Get ARM Candy For Your Mortgage Program

PenFed’s 5/5 ARM is a sought-after product but one that takes commitment to efficiency.


Pentagon Federal Credit Union’s ($15.1B, Alexandria, VA) member-friendly 5/5 ARM has received much attention from other credit unions interested in offering similar products. But how does PenFed manage the 5/5 ARM as its lead product from a balance sheet perspective?

The simple but elegant strategy, as Rocky Mitchell, CFO of PenFed, puts it, is a hard product to replicate, but it has several advantages for both the credit union and its members

“We firmly believe in the concept of being a cooperative,” Mitchell says. “We want to drive as much value back to the member as possible…If I was running a for-profit business I wouldn’t be making this argument.”

A Member-Friendly Product

The 5/5 ARM allows members to get a low-rate mortgage that adjusts every five years instead of annually with a 2% adjustment cap every five years, and a lifetime adjustment cap of 5%.

PenFed does this by consistently cutting operating expenses to increase efficiency and offering low loan rates and high deposit rates. PenFed’s operating expense ratio — its key metric — is at 100 basis points, or 1% through March, and Mitchell says the credit union wants to run at 90 basis points by the end of 2012.

The credit union demonstrates its commitment to efficiency by operating only 26 branches and focusing on driving its members online for lower rates. Credit unions of similar size operate with significantly more branches. For example, BECU ($10B, Seattle, WA) has 43 branches and State Employees ($23.7B, Raleigh, NC) has 240.

PenFed consistently has a high loan-to-deposit ratio on its balance sheet and its 5/5 ARM makes up more than 40% of its loan portfolio. At the end of 2008, PenFed was running at 120% on its loan-to-share ratio and decreased the ratio to 110% by the end of 2011. The credit union is expecting to decrease its ratio to 90% by the end of this year, Mitchell says. 

“We have a planned strategy to lower our loan-to-share,” Mitchell says. “As one of the largest credit unions in the country, we could be subject to Basel III’s higher liquidity requirements.” Basel III is a global regulatory standard that increases a financial institution’s capital requirements, including requirements that regulate liquidity and leverage.

Funding Model Focuses On Operating Inexpensively

PenFed manages the significant amount of loans they originate by offsetting the assets with long-term member certificates and borrowings from the Federal Home Loan Bank. The way PenFed funds the product and its reset feature helps the credit union balance its funding needs. PenFed is also selling the long-term fixed-rate loans it originates and working to convert its portfolio to ARMs only.

Net interest margin is another ratio that PenFed works diligently to control. Mitchell says PenFed tries to drive the net interest margin as low as possible. It provides member value with high deposit rates and low loan rates.

“We’re able to do this because we have a low cost strategy,” Mitchell says of the strategy that’s carried across all of the credit union’s products and both sides of the balance sheet.

The credit union challenges its balance sheet by regularly running interest rate “shocks.” NCUA’s recommendation is to shock at 300 basis points, but PenFed takes it a step further, shocking up to 800 basis points. Mitchell says PenFed has minimal to moderate risk at 800 basis points due to the hedging strategies used for its balance sheet.

Interest Rates And Purchase Markets

“In reality, it works more as a 10/1 than a 5/5,” Mitchell says. Members are using the 5/5 ARM as more of a fixed product. The members have no incentive to refinance to a 30-year fixed rate mortgage or a shorter term ARM. Because of the 2% caps it would be 10 years before the rate increased 4%. So if the rates were to jump 3% to 4% it still makes sense keep the 5/5 ARM. The average rate through the first quarter of 2012 is 3% to 3.125%, a rate that gives members significant leverage.

The 5/5 ARM product also positions PenFed for a shift from a refinance-driven market to a purchase-driven market, says Mitchell, who believes that shift is inevitable.

“When interest rates do turn and the refi market dries up, we think this is going to be a great product,” Mitchell says. “We’re properly positioned to capture purchase money.”

The visibility and appeal of the product among PenFeds’ members makes the 5/5 ARM a “go to” loan when members buy a home.