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FinTech Lending – Don’t wait for strategic planning to have this strategic discussion

While some FinTech lenders may be struggling, credit unions should not assume the threats are going away.

FinTech lenders have taken a huge bite out of the lending pie.  Consider the following:

FinTech Table

It is no secret that FinTech lenders have recently taken a big hit.  However, even if Lending Club, Prosper, or OnDeck are not long-term survivors, the value proposition they championed will likely be carried on and taken to a higher level by other FinTech companies, banks, or credit unions.  The largest banks in the United States are paying attention to the trends.

In a recent interview, the CEO of JPMorgan noted that while there is nothing “mystical” about what marketplace lenders are doing, they are filling a fast-growing niche, and have effectively reduced the “pain points” for consumers seeking to borrow and invest.

Credit unions should proactively engage in strategic discussions around the implications, good and bad, of FinTech lenders. Consider questions such as:

  • What is driving consumers to online lenders?
  • What can your credit union do to ease your members’ pain points when it comes to the loan application and funding processes?
    • For many consumers, a big pain point is speed. Another is mountains of paperwork and documents to sign. Some marketplace lenders have very short applications and can decision loans within minutes, not hours or days, while having much faster funding
  • Or perhaps it’s privacy? Chatting with someone online can have a different feeling than sharing sensitive financial data in a face-to-face setting
  • What does your credit union need to do today, to ensure relevancy and sustainability, as the competitive environment changes at lightning speed?

These are just a few of the many questions that should be asked during strategy discussions.  While in this blog the focus was on loans, don’t forget there are many strategic disruptors in the world of payments.

 

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CECL’s Threats To Your Business Model: Six Questions To Consider

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CECL is a new set of rules that every credit union eventually will have to play by. While it may not be in effect until 2021, many credit unions could find that they need all that time to reposition their business models to prepare for its impact. Keep in mind that the impact being discussed currently is in a good credit environment. How does the exposure to CECL change in a bad credit environment?

At the end of 2015, the nearly 500 credit unions with assets over $500 million had an average net worth ratio of 10.9% and an ALLL of 0.9%. If the impact of CECL causes ALLL to increase 50%, or even what some refer to as a worst case of 100%, the net worth will be reduced but not dramatically for most.

For those same credit unions, if you were to go back to the Great Recession, what potential impact could CECL have created?

CECL Graph

While many experienced a reduction to ALLL in the years following, what would have happened to the credit unions that would have had materially lower net worth? How could this impact business models and strategic decisions going forward?

Every credit union should be asking:

  • Because CECL will be extremely volatile in changing economic conditions, how much net worth do we need to have to prepare for that potential additional volatility?
  • How should our business model be repositioned so that we have enough net worth in volatile, bad case scenarios?
  • If our current target markets are susceptible to credit risk and could wipe out significant amounts of net worth under the new CECL rules, do we need to adjust who we target in the future?
  • After CECL is in place, loan growth, especially strong loan growth, will come at much lower initial profitability. How does this impact our business model?
  • What changes should we be making, if any, to our concentration risk policy?
  • If the battle for prime paper increases materially, will we choose to increase our presence in that battlefield, and how will we differentiate ourselves in order to remain relevant?

If you don’t think these questions are relevant, consider that in today’s good credit environment, 22% of all existing auto loans are to subprime borrowers (Wall Street Journal). How much could this increase in a recession due to credit migration?

As you wrestle with the mechanics of implementing CECL, it is even more important to think about the business model implications. In addition to the current economic environment, think through what could happen in a recessionary environment when loan losses can mount rapidly and the impact of CECL can be magnified.

The point is not to dissuade you from taking credit risk, but rather to stress that the rules have changed; everyone will need to be much more deliberate with their business models, strategic plans, and the execution of those plans to be well-positioned for CECL.

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5 Things Not To Do With Your Investment Strategy

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1. Don’t manage investments in a silo.

Investments are an integral component of the business strategy. Investment strategy should be developed in light of a credit union’s unique financial structure and strategic objectives.

Understand how the whole financial structure works together. For example, if the lending portfolio includes a significant amount of long-term loans, investments can be purchased to offset interest rate risk while still contributing some yield. Conversely, a shorter or more variable rate loan portfolio might be complemented by some higher-yielding mortgage-backed securities (MBS) or fixed rate collateralized mortgage obligations (CMO).

Most importantly, ensure management and the board have a clear and holistic understanding of the investment strategy and how it fits with the financial structure and overall strategic objectives. Get agreement as a group on investment risk appetite, stick with it, and manage to it. Document the rationale for major decisions and review the strategy regularly.

Understanding the bigger picture can then make it easier for you to evaluate individual investment decisions. As you review investments with different structures and yields, the overall strategy objectives will provide clarity to the choices you make.

2. Don’t get yield envy.

Seeing credit unions with higher yields on investments can be frustrating and tempting. What if money is being left on the table? If your credit union could earn that same investment yield, how much would it boost the return on assets?

Buying those higher-yielding investments is a simple matter, as your broker will no doubt confirm. Remember, though, that with higher returns come higher risks. Do those investments fit your strategy?

It’s critical to understand the environments in which your investments are designed to help and those in which the investments can hurt. Every investment has a trade-off, and getting a clear picture of that trade-off is key. If you aren’t seeing a trade-off of risk somewhere, then something is missing.

Knowing your own investment strategy and how it supports the overall financial structure and Asset/Liability Management (A/LM) needs can guide you through such potential pitfalls.

3. Don’t assume a callable investment will be called.

We continue to see credit unions purchasing callable bonds with long final maturities. The yields can be attractive and, often, lead managers to believe the investment will be called “because the last 10 did.” Moreover, the unprecedented low interest rate environment of the last 8 years can seem to bolster that expectation.

But what happens if rates rise? Typically, people say they will sell the investment before rates become unfavorable and, 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.

Callables will NOT get called if rates rise. Make sure your credit union is evaluating the risk to final maturity if you consider investments with optionality like callables, or mortgage-related products. Buying long-maturity callables with the expectation that they will be called can be a risky strategy.

4. Don’t abdicate your investment decisions to any advisor.

Linking investment strategy to the credit union’s unique and changing financial structure is a role that credit union leaders are best equipped to play.

Working with trustworthy investment brokers can certainly help to identify effective investment alternatives. But, decision-makers should independently simulate the risk/return trade-offs to help ensure that the recommended investment strategy complements their entire financial structure and fits within their overall strategic objectives and future business needs.

Every investment strategy has risk/return trade-offs. If simulations show gain and no potential pain, it is highly likely that the strategy is too good to be true. Digging deeper as to why would be the essential next step.

5. Don’t ignore what your strategy might call for in the future.

Are loans growing significantly? Is the growth in autos or mortgages? What if economic conditions change? Is the credit union at risk to have deposits leave or migrate to higher- yielding options?

Consider the deposit growth shown for credit unions over $1 billion in assets. While the number of accounts has increased significantly since the last rate peak in 2007, the average balance per account has increased even more. What will those depositors do if rates begin to return toward those 2007 levels?

Business strategies and annual plans should inform the investment strategy. Liquidity should be considered. In addition, investment planning should incorporate effective A/LM to determine how the strategy could be expected to perform in a changing environment.

Investment decisions should contribute to and complement the credit union’s strategic objectives. Agree on how long you are willing to live with investment decisions if things don’t go as planned. What conditions would determine when it’s time to unwind investments before they result in unacceptable risk? It is up to decision-makers to understand how their investment strategy works not only today, but as the environment changes.

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Of Bulls and Bears – Margin Impact from Changing Yield Curves

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After the blog published on April 21, 2016, we have received a number of comments regarding why we were silent on the industry “conventional wisdom” that a wider yield curve can provide stronger net interest margin, and that a narrower yield curve can squeeze the margin. This can be true, but often is not. All else being equal, a wider yield curve would produce stronger margins. However, real life seldom results in an “all else being equal” outcome. Business, and the economic climate, are not static. There are constant changes to the regulatory, economic, and competitive landscape that can (and does) change consumer behavior – and the changes in consumer behavior result in changes and shifts in credit union financial structures.

Bear Flattener

If we were to apply “conventional wisdom” to the most recent “bear flattener,” which occurred from 2004 to the end of 2005, real world results are not what would be expected. In June 2004, the industry net interest margin was 3.26%. In June 2006, the industry margin had barely moved down, reaching 3.20%. This barely quantifiable movement in margin happened when the yield curve moved from roughly 350 basis points (bps) to about 20 bps – a reduction in steepness by more than 300 bps.

Using the “all else being equal” argument, margins may have been squeezed more. However, there was a mitigating factor that helped to preserve the margin – the loan-to-asset ratio for the industry increased more than 5% over that same time frame. The increase in the loan-to-asset ratio helped to offset margin pressures that could have been realized if “all else being equal” loan demand had not increased.

Bear Steepener

Applying the same conventional wisdom to a recent “bear steepener,” which occurred from 2012 to 2013 long-term rates increased more than 100 bps, translating to a yield curve that is roughly 100 bps wider than it was December 2012. However, net interest margin for the industry dropped from 2.94% to 2.80%. Comparing the end of 2012 to the end of 2015, the yield curve has been consistently steeper and loan-to-asset ratios jumped 7% (to 65%), but the margin of 2.86% has not rebounded to the 2012 level.

Now, some may argue that there were so many other variables and moving pieces in the broader economic climate, “all else being equal” or using an “apples to apples” comparison, margins should have increased. That may be the case. The same arguments are brought up in relation to static income simulation. Breaking it down into the fundamental components, everyone realizes that real life isn’t static – things change, member demands and consumer behaviors shift, and the competitive landscape has a significant impact on credit union earnings and risk profiles. The entire reason for the thought that wider yield curves bring stronger margins is a lack of change in the composition of assets and liabilities in static income simulation. This is antiquated thinking that has resulted in potentially misleading “conventional wisdom.”

Conventional Wisdom can be Misleading

As an industry, we have seen yield curves widen (steepen) and yield curves narrow (flatten), loan-to-asset ratios increase and loan-to-asset ratios decrease, with inconclusive correlations between changes in the yield curve in relationship to actual bottom-line net interest margins. Credit union management teams, boards of directors, and even regulators should be concerned with an assumption of static replacement regardless of the change in the environment, as it is often misleading. For decades we have been modeling a huge range of yield curves and environments, and this experience has taught us the importance of modeling how members may respond differently in these environments. Additionally, it has demonstrated that better business decisions can be made by first understanding the potential profitability (or losses) from the existing structure, prior to layering on guesses about what the new business may be able to do in all of the different environments.

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Of Bulls and Bears – Twisting the Yield Curve Is More Than Just a Stress Test

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If you’re a financial institution, you need to understand how changes in market rates could affect your financial well-being. That’s what A/LM analysis is for. Traditional A/LM analysis has revolved around simple, instantaneous, and parallel shifts in rates. But in reality, rates have rarely shifted in parallel (not to mention instantaneously). As an example, using the interest rate environment and yield curve at the end of March, an instant and parallel change in rates would result in the below rates:

twisting the yield curve, c. myers. credit union,

Each of the rates increases 300 basis points (bps) and the relationship between the short- and long-term rates does not change. While the above approach does represent a change in interest rates, there is no change in the yield curve. In the +300 bps change in rates, the spread between the 3 month and the 10-year yield is 1.57% – which is exactly the same as it was on March 31. An effective interest rate risk management program must include an analysis of the impact to earnings and net worth caused by a shift in the relationship between short- and long-term rates. This is referred to as twisting the yield curve. As that relationship changes, it results in yield curves that are either flatter (meaning the difference between short- and long-term rates decreases) or steeper (meaning the difference between short- and long-term rates increases). And, depending on the financial structure, flatter and steeper yield curves may produce very different financial effects.

“Bullish” Twists

The yield curve is said to twist in a bullish manner when the Federal Reserve is expected to lower interest rates.

A bull flattener is characterized by long-term rates decreasing more than short-term rates. This yield curve shift can cause disproportionate reaction across a credit union’s balance sheet, typically influencing longer-term assets or liabilities more than short-term assets or non-maturity deposits. For example, cost of funds may not change much (as the short-term rates tend to influence cost of funds on non-maturity deposits), but longer-term assets like mortgages may experience an increase in prepayment speeds (as decreases in long-term rates typically correlate with decreases in mortgage rates and more refinance activity). A good historical example of a bull flattener is the movement in Treasury rates experienced in 2011, when long-term rates dropped roughly 150 bps, moving from 3.36% at the start of the year to 1.89% at the end of the year. Short-term rates moved 13 bps, dropping from 0.15% to 0.02% over the same period.

Bull Flattener, c. myers, yield curve twists

A bull steepener, on the other hand, is characterized by short-term rates falling faster than long-term rates. The most recent bull steepener occurred from the middle of 2007 to the end of 2008, when the yield curve shifted from a slightly inverted/flat curve as short-term rates dropped roughly 500 bps and long-term rates dropped only about 250 bps over that 18-month timeframe.

“Bearish” Twists

The yield curve is said to twist in a bearish fashion when there is an expectation that the Federal Reserve will increase interest rates.

A bear flattener is characterized by short-term rates rising faster than long-term rates. This yield curve twist tends to increase non-maturity deposit rates, without a significant corresponding increase in long-term rates. This can cause pressure on net interest margins, and can often cause non-maturity deposit migration (movements from non-maturity shares into more expensive short- and intermediate-term certificates of deposits). The most recent bear flattener occurred from the middle of 2004 to the end of 2005, when long-term rates moved nominally, but short-term rates increased over 300bps during that 18-month period.

bear flattener, twisting yield curve, c. myers, credit unions

Conversely, a bear steepener is characterized by long-term rates increasing faster than short-term rates. This yield curve twist tends to slow down existing asset prepayments, and not influence non-maturity deposit behavior. The most recent example of a bear steepener occurred from the middle of 2012 through the end of 2013, when short-term rates hardly moved but long-term rates moved in excess of 100 bps.

Twisting the Yield Curve Is More Than Just a Stress Test

The examples above represent a fraction of the possible effects of yield curve changes. A myriad of factors play into how a bull flattener, bear steepener, or any yield curve change will affect the earnings and net worth of a given financial structure. Member behavior factors – members exercising their options to refinance loans or shift deposits between non-maturity deposits and certificates – can have significant impact when the yield curve changes. Understanding the impact to profitability in a wide range of rate environments and yield curves, and the resulting impact to net worth, should not be simply a stress test – it should be a matter of course in any effective interest rate risk management program.