The job of a CFO to optimize a credit union’s return on assets while controlling expenses and risk got a lot harder with the United Kingdom’s referendum to leave the European Union (Brexit).
The shock of Brexit should put the Federal Reserve on hold for the rest of 2016, keeping funding rates at record lows. Meanwhile, longer-term rates will decline, flattening the yield curve and compressing already low net interest margins. Declining NIMs will increase the already considerable weight on credit unions to generate non-interest income. The ability to control the operating expenses, credit risk and compliance risk that come with expanding NII-generation platforms will be vital in maintaining financial stability.
The global demand for positive-yielding interest rate duration continues to climb as the total amount of global bonds with negative yields continues to increase. The shock and subsequent economic turmoil that will be caused by Brexit will most probably see the European Central Bank and the Bank of Japan expand their programs of negative interest rate policy, as well as press on with their programs of quantitative easing—an unconventional monetary policy in which a central bank purchases securities from the market to lower interest rates and increase the money supply so financial institutions have higher liquidity and better ability to lend.
With this in mind, I believe we can see the yield on the 10-year U.S. Treasury note fall through 1.38 percent, its all-time low set in 2012. The yield on the seven-year and five-year U.S. Treasury notes could also fall to historically lows levels.
This projected decline in yields has very little to do with relative value and everything to do with trillions of monetary flows that need to obtain some sort of positive yield, as well as the relative safety of the U.S dollar. When projecting the future path of rates, it is important to remember that we are in a new paradigm. Two of the three major central banks of the world are currently engaged in long-term NIRP. Until recently, having NIRP as a long-term monetary policy was unthinkable. Now it is a reality. Therefore, we must be able to imagine Treasury yields at levels we once never thought possible.
The good news with regard to a drop in longer-term yields is that mortgage rates can fall to all-time lows, sparking a refinancing boom that boosts NII through increases in fee income and trading gains for credit unions that sell mortgages in the secondary market.
With the drop in rates and the flattening of the yield curve, competition from large bank mortgage originators may be very strong. Those institutions are also struggling with the problem of compressed NIM as well as depressed trading operations and soured energy loan portfolios. The large bank originators have been rebuilding their mortgage origination and servicing infrastructure and are ready to compete harder for market share. Therefore, retaining member mortgages may be harder, and gains on sale of mortgages may be squeezed.
Additionally, for credit unions that portfolio their mortgage origination, challenges may arise with regard to controlling interest rate risk. The mortgage loans that will be made will most likely be below 3.75 percent and might get as low as 3 percent. At some point in the future, when long-term interest rates rise, the duration on these mortgages will be perhaps the highest ever registered. This will be a risk that needs to be addressed.
With regard to the U.S. economy, manufacturing and capital investment have been declining throughout the year. The problems that Brexit will cause will provide further headwinds, as new trading regulations, duties and tariffs will have to be worked out with the United Kingdom. In 2015, U.S. trade with the European Union totaled $1.1 trillion. This is the largest bilateral commercial relationship in the world. According to U.S. Commerce Department data, 21 percent of that trade was with the United Kingdom. Furthermore, as Federal Reserve Chairwoman Janet Yellen recently noted, U.S. employment growth appears to be slowing.
A slowing economy may bring a decline in demand for consumer loans, such as auto loans. With that could come a decline in the fee income associated with consumer lending. Additionally, credit unions may have to contend with the increased levels of loan delinquencies that come with a slowing economy. Currently, loan delinquencies are at historically low levels. Growth in delinquencies, combined with the tremendous growth in consumer lending portfolios, may present a significant challenge in the form of increased operating expenses related to servicing and risk managing delinquencies and increased loan charge-offs. Efficiencies in this area will be paramount to credit unions maintaining a desirable efficiency ratio and return on assets.
The credit union industry has made tremendous strides at becoming a major force in servicing the financial needs of its communities. I believe that the second half of 2016 will be a very challenging environment for credit unions and their CFOs. However, with the proper mix of expense discipline and risk management, credit union CFOs will weather the storm.
Eric Salzman is institutional sales, with CUES Supplier member SWBC Investment Services, LLC, San Antonio, Texas. Securities offered by SWBC Investment Services, LLC, member SIPC & FINRA. Advisory services offered by SWBC Investment Company, a Registered Investment Advisor.