/by

Are Investments Now Yielding More Than Indirect Autos?

,

For many credit unions, taking a serious look at indirect auto profitability is long overdue.  Two years ago it was easier to make the argument that indirect autos were a better financial alternative than a like-term investment.  Now, the issue is more complicated as investment yields have increased far more than auto yields in the last couple of years.

Auto pools often have average lives of about 2 years, so for example purposes, a 2-year investment will be used as a point of comparison in this analysis.  Since April of 2016, the yield on a 2-year Treasury has increased about 170 bps.

Historical Government Interest Rates

A graph of historical government interest rates 2014-2017

How much has your credit union increased auto rates over the last 2 years?  In working with credit unions all over the country, we have observed that many institutions have only increased their auto rates by 50 – 75 bps over that period of time.

The example below is using a coupon rate of 2.99%, which is based on the rate many credit unions are currently offering.  While dealer fees often range from 1 – 2%, a fee of 1.50% is used for example purposes.  Note that different levels of dealer fees will impact the answer.  After factoring in dealer fees and a loan loss assumption of 15 bps, the net yield is 1.95%.  Compared to a 2-year investment yielding 2.75%, a credit union would be giving up 80 bps of earnings.

It wasn’t always like this.  A couple of years ago, a typical “A” Paper rate might have been 2.49%, and like-term investments would have yielded closer to 1%.  So, even after factoring in dealer fees and credit losses, the spread to a like-term investment was a positive 45 bps.

Amortizing Dealer Fees Using “Level Yield” Methodology

A table showing amortizing dealer fees using level yield methodology

While profitability is important, there is more involved in making decisions regarding pricing and asset concentrations than simply comparing to an alternative investment.  Consider:

  • The indirect auto example above does not include the expense of collections, underwriting, or managing the dealer relationships, which can vary materially from credit union to credit union
  • In the event of a slowdown in the economy or continued pressure on used auto values, the auto loans could have additional credit risk exposure beyond the 15 bps used in the example
  • Loan profitability versus investments is particularly relevant to indirect autos, because it is difficult to engage members through the indirect channel.  We commonly hear that only 3 – 5% of indirect members utilize other credit union services.  Once the loan is paid off they generally move on.  If you can’t convert those indirect members into fully engaged members of the cooperative, what is the business case to originate these loans at a relative loss?
  • Your credit union could have the same discussion on direct loans, but there might be a reason to offer lower rates from a member service perspective
  • Steps you could take to improve the profitability of indirects.  Many credit unions are worried that if they raise rates too much, they will lose the dealer relationship and have a hard time earning that business back.  If your credit union is in that position, key stakeholders should at least understand the trade-offs, and how much revenue is being given up by continuing to compete aggressively in the indirect space
  • You may need to have a different evaluation of indirect loans made to existing members, as the indirect channel is often viewed as a member service for existing members

If you know, or believe, your credit union is in the position of making unprofitable indirect auto loans, it is time to revisit your strategy around this delivery channel.  It’s possible that in the near future auto rates will increase enough for this to become a less pressing issue.  It is also possible that this will have to be dealt with for a while.  Build and execute your game plan now to ensure that if income is going to be lost, it is a conscious decision.

/by

Additional Considerations of A/LM Implications of Recent Tax Reform

, ,

In early February, the blog post, The A/LM Implications of Tax Reform, addressed some of the potential A/LM considerations of the recent Tax Cuts and Jobs Act.  The focus at that time was on the potential challenges and opportunities stemming from:

  • Lower corporate tax rate
  • Reduction in the mortgage interest cap
  • Changes to individual tax rates

We mentioned there would be more to discuss from the relatively new Tax Cuts and Jobs Act.  The focus of this follow-up blog is on helping credit unions consider strategic questions and potential impacts from changes to home equity tax code and property taxes.

2018 Tax Cuts and Jobs Act - ALM Implications to Consider

Home Equity Loans

In our discussions with credit union executives, one concern that rises to the top is the potential for a reduction in demand for home equity loans as a result of changes in what is allowable as a deductible.  Changes under the tax reform act now require the home equity loan to be used to buy, build, or substantially improve the taxpayer’s home.

Consider that many home equity loans are used for vacations, debt consolidation or even to purchase a car.  In fact, studies show that roughly 50% of home equity loans are used for reasons other than home purchase/improvement.

Uncertainty surrounding home equity loans leads to several strategic questions for credit unions to consider:

  • Could demand for home equity loans decrease if interest isn’t entirely deductible?
  • How could our interest rate risk profile change if variable rate home equity loans become a smaller part of our structure?
  • Could recent tax reform push more members towards our unsecured or signature loan products?
  • How can we best communicate with members so that they continue to value our home equity loans?

Property Taxes

In the spirit of reducing the risk of losing readers to stimulating tax code details, we can summarize the impact of changes to property taxes by saying there is now a cap on property tax deductions and therefore potentially less benefit of home ownership than in the past.

In many areas, property taxes are on the rise due to recent increases in home values.  The S&P/Case-Shiller National Home Price Index graph below shows that nationally, prices have surpassed the previous peak from 2006.

S&P/Case-Shiller U.S. National Home Price Index

U.S. National Home Price Index Graph - S&P/Case-Shiller

The potential decrease in tax benefits from large property tax bills also comes at a time when the cap on mortgage interest deduction is being lowered.  The combination of these factors leads to several strategic questions for credit unions to consider:

  • Will tax reform make home ownership less attractive and cause real estate lending to slow?  If yes, how can that impact our earnings stream?
  • Will tax reform cause home prices to decline, potentially leading to increased loan losses?
  • What other loan and investment products should be tested in our A/LM model to help replace a potential reduction in mortgage revenue?

At this point, it is impossible to predict the real impact of recent tax changes.  However, proactive A/LM discussions combined with testing of potential short- and long-term balance sheet outcomes will help inform strategic implications, if any.

 

/by

Is ARM Refinancing Set to Increase?

, , ,

Last week we posted a blog on the evolving mortgage landscape, focusing on changing consumer behaviors and expectations.  This blog addresses a more specific aspect of mortgage lending, the likelihood that due to increases in mortgage rates, financial institutions will see an increase in existing adjustable rate mortgages (ARM) that refinance, as well as an increase in ARM applications.

Consider that the typical ARMs price off of either LIBOR or Treasury rates.  The 1-year Treasury for instance has increased roughly 160 bps in the last 18 months, and many ARMs are now positioned to reprice to the 4% – 5% range, and those rates would price up further again in a year if the rise in market rates continued.  The FRED graph below shows a new 5/1 ARM is around 3.7% right now, and provides a consumer the certainty their rate is locked in for 5 years.  A conventional 30-year fixed mortgage is priced around 4.5%.  Given projections for rates to continue increasing in 2018, refinancing now, even into a newly issued ARM, could make sense for many consumers and offer some peace of mind.

5/1-Year Adjustable Rate Mortgage Average in the United States

Graph showing 5/1 Adjustable-rate Mortgage Average in the United States thru January 2018

As we enter the 2nd quarter of 2018, the Mortgage Bankers Association has projected a 5% increase in purchase mortgage activity, but a 27% decrease in refinanced loans in 2018.1  While overall refis are projected to be lower this year, it is possible there will be an increase in the number of ARMs that get refinanced into either fixed rate loans, or into a new ARM.  And, as mortgage rates have risen, there has been an increase in applications for new ARM loans over the last year as members seek ways to keep their payments more affordable.  Note that in the first week of March this year, almost 7% of mortgage applications were for ARMs, compared to 5% 2 months earlier.2

Some of the credit unions we work with are seeing an increase in payoff amount requests on ARM loans while others are already starting to see a spike in ARM refinancing.

Is your credit union ready to capitalize on this potential opportunity?  Consider:

  • If your credit union has quite a few ARMs on the books already, how you will market refinancing to those current ARM holders?  Chances are they are thinking about it, and seeing articles and advertisements from your competitors.  If your credit union can reach them early, there is a better chance your institution is the one the ARM holders will choose if they decide to do something.
  • Even if you don’t make or have many ARMs, consider whether or not your credit union should get aggressive in advertising toward current ARM holders.  If so, be clear on what you have to offer them.  Do you have the products they would want and the ability to deliver?
  • If members begin to show a preference in refinancing into a fixed loan, does your credit union offer the fixed rate products they would want?
  • Consider testing scenarios in your A/LM model to understand the impact that a shift from ARMs to fixed rate mortgages (or newly issued ARMs) could have.  If balances shift from ARMs to fixed rate loans, this will increase interest rate risk at a time when risk is already increasing for some credit unions as rates have begun to move upwards.
  • If you are expecting an increase in fixed rate mortgages held on your balance sheet, does your institution need to create room from an interest rate perspective to potentially hold more fixed rate loans?  Are you equipped to sell them if there is no risk appetite to keep them?

It may be too early to really understand how big an impact this shift in the rate environment will have on mortgage balances and consumer preferences.  However, thinking through the strategic implications and modeling out different possibilities will help your credit union be prepared for what happens next.

 

1Homeowners Ditch Refinancings as Mortgage Rates Rise, WSJ, 3/26/18.
2Adjustable-Rate Mortgage Applications Have Lower Fraud Risk, National Mortgage News, 4/02/18.

 

/by

Is Your Mortgage Experience Designed for Today’s Borrowers?

, , ,

If you’re not already taking a closer look at the real estate lending side of your business, there are plenty of reasons to do so.  Home shortages, rising rates, competition, and tax law changes are some of the forces at work that warrant a renewed look at mortgage lending.  Many credit unions will find they have to fight harder for their share of the mortgage lending market.

Does your mortgage experience hit the nail on the head for today’s borrowers?

From the purchaser’s point of view, low housing inventories are pushing many to consider homes that are priced higher than they had initially Is the credit union's mortgage experience designed for today's borrowers?intended.  In addition, they need to be able to move quickly before homes are snapped up.  Think through what first-time buyers are facing – lack of inventory in their price range, higher payments, short timelines – and figure out how you can help them navigate.  Consider that in a shortage, sellers don’t want to wait for financing – and don’t have to.  A speedy lending process makes it easier for buyers to jump on deals.

From the refinancer’s point of view, refinancing to lower the rate or payment has mostly run its course, which has been slowing the refinance market for quite some time.  Those who would like to refinance, but have not, may have issues with their credit or loan-to-value ratio.  Are there situations where you would lend to some of those members?  Do you have any products geared for those situations, assuming you have consciously chosen to shoulder the additional risk?

As rising home prices boost homeowners’ equity, home equity lines of credit and fixed rate second mortgages will continue to meet the needs of many who would like to make use of that equity.  Some of those who previously would have sought a home equity loan may be more interested in a cash-out refinance now that the tax laws are stricter on mortgage interest deductions.  Are those members aware of how you can serve them?

Take all of these market shifts, and view them under the umbrella of tougher competition sparked by fewer originations and new entrants into the market.  Here are some thought-provoking questions to consider as you formulate your responses to these changes:

  • Have you identified and found ways to meet the changing needs of borrowers?  Start with the needs mentioned previously and add others as you identify them.
  • Should the credit union consciously shift focus from refinances to purchases?  This goes beyond marketing.  For example, the target market may shift toward real estate agents.  Think through what agents want for their clients in this market and how you can turn that into a value proposition for agents.  Consider how members shop for homes today.  How is it different from a few years ago?  How can you become part of the buyer’s process and establish a relationship earlier?
  • Have you considered implementing changes in your lending processes to take advantage of new legislation?  Laws are changing at the local, state, and federal levels, and in the current climate many of them represent the easing of regulations and the ability to make mortgage lending less paper driven.
  • What is unique about your market?  Use that knowledge to shift marketing focus, design products, and alter your processes to better serve your members and truly stand out in the crowd.
  • What does the competition offer that you don’t?  You do not need to, nor should you, try to match every value proposition that is offered by competitors.  But you should have a candid idea of what borrowers have to choose from.  Don’t forget non-traditional lenders – your members haven’t.

Today’s mortgage market is not the same market that it was a year or two ago.  Given the changing situation for consumers, combined with the highly competitive mortgage market, you should keep answering the question, Why should someone get a real estate loan with you instead of your competition?  The answer must be clear and brutally honest.  If there’s not a good enough reason, that’s your cue to figure out how to create one, because that reason is one of the keys to sustainable success.