From March 2020 until two years later when the Fed began its rate increases, overnight rates were near zero. For these years and the decade prior, monetary goals were dominated by ZIRP, or zero interest rate policy. Federal reserve actions were characterized by “easy money” to encourage growth almost at all costs.
TINA was the real world consequence of an ever expanding money supply seeking higher returns. There is No Alternative led to speculation in every market sector from crypto and all of its virtual spinoffs, the stock market with historically high valuations (price/ earnings ratios) and in most other forms of investing such as residential and commercial real estate.
With near zero cost of funds and asset appreciation occurring in every category, how could an investment not pay off? Holding cash or buying short term bonds was for fools when higher returns were possible from virtually any other investment.
Now the bubbles are starting to burst as the Federal Reserve continues its interest rate hikes and as these flow through to longer term yields.
The combination of ZIRP and TINA meant that valuations in stock markets, or new ventures , as well as traditional collateral based lending on real estate or commercial buildings became separated from actual earnings or cash flow analysis. Money managers were drawn to these alternatives assured by the decade long monetary easing culminating in ZIRP.
Entrepreneurs, startups and even established firms made decisions not based on actual business performance but future projections. These choices were based of valuations underwritten with assumptions of low cost of funding.
Impact on Credit Unions
In 2020 and 2021 credit union shares grew by double digits. Consumers were flush with cash from multiple government stimulus spending packages. They used these new funds to pay down traditional borrowings.
With only a 5-10 basis points return on short term funds, credit unions looked for alternatives. They extended investments out the yield curve, sought higher yields from longer loan maturities, commercial participations, or other forms of indirect lending pools and even new CUSO investments.
In 2023 credit unions will navigate the 1-2 year adjustment process to correct these prior decisions. With patience and prudent balance sheet management most will transition to this new rate era and recover unrealized market losses.
This rebalancing may entail paying below market dividends on core shares until asset returns adjust to higher yields. If the institution has a strong service culture and earned loyalty, this reliance on member’s patience should be successful.
However there were other investments by credit unions where the process becomes more complicated. The two areas most vulnerable to ZIRP/TINA overvaluations are whole bank purchases and mergers. Or any other transaction which resulted in the creation of significant accounting goodwill.
The Bank Purchase Challenge
Most credit union bank purchases, where information is public, have been at multiples of 1.5X to 2X book value. For publicly traded banks, these credit union offers were often much in excess of the most recently quoted stock price.
Total cash paid to bank shareholders depends on the size of the acquisition. But these outlays are large involving tens to hundreds of millions of dollars.
Credit unions book the difference between the cash paid and the net value of the assets as goodwill. This is an intangible asset. It is non-earning. These valuations are based on forecasts about cost of funds, the credit union tax exemption and any market synergies that may be achieved.
Most sizeable bank purchases will take 3-5 years to determine if the price paid will result in an accretion to ROA or perhaps reduce the prepurchase financial performance. Operational and market integrations alone will take several years. For purchases made in the ZIRP environment, these forecasts will have to be rerun. Is the goodwill premium “real” or was it miscalculated?
Similarly in mergers combined with purchase value accounting, a goodwill gain for amounts greater than book value may be added to “equity acquired in merger.” But is that goodwill actually long term or just a momentary valuation bubble caused by the low interest rates paid on deposits versus market yields?
If the goodwill recorded is unrealistic for any reason, then the valuation write downs come out of current earnings. In this case, members pay twice: once by sending out cash to bank shareholders and again for expensing the decline in goodwill from current income.
Looking at Case Studies
In future blogs I will examine several whole bank purchases looking at the credit union’s performance before and after, and by benchmarking with peers.
I am inclined to prefer cooperative strategy which prioritizes organic growth through continuous innovation and consistent market focus for member benefit. Engineering growth through acquisitions is a very different financial and operational skill.
In the capital markets these transactions are most often done with “play money,” that is the stock of acquiring companies, not actual outlays of cash. The market’s judgment via the stock price of post-acquisition performance is constant and public.
There is no such accountability in similar credit union purchases. CEO’s and boards leave and their successors must then prove that these “investments” with a long tail were wise.
Ultimately it is not the valuation at the time of purchase that reflects opportunity; rather it is the ability to convert externally acquired assets for real member benefit.
2023 will entail assessment of investments driven by ZIRP, TINA and consultant’s fees to see if they really enhance the cooperative difference. That reckoning could be more critical and harder than traditional cooperative balance sheet transformations.