Credit unions leverage asset liability management tools to weather the pandemic storm.
The COVID-19 recession has landed squarely on the desks and computer screens of credit unions’ asset liability committees and the finance staffs that carry out ALM strategy. The current situation is confronting them with the formidable challenge of carrying out two CU imperatives: help members and stay solvent. Just how useful ALM tools can be is something they are carefully assessing.
U.S. and Canadian government subsidies and mitigation efforts to bolster their economies and some forbearance policies by financial institutions have delayed any tidal wave of delinquencies, but anticipating those losses and the impact on income is a top concern for credit unions.
“We haven’t seen a big increase yet,” reports CUES member Tammy Buchanan, CPA, CGA, VP/CFO of $1.5 billion Northern Credit Union Ltd., Sault Ste. Marie, Ontario. “But we expect them to rise, and our people are proactively contacting members by phone to gauge how they are doing. We closed some branches and moved staff to the call center to make these outbound calls. We contacted all of our commercial accounts and the individual accounts as soon as they became delinquent. Those conversations reportedly went well. We saw more delinquencies in March, but since then, the growth rate has come down.”
PAHO/WHO Federal Credit Union in Washington, D.C., serves a membership that is in the thick of the pandemic crisis. (PAHO stands for Pan American Health Organization, and of course, WHO stands for World Health Organization, who.int.) But the CU’s finance operation is calm and not in crisis-management mode, at least not yet, according to CUES member Derek Fuzzell, CPA, CMA, CSCA, CFO of the $240 million institution.
“We’ve seen some activity from savers because of the low interest rates,” he reports. Some are switching from certificates of deposits to savings accounts because the rate difference has virtually disappeared.
“They’re staying short to avoid locking in these low rates,” he explains. “So we’ve shortened liabilities some, but we have to protect retention. About 96% of our members with CDs automatically renew for the same maturity, so we supply them. But we’re not worried. Our liabilities are still shorter than our assets, but we have a good mix of adjustable-rate mortgages on the asset side.”
Trouble Is Coming
That’s fine for now, but Fuzzell knows trouble is coming.
“My biggest concern,” he says, “is what we might face one-and-a-half to two years out. We have an 18% capital ratio and plenty of liquidity, but if credit losses get bad, it will be hard to offset them with earnings from such low rates. And low-yielding mortgages could be a problem if interest rates go up quickly.”
Nevertheless, with mitigation delaying credit problems and so much uncertainty about a pandemic-caused recession, most CUs are not taking dramatic actions so far. “Nobody seems to have implemented a bold strategy,” reports Dave Wicklund, director of ALM advisory services at CUES Supplier member Plansmith, Schaumburg, Illinois. “I haven’t seen anything creative yet, anything that would move the needle. People are waiting for more clarity.”
And that’s fine, suggests Neil Stanley, founder/CEO of The CorePoint, Omaha, Nebraska. Right now is the time to pay close attention to what’s happening with your numbers rather than move too quickly.
“Don’t overreact and create problems when incremental adjustments may be enough,” he advises. “Stick with tested responses, but watch and rethink whether the paradigms still apply or whether they need to be revised under your particular circumstances.”
At the same time, some experts are calling for more action.
“Time is not your friend,” warns Frank Farone, managing director at Darling Consulting Group, Newburyport, Massachusetts, “and now is the time for credit union executives to look in the mirror and ask themselves if they have properly positioned their balance sheets to optimize earnings, regardless of the direction of rates. At the end of the day, all roads lead to the ALM process and being able to defend and support balance sheet management decisions. It’s all about managing risk and not regulatory appeasement or taking the path of least resistance, which can be the greatest risk of all.”
ALM actions generally stem from looking at the results of running data through a model, Wicklund points out, so make sure you have a good one.
“It needs to fit the complexity of the credit union,” he explains. “It needs to reflect all the areas where choices are available, including the range of investment instruments and options like step-up deposits. [A step-up CD, for example, is a deposit account that increases its interest rate before maturity, usually several times.] It needs to reflect the sophistication of the CU’s activities, and it needs to be used in compliance with regulations and the policies of the asset/liability committee.”
If you have the right model, CU finance staff have to administer it properly, making sure the right data are fed into the model at the right times, Wicklund adds. And then, since it’s a predictive model, the staff has to enter critical assumptions, and that’s the rub. If assumptions are off, the model will be off. With the COVID-19 pandemic looming over everything, it’s never been more difficult to make confident assumptions.
Wicklund recalls what happened in 2007 and 2008 when rates fell 375 basis points in a few months. All the models projected that borrowers would refinance their mortgages in droves, but it didn’t happen because home values tanked.
While Buchanan studies her model and looks for trends in internal data, Northern CU also uses an ALM consultant, Picuz Solutions to provide peer insight, enhanced analytics and advice. She also participates in regular talks with economists in the treasury department of Central 1 Credit Union, Toronto. “To survive, you have to know your internal data, but you also have to understand the macro environment,” she says.
Credit union finance teams should be doing four things now with ALM, advises Vincent Hui, a managing director at CUES strategic partner for technology services Cornerstone Advisors, Scottsdale, Arizona:
Watching their net interest spread (difference between the average yield received from loans and the average rate it pays on deposits and borrowings), how it is changing and what they can do to maintain it. Looking at their deposit costs and mix and calculating how they can keep enough low-cost or no-cost deposits without causing a runoff (early withdrawals).
Creating a calendar of when their adjustable-rate loans will reprice or their fixed-rate loans will mature and what the consequences are likely to be on those dates. It may be time for CUs that don’t normally use interest-rate swaps to consider them. (An IR swap is a derivative investment involving an agreement between two parties where one stream of future interest payments is exchanged for another based on a specified principal amount. Notably, five federal agencies just updated their rules about swaps for banks—see tinyurl.com/bankswaprules—increasing flexibility in their risk management efforts.)
Being aware of such off-balance-sheet “assets” as mortgage servicing rights and how their valuations could change.
Wicklund is skeptical about most CUs turning to derivatives to control interest-rate risk. “Swaps are fairly common,” he notes, “but anything else should be used with caution and a thorough understanding of how the derivatives work.”
It’s possible and useful to hedge a transaction with a swap, he concedes, but not a whole portfolio. And even hedging a single transaction needs to be done carefully.
“If a member wants a 20-year fixed-rate loan and the credit union doesn’t want to carry that risk, it can neutralize it with a swap,” he points out. “But if the member prepays the loan, the swap would need to be unwound or the credit union will have created interest-rate risk.”
Going Long or Short?
If governments are heading off a liquidity crunch for now and the course of the pandemic is uncertain, the precipitous fall of interest rates is a current fact of life CUs have to address. And that, for many, means it’s time to stay short.
PAHO/WHO FCU’s investment portfolio has risen by $2.5 million in market value due to the rate drop, but Fuzzell intends to hold those securities as long as he can and reinvest in LIBOR floaters (a fixed income security that makes coupon payments tied to the reference rate).
“With the yield curve so low and flat, there is absolutely no temptation to go long,” he notes. “Those low yields will be a challenge to our income, but we’ll keep the opportunity to gain as interest rates start to rise again.”
Liquidity is a pain credit unions live with, Northern CU’s Buchanan agrees.
“We anticipated a big run on cash when members lost their paychecks and fell back on savings, so we built up liquidity. But it didn’t happen,” she reports. “People stopped spending. So we’re sitting on more liquidity than we’d like.”
Northern CU normally prefers a small investment portfolio, but it’s up to about 10% of assets now as a result of the liquidity boost. Buchanan is parking that money in 30- to 60-day deposits at other financial institutions for very little interest, but it will be available if needed. “We don’t want to go out a year,” she explains.
Not everyone agrees with staying short when rates could stay low for a long time. When rates fall and the yield curve flattens, a lot of CUs try to extend liabilities and shorten assets, but that’s the worst time to do that, Farone insists.
“That’s when you need to lengthen assets and shorten liabilities, but it doesn’t feel good,” he says. “You don’t buy life insurance to collect, and you don’t lengthen assets to win. You hope and pray that rates will rise again, even though you hedged by betting against it.”
When rates eventually start to rise, Farone reasons, “a credit union’s business will revive and thrive as cash flows are reinvested into higher-yielding loans and investments, which will outpace the rise in funding costs due to the low-cost nature of CUs’ core funding base. Margins will widen and earnings will rise despite a potentially below-par investment portfolio.
“Meanwhile,” he continues, “if rates stay low for a protracted period given the current pandemic and worldwide recession, CUs will need all the income they can get from those longer-term assets to cover overhead and, for many, just to survive,” he explains. “It’s natural to hope that rates will recover and slope will return to the yield curve, but hope is not a strategy. Now is the time to revisit ALM and consider what you would do if rates stay low for a long time. It’s time to consider extending assets and buying long-term bonds as a necessary evil.”
If CUs are not going to be able to maintain sustainable interest income and can’t find ways to increase noninterest income, they are going to have to make a new best friend: the bond market. And that won’t be fun, notes Eric Salzman, co-founder of Blanton Research LLC, New York.
“In recent years, credit unions have had loan-to-share ratios of 85 or 90%, so the investment portfolio was a stepchild,” he reports. “If the loan market stops growing, as most people expect, CFOs are going to have to switch back to being investors, and they’re going to have to lengthen durations to get any kind of return, even though the yield curve is pretty flat. To get yield, they will have to accept features like call options (financial contracts that give the option buyer the right, but not the obligation, to buy an investment), even daily call options. They will have less control than they’re used to. Those will be the trade-offs.”
Farone also thinks CUs make a big mistake by treating core deposits as short-term liabilities.
“Those checking account, savings account and other non-maturity deposits may be short-term by definition,” he says, “since depositors can withdraw them at a moment’s notice—but they don’t. Those deposits behave like long-term liabilities and should be managed as such. Credit unions have a huge funding advantage with so much free or cheap money, but they leave opportunities on the table and actually create a lot of risk by exposing the balance sheet to low rates. Those liabilities should be matched with long-term assets to increase net interest margin, but they often aren’t.”
The outlook for boosting interest income isn’t great. While home sales jumped in May, car sales continue to be fairly weak in this economy, Hui observes. It may be tricky to expand a loan portfolio significantly. Used cars have dropped significantly in value, so collateral in some cases could be worth less than the balance on the loan. Credit cards are an exception.
“We expect an increase in credit card outstandings,” he says. “For credit unions that have not outsourced their card portfolios, that means an interesting risk/reward trade-off. The higher yield will be welcome, but when people have trouble paying all their bills, the credit card is one of the first they skip.”
The pandemic has frustrated Fuzzell’s plans. “I’m trying to make us balance-sheet neutral so we can ride out any interest-rate environment,” he reports. “We’re trying to increase our loan diversity, add car loans, credit card loans and home equity lines of credit, but COVID has upset those plans. It’s not a good time to try to add auto loans, so we are shortening maturities in the investment portfolio.”
Loan loss reserves will rise sharply as a percentage of loans, but gross amounts could also reflect falling loan volume, Salzman observes. Auto lending could be a minefield. Automakers are using their captive finance companies to promote car sales. They have ways to make money on no-interest loans, but credit unions don’t, he points out. The used car market is a mess.
“A lot of cars will be dumped and auctioned,” Salzman predicts. “Lenders could have trouble recovering their collateral. Outsourced debt collection services are expecting a very busy time, but recovery rates will be down.”
Regulators will react, he thinks, perhaps requiring more capital and higher credit standards. “But there will be a shakeout. It will be a very challenging time to make money. You have to expect a lot of mergers and that well-capitalized financial institutions will gain market share.”
The outlook for finding noninterest income is equally bleak. What keeps Buchanan up at 3 a.m., she says, is how the CU can offset a loss of interest income with noninterest income.
“With everything moving to digital and with all the fees we’ve been waiving around do-it-yourself banking,” she says, “we’ve kind of tied our hands on that potential income stream.”
Farone agrees. Noninterest income is becoming less and less available, he notes, as technology and competition continue to make services automated, convenient, self-activated and free. “Credit unions especially don’t like to hit their members with fees, but they may have to reconsider that,” he says. “Even if they do, it will be hard for any financial institution to increase fee income. It’s becoming a thin-margin business, which puts a premium on volume.”
CUs also overpay for deposits, Farone says. “It’s part of their member-centric culture, which is admirable when you can afford it, but you can’t help members if you aren’t around.” It’s time to do all you can, he urges, to keep your cost of funds as low as possible. cues icon
Richard H. Gamble writes from Grand Junction, Colorado.