavirus. Also, the legislation does not require a troubled debt restructuring (TDR) status for these loan modifications. Given the immediate and lasting economic uncertainties along with government policy reactions, determining actual future losses will be challenging for credit unions. Credit models generally are challenged with the uncertainties of government policy reactions. One possibility would be to consider different economic distress scenarios and be aware and prepared for the most severe that has a material probability of occurring.

During the last financial crisis and recession, credit unions generally experienced member share growth and even an acceleration of share growth at certain times. However, can we be certain this will be the case again? Various liquidity drivers impacting the balance sheet should be considered. For example, as opposed to share growth continuing unabated, what if members have a greater reliance on using savings to pay expenses. In addition, lower interest rates generally mean faster real estate prepayment rates, however, this will be offset by loan forbearance programs and the possibility of some members needing short term loans. As this is a vastly different crisis that may have a longer, more drawn-out lasting impact, the credit union should be on a heightened liquidity risk assessment and management alert.

From 2016 through 2018 the Federal Reserve gradually increased the federal funds rate and the U.S. Treasury yield curve also increased. Credit Unions began to see net interest income increase as balance sheets grew and margins expanded. However, during those later years, the U.S. Treasury yield curve began to flatten and even invert at times. During the second half of 2019, the Federal Reserve decreased the federal funds rate 75 basis points and many credit unions began to see net interest margin pressures emerge in the fourth quarter of 2019. With the onset of the Coronavirus crisis, the federal funds rate was swiftly taken to zero and the U.S. Treasury yield curve was well below 1.00% out to a 10-year term at the end of the first quarter. Net interest income will continue to be under pressure again due to a lower interest rate environment and possibly lower or even negative loan growth for some credit unions. Base case expectations for net interest income pressures should be assessed, but also the possibility of further pressures such as a lower level of loan growth or even negative loan growth stress scenarios.

Risk management is a function of credit union management and the need for risk management is heightened with such a high level of uncertainties and potential for adverse outcomes. Base case and stress scenarios allow the credit union the ability to assess the impact on capital and plan accordingly. Through all of this, keep in mind that it’s times like these where the credit union can show members their value by supporting them through financial challenges. Times like these can present the credit union with the opportunity to step up support for members with actions such as loan forbearance and small-dollar lending programs. Risk management is a function of credit union management and needs to be heightened during these times, but it is ultimately done to provide the best service to members and particularly in their time of need.

Apr 21 2020

Opportunities For Credit Unions – People Helping People

In February 2020, I attended the CUNA GAC conference. It was a treat to attend a conference with intelligent, friendly, down to earth people working in the credit union industry. One take away from the conference was the continued importance of credit unions as a financial resource for many Americans. The motto of, “People helping people”, or “Not for profit, not for charity, but for service” emphasizes the unique purpose of the credit union industry. I am familiar with a credit union that recently changed its mission statement as it went through an extensive reevaluation of its culture. The new mission statement is, “We help when no one else will”.

Listening to the speakers, I was again reminded that credit unions are in a position to provide financial services and help many of its members that may not be best served by the for-profit banking sector. The last FDIC household survey conducted in 2017, showed that more than one in four households (26.9%) are either un-banked or under-banked. This means they are conducting some or all of their financial transactions outside of the mainstream banking system. Credit unions can be a shorter and easier step to becoming fully banked. One way to tap into this under-served segment is with the low-income designation and developing processes and products to serve the under-served. Some of the solutions involve technology such as mobile banking and bill pay. Others may include credit counseling along with small-dollar loans for school supplies or unusual loans such as loans to cover funeral expenses. There are still opportunities in the market place to develop and offer financial services to the under-banked.

Credit unions have been successful when their products and services do not compete head-to-head with the larger banks. They should constantly be on the lookout for the unique needs of their members and continually create solutions that fit those needs. Areas of opportunity may be more small-dollar loans and real estate lending. Real estate loans have potential interest rate risk that should be evaluated but they usually have higher yields than investments. The risk-reward trade offs come into play with this decision. In my experience, many credit unions have balance sheets with very little interest rate risk and are well within their interest rate risk policy limits. Long-term loans or investments may present options for increasing interest income. Recently, numerous mortgage companies have tightened their lending standards to protect themselves because of the pandemic. This tightening may be an opportunity for a credit union to get to know its members better and to help in a way that is congruent with the CU philosophy.

Historically, credit unions have offered a variety of unsecured loan products and have been able to differentiate themselves from banks. According to CUNA Mutual Group’s Credit Union Trends Report for March, the data showed a 6.7% year-over-year total loan growth, down from 8.7% as of January 2019. Unsecured loans have stayed relatively steady with year-over-year growth at 7.7%. As overall loan growth declines, the unsecured loan or small-dollar loans may help the diminishing loan-to-asset ratios. Banks and other financial companies may also see this as an opportunity. Therefore, understanding and meeting the current needs of members may eliminate their exploring outside solutions.

The conference occurred before the Coronavirus pandemic hit the US. The country has changed significantly over the last 2 months, and the economic impact is still unfolding. Progressive, nimble, and attentive credit unions may look at this as a prime time to help members. If and when another challenge happens, those that were helped will remember who assisted them. Stronger relationships and bonds are developed during times like this.

There have been many stories in the news of people going above and beyond to helps others in need. The unusual Easter bunny visits, the waives and smiles through windows, the sharing of a travel trailer, and the offerings to shop for the elderly are only a few examples. The efforts to connect with and help another person, even in a time when social distancing and quarantining have become commonplace, are inspiring. The credit union industry’s purpose and mission are parallel with the actions of caring and helping that we are witnessing during this crisis. I feel that credit unions are essential and play an important role in offering quality and affordable financial services to their communities. Now is the time for credit unions to show how they are different from banks. Let’s put our words into action and help members navigate and survive this unusual event in a way that is consistent with the mission of “People Helping People”.

Dec 28 2019

2019 Interest Rate Recap and Outlook

2019 Recap

In 2019 the Federal Reserve’s FOMC (Federal Open Market Committee) did a complete 180 from many expectations at the end of 2018. December of 2018 saw the FOMC increase the Fed Funds rate 25 basis points to a range of 2.25%-2.50%. At this time, along with the Federal Reserve’s guidance, many were expecting a continued upward trajectory in rates for 2019. However, leading up to December of 2018, the U.S. Treasury yield curve had been flattening. To many, this was a potential warning sign that maybe a continuation of the upward trajectory in interest rates was not such a sure thing.

During the first half of 2019, the FOMC remained on hold with respect to further increases in the Fed Funds rate and the yield curve continued to flatten. Global economic weakness and political uncertainties such as the trade negotiations were often cited as reasons for the pause. Beginning on August 1^st of 2019, the FOMC began reducing the Fed Funds target range and reduced the range by 75 basis points over the following three months to where the range currently stands at 1.50%-1.75%. In August of 2019, the spread between 2 year and 10-year U.S. Treasury yields reached a slight inversion point of -5 basis points. Since that time, this spread has reversed in conjunction with the Fed Funds target range decreases and is a positive 30 basis points at the time of this writing. Furthermore, the FOMC has paused reducing the Fed Funds target range since the last reduction on October 31^st of 2019.

The Current Environment

The last FOMC meeting was December 11^th of 2019. The press release from this meeting cited a labor market that remains strong and that economic activity has been rising at a moderate rate. Following this meeting, most Fed officials expected that the Fed Funds rate would likely remain unchanged in 2020. They still believe the risk is biased to the downside, however, further reductions would not likely occur without a material change to the downside in economic activity. At this time, markets are not expecting additional reductions in the Fed Funds target range until later in 2020 and only one reduction is being discounted in the market. In addition, as noted above, the spread between the 2 year and 10-year U.S. Treasury yield has steepened and remains at approximately 30 basis points. This spread represents the steepest the curve has been in 14 months. Does all of this mean that further reductions in short and longer term interest rates in 2020 are on pause?

Outlook

Certainly, a reasonable base case outlook would be for no reductions in the Fed Funds target range in 2020 and a U.S. Treasury yield curve that remains relatively constant around current levels or maybe even steepens further. However, keep in mind how relatively quick the timeframe was from rates increasing to rates decreasing. The FOMC took back 75 basis points of Fed Funds target rate increases in a mere three month period. That represents a third of Fed Funds rate increases that had been gradually occurring during the previous several years. Many market watchers point out that every recession in the past 50 years has occurred following a yield curve inversion and no recession occurred that was not preceded by a yield curve inversion. Furthermore, often was the case in these instances where the yield curve uninverted, but a recession still followed. If history follows suit and a recession occurs in 2020 or early 2021, it is expected that the FOMC would continue moving the Fed Funds target rate down and yields across the entire term structure would continue moving down. The reasonable base case noted above may well play through during the first half of 2020 and possibly even the entirety of 2020. However, the risk for most credit unions lies in the possibility of a resumption in rates moving down and that possibility occurring sooner then the FOMC or markets are currently anticipating. Credit Unions should keep this in mind in 2020 and beyond even if the near term outlook remains or becomes increasingly complacent to the possibility.

Dec 28 2019

As Interest Rates Go Down, What Does That Look Like For ALM?

On December 11^th, 2019, the Federal Reserve left short-term interest rates unchanged at a target range of 1.5% to 1.75%. This year, the Federal Open Market Committee cut rates three times but signaled it was unlikely to extend the easing cycle into 2020 unless there were material changes to the economy. The three rate cuts and the unease about the future economy lead to the question about negative interest rates which is on the minds of many board members and managers.

Emphasis is placed on increasing interest rates and the anticipated adverse effect on net interest margins and liquidity, and not much attention given to the implications of declining interest rates. When interest rates were at historic lows for such a long time, interest rate risk in the down-rate analysis was quickly glossed over and passed as unrealistic. In the same vane, NCUA’s list of supervisory priorities includes the potential negative effects of rising interest rates and very little is mentioned about declining interest rates.

During the past few years, as rates went up, deposit growth continued, funding mix did not significantly change, loan growth increased, and many investment portfolios completely repriced to the higher yields. Therefore, during this period of rising interest rates, many credit unions also experienced improved net interest margins and ROA. The improved earnings throughout the credit union system confirmed the results of the ALM models that forecasted improvement in net interest margins when interest rates increase. The improved net interest margins can be attributed to a significant portion of the credit unions’ loan and investment portfolio repricing in 3 years or less, and a large percentage of funding is stable with low rate sensitivities.

Now that interest rate trends are shifting and moving down, most credit unions need to prepare for a negative impact on earnings. As stated above, the interest rate risk scenarios in the up-rate typically forecast positive results, and interest rate risk lies in down rates. Also, many of the down-rate forecasts are showing results that exceed policy limits and boards and management are becoming more worried about down rates or even negative interest rates. When the down-rate scenarios are forecasting a decrease in net interest margins, the direction of the decline should be taken seriously. The amount of the drop should be further evaluated for reasonableness. If the forecasts are showing net interest income changes are outside policy guidelines, researching and understanding the details and assumption inputs becomes critical in determining if the results warrant attention and corrective action.

Yield on Loans & Investments and Cost of Funds

The graph above shows that loan rates lagged considerably and did not increase when market rates were increasing. We began to see small increases in the past two quarters and now interest rates are going back down. Investment yields improved and the cost of funds nudged up a bit. As short-term interest rates decrease, investment yields are directly correlated and will also decrease, but loan yields and the cost of funds may not change with the market. If a credit union holds a large investment portfolio, the interest income is going to be negatively impacted more than a credit union that has a smaller investment portfolio.

Interest rate risk management is a balancing act between risk and reward. If interest rates are moving down, investing and lending in long-term fixed-rate products lock in current yields and help future interest income. On the flip side, if a credit union makes mortgage loans or invests longer-term in preserving interest income now and then rates turn and start to go back up, the ability to increase interest income is limited. This conundrum, whether it be loans or investments, is best solved by sticking to a strategy and within well thought out interest rate risk limits, and not trying to guess or time the market.

On the funding side of the balance sheet, costs are easier to manage and control in a down-rate scenario. However, since dividend rates did not go up much and remain low, the ability to reduce the cost of funds is severely restricted. The following example illustrates the change in yields and dividends in a down 100 basis points scenario. The credit union’s loan yields, based on repricing assumptions, are forecasted to move from 5.27% to 4.59%, and investments yields decline from 2.09% to 1.09% over 12 quarters. The cost of funds is at 0.40% and can only go down to 0.07%. The limitation and cause of most of the interest rate risk as rates go down is due to the inability to reduce the cost of funds below 0%. If deposit rates get to 0%, but loan yields and investment yields continue to decline, a solution would be to charge members for keeping their money safe and facilitating transactions. This is an example of negative interest rates. The likelihood that negative rates will become real for credit unions is very low. Large institutional investors and large financial institutions would implement negative rates before credit unions.

In this environment, the goal should be to preserve loan yields, move funds out of the investment portfolio into loans, and stick to your investment strategies. Lastly, reduce the cost of funds but understand the limitations we discussed above. Be mindful that fee income and other non-interest income are crucial components to maintaining ROA as rates go down.

A down-rate environment will unwind the improvements in net interest margins credit unions experienced in the last few years. The goal of this article is to caution, encourage preparedness, and inform that the down-rate scenarios in your ALM analysis should not be ignored. The assumption that loan rates will decline more than they went up when market rates increased by over 2% may indicate more interest rate risk in your analysis than may occur. Discussing and understanding the results of the down-rate forecasts is essential when comparing the results to policy limits. If the results are out of policy limits, determine if the results are realistic, and if corrective action is warranted. Lastly, document this process as part of the ALCO or board meetings.

Dec 28 2019

CECL and Your Credit Union’s Investment Portfolio

As many credit union executives have likely heard, the current expected credit loss model (“CECL”) is a new Financial Accounting Standards Board (“FASB”) accounting rule. CECL was scheduled to become effective on December 31, 2021, but in July of 2019, FASB extended the effective date for credit unions to January 2023. Regardless, in NCUA Letter No. 16-CU-13, the NCUA wrote, “…your credit union needs to take steps in advance to ensure effective implementation of the standard. The board of directors and senior management of your credit union should become familiar with the new accounting standard to assess how the new standard differs from the existing incurred loss model.” The standard changes how credit unions account for credit losses on their loans and on debt securities in their investment portfolios.

In a nutshell, the purpose of CECL is to address delays in the recognition of credit losses. In effect, CECL will require credit unions to record at the time of origination, credit losses that are expected during the life of loans and Held-to-Maturity securities. This is different than the “incurred loss” accounting methodology used today in which losses are recorded by credit unions when it’s probable that a loss already has occurred.

Much has been written about the effect of CECL on loans, but relatively little about its effect on credit unions’ investment securities. Currently, debt securities at purchase are designated as either Trading, Held-to-Maturity (“HTM”), or Available-for Sale (“AFS”). The accounting treatment is different for each designation, as are the applications of CECL and related FASB amendments. Changes may be coming, particularly in response to a growing concern about the chilling effect CECL may have on loans to low income borrowers, but here’s a quick summary of what we know so far in connection with CECL’s application to debt securities in credit union investment portfolios:

Securities designated “Trading” are accounted for monthly on a mark to market basis and the adjustment in value is recorded to income. Credit losses are accounted for immediately. CECL does not impact securities designated “Trading.”
HTM securities accounting is performed monthly on a book basis. Valuation changes are not recorded to income or equity. Currently, losses or Other Than Temporary Impairment (“OTTI”) are recorded to income when it is determined that a loss has or will soon occur. HTM is primarily used to reduce volatility to equity. HTM securities will be subject to CECL. CECL will require an allowance on these HTM debt securities for lifetime expected credit losses, determined by adjusting historical loss information for current conditions and reasonable and supportable forecasts. The forward-looking evaluation of lifetime expected losses will be performed on a pooled basis for bonds that share similar risk characteristics. These allowances for expected losses must be made by the holder of the HTM debt security when the security is purchased. So, when credit unions buy HTM securities, they will be required to look in the rear-view mirror and also squint down the road through the windshield to determine whether the new security will encounter trouble. If so, the expected trouble must accounted for at the time of purchase.
AFS securities accounting is performed monthly on a book basis. Valuation change is not recorded to income but is recorded to equity in the form of Other Comprehensive Income (“OCI”). Currently, losses or OTTI are recorded to income when it is determined that a loss has or will occur. The income adjustment is recorded as a reduction in the security’s cost basis. Recovery of a previously recognized impairment is recorded in interest income prospectively over time. The FASB decided that CECL should not apply to AFS debt securities. Instead, targeted amendments were made to the existing AFS debt security model. Under the new guidance, an allowance will be recognized for credit losses rather than as a reduction in the cost basis of the security. Subsequent improvements in credit quality, or reductions in estimated credit losses, will be recognized immediately as a reversal of the previously recorded allowance, which aligns the income statement recognition of credit losses with the reporting period in which changes occur. Consequently, the guidance eliminates the theory of OTTI, and instead emphasizes determining whether an unrealized loss is credit-related, or due to other factors. Specifically, the length of time the security has been in an unrealized loss position will no longer be used to determine whether a credit loss exists. Impairment must be evaluated at the individual security level, at each reporting period, through a comparison of the present value of expected cash flows from the security with the amortized cost basis of the security.
In addition to most existing disclosure requirements, disclosure of an allowance roll-forward, by major security type, for both HTM and AFS debt securities will be required. For HTM debt securities, by major security type, disclosure of credit quality information and allowance for credit losses and management’s estimation process will be required. Also, for AFS debt securities, disclosure of the accounting policy for recognizing write-offs will be required.

Stay tuned for more changes to CECL in the next few years – or maybe even months.

Although CECL may not inspire us to whistle while we work, we can take heart in the words of Disney’s Mary Poppins who sang, “In every job that must be done there is an element of fun.”

The author would like to thank Ken Jeffery of Heber Fuger Wendin for his contributions to this article.

Heber Fuger Wendin, established in 1934, is a fee-only, independent, fee-only SEC-registered fiduciary investment advisory firm (not a broker) to credit unions and other depository institutions. Mr. Barnes leads the Heber team in helping to manage $4 billion for over 100 clients. Mr. Barnes can be reached at dbarnes@hfw1.com or HeberInvestments.com