In spite of recent signs that the economy may be turning around—including a 0.3% increase in real consumer spending in January to the highest level since May 2008—consumers still don’t seem to be buying a strong recovery.  February’s present situation index, which serves as an indication of how consumers are feeling with regard to the economy, hit a 27-year low (not since 1983) of 19.4 (Consumer Confidence Tumbles in February, CNNMoney.com, 2/23/10).

The lack of consumer faith in the economy can be seen across the lending landscape:

• Banks in the U. S. posted their sharpest decline in lending since 1942 as of year-end 2009, dropping about 7.4%  (Lending Falls at Epic Pace, The Wall Street Journal, 2/24/10).  Credit unions experienced only modest loan growth of about 1% according to the NCUA

• In the 4th quarter 2009, revolving consumer credit decreased at an annual rate of 13% (Federal Reserve Statistical Release G.19, 2/5/10).  In January, the trend continued as consumer credit dropped for the 11th straight month

• With regard to mortgage lending, existing home sales dropped 17.7% in December 2009.  Even with the extension of the government homebuyer tax credit, existing home sales dropped again in January another 7.2% to a 7-month low (Existing Home Sales Fall, Market Watch, 2/26/10)

It appears consumers are feeling even worse than when the economic collapse was in motion and that the “economic recovery” is still shaky.  How soon can credit unions expect a sustainable increase in their members’ loan appetite?  What can be done in the interim?  It is essential for credit unions to continue to focus on what they can control and to perform in-depth evaluations of their business models—making appropriate changes, timely.

The Treasury yield curve is rarely as steep as it is today.  The spread between the 3-month and 10-year has recently exceeded 350 basis points.  In more certain times, steep yield curves are beneficial to credit unions because the rates paid on non-maturity deposits are influenced by the short end of the curve and the rates charged on many loans are influenced by the long end of the curve.

When managing risk, we suggest you consider what could happen if the yield curve environment:

• Remains steep
• Steepens
• Flattens by short-term rates increasing (as it did following the last recession)
• Flattens by long-term rates declining

As you consider these environments, be sure to reflect on how different yield curves might impact member behavior.  For example, a flatter yield curve could be accompanied by lower non-maturity deposit balances as the competition for deposits increases.  Loan demand could also be impacted depending on the reasons for different yield curves.

In 2009, we experienced an unprecedented level of government intervention in the mortgage market; and it is not over yet.  What happens when it is over?  The expected end of the new home buyer credit in 2009 no doubt greatly contributed to the 17% decline in home sales (Source:  Bloomberg News, U.S. Economy: Existing Home Sales Decline More Than Forecast, January 25, 2010).  Now that this credit has been extended to early summer, can we expect sales to return?  What about the 75% of mortgages that FNMA and FHLMC financed in 2009?  What about the $1.1 trillion MBS purchased by the Fed in 2009, a program that ends in March?  If this government support for the mortgage market were to end, what else could happen to the mortgage market beyond an increase in mortgage rates?

If you rely heavily on mortgage volumes, we recommend you test drive the potential impact to your business model of an end to government support of the housing market.  Questions to consider include:

• What could happen to mortgage rates?
• How might loan volumes change?
• What could be the impact to a strategy of originate and sell?
• What could happen to non-interest income?

Investing time to run through a test drive can help management better respond should this scenario unfold.

Who doesn’t want to have the right things done, at the right time, within budget?  Nobody.  Yet, across all industries, up to 72% of projects fail (Source:  The Chaos Report, Project Management Institute, April 2009).  A poor project management process is the single largest reason for this high rate of failure, which costs money, wastes time and increases frustration.

In today’s chaotic environment, it is advantageous for management teams to focus on the key items in their control so they are better prepared to handle the blows from external forces that are likely to persist.  One of the key areas over which managements have most control is strategic allocation of human and financial resources (efficiencies and operating expenses).  This strategic allocation is critical to the success of daily operations as well as new projects.

Many credit unions are undertaking projects with the intent of bottom line improvement that are failing or adding to expenses due to lack of prioritization, proper scope and execution.  The following three actions can improve strategic allocation of human and financial resources, efficiencies, and employee, management and/or member satisfaction:

1. Developing an effective, repeatable project management process.
2. Dissecting key processes and implementing appropriate changes to create sustainable efficiencies.
3. Creating a reliable process for CEOs and senior managements to use to successfully manage a portfolio of projects.

For a more detailed framework on how to achieve these actions and possibly an improved ROA, please refer to our recent c. notes articles:

• Project Management:  Essential Project Planning, November 2009
• Project Management:  Execution, Control And Closure, December 2009

2010 begins with an immense question attached to it:  Where will the economy go this year?  Confounding any sort of clear answer are the conflicting signs of continued recovery and renewed downturn that came with the close of 2009:

• The housing market has seen home prices rise for the sixth straight month in October.  However, the recovery appears fragile as one-in-seven households are either in foreclosure or delinquent on payments, while almost one-in-four households are underwater (Real Estate Faces Tough Recovery Slog, WSJ, 1/4/2010)
• Car sales surged at the end of the year to an annualized rate of 11 million, making December the second-best month of the year.  However, this was still far below the 16 million annualized rate seen as an indicator of a healthy auto industry (Late Surge in Car Sales Raises Hopes for 2010, WSJ, 1/4/2010)
• The Dow Jones finished up 18.8%, however, unemployment remains around 10% and the Fed, concerned with the fragility of the recovery, continues to keep the Fed Funds rate at a record low of 0-25bps (Fed Will Hold Down Rates, Citing Tenuous Recovery, NY Times, 12/16/09)

It is fair to assume that 2010 will hold its fair share of surprises, opportunities and crises that will require tough decisions and quick, deliberate action on the part of credit unions.  One question credit unions are asking themselves right now is, Are we as prepared as we can be? Below is a brief list of questions to consider to help assess your preparedness for what promises to be an interesting year:

• Have we thoroughly explored the impact of a further economic downturn on our business model and business plan?  A material recovery?
• What is our short list (no more than five) of strategic initiatives that must be pursued regardless of the economy to better position the credit union for the long term?
• Have we created and communicated detailed game plans and do we have a defined project control process to ensure that progress on these strategic initiatives will be accomplished in 2010?
• Are our board and senior management aligned on the definition of success for 2010?
• Given the level of uncertainty and the likelihood of “surprises,” have we blocked, in advance, regular time for key decision makers to discuss new issues and make decisions?

With answers to these questions, your credit union will be in a better position to make decisions and react to unforeseen events.  This is especially important, as the point at which you address a problem is directly related to the number of viable options you have for solving it…

Evolving consumer behavior and internet usage trends may have an even more significant impact on the fundamental way credit unions strategically manage their business model and create differentiation in the future—and these trends aren’t necessarily isolated to a particular generation.  Consider the following statistics from the Pew Internet & American Life Project, January 2009:

Today, with many credit unions working hard to allow their members to do everything online, the industry seems uncertain as to how the role of traditional brick and mortar branches may change in the future.  Some ask: Do we keep building them?  Do we build smaller, storefront branches, kiosks or install more full-service ATMs?  What kind of members are using branches vs. those using home banking?  How do I cross-sell if I push my members toward home banking?

Internet-Based Financial Institutions

Adding complexity to the delivery channel issue is the growing popularity of internet-based financial institutions (financial institutions with only an online presence, such as ING or, more recently, Ally Bank).  An article published by the American Bankers Association cited that nearly 40% of internet households have a relationship with an internet-based financial institution—compared to only 20% as of 2007. Supporting this trend is the broadening availability of mobile internet access with the growing popularity of the smartphone.  Despite current economic woes, smartphone sales actually increased 13% year-over-year in the 3rd quarter of 2009—representing the fastest growing segment of the mobile market, according to Gartner Inc.

Cross-Industry Perspectives

In another context, consumers spent 11% more than they did in 2008 on “Cyber-Monday,” according to Coremetrics Inc., a Web analytics company that tracks shopper behavior.  (Cyber-Monday is a term coined in recent years to describe the first Monday after Thanksgiving.) According to Forrester Research, online shopping this holiday season may grow by as much as 50%.  “The shift to online shopping, fueled by deal seekers in the recession, may be coming at the expense of sales at traditional stores later in the holiday season, Forrester says.” (Source:  ‘Cyber Monday’ Sales Appear Strong, WSJ, 12/1/09)

Strategic Thinking

As consumers increasingly use technology, looking for better deals and enhanced convenience (especially in tough economic times), the trend toward using online delivery channels, internet-based financial institutions and online shopping is likely to continue. But remember, back in the 1970s when ATMs were a novelty, many assumed that they would replace branches and tellers.  Of course, they didn’t.  As a matter of fact, from 2002 to 2007, banks alone have constructed over 10,000 branches according to the Associated Press. Nevertheless, consumers’ consistent increase in using online commerce has brought to the forefront some questions that credit unions and other financial institutions need to answer as part of their strategic thinking:

• How do we strategically deploy our finite resources in order to appropriately position our delivery channels for our target market over the next several years?
• If a growing portion of the population is becoming more comfortable using internet-based financial institutions, what differentiation can we create or improve upon for our distinct target market to get our share of their wallet?

These are difficult questions, but seeking out answers should not be avoided.  Moreover, each credit union’s answers will be unique, as there are different delivery channel strategies depending on the behaviors, backgrounds and demographics of various target markets.  We encourage credit unions to approach the questions seriously in strategic planning sessions and discussions, especially in uncertain economic times when operating expenses are so critical to success.

In February 2009, we published a c. notes article titled, Liquidity: 9 “What-Ifs” Worth Exploring.  Even though liquidity is not a concern now for many credit unions, events outside of their control could quickly make it a serious issue.  The article encourages credit unions to answer key valid questions to help prepare them for the possibility of heightened liquidity risk.  The article can be found here.

This blog post is intended for a subset of credit unions that may come to the realization that a business model that assumes a high loan-to-asset ratio is inappropriate for them.  The evolution of consumer spending and saving habits as a result of this economy may provide an opportunity for these credit unions to revisit their business model—focusing on if the credit union should tilt toward specifically serving borrowers, savers or both.  Here’s some background to consider…

Over the past several years, many economists, most notably Stephen Roach of Morgan Stanley, warned of the consequences of the transformation of our economy from being income-based to asset-based.  Said another way, starting in the late 1980s, the rapidly growing value of consumer assets played an increasingly larger role in the economy.

For example, during the second half of the 1990s, appreciation in stock market holdings emboldened consumers to spend due to the wealth effect.  The bursting of the tech bubble reversed this wealth effect and initiated the last recession.

During the subsequent recovery, consumers began to feel wealthy from the value of their homes.  We all know too well that consumers used their homes as ATM machines.  This led to an increase in household debt from 90% of personal income to a record 133% by the end of 2007 as we went into our most recent recession.  For more detail, see this article from the NY Times.

Many consumers have now reversed course.  They are saving more than they are spending.  In September and October, the personal savings rate was 4.6% and 4.4%, respectively (Source: U.S. Bureau of Economic Analysis).  It wasn’t that long ago that consumers had a negative savings rate.

Layer onto this the fact that 14.4% of homeowners with mortgages are behind on their mortgage payments or are already in foreclosure (WSJ, More Homeowners Fall Behind on Mortgages, 11/21/2009) and 23% of all homes with mortgages are under water  (WSJ, 1 in 4 Borrowers Under Water, 11/24/2009).  And the icing on the cake: Over 70 million Baby Boomers are not feeling very wealthy as they head into retirement.  They’ve likely already started to alter their spending habits.

To sum it up, for the foreseeable future there will likely be no bubble in asset appreciation to drive consumer spending and borrowing.  Like they did for decades before the 1990s, many consumers will need to rely on their income to support their debt burden, not the value of their assets.  In other words, they will likely be borrowing less.

What might this mean for credit unions?  With about 18,000 depository institutions in the U.S., competition for loans may become quite interesting.  Credit unions may find themselves facing irrational competitors who have once again loosened underwriting standards to achieve a potentially dangerous loan-to-asset ratio target.  (Read more about appropriate measures of success in our white paper, Managing Success In A Changing World, to understand more about why this target could be dangerous.)

A subset of credit unions may want to take this point in history to revisit their business model and ask:

• Do we have a well-thought out plan to invest finite resources to continuously adapt to the competitive environment to remain a “credit” union, or would our membership be better served if we transitioned more toward a “savings” union?
• If we made that transition, what else would need to change in our credit union so as to serve our members and keep the credit union safe and sound?

There are successful credit unions that, for many years, have had a low loan-to-asset ratio.  Many seem to have a clearly and narrowly defined target market.  They remain successful even through this deep recession.  Besides low loan losses, their low operating expenses contribute to their success.  For example, they don’t need significant branch or lending infrastructure to support aggressive loan generation.  Rather, they have an infrastructure that supports competitively priced deposit gathering and selective, organic loan generation.  Branches that are needed can be low-cost storefronts, as an example.  Investments, usually managed by one person, are very carefully invested so as to not take on undesirable interest rate risk.  Granted, in this historically low rate environment, that means low investment yields.  Many of these credit unions are satisfied with a resulting low ROA as they know they have positioned themselves for the benefits of higher rate environments when they return.

The transition to a “savings” union can take years and has many hurdles.  It should not be taken lightly.  While it will not be a reasonable alternative for most credit unions, it may be worth a strategic discussion for those that are seeing a critical change in the borrowing and saving patterns of their members.  Those credit unions who seek a business model that is not as susceptible to credit risk could also benefit from this strategic discussion.

Loan interest income may be overstated in the budget if there is a large balance of non-performing loans.  This occurs if loan income is budgeted based on what the members are contractually obligated to pay rather than the actual payments received on performing loans.

Here are the two most common ways credit unions are adjusting for this:

• Code the non-performing loans to separate them from performing loans so that non-performing loans do not overstate the yield on the overall portfolio.  Additionally, this information is helpful in making assumptions as to whether the budget for non-performing loans should show an increase, decrease or stay at current levels over the budget timeframe
• Calculate, by category (e.g., new auto, used auto, etc.), the difference between current contractual obligations and the current yield on loans and factor this into the budget.  General ledger income can be useful in obtaining the data for this calculation

The decision between the two paths often comes down to how you handle non-performing loans in your database, data processing/reporting capabilities and the style of budgeting that is used.

The frequency and magnitude of surprises in 2009 have created a unique learning opportunity that should not be passed up.  Too often, after navigating through a strategic challenge or opportunity, managements move on to the next issue without identifying the lessons learned from the most recent experiences.  This need not be a complex exercise.  In fact, identifying lessons learned can be as simple as answering:

• What happened?
• Why did it happen?
• What is the lesson learned?

Determining why something happened is the key to the lesson.  For example, assume that auto loans have grown 10% so far in 2009.  It might be tempting to identify the lesson learned as:  Even in a down economy, we can grow auto loans at a double-digit pace.  However, the real lesson to be learned lies in why they increased.  For example:

• Did they grow as a result of a new focus on sales and service?
• Did they grow primarily because major competitors were losing money and/or had a liquidity crunch and therefore had to cut back on lending?  If so, how long will that last?
• Did they grow because competitors have gotten out of auto lending due to profitability concerns?
• Did they grow due to a one-time program like Cash for Clunkers?
• Did they grow because of offering the lowest rate?

It may not be possible to be certain why auto loans grew, but it is possible to explore the potential reasons and draw a conclusion.

In analyzing lessons learned from the unprecedented events experienced in 2009, also consider key areas of the organization and environment that are impacted:

• Underwriting:  How effective has our underwriting been at assessing risk?  What could make it better?
• A/LM decisions:  Did the decisions we made have the desired financial impact?
• Member behavior:  How did our members behave with regard to spending, borrowing, etc.?
• Net worth adequacy:  What have we learned about the adequacy of our net worth in light of experiencing higher loan losses, unexpected rate conditions, corporate capital write-downs, NCUSIF assessments and looming threats to non-interest income?  Have these experiences confirmed our long-held beliefs about the right amount of net worth for our institution or should we target a different level going forward?
• Competitors:  How did their circumstances, financial condition and decisions impact us?

While the previous five issues are key, taking the time to discuss and document lessons learned from any recent experience is invaluable.  Such a process leads to better decision making, fosters strategic thinking (in a time when many are consumed with putting out fires) and creates opportunities for cross-departmental learning.  As a result, the organization is stronger and better able to address challenges and take advantage of opportunities when they arise.

This statement sounds eerily similar to the statement we heard from many people in 2008 about 2009.

By now most have read or heard the U.S. financial highlights for 3rd Qtr 2009.  Headlines touted the 3.5% annualized growth in GDP.  It is important for any business to evaluate the sustainability of this “good news” and how long it will take to have positive impact as they are making financial and business decisions, especially for 2010 and quite possibly through 2011.

We are starting to hear from many credit union managements and boards that they believe PLL will begin to decline and loans will start to increase in 2010.  While everyone hopes this is the case, there is still a tremendous amount of uncertainty.  Therefore, we believe it is beneficial to… hope for the best, but prepare for the worst for at least one more year.  This means evaluating various scenarios for financial performance instead of landing on, or promising, one set of financial numbers to your board.  This effort can go a long way to appropriately managing expectations and reducing frustration for all stakeholders.

A few reasons we bring this to light.  Consider the following:

While the recent GDP growth would seem like good news on the surface, further evaluation of the numbers suggests that there could be more trouble ahead and a sustained recovery is not necessarily underway.  In looking at the details, a considerable portion of the growth in GDP was a result of government spending, including the Cash for Clunkers program.  The Cash for Clunkers program factored into the consumption/consumer spending portion of the GDP equation and certainly did help to increase auto sales over the summer.  However, it “pulled sales forward,” which means auto sales figures are likely to be far less rosy in the coming months.  Consumption is critical, as it has accounted for 70% of the economy since 2002 (67% 1929 to 2008).  If Americans are uncertain about their jobs or the economy (consider consumer confidence falling to 47.7 in October), they will likely continue to save, putting further pressure on GDP growth and ultimately job growth going forward.

While the economy did grow in the 3rd Qtr, it did not translate to any net improvement in the unemployment picture.  Unemployment has continued to rise, from 9.8% in September 2009, to 10.2% in October 2009.  From a historical standpoint, unemployment is at its highest level since March 1983 when it stood at 10.3%.  (For perspective, note that unemployment was at only 5.0% a short 18 months ago.)  Unemployment is a lagging indicator, meaning that even after the economy ultimately stabilizes and begins to grow, it is likely that unemployment will to continue to increase for a period of time.  In looking at historical data, some post-recessionary periods have seen quick improvement in U.S. employment, while others have not.  For the recession ending in March of 1975, unemployment peaked 2 months later in May of 1975 and then began to fall.  However, when the 2001 recession ended in the 4th Qtr of 2001, the unemployment rate stood at 5.7% and remained at 5.7% or higher until April 2004.  Some economists believe we are headed toward the slower job recovery scenario seen in the years following the 2001 recession.  Either way, as noted earlier credit unions might be wise to consider the old adage… hope for the best, but prepare for the worst.

Source Data:
http://www.gpoaccess.gov/usbudget/fy05/hist.html

http://www.cepr.net/index.php/data-bytes/gdp-bytes/c4c-drives-growth/

http://www.nber.org/cycles/cyclesmain.html