Ready for Rising Rates?

Until recently it seemed that low short-term interest rates would persist until well into 2005. But now the prospect of tighter monetary policy in the very near future has become almost a certainty. A surge in the payroll employment numbers in March and April, coupled with an uptick in the inflation indices, has convinced the market that it is time for the Fed to start raising rates. The Fed acknowledged the change in economic conditions in the press release following its May 4 Federal Open Market Committee (FOMC) meeting.

 

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Until recently it seemed that low short-term interest rates would persist until well into 2005. But now the prospect of tighter monetary policy in the very near future has become almost a certainty. A surge in the payroll employment numbers in March and April, coupled with an uptick in the inflation indices, has convinced the market that it is time for the Fed to start raising rates. The Fed acknowledged the change in economic conditions in the press release following its May 4 Federal Open Market Committee (FOMC) meeting. From March 16 through the release of the April employment numbers on May 7, medium-term rates rose by some 120 basis points. The market has subsequently settled down a bit and rates have pulled back 15-20 basis points. The Fed is now expected to take action at the next FOMC meeting from June 29 to 30. The consensus forecast is that the Funds Rate will reach 2 percent, an increase of 100 basis points, by January 2005. The November election does cause some questions about the actual timing of these increases. The Fed will want to keep out of the way of the elections as much as possible. The current yield curve has already priced in the 100 basis-point rise in the Funds Rate this year followed by a steady climb toward 4.5 – 5 percent over the next two to three years. These rates are already embedded in the market and into the pricing of loans, investments and hedges.

If rates do move to the levels the yield curve predicts, what will be the impact on credit union margins and risk profiles?

Shrinking Margins
Net interest margins have been under pressure for some time; however, many credit unions did benefit temporarily from their cost of funds declining faster than loan portfolio yields. This is particularly true for those with higher concentrations of long-term fixed rate loans. But in 2003, the pressure on margins intensified and anecdotal information suggests that 2004 will be a tough year for most credit unions. At a recent conference, a show of hands indicated that every attendee expected their margin to be lower in 2004. In some cases the declines may be very significant. Looking forward, we should expect to see the yield on loan portfolios continue to decline as seasoned high-rate loans pay down and are replaced by new loans with lower yields. It looks like the cost of liabilities has started to “floor out,” although the average cost of funds did decline in the first quarter of 2004 by nearly ten basis points. Don’t look for that to continue. Investment portfolio yields have finally stabilized and should start to benefit from today’s higher yields. However, we still expect net interest margins to decline if short-term rates do rise fairly rapidly. Over the last couple of years credit unions have been able to increase fee income fairly substantially, but there may not be much mileage left there either.

Shares and Liquidity
For most credit unions, liquidity is not likely to become a serious issue in the immediate future. Excess funds within the system have grown by more than $105 billion since the Fed started cutting rates in January 2001. However, averages are very misleading and there are still quite a few credit unions with loan-to-share ratios in excess of 90 percent. Most of the growth in share balances (72 percent) has come in the form of regular shares and money market shares, although share drafts, certificates and IRAs also grew in that period. Administered-rate non-maturity accounts, share drafts and regular shares, now account for nearly half of all shares, with money market accounts making up another 18 percent. Credit unions need to evaluate how the combination of rising rates, potential share outflows and the pricing of competitors will impact their own pricing behavior. Some credit unions may respond very differently this time around.

Loan Portfolios
Real estate loans continue to dominate many credit union portfolios. Overall, real estate loans comprise approximately half of total credit union loan balances. First mortgages make up about 70 percent of all real estate loans, and over 80 percent of those loans have fixed rates for some period. This includes both traditional 15-year and 30-year fixed rate mortgage loans as well as hybrid ARMs, which typically have a fixed rate period up-front for terms between three and ten years. Interestingly, the NCUA has just moved hybrid ARMs into the fixed rate category on the March 2004 call report. Aside from the addition of new fixed rate loans, most existing fixed rate mortgage loans have refinanced to lower levels with the lowest rates seen in the last 40 years. Clearly, some credit unions have increased their sensitivity to rising interest rates. The remaining loan growth largely came from indirect auto lending programs.

Understand Your Risk Position
It is more important than ever to understand your current interest rate risk position. As mentioned above, two areas that warrant particular attention are administered rate non-maturity accounts and real estate loan portfolios. Double check your numbers and make sure the underlying modeling assumptions are still valid. Once you know where you are today, you need to take a look at your current business strategy and see if it is still viable. What will happen to your margins as rates rise and what will your risk position look like at the end of the current planning cycle? You might also want to extend your analysis out a little longer than usual since the current yield curve has rates rising throughout 2006 as well. If both look acceptable, you may not need to make any major changes. If that is not the case, you may need to change your earnings expectations and/or change your balance sheet strategy. Remember, significant increases are already built into the yield curve and any action will be based on forward interest rates, not today’s levels. Make sure your models utilize forward rates or you may be building in considerable modeling error.

Getting a Second Opinion
If the current situation seems overwhelming, get some outside help. In spite of all the resources we have available at WesCorp, we still get someone in from outside every two years to take a look at what we are doing and let us know if we are missing anything. Sometimes you are just too close to the situation to make objective assessments. There are many consultants, including WesCorp, that can help you in this area.

Changing Your Risk Profile
If you need to quickly change your current interest rate risk position, there are four actions that are readily available: 1) Rebalancing the investment portfolio; 2) Selling loans as participations or whole loans; 3) Taking down fixed rate advances to match off against long-term assets; and 4) Utilizing derivatives to hedge your liability costs. Which combination of these works best will depend on your particular balance sheet composition and the nature of the specific assets/ liabilities involved. At WesCorp, we offer a full range of balance sheet and ALM consulting and hedging services delivered by a dedicated team of experts. If you would like to learn more, please call our Financial Solutions Group at (800) 442-4366, ext. 6585.

 

June 14, 2004


Comments

 
 
 
  • I find it interesting that those credit unions who were successful at lending over the past few years are have more risk than those credit unions who were not good at making loans.
    Anonymous
     
     
     
  • Well written with good content
    Anonymous
     
     
     
  • Better than most article because it is more in depth and offers different solutions. Glad that you ran the article; it's an area of increasing concern for CUs in general.
    Anonymous
     
     
     
  • Very timely. How should fixed rate mortgages be addressed in a rising rate scenario??
    Anonymous
     
     
     
 
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