We strongly recommend that credit unions annually invest the time to forecast financial performance for at least three future years.  The baseline forecast should compliment the strategic plan and include the cost of major initiatives, as well as expected growth trends.  If the baseline does not produce satisfactory performance, determine what changes could be made.  Once a baseline is established, senior management should identify the issues they feel could have the biggest impact on future financial performance and then test each issue as a what-if.  Typical what-ifs include:

• Provision for loan loss doubles from the baseline plan for 24 months
• Non-interest income decreases 50%
• Lending volume declines significantly
• NCUSIF assessments are twice the level in the baseline
• Interest rates increase to the credit union’s self-defined, worst-case scenario

We recommend that a deflation scenario be included as well.  Many management teams have not discussed the possible impact of a sustained period of deflation, and even fewer have taken the time to forecast the possible financial impact of such a scenario.  Following a structured strategic thinking exercise on deflation could be helpful to explore the issue.  Create the what-if forecast by evaluating the impact on all major components of the financial structure and updating assumptions.  Often these forecasts include lower long-term rates including loan rates and investment rates, an increase in loan and investment prepayments, decreased loan demand and an increase in deposits.  While this may sound similar to today’s economic environment, the magnitude of such conditions may be greater.  For example, long-term rates could fall to 2% or lower and loan growth could decrease materially due to accelerated prepayments and consumers postponing purchases.

Management teams are often surprised by the possible significant, negative financial impact of a deflation scenario.

As with all of the what-ifs tested in this process, if the financial performance is not acceptable, determine what actions could be taken and test the impact of these actions.  At the conclusion of the exercise, decide if any of the actions to address the risks in the what-ifs should be implemented in the baseline plan.

As we discussed in our April post, Bankruptcies on the Rise and the Evolving U.S. Debt Burden, bankruptcies have been rising at an alarming rate this year. The trend is likely to continue—it will be interesting to note how the situation evolves (since 1st quarter) when the U.S. Judiciary releases second quarter figures in the coming weeks.

In the meantime, more and more consumers are taking advantage of a loophole in Chapter 13 bankruptcy proceedings to effectively remove the debt of their second mortgages. Bankruptcy courts can reclassify 2nd mortgages as unsecured if the appraised value of the home is less than the amount owed on the 1st mortgage—in essence, when there is no value securing the 2nd.

For example, a borrower has a $200K first mortgage and a $40K second mortgage; the borrower’s home only appraises for $180K. Thus, since there is no equity, or value, to secure the second mortgage—the borrower can file suit to have it removed.

With unprecedented decline in home values across the nation, one lawyer estimates at least 20% of his clients would qualify for a reclassification (Liening on banks: Second mortgages are next housing crisis, New York Post, 7/11/10).

If you have a significant portion of assets in second mortgages, we recommend stress testing what could happen to your risk profile should a significant amount be charged off due to continued credit risk and bankruptcy proceedings.

Furthermore, everyone should consider what could happen to the broader economic landscape should 20% of the nation’s $1 trillion second mortgage market be put at risk of reclassification.

At the moment, there aren’t many credit unions that would make this statement.  Net interest margins continue to be squeezed by the extended low rate environment.  Deposit pricing is nearing the bottom, but there’s still plenty of room for loan and investment yields to decline.  It’s no different for big banks.  Just from the first to second quarter, net interest margins fell 26 basis points at JPMorgan, 17 basis points at Citigroup and 16 basis points at Bank of America.  Deutsche Bank analyst Matt O’Connor commented, “There’s no loan demand, and long-term rates have declined so much.  So as you look out over the next few quarters, it’s potentially a very dire situation for the overall industry.”[1]

Many credit unions also are experiencing low loan demand coupled with high deposit growth.  According to NCUA data, the loan-to-share ratio for credit unions has dropped from 80% in March 2008 to 73% in March 2010 and that typically equals growing investment portfolios.  It has been difficult for some to put the brakes on growth, even while lowering rates to previously unheard of levels.  There are others who want to stick with their growth plan or are reluctant to lower deposit rates further.  What those folks are really saying is, “I want to grow our investment portfolio.”

It doesn’t make much sense when you put it that way.  The critical question is, what is the credit union doing to offset the lower yield on assets that an expanding investment portfolio brings? Some credit unions have been nudged into bad business decisions such as:

• Loosening underwriting standards in a desperate attempt to add more loans
• Delving into business lines for which they lack expertise such as business lending
• Adding indirect and participation loans that are outside of the credit union’s core business and for which the credit risk may not be thoroughly understood
• Increasing interest rate risk by adding fixed-rate mortgages
• Increasing interest rate risk by adding longer investments

The current environment is challenging enough without adding the burden of excess deposit growth and expanding investment portfolios.  If this is an issue for your credit union, everyone on the management team needs to understand what steps will need to be taken to compensate.  A non-decision on this issue can lead to small, incremental adjustments that add up to an unintended change in strategy for the credit union.

Chinese rating agency Dagong Global Credit Rating Co., known in China for rating companies, recently issued credit ratings for 50 countries for the first time. (Dagong’s Report)

Below is an excerpt of the top 20 nations rated:

Perhaps the most notable was the downgraded AA rating given to the U.S.—two levels below the top grade.  While Dagong’s downgrade of U.S. creditworthiness hasn’t created the financial turmoil that Moody’s or S&P’s could, it has raised some interesting questions:

• Why would Dagong downgrade a significant portion of investments owned by China?
• What will China do with its current Treasury holdings given the downgrade?
• How will the downgrade affect China’s Treasury purchases and holdings in the future?
• Inasmuch as the downgrade has had nominal, if any, impact on U.S. financial markets thus far, will it have any influence at all on Western rating agencies?

As the largest foreign holder of U.S. Treasurys (around $868 billion as of May 2010 according to the U.S. Department of the Treasury), China’s response to these questions will have a significant impact on the U.S. economy.  Whether purchasing, selling or holding Treasurys, China influences the trajectory of interest rates here—which changes the economic conditions that businesses, including credit unions, must operate in.

So while Dagong and China may not be a daily consideration for credit unions, following developments in the U.S. Treasury market will be an important factor to business planning and exploring where interest rates will go.

The recent news about the European bank stress tests has us thinking about when a stress test isn’t a stress test.  By now, you may have heard that out of the banks tested, 7 out of 91 failed the “stress tests”.¹  That is a 92% pass rate, and should earn the European banking system an A grade, right?  As it turns out, there are many critics of these tests.  For example, only trading securities were subject to market devaluations, so all held-to-maturity securities were excluded from the tests.  Further, some of the economic “stresses” were little more stressful than the current environment.

For example, “The worst-case scenario envisioned…the overall euro-zone economy shrinking 0.2% this year and 0.6% the next year.   In some of the 20 countries that conducted the tests, regulators figured that property values would keep rising or hold steady in a worst-case economic scenario…”  In Austria, for example, properties under the stress test were assumed to increase 2% this year and 2.7% next year.²  Try telling a “sand state” credit union that a 2% increase in property values is a stress test.

Why this interest in Europe’s stress tests?  As regulators/governments publish the results, it could provide consumers with a sense of security and hope that may not be justified—ultimately adding more confusion to an already delicate environment.  We often find that appropriately managing expectations is nearly half the battle.

When you decide to conduct stress tests for your organization, don’t shortchange yourself by designing a test that can be easy to pass.  AND, don’t limit your stress tests to what is probable.  Again, nobody thought the cascading events that occurred over the last few years were probable.  It’s the improbable that is currently bringing long-standing organizations to their knees.

¹Cozy Stress Tests Fail Confidence Test, The Source, 07/26/10

²Europe’s Stress Tests Relied On Mild Assumptions, Wall Street Journal, 07/26/10

Given the flight to safety combined with sustained low loan demand, threats to non-interest income and NCUSIF assessments, many credit unions are reevaluating their investment strategy.

The problem is not enough credit unions are evaluating their investment strategy in light of their entire financial structure and strategic objectives.  They are evaluating one investment at a time. In other words, this investment seems to be a good deal today. But how long will it be a good deal?  And, if/when the decision needs to be unwound, what will be the viable options?  How does it fit with the credit union’s strategic objectives and financial structure?

Let’s take an example using callable bonds.  We are seeing credit unions purchase callable bonds with final maturities of 10 and 15 years.  The reasoning too often is, we need to do something, and they are going to be called anyway, so we may as well get the extra yield today.

Typically, people say they will sell it before rates become unfavorable, therefore they won’t be stuck with it.  The only reliable way that this could happen is if the credit union could accurately forecast rates.  A strategy assuming that you know what will happen in the market, before the market occurs, is fraught with danger and has burned many institutions.

Some say that if rates go up they won’t need to sell low-yielding investments because loan demand will be so good, the yields on new loans will offset the risk of the lower-yielding investments.  This could happen.  However, it is important to keep in mind that rates can go up without economic recovery.

Stating the obvious, there is a tremendous amount of uncertainty—there always has been.  Yet decisions have to be made.  Just make sure your decision framework is sound.  Stick with the basics:

• Make decisions in light of your entire financial structure.
• Agree on how long you are willing to live with your decision if things don’t go as planned.  In the above example, answer:  are we willing to live with this decision for the next 10 or 15 years?  If not, how are we going to know it is time to unwind before it results in unacceptable risk for our credit union? This thought process should be followed when making any decision with potential long-term consequences.
• Don’t assume that the future will be brighter or more forgiving than the present.  Isn’t that part of the mindset that got us here in the first place?
• Document the rationale for major decisions.  Memories are short, so it’s important that key players remember why the decision was made in the first place.  Especially if the changes in the environment result in unfavorable financial performance.
• Test drive your investment strategy before you implement it by using your A/LM model.  Don’t just look up +300 basis points either.  Remember, rates were 500 basis points higher just three years ago.  By rehearsing tomorrow today, you can understand the potential risk of what you are buying and can decide if that risk is worth today’s reward.
• Agree on your appetite for risk for your entire enterprise, stick with it and manage to it.

This writing is not intended to say that callable bonds are bad, we are using them for example purposes only.  Our philosophy is that every decision has a trade-off; it is critical to understand the trade-off before implementing decisions.  It is up to decision makers to understand how each investment they purchase works not only today, but as the environment changes.  Decision makers must also understand how investments complement or compound issues in their entire financial structure and risk profile.

Establishing concentration limits that enable you to make sustainable, sound business decisions while trying to satisfy new regulatory pressure is very tricky.

The supervisory letter on concentration risk states that examples of concentrations within an asset class include…

“Residential Real Estate Loans—collateral type, lien position, geographic area, non-traditional terms (such as interest-only, payment option, or balloon payment), fixed or variable interest rates, low or reduced underwriting documentation, and loan-to-value (LTV).”

If you are contemplating multifactor concentration limits as described above, consider the following example and how this approach could impact your strategy and business decisions.

Let’s assume:

8 real estate types, with
4 different LTV ranges for
20 ZIP codes (geographic areas) and
6 credit score ranges, would result in

3,840 total risk limits for the Residential Real Estate Loans

Keep in mind the above example is just for Residential Real Estate.  Imagine applying the same multifactor approach to other asset categories.  The number of limits can become daunting and unmanageable.

We recommend listing every limit on a single piece of paper to help decision makers understand the magnitude of their potential policy commitments.

Slicing and dicing portfolios absolutely is a key component of portfolio analysis and risk management.  However, we are concerned that the establishment of these limits in policy is being rushed in anticipation of the next exam or, during the exam process, examiners are pressuring credit unions to establish concentration limits quickly.

Rushing to establish concentration limits without appropriate analysis, including potential impact to strategy and business model, could result in unintended consequences with serious implications.  Not to mention the red flag noted in the supervisory letter regarding changing concentration limits if a credit union is outside of policy.

We highly recommend following a deliberate process to establish limits.  Test drive your limits under various economic scenarios to understand, in advance, how they will impact strategy and business decisions.  This includes the changes that may be necessary to the credit union’s business model in order to manage within the new limits.

This blog addresses only a sliver of the issues regarding concentration limits.  There certainly will be more to follow, such as the correlation between the speed with which concentration increases and poor financial performance.

For months many have been watching and wondering when the inevitable increase in market rates might materialize.  Now, with some economists projecting that rates will stay at historic lows for another 12-18 months, credit unions should evaluate how, or if, they can continue to maintain net interest margin and ROA.

Not all institutions have room to lower deposits enough to mitigate the continued erosion in the yield on assets.  In a sense, deposit pricing is reaching a “floor” for many credit unions.  All else being equal, ROA will continue to erode and interest rate risk profiles will weaken as higher-rate loans and investments roll off, being replaced with lower yielding assets.

So what should credit unions do?  Common strategies include looking beyond the margin and evaluating expenses, as well as potential new sources of non-interest income.  As mentioned in previous posts, some institutions are stretching for yield, either in loans or investments.  If this strategy is employed, institutions need to carefully monitor the impact on the risk profile, and make sure decisions are tested beforehand and fit within the credit union’s philosophy and A/LM policy/guidelines.

Finally, some institutions have chosen to not take any drastic steps at this time, and have instead begun to adjust expectations at both the employee and board level, re-evaluating what success looks like in this environment.  One potential saving grace is that loan losses seem to be stabilizing in many areas, but should not be taken for granted given what institutions have experienced over the last two years.