Last week a reader responded to my analysis of credit unions investments at June 2022. His comment was so insightful and comprehensive, I asked Mike Higgins to convert his response to a post, which follows.
Musings On the State of Credit Unions June 2022
Another quarter has passed, and the economy is behaving like a moody teenager – one day up, the next day down. Wall Street has a slightly optimistic outlook, but the Federal Reserve has different plans. A lot of mixed messages. This leads me to a handful of musings and situations to consider based upon second quarter credit union call report data.
- Net interest margin finally improved this quarter (up 16 bps to 2.73%). It was driven by two items:
- Rising loan to asset ratio (more assets earning higher loan yield vs. lower surplus funds yield).
- Higher surplus funds yield (up 34 bps).
I count cash as surplus funds because I am ruthless about sloppy funds management, so if you see a slightly different number somewhere else, you will understand why.
- Those credit unions with short weighted average maturities (WAM) in surplus funds will see immediate benefit from continued (signaled) rate hikes.
- Loan yield barely budged this quarter. It increased 1 bp to 4.29%. Why? Let’s look at where the massive amount of loan growth came from this quarter:
- 40% from real estate lending (1st mortgage held and commercial real estate).
- 35% from vehicle lending.
Those tend to be fixed rate. So huge loan growth, mostly fixed rate, adds little movement in loan yield. When rates go up, the incentive to pre-pay is reduced, so duration will extend here.
- On the funding side, we normally see price inelasticity as rates on core checking and savings are “sticky” tending to lag markets. However:
- The Federal Reserve is starting quantitative tightening. Bank deposits declined this quarter, which rarely happens — the supply of funds is shrinking.
- Credit union deposits were basically flat this quarter.
- Credit union borrowings and non-member deposits increased by 36% this quarter.
- Deposits are becoming valuable again! The spread between cost of funds and the yield on surplus funds is producing a high rate of return after being low for so long.
Banking Like It Used to Be
So, the tendency is greater demand for funds going forward. Banking like it used to be with deposit and loan spreads near equilibrium (deposit spread = surplus funds yield minus deposit cost; loan spread = loan yield minus surplus funds yield).
- Unrealized losses on available for sale (AFS) securities now represent 12.6% of credit union net worth. This will only grow larger with each rate hike. I realize there is no loss on any security held to maturity, so it’s just a paper loss, but it reflects the following:
- Credit unions will be reluctant (or unable) to stomach losses, so they will hold the securities until maturity.
- This effectively converts the securities to fixed rate loans for interest rate risk purposes.
- Fixed rate loans held to maturity reduce liquidity, thus increasing demand for funds to support continued loan growth. Fortunately, there is still room left in the loan to asset ratio. However AFS securities should really be viewed as a loan for ALM analysis, because they are going to model the same behavior.
Navigating to a New Normal Interest Rate Curve
How would you characterize your balance sheet today? What concerns do you have and how do you plan to address them?
Every credit union will be in a different position, but here are four general situations I am seeing right now:
- Nothing Changes. Credit unions that are good at lending don’t have to worry about surplus funds management — because they don’t have lots of surplus funds to begin with. Assuming they are following sound ALM practices, they should be just fine. Suggestion: Stay the course.
- Happy Days Are Here Again. For credit unions who are not so good at lending, and as a result, have excess amounts of surplus funds, but did not chase yield in the investment portfolio, their ROA is in for a big boost from rapidly rising rates. A reasonable deposit spread has finally returned after a long drought. Suggestion: Closely monitor any outflows of deposits and increase rates on shares to avoid runoff–which should also make members happy.
- Can You Say Liability Sensitive? For credit unions good at lending but chasing growth using price/terms as a differentiator (low yield, fixed rate), you will experience increasing liability sensitivity. The funding side of the balance sheet will see faster increases in costs than the asset side can absorb. Decreasing net margin may cause ROA to wane. If you have a large enough net interest margin, you should be able to ride things out; however, run some net income simulations to get a better read on P&L exposure.
- A Forecast That May Incur Pain. Those credit unions not so good at lending, and with excess amounts of surplus funds which chased yield hard, are facing a net margin squeeze. Rapid rate increases are not a friend. Increased unrealized losses will come with each rate hike. Suggestion: Re-evaluate your liquidity. Your securities are like fixed-rate loans in ALM analysis. To grow, you may need new funds since much of your liquidity is “underwater.”
Asset liability management is changing quickly now after a two plus years of historically low rates and a flat yield curve. The current market consensus forecasts an overnight rate in the 3.50-4.00% range before the Fed pauses to let things get sorted out.
Those of you who remember banking before the Great Recession can draw upon your experience. Those who were not in the industry at that time may want to do a little research of the interest rate cycle post 9/11 and the return to “normal.”
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Mike Higgins is a consultant helping credit unions and community banks improve their competitive position through performance-based compensation. He sees financial statements for just over 100 financial institutions every month. He was also a founding investor in a 2006 community bank startup.