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, and that leads me to a handful of musings and items to think about based upon second quarter credit union call report data. Get the details in Filene’s Credit Union Financial Performance Indicators, 2022 Q2.
- Hooray! Net interest margin finally improved this quarter (up 16 bps to 2.73%). It was driven by two items:
- Rising loan to asset ratio (asset concentration; loans earn more than investments).
- Higher surplus funds yield (up 34 bps).
- 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, leads to no movement in loan yield. With rates up, the incentive to pre-pay is reduced, so duration will extend here.
The fact loan yield showed very little movement is a bit troubling for credit unions who are pursuing rapid growth strategies while not paying enough attention to interest rate risk.
- On the funding side, we normally see price inelasticity as rates on transactional checking and savings tend to lag; however, from Economics 101 we know that prices go up when supply shrinks or demand increases. Both are happening at the same time.
- The Federal Reserve is starting quantitative tightening. Bank deposits declined this quarter, which rarely happens—the supply of funds is shrinking (FDIC: Quarterly Banking Profile).
- 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 surplus funds yield is producing a high rate of return after being so low for so long.
- Non-maturity deposits (transactional checking and savings) now have enormous strategic value. Economically over the past 8-10 years, they have had very little value due to the low rate environment. But now, everyone is going to want your deposits. And those who need more liquidity (out of desperation or because of opportunity) will be willing to pay to get it.
So, expect a tendency toward greater demand for funds going forward. For those of you old enough to remember, this is banking like it used to be: deposit spread and loan spread 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, but AFS securities should really be counted as a loan, because they are going to behave like it from an Asset Liability Management (ALM) perspective.
Credit Union Financial Positions
Every credit union will be in a different position, but here are four general ones that 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 any 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 were patient and did not chase yield in the investment portfolio, your ROA is in line for a big boost due to rapidly rising rates because a reasonable deposit spread has finally returned after a long drought.
Suggestion: Closely monitor any outflows of deposits and be prepared to increase rates on shares to avoid runoff (this will also make members happy).
- Can You Say Liability Sensitive? For credit unions that are good at lending but were using price/terms to capture market share (low yield, fixed rate), you are going to experience liability sensitivity. Your funding side of the balance sheet will see faster increases in costs than the asset side can absorb and that will cause ROA to wane.
Suggestion: 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 your exposure. If you were not too greedy, you can avoid pain (see next position).
- The Forecast Calls for Pain. Those credit unions who are not so good at lending, and as a result have excess amounts of surplus funds and were chasing yield in the investment portfolio are going to get squeezed. Rapid rate increases are not your friend. You are going to see an increase in unrealized losses with each rate hike.
Suggestion: Re-evaluate your liquidity position because your securities are effectively fixed-rate loans. If you want to grow, you may need to attract new sources of funds (shares).
ALM is changing quickly now after a period of low rates and a flat yield curve. The consensus on the street is an overnight rate in the 3.50-4.00% range before a pause to let things get sorted out. Those of you who remember banking before the Great Recession will be able to draw upon your experience. Those who were not in the industry at that time need to do a little research.
How would you characterize your balance sheet today? What concerns do you have and how do you plan to address them? Given the rapid pace of change it is important to be thinking about it.
Stay tuned for another quarterly update after 2022 Q3 data comes out in December.