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.

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.

It’s natural to wonder when things will get back to “normal.”  But week after week, the only thing consistent in the economic indicators is that they are not consistent.  So how do we plan for the future?

Most credit unions are designed to thrive in a different type of economic environment─one we may not see again for a long time.  Yet opportunities exist in every environment.  The key is the ability to alter our mindset and look for ways to take advantage of the current reality.

Try test driving the scenario:  “It is 2015 and we are thriving.  The economy is about the same as it was in 2010.”  What did you do to thrive?  How is your strategy different than it was in 2010?  Instead of looking for a “magic bullet,” consider staying true to your core business and improve areas of expertise.  For example, there may not be much loan demand at the moment, but by truly understanding what your target market needs and values, you can work toward getting more of the loan demand that currently exists.

Also, many institutions are focused on cutting costs; according to NCUA’s aggregate FPR for March 2010, there was a 36% decline in the industry’s average operating expense ratio from March 2009 to March 2010.  However, keep in mind that some cuts are not sustainable, such as pay cuts and leaving critical positions vacant.  While they may be necessary in the short term, work toward sustainable cuts like improvements in processes and strategic changes in product offerings.  Consider the following statistics from the Harvard Business Review’s July-August 2009 readers’ survey, How Bleak is the Landscape?

• Only 27% of businesses surveyed are streamlining product or service offerings
• Only 34% are reengineering processes
• Only 37% are improving current products, services or customer support

Rather than hunkering down and waiting for the storm to pass, meet the storm head-on.  Stay focused on strategy and never stop thinking about ways to improve your business.