/by

To Grow Or Not To Grow—What? Is The Question

For credit unions that are growing deposits faster than they are growing loans, the question often asked is “what do we do with the money?” Perhaps the question should be changed to “should we have the money in the first place?”

While it may seem that no matter how low deposit rates are taken money still flows in, are deposit rates really that low?

Consider a credit union paying 25 basis points (bps) on money markets.  While that may sound low, recent yields on some of the largest uninsured money market mutual funds have been between about 1 to 4 bps, according to Bloomberg.  By comparison, this “low” rate paid by the credit union is about 6 to 25 times greater than what the consumer can get in the market—and it’s insured.

The point isn’t that credit unions should drop their money market rates to the same level as the mutual funds, but to point out that, even at these low rates, 25 bps can still be attractive considering the alternatives.

Some credit unions have instituted relationship pricing, rewarding members who participate in the cooperative and encouraging those who don’t to leave.  Others have identified that the growth is coming from their target market(s) and feel that they have the net worth ratio to “ride it out” for a while.

If your credit union is growing deposits faster than loans, at least two things you should know about the growth is:

  1. Who is bringing in the money?
  2. Why?

Growth that is coming from the target market(s) can provide opportunity, if not now, then in the future.  Growth that is coming from members parking funds may be money that should be discouraged or limited.

/by

One Of Many Ways For Management To Add Value To The Strategic Planning Process

Front-line staff members are the first line of defense with an unsatisfied member, and are also the first line of offense with respect to communicating the credit union’s marketing messages. Routinely, credit unions identify themselves as “member-focused” or “service-oriented”—both of these identifiers lean very heavily on member experience, which is in turn influenced by the experience those members have with your front-line staff.

As the second calendar quarter is closing, and credit unions are beginning to formulate plans for next year’s strategies and goals, gathering input from the front-line staff can enhance the process.
Consider brief, but direct, surveys of those employees who deal with member concerns every day.  Some valuable questions include:
  • What is the top member complaint that you receive?
  • How does this complaint typically get resolved?
  • If it were up to only you, how would you solve it?
  • What three things take up the majority of your time during the day?
  • Of those three things, which do you think provides the most value to the membership, and why?
However these surveys are conducted, ensure that controls are in place that promote candid feedback.  Set a participation goal for your staff, such as 95% response, and tie the goal to a credit union sponsored pizza lunch some Friday during the summer.
Most importantly, take steps to ensure that the participating staff realize that their responses were heard by management, and did not disappear into some “survey vortex” where there is no perceived value from their time filling out the surveys.  It is amazing what information a couple slices of pizza and a receptive management team can elicit from front-line staff, and their input could be invaluable in spurring discussion on plans for the future.
/by

Risks In A CMO Portfolio – How Government-Sponsored Refinancing Increases Extension Risk

On June 1st, the Federal Housing Finance Agency (FHFA) issued a press release noting that Home Affordable Refinance Program (HARP) refinances have nearly doubled to 180,000 from 93,000 when comparing 1st quarter 2012 to 4th quarter 2011. While this is good news for struggling and underwater borrowers that can take advantage of the program, this is most definitely not good news for many CMO investment portfolios on credit union books today.

A “typical” CMO is derived from a pool of mortgages and is engineered to assign priorities to the cash flows received from payments, both scheduled payments and unscheduled payoffs. The same pool of mortgages typically results in multiple CMOs which are divided into Planned Amortization Class (PAC) or Companion (Support) tranches. Although other types of CMO tranches do exist, this brief analysis will focus on the relationship between PACs and their companion tranches.

A PAC (sometimes divided into multiple levels, e.g., PAC I, PAC II, etc.) is designed to establish a fixed principal payment schedule that is relatively stable in a range of environments. These tranches have first priority to cash flows from the underlying mortgages. Once the portion of scheduled cash flows has been satisfied, any remaining cash flows from principal payments flow to lower-priority PAC tranches and then to their support tranches.

If these PAC tranches, especially PAC I or II with the highest priority, are engineered to have the most stable cash flows out of any CMO investment, where does the risk come in? The risk comes from the reduced principal balances in the support tranches. As the underlying mortgages either prepay or extend, the cash flows for the support tranches either speed up or slow down. As the economy has been in such a historically low interest rate environment, those borrowers that have been able to refinance probably already have, sending more principal to the support tranche of the respective pool of mortgages that make up the CMO investments. This reduces the ability of the support tranches to continue to support prepayment activity and, more importantly, help absorb the extension risk of the underlying mortgages.

Increasing the refinance activity of all FNMA or FHLMC guaranteed mortgages can have the unintended consequence of extending the principal cash flows on PAC tranches, especially if rates were to go up, by continuing the reduction of the support tranches. Any mortgages left in the pool that are not eligible for the refinance program may continue to pay as agreed, resulting in the extension in the CMOs that are left—which will undoubtedly include some PAC I and II tranches.

Credit unions should be continually monitoring the extension risk in their CMO portfolios. Minimally, credit unions should be looking in the current rate environment and in a +300bps rate shock scenario though going beyond a +300 is ideal. For clients of c. myers that elect to have their CMO cash flows analyzed, the cash flows are analyzed in at least 13 different long-term rate environments. This level of analysis goes well beyond industry standard and can help credit union management teams realize when investment strategies may need to change to accommodate the presence of extension risk in CMO portfolios.

/by

Net Interest Margin and Risk Limits

A/LM measurement systems, policies and defined risk limits are intended to help ensure that credit unions do not take unacceptable risks relative to their insurance—which is net worth. While this sounds straightforward, much depends on the measurement system and policies in place.

Consider the example of a credit union that uses net interest income (NII) to manage risk and has established NII limits in policy. These types of limits are typically based on a percent volatility compared to today’s NII (click here for a related c. notes article on this topic).  By taking more credit risk, the credit union could improve their NII today—as a result of higher asset yields—thus reducing their volatility and, in some cases, putting them back within policy limits.

However, NII misses an important piece of the risk puzzle—the impact of increasing credit risk.  Recall that NII ignores any losses due to increasing credit risk since it is calculated before dealing with net operating expenses.  As a result, the credit union could be within its volatility limits yet unintentionally increase risks to net worth to unacceptable levels when accounting for credit risk.

Ultimately, the risk management process should help decision-makers understand threats to bottom-line earnings and most importantly, net worth.  Therefore, taking a comprehensive approach to taking, managing and aggregating risk is essential. This comprehensive approach should include all strategy levers—yield on assets, cost of funds, operating expense, PLL and non-interest income.

This approach also ties to the NCUA IRR Rule, which stated that “net worth is the reserve of funds available to absorb the risks of a credit union, and it is therefore the best measure against which to gauge the credit union’s risk exposure.”

/by

A Few Questions To Consider Regarding Branch Strategy

What is your credit union’s long-term branching strategy?  That might be a tough question to answer for many institutions.  As margins have decreased, many credit unions have had to take a long and hard look at the effectiveness and profitability of their branch network.  While the bulk of new memberships, loans and deposits originate in branches, many institutions have considered shifting toward a model more geared toward e-services.  There are a multitude of questions that could be considered with respect to credit union branching, a few of which are outlined below:

  • How does the branch strategy align with the overall strategic direction of the credit union?
  • Can your institution afford to operate one or more branches that consistently have a negative overall contribution to the credit union?
  • Are branch location decisions based on where your current members live, or where members of your desired target market live?  Answering this question could lead to different decision-making regarding where to position future branch locations
  • Does your institution have the technology to allow for reduced member reliance on branch locations?  If not, how quickly are your technology offerings improving, and at what cost in terms of dollars and resources?
  • What might be the unintended consequences of your branching decisions?
  • How does the credit union measure branch success?
  • If the credit union is moving toward a model that relies less on physical locations, how will your organization effectively cross sell to members or prospective members?
  • Does the strategy fit with the financial realities your organization is facing now, or could face in the next 3 to 4 years, especially if rates remain low and loan demand is slack?
Continued margin pressure is likely to increase the importance and timeliness of these types of decisions.  Meanwhile, members are increasingly asking for more from their financial institutions which makes this a tricky balancing act.