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2010 has got to be better than 2009… Right?

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

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Consumer Behavior And Non-Interest Income

Last week, we identified some of the many threats to earnings. With regard to non-interest income, potential changes in regulation were identified to be a major threat. Building on that, here we would like to suggest changes in consumer (i.e., member) behavior as an additional threat to non-interest income. In these trying times, consumer behavior has evolved and people are spending less and saving more. Both of these actions sound like responsible things for consumers to be doing (and they are), but for your credit union, they likely translate into lower earnings. Many places we are working with are reporting decreases in both interchange income and overdraft (or courtesy pay) fees. Members are also working hard to deleverage themselves, leading to lower loan volumes and fewer late payment fees. Whether these are short- or long-term behavioral changes is a topic for debate, but, for the present, credit unions are feeling the impact.

If you aren’t already, make sure you begin to analyze the sources of your income inside and out. Do not merely look at your level of non-interest income as a whole, but understand the components of it and how they are changing. Many credit unions are seeing higher overall levels of non-interest income due to extraordinary mortgage originations. This extra income may be hiding declines in other areas, or increases in operating expense. While higher-than-normal levels of origination income may be helping your earnings today, they most likely are a short-term source of extra income. Sooner or later, interest rates will rise (no predictions here!) and/or the refinance boom will end and mortgage volumes will fall.

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2010 Budgeting Process: Focusing On What You Control

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There are only five levers that are pulled to arrive at an ROA, and every single one is under threat to some degree:

  1. Yield on assets is under attack from external forces as rates are at historic lows and loan demand is down.
  2. Cost of funds has been helped somewhat by low rates.  However, it may take time for the cost of funds in many credit unions to decrease after they were blindsided by a flight to safety as they launched aggressive CD promotions and high interest-bearing checking accounts.
  3. Provision for loan losses for many are higher than their worst-case assumptions because of economic woes, increases in strategic defaults and inadequate underwriting policies or inadequate enforcement of otherwise sound underwriting polices.
  4. Non-interest income is mostly controlled by credit unions – for now.  But at some point, possibly in 2010, the government may wrestle away some control of that lever.  It is expected that the Consumer Financial Protection Agency (CFPA) will be created in the near future and likely will not be slow to wield its power. (Draft summary of CFPA legislation)
  5. Operating expenses appear to be the one lever over which you have the most control.  However, that is also being threatened by the likelihood of additional assessments and mounting compliance requirements.

With these levers in mind, as you work on your 2010 budget, consider the following:

Understand the largest sources of your PLL and the processes in place that allowed it to be the largest source.  While those “horses are out of the barn,” make sure appropriate steps are taken to avoid the same problem with all new loans going forward.  Consider the following:

  • If we never got into the business of making the loan that created the greatest losses for us, and we didn’t need the funds to support them so we paid a lower rate to slow growth, what would our PLL be today? Some credit unions are surprised to find out that over 90% of their PLL comes from just one loan product.
  • Are our underwriting policies adequate?
  • What are our decision drivers that got us into this loan product?  Do we need to rethink our decision drivers? (As it is turning out, a high loan-to-asset ratio isn’t always the best decision driver.)  For more on decision drivers, please see our white paper, Managing Success in a Changing World: Best Practices of Highly Successful Credit Unions.

Do not compromise your tolerance for risk. None of us, our parents, or our grandparents have lived through such a low rate environment.

government interest rates

Test your decisions to make sure you’ll be as happy with them in a higher rate environment – and flatter yield curve – as you might be today.  Remember that when the Federal Reserve started raising rates in June 2004 following the last recession (recessions shaded in gray in the above graph), they raised short-term rates 425 basis points while the 10-Year Treasury Rate moved up less than 100 basis points.

Look for inefficiencies in processes and projects throughout the organization.  Investing modest effort identifying solutions to improve processes and to better allocate resources toward projects can have a quick, positive impact to ROA.