The economic recovery has started. GDP surged back into positive territory. Home and auto sales are up from a year ago. Housing prices have increased 2.0% nationally according to the Case-Shiller indices, with both the 10-city and 20-city composite indices posting gains over the past year. Unemployment remains elevated but jobs are being created again and both the manufacturing and service sectors are expanding.
The economic recovery is a key factor in improved performance at America’s 7,653 credit unions. Earnings are up over both year-end and first quarter 2009 results as net interest margin rises and expenses remain under control. Asset quality is improving, with both delinquency and net charge-off rates down from year-end. Share growth continues to be strong, though lending has slowed due in part to re-emerging competitors.
While the broad results indicate that we have reached a turning point, the strongest evidence may be seen in the positive results of credit unions that have been managing through the most severe downturn many have ever experienced. Credit unions in California and Florida such as North Island and GTE have returned to profitability in 2010 following 2 years of negative earnings. Expenses are being controlled, delinquency rates are improving and the positive ROAs are helping to bolster capital at these institutions.
Credit unions’ ability to manage through the Great Recession while posting record increases in shares and lending activity is a testament to the industry’s continued focus on the long-term well-being of its 91.5 million members. With the economy returning however, competition is also back. Credit unions benefitted from the pull-back of many competitors during 2008 and 2009, but now must re-double their efforts in order to sustain the momentum achieved during the downturn, particularly as consumers continue to demonstrate a reluctance to borrow. All financial measures indicate they are well-positioned to act on market opportunities. The key question for the industry and each credit union is, will they write their own success stories in 2010 or will they allow market forces to dictate their results?
Margin and Expense Management Drive Earnings
Credit union earnings are improving, with each key component posting stronger results. Return on assets rose to 47 basis points. ROA prior to NCUSIF assessment expenses is up to 50 basis points from a loss of 3 basis points a year ago. The core earnings ratio, which represents earnings prior to non-operating expenses such as the assessment as well as the provision for loan losses, is up 20 basis points from a year ago to 1.34%.
The net interest margin has expanded to 3.24% through the first quarter, up 12 basis points from a year ago and the highest first quarter net interest margin since 2005. The margin has improved as the average loan yield has fallen 23 basis points over the past year to 6.13% while the cost of funds has declined 72 basis points over the same period to 1.49%. With interest rates expected to remain low throughout the year, lending activity will be the driver of credit union margins in 2010.
Non-interest income is up 2.7% over the past year as credit unions continue to grow transaction-based service revenue. Key sources of non-interest income are under pressure due to regulatory reforms being enacted by Congress. Regulation E goes into effect this summer, requiring members to ‘opt in’ to overdraft protection programs. A potential reduction in interchange income from debit card transactions is being considered as part of the Financial Services Regulatory Reform bill being finalized by a joint House-Senate Committee as this publication goes to press.
These two sources of non-interest income are the two largest for credit unions, representing over 45% of non-interest income according to Callahan’s 2010 Non-interest Income Survey. In response to potential reductions in these revenue streams, credit unions are taking steps ranging from raising fees to emphasizing other non-interest income sources such as insurance sales to developing new product lines such as title insurance or business services.
Operating expenses continue to be well-managed. As a percentage of average assets, operating expenses are 3.11% through the first quarter. This is a 13 basis point improvement over the first quarter of 2009 and the lowest first quarter result since 2002. The ratio has benefitted from solid balance sheet growth but expenses are up just 2.6% versus a year ago, even as many credit unions accrue for a 2010 NCUSIF assessment in operating expense categories such as member insurance. Salaries and benefits, which account for half of total operating expenses, are up just 1.4% over the past year across credit unions.
The expense line item that has drawn perhaps the most focus recently is the provision for loan losses. With the economy and asset quality improving, the provision expense fell 12.5% from the first three months of 2009 to $1.9 billion. This is the lowest quarterly provision expense since the second quarter of 2008 and the first below $2 billion since the third quarter of 2008. A reduction in the provision expense going forward could provide a significant benefit to the industry’s bottom line in future quarters. Delinquency and allowance for loan loss trends indicate such a trend is likely.
Share Growth Remains Strong
Share balances have risen $20.8 billion, or 2.7%, over the first three months of the year to reach a record $784.2 billion. Over the past 12 months, deposits are up $48.7 billion, or 6.6%. While the annual growth rate has slowed from the 8.3% rate posted in first quarter 2009, the core deposit categories of regular shares, share drafts and money market accounts are each growing at a faster rate this year than a year ago.
Money market accounts are leading the rise with a 20.2% jump in balances over the past year. Regular shares are also increasing at a double-digit pace, up 10.2% since March 2009. Share draft balances are higher by 9.8% over the same period. A key driver of the growth in these categories is the value credit unions continue to provide to savers. Over 1,300 credit unions report a money market account rate of 1% or higher as of March 31. Over 2,800 credit unions, or nearly 85% of those that offer a money market account, are paying at least 50 basis points. These incredible returns come as many money market mutual funds are yielding less than 10 basis points due to continued low overnight rates.
IRA balances are up 8.1% over the past year, while share certificates are the only deposit category that has declined, falling 6.0% since March 2009. The decline in certificate balances in part reflects members’ reluctance to lock up funds with interest rates at historic lows. In addition, given the pressure deposit growth is putting on net worth ratios, some credit unions are allowing short-term certificate balances to roll off the books. Rather than lose the member relationship, some credit unions are reaching out to members prior to certificate maturity and offering options through their retail investment programs. Elevations Credit Union ($931M, Boulder, CO) has seen off-balance sheet investment balances rise 23% over the past year due in part to such a program.
Loans Decline as Mortgage and Consumer Lending Slows Nationally
Loan volume fell nearly 25% from the record pace established in the first quarter of 2009 to $51.8 billion. The mortgage refinance boom was a driver of the record volume a year ago, and first mortgage originations fell 44% versus the first three months of 2009 to $14.4 billion. The annual rate of decline in credit union mortgage volume is much steeper than the 3% decline reported by the Mortgage Bankers Association. As a result, credit unions’ share of the first mortgage market nationally fell from 5.8% to 3.4% year-over-year but remains above the historical average of 2%.
Consumer loan originations at credit unions declined 12% to $30.9 billion, led by lower auto loan volume. The auto lending market started to become much more competitive beginning in the fourth quarter of 2009. Credit unions’ share of the auto lending market has fallen from 19.6% in March 2009 to 14.3% in March 2010. The March market share is the lowest monthly market share captured by the industry since April 2008, and the industry’s share declined for nine consecutive months before posting an increase in April.
With both mortgage and auto lending, the two largest components of the loan portfolio, slowing, loans outstanding on the balance sheet posted a slight decline over the past year to total $573.5 billion as of March 31st. During the first three months of the year, loan balances fell $6.9 billion, or 1.2%. These trends are in line with the Federal Reserve’s reports on consumer credit outstanding, which show both revolving and non-revolving credit declining in every quarter over the past year, including a 2.7% annual rate of decline in the first quarter of 2010.
First mortgage loans outstanding are up 3.3% over the past year although growth is muted as credit unions continue to sell long-term, fixed rate first mortgages. Credit unions sold $7.9 billion in first mortgages to the secondary market during the quarter, accounting for over half of all first mortgages originated in the first three months of the year. Other real estate loans, primarily home equity loans, are down 4.6%. Used auto loan balances are up 2.8% but new auto loans outstanding have dropped 11.7% since first quarter 2009.
The two fastest growing categories of the loan portfolio are member business loans and credit cards, up 9.5% and 7.4%, respectively. Credit cards are the only loan category that has posted a higher annual growth rate in first quarter 2010 versus a year ago.
Credit unions are taking advantage of market opportunities in both credit cards and small business loans. The CARD Act continues to provide an opening for credit unions as consumers look for alternatives to large issuers. Total credit card lines of credit reached $109 billion at the end of the first quarter, continuing the steady rise that has been sustained throughout the downturn.
Small business lending remains the fastest growing category of the credit union loan portfolio. Although accounting for only 5.2% of loans outstanding, credit unions are a critical source of credit for many member businesses at a time when other financial institutions have cut back on lending to this segment of the market. Perhaps the strongest indication of this is the over $2.3 billion of loans credit unions originated to businesses in the first quarter. This result exceeds the $2.1 billion of first quarter small business loan originations touted by JPMorgan Chase in full page ads being run in major newspapers, despite the bank’s $2.1 trillion balance sheet holding more than 2.3 times the assets of the $910 billion credit union industry.
Asset Quality Measures Improve
Delinquency fell to 1.77% at the end of the first quarter, down six basis points from year-end results, while the annualized net charge-off rate declined three basis points over the same period to 1.19%. These represent the first quarterly improvements in both categories since the economic downturn began in 2007.
Credit union asset quality continues to exceed that of banks. The FDIC reported a 5.45% delinquency rate and 2.84% net charge-off rate as of March. Both numbers continue to rise at banks, though at a slower pace than in previous quarters. Since banks report delinquency as 90 days or more past due while credit unions report it as 60 days or more past due, combining loans 30 days or more past due with net charge-offs provides the best apples-to-apples comparison between the two industries. The “problem asset” ratio under this formula is 8.08% for FDIC-insured institutions and 3.51% for credit unions through the first quarter. These numbers were only 25 basis points apart at the beginning of 2007 (1.92% vs 1.67%), and the continuing expansion of this gap is one indicator of credit unions’ relative strength and ability to better capture market opportunities.
One other important measure of balance sheet strength is the coverage ratio, measuring the percentage of delinquent loans covered by the allowance for loan loss account. Credit unions’ coverage ratio reached 89.8% as of March versus the FDIC-institution average of 64.2%. This measure is another indicator that credit unions are better prepared to handle potential loan losses and should be able to reduce their provision expense, and thus grow earnings, at a faster relative rate than banks.
Managing the Balance Sheet is Critical as Investment Balances Top $300 Billion
As shares continue to flow in and loan growth slows, liquidity is rising at credit unions. Total investments including cash exceed $301.6 billion at March 31st, up 14.4% over the past year. The loan-to-share ratio is 73.1% at the end of the first quarter, down nearly 5 percentage points from March 2009.
The increased liquidity is a challenge given the interest rate environment. Investments are yielding 2.07% through March, approximately one-third of the average loan yield. Although credit unions have extended their investment portfolios, with investments maturing in less than one year accounting for 50% of the portfolio today versus 59% in March 2009, continued low interest rates are providing little yield benefit.
To increase asset yields, credit unions are looking for new sources of loans. Balance sheet-friendly products such as adjustable rate mortgage and private student loans are receiving increased focus. In addition, loan participations are being increasingly utilized. Loan participation purchases increased 19% year-over-year through March as credit unions sought to not only pick up additional yield versus investment alternatives but also diversify their loan portfolio.
Capital Ratios Rise across Industry, Including in ‘At Risk’ Credit Unions
The net worth-to-assets ratio rose 20 basis points versus March 2009 and held steady versus year-end at 9.9%. The total capital ratio, including the allowance for loan losses, has improved even more dramatically, up more than 70 basis points over the past year.
As cooperatives, credit unions have the benefit of taking the long-term view. Even those credit unions in the most difficult financial circumstances are benefitting as the economic cycle turns positive:
- Nearly 65% of credit unions reported a positive bottom line in the first quarter, up from 50% at year-end 2009
- The percentage of credit unions that have a net worth below 7% is unchanged from one year ago while the percentage of credit union assets held by well-capitalized credit unions has increased from 86.8% to 90.8% over the past year
- The total capital ratio of credit unions with a net worth ratio below “well-capitalized” is 7.7%
- The coverage ratio for these ‘at risk’ credit unions has risen steadily over the past year and is now just below the industry average of 89%
- ROA and core earnings have also risen steadily at these credit unions over the past year
Return to Normal or a New Era?
As earnings and capital rise across the industry and delinquency ratios improve from year-end in 40 states, it is clear that credit unions have managed through the worst of the downturn and can increasingly turn to opportunities in the market. Credit unions can leverage the momentum of the past two years as a launching point for new growth possibilities. Will credit unions seize the opportunity? This year will be a key indicator of the industry’s trajectory going forward.