DP Conversions and Lending High on the List

Next week, the Fed will meet to discuss whether or not they should adjust the overnight rate. Currently the overnight rate is 1.25%, and it is highly speculated that the Fed will decide to cut rates either 25 or 50 basis points. While a Fed rate cut impacts lending, borrowing and savings rates across the board, it has a direct and immediate impact on short-term investments. Credit unions have a high percentage of their investments in overnight and other short-term accounts, and will lose a substantial amount of investment income if the rates are cut.
In the first quarter of 2003, credit unions grew their short-term investments 31%. These short-term investments, defined as cash and cash equivalents, now make up one-third of the industry's investment portfolio and total $72 billion.

 
 

Next week, the Fed will meet to discuss whether or not they should adjust the overnight rate. Currently the overnight rate is 1.25%, and it is highly speculated that the Fed will decide to cut rates either 25 or 50 basis points. While a Fed rate cut impacts lending, borrowing and savings rates across the board, it has a direct and immediate impact on short-term investments. Credit unions have a high percentage of their investments in overnight and other short-term accounts, and will lose a substantial amount of investment income if the rates are cut.

In the first quarter of 2003, credit unions grew their short-term investments 31%. These short-term investments, defined as cash and cash equivalents, now make up one-third of the industry's investment portfolio and total $72 billion.

If the Federal Reserve lowered interest rates 25 basis points, it could cost credit unions $180 million in yield. If the rates were lowered 50 basis points, as some analysts anticipate, the loss in investment income could be as high as $360 million.

There are a few strategies to compensate for this loss of income. The first strategy would be to lengthen the duration of their investments. When rates were cut in November of 2002, credit unions increased the portion of their portfolio in 1-3 year investments nine percentage points. By lengthening their investments, credit unions can earn higher yields and reduce their potential losses.

Many credit unions will not, however, be able to implement this strategy. The industry's short-term deposits have been the driving force for share growth for some time now. These short-term deposits have been used to fund lending, which has been fueled by mortgage lending. Long-term loans funded through short-term savings create potential ALM issues (asset and liability management). These potential ALM issues caused the growth of short-term investments seen in the first quarter, and a Fed rate cut will do nothing to solve the issues, so many credit unions will have to maintain a high percentage of their investments short.

The other strategy for credit unions will be to increase their income in other areas. Credit unions would prefer to generate more interest income through shorter-term auto and unsecured loans. However, credit unions have had trouble generating loans other than mortgage loans recently, so they may have to focus their efforts on generating more fee income. As was written a couple of weeks ago, credit unions may already be facing a loss of some fee income due to a reduction of debit interchange income. Credit unions will have to look to other areas of fee income generation to overcome two potential income obstacles. This provides an opportunity for suppliers to help credit unions generate enough income to compensate for recent and potential declines in earning power.

If credit unions cannot find a way to increase their interest or fee income, then they will have to control costs. Credit unions could, and almost certainly will, pass through the rate deductions to their dividends. The amount they pay on savings accounts will probably be reduced a comparable amount to the rate cut. This reduction in interest expense will help alleviate the pain of less interest income. The amount that credit unions cut those dividend rates will depend on their success, or lack thereof, in generating additional income.

 

 

 

June 23, 2003


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