Credit unions will face a challenge meeting income needs in the coming year as deposit growth has been strong but loan demand is still limited. Investment portfolios are taking center stage as credit unions must invest these excess deposits in a time when yields are low and risks are high.
Growing Investment Portfolios
Investment portfolios of credit unions have grown by $31.3 billion during the 12 months ending September 30, 2011, according to Callahan and Associates’ Peer-to-Peer data. During the same period total credit union assets grew by $50.8 billion implying that for every new dollar of deposits members brought to credit unions, 62-cents went into the investment portfolio.
Peer-to-Peer data reflects that credit unions had $93.2 billion in cash at the end of September, 9.7% of total assets. During the year “liquid deposits” of share drafts, regular shares and money market shares grew by $54.4 billion to $532.9 billion and now represent 55.3% of total credit union liabilities.
What are credit unions to do when their savings and money market rates are similar to yields on 2 – 3 year Agency notes; regulators presenting white papers on rate risk management and it is too expensive to shift member deposits into longer-term certificates?
When, and if, credit unions receive derivative powers then this asset-liability risk can be hedged with interest rate swaps. Until then this risk must be managed with on-balance sheet float rate assets. With the yield of floating rate securities similar to 2 -3 year agencies, this investment strategy is made easier.
Know how the security will be priced once rates increase. The asset-liability benefit of rate responsiveness securities is diminished when the market prices them below their book value, creating a secondary problem of an unrealized loss in a security you are counting on for liquidity.
Can You Live With The Risk?
In December I recapped to ALCO the income challenge that has occurred in 2011 with a rhetorical question.
At the start of 2011, you could generate 2% yield with a five-year Treasury, which also had good roll, or aging, characteristics because of a steep curve. To get 2% yield now you have to invest in a 10-year Treasury – twice the maturity than at the start of the year, with worse performance characteristics and which is the longest maturity permitted by our Policy.
A question for thought: “At beginning of the year you feared rates would rise. Rates on five-year certificates were above 2% and you were comfortable with buying five-year Treasuries and effectively losing money to certificates. With the Fed now likely on hold for a 2+ years, five-year CDs below 2%, and the credit union needing more interest income from the portfolio, are you comfortable with 10-year Treasuries at a breakeven yield to member CDs?
Remember, economists were wrong with their rate forecast for 2011. Can we live with the results of our decision if we are wrong and rates unexpectedly rise?
Another Question to Illustrate Risk
Here is an earnings dilemma to discussion risk tolerance to replace rolling-off investment income. With 20% of the portfolio to mature or prepay in each of the next two years, do we want to replace the average 3% book yield of the cash flow? If yes, are we willing to live with the risk?
Timely to the discussion was a newly issued agency note due in 10-years, with a call in two years, and a 3% coupon. You can replace the 3% book yield with this bond but can you live with the residual risk if you are wrong? Specifically, in two years we will either have cash to reinvest in an even lower interest rate environment, or an eight-year agency note with a 3% coupon at unrealized loss.
To quantify the risks of the rates rising, if rates increase by 100 basis points than every $10 million invested in this bond will have an unrealized loss of $700,000. Could you live with this unrealized loss? Another question, if you are then convinced that the economy has recovered and rates will go up further, will you sell the bond and realize the $700,000 to avoid an even greater future unrealized loss?
Find “acceptable yield,” a reasonable level of income with the potential for price appreciation and limited risk if I am wrong. Finding this “acceptable yield,” has become increasingly more difficult – if not impossible – this year given the compression of short-term yields and the flattening of the curve.
The Ultimate Goal
The goal for 2012 is to manage risk and try to produce acceptable net income for an extended near-term.
If you are in the camp that says the economy is improving, rates will have to go up some time soon and you need to offset the risk of your rate-sensitive deposits so invest in floating rate securities that reset monthly. You can reasonably project their liquidity and price once rates rise.
If you are in the camp that says we are in a protracted recovery, the Federal Reserve will be on hold for an extended period and you value reasonable income for 3–4 years rather than 1–2 years, then invest in securities that delay principal repayment for four to six years. Those investments take advantage of the steepness in the six- to eight-year sector of the yield curve and have limited extension risk if you are wrong.
The first option addresses the asset-liability risk presented by the rapid growth of deposits with no growth in loan demand. The second option recognizes the new reality that the investment portfolio is becoming the marginal driver of credit union revenue – and risk.