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?
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.
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.