/by

Opportunities within the Treasury Yield Curve

,

Much has been written about the U.S. Treasury yield curve recently – it’s narrowing, it’s widening.  It’s nearly impossible to predict.  While there will always be uncertainty regarding market interest rates, the current shape of the yield curve offers credit unions some opportunities to explore.

Consider the decision to borrow funds.  Many credit unions are feeling liquidity pressure and structured borrowings are a viable option to help improve liquidity.  Along with borrowings comes the important decision of term.  Depending on the risks that the institution is looking to address, the yield curve is creating unique cost versus risk trade-offs to consider.

For example, in the following table let’s evaluate two potential borrowing terms, 3- and 5-year Federal Home Loan Bank (FHLB) fixed-rate advances:

FHLB Dallas – Fixed-Rate Advances (as of 02/13/18)

Table of fixed-rate advances from the Federal Home Loan Bank as of 2/13/18

As expected, the 5-year borrowing rate is higher than the 3-year borrowing rate.  However, the difference between the 2 rates is at some of its narrowest levels in the past 10 years.  The credit union pays an extra 0.27% per year for 2 additional years of funding and protection from rising market interest rates.  However there is always a trade-off, and market interest rates could stay relatively flat or not increase as much as expected.  The possibility needs to be understood and tested with what-if scenarios.  That being said, some decision-makers are finding the risk return trade-off between these 2 points along the yield curve is quite advantageous for their risk profiles.

Likewise, there are similarities with the Libor Swap Curve.  Notice in the graph below that the highlighted points between the 3- and 5-year Libor Swap Curve are among the flattest of any point along the 30-year curve.

A graph of a 3-month LIBOR Forward Swap Curve (last 4 months) showing a flattening between 3-year and 5-year marks.Note:  Analytics Provided by The Yield Book® Software

Swaps and other derivatives are additional tools that can decrease interest rate risk in a rising rate environment.  The challenge for some can be that along with derivatives comes material increases in operating expenses like accounting costs, expertise in the form of staffing, and additional A/LM analysis, to name a few.  With that in mind, the flatness in the swap curve is an opportunity some feel could be a good fit for their risk profile.

Another area impacted by the slope of the yield curve is the investment portfolio.  For example, a simple fixed-rate, 3-year agency bullet is currently yielding roughly 2.30%, while a 5-year agency bullet is yielding close to 2.55%.  As demonstrated in the following table, the risk versus return of the 3-year agency bullet is more favorable now, in a +300 bp shock, than the risk versus return of the 5-year agency bullet.

A table comparing a 3-year agency bullet and 5-year agency bullet in an investment portfolio

The yield curve will continue to change, along with the unique opportunities it creates.  While the actions of the Federal Reserve and the level of interest rates continue to get most of the attention, it is important for credit unions to look for opportunities created by the differences between short-, intermediate- and long-term rates.  In addition, twists and changes in the yield curve also need to be modeled routinely as part of asset/liability and interest rate risk management.

/by

The A/LM Implications of Tax Reform

,

While it could take years to quantify and understand the full impact of the recent Tax Cuts and Jobs Act, it is not too early to start thinking through the potential A/LM implications.  There are several intriguing changes, embedded within hundreds of pages of legislation.  The focus here will be on a few key highlights, including the evaluation of potential opportunities and challenges to credit union financials under new tax reform.

The ALM implications of tax reform legislation for credit unions.

Corporate Tax Rate

Corporations, including banks, are expected to have a lower tax bill going forward.  Since banks are a key competitor of credit unions, this area has the potential to be quite impactful.  Under the new tax reform law, the advantages of having a tax-exempt status will narrow.  What will banks do with the extra profits?  One possibility is to pay shareholders in the form of dividends.  Another possibility is that banks become more competitive.  Perhaps banks will try to increase market share, increase deposit rates, or decrease loan rates, which could create more competition for credit unions on both sides of the balance sheet.  These additional deposit pressures could come at a time when Americans are saving at a 12-year low and the cost of funds is already on its way up, due to increasing market interest rates and liquidity pressures.1

Increased competition in lending could delay the expected increase in loan revenue from a rising rate environment.  The outcome is uncertain but what-if analysis in A/LM modeling can better prepare the credit union for these potential pressures.

Mortgage Interest Deduction

Also under the Tax Cuts and Jobs Act, mortgage interest deductions will be capped at a lower principal balance than in years past.  Many credit unions may not be materially impacted because the new limit is on mortgage principal amounts of $750,000.  However, there are many credit unions in areas that have recently experienced significant appreciation in home prices or are in markets where the median home price is currently close to $750,000.  As a result, there have been several credit unions recently that are keeping a keen eye on their high balance mortgage loans.  There is speculation of potentially higher prepayment speeds on the higher balance mortgages, particularly if the same member has a high-balance deposit account from which to pay down the mortgage loan.  The credit union can begin using its business intelligence to start tracking this information, and likewise consider what-if analysis to determine the impact of accelerated prepayment speeds.

Individual Tax Rate

The impact of lower individual tax rates is extremely difficult to predict.  There are several moving pieces–most notably itemized deductions versus standardized deductions, potentially resulting in an individual paying more taxes.  But if it saves individuals money, the economy could continue to benefit and create a significant opportunity.  Loan growth might accelerate, deposit growth could increase and credit unions could benefit.

Internal discussions surrounding the Tax Cuts and Jobs Act are perfect 180-second exercises for management teams.  Also, testing out the potential balance sheet impacts in the A/LM model is essential to long-term planning.

We will follow up with another blog in a few weeks to discuss other key highlights of the Tax Cuts and Jobs Act.  Stay tuned.

 

1With Stocks Surging, Americans Are Saving at 12-Year Low, WSJ, 2/08/18.

 

/by

Now is the Time to Strategize on Investments

, ,

After the Great Recession, credit union loan-to-share ratios declined steeply and didn’t begin their long, slow recovery until 2013.  It has taken 4 more years to approach pre-crisis levels.  Now, credit unions are beginning to face very different questions than they have since the financial crisis.

Even if your credit union isn’t feeling a liquidity squeeze, now is the time to strategize on the investment portfolio you’ll want to have if loan growth continues to outpace share growth.

Graph showing loans-to-shares for all credit unions in the U.S., 2006-2017

The type of investment portfolio that works well for an institution with 35% of shares in investments will likely be quite different from one that has 10% in investments.  Large investment portfolios often shoulder a hefty profitability burden for the institution.  As loan balances grow, investments may need to serve more of an interest rate mitigation function.  Of course, liquidity needs are also a factor.

Here are some things to keep in mind as you think through the possibilities:

  • If loan growth patterns continue, will the loan portfolio shift toward having more or less interest rate risk?  Will the loan growth cause the yield on loans to increase or decrease?  This can help guide the structuring of investments to balance risk and profitability for the institution as a whole
  • How does the future loan portfolio align with risk limits?  For example, if loan growth is pushing the balance sheet up against interest rate risk limits, can the investment portfolio be used to offset the additional risk?  At the same time, if there isn’t much interest rate risk in the loan portfolio, there might be more room for interest rate risk, and the higher returns that usually accompany it, in the investment portfolio
  • What will be needed for liquidity?  While there are a variety of levers to pull for liquidity, be sure to consider how much of the investment portfolio strategy will be dictated by liquidity needs
  • How might selling investments help to rebalance risk or increase liquidity even if those investments are sold at a loss?  Selling at a loss does not mean the investments were “bad.”  Looking at the total interest earned in comparison to the loss can help provide perspective on how the investment performed for the credit union.  Also factor in what the funds will earn when they are loaned out (and serving members).  Often the loss is a small price to pay to address greater strategic needs
  • Test, test, test!  Test drive your ideas by modeling various future structures in a wide range of interest rate environments

Thinking through what your structure could look like if current trends continue will help lead to better investment decisions today in preparation for tomorrow.  Taking the time to strategize now and form a clearer picture of the future can only enhance the sustainability of your business model.

/by

Keep Risk Concerns in Mind with New Uses for Blockchain Technology

, ,

Blockchain and digital currencies continue to gain more attention and traction in the market.  As this happens, the uses and applications of blockchain are becoming more varied as companies and people think innovatively about how to use this technology to enhance their businesses and lives.  While this is happening, it’s important to consider the risks of blockchain and be intentional in decision-making.

Graphic showing how blockchain technology connects businesses and consumers.

We recently discussed some ways in which blockchain technology could change the way consumers and companies conduct business, making it easier and more efficient for both.  This trend is evident in the Eastman Kodak Company’s recent announcement that they will be offering KODAKCoin which will help photographers address a long-time pain point, tracking unlicensed use of their work.

With all this attention, it is easy to forget that the broad use of blockchain technology is still new.  While blockchain is supposed to be more secure because of its shared record of transactions, questions still remain about its security.

Bloomberg recently highlighted this question in an article that reports hackers have compromised more than 14% of Bitcoin and Ether (another digital currency) supplies in less than a decade.  This equates to about $1.2B.  Security experts note in the article that blockchain’s vulnerability is similar to that of software in some cases, especially as there are thousands of entrants, each with its own concerns.

The “so what” for credit unions is no different than when evaluating any new technology or software.  Start by understanding the technology as much as possible.  While blockchain is more secure in some ways, it is still vulnerable.  On the other side, organizations are just beginning to recognize the amazing uses and applications of blockchain technology, and how they can benefit consumers and businesses.

The risks of blockchain should be weighed against the opportunities to provide additional member benefits and enhance relevancy.  Being aware of this, and keeping the organization’s strategy in mind, can help decision-makers make conscious choices about how they want to enter the market and better position the credit union with this technology.

/by

FinTechs vs. Traditional Lenders – Is There a Difference?

TransUnion recently released a study comparing FinTechs to other lenders, and used personal loans issued between 2014 and 2016 as the basis for the study.  The study’s objective is to answer the question, “Are FinTechs different from other lenders?”  Interestingly enough, this is a question credit unions have been speculating on for years in an effort to understand the new type of competition FinTechs are bringing to the industry and how to respond.

While the study contains a wealth of fascinating information, we are going to focus on two areas in this blog.  The first is age distribution of consumers by lender type.  Often, credit unions believe that FinTechs are more popular in the younger age demographics, as those age groups are likely more tech savvy and willing to bank in non-traditional ways – two of the main value propositions of FinTechs.

Surprisingly, the following graph indicates that credit unions do better in attracting the younger demographics than any of the lender types – including FinTechs.  Where FinTechs shine is in the 30-64 age range, which is when most consumers are borrowing.

Table:  Age Distribution of Consumers by Lender Type

Graph showing age distribution of consumers by lender type in FinTechs study

This raises a number of questions for credit unions, some of which are:

  • Why are credit unions attracting more 18-29 year olds?
  • What sort of business are credit unions receiving from this group?
  • Is the competition for the younger age demographic detracting from competing in the age demographics where consumers do most of their borrowing?
  • If FinTechs often compete with traditional lenders on technology and non-traditional banking, why are they more successful with the 30-64 group compared to credit unions than the <30 age demographic?

Some of the answers may challenge credit unions, given the strategic focus and discussions about how to increase Millennial membership in recent years.

The second area of the study is on credit risk.  There is often a question about how much credit risk FinTechs are willing to take, with the speculation that they are generally taking riskier loans.  According to the study, the FinTechs’ approach to credit risk is more nuanced.

The chart below show that FinTechs are generally willing to lend more money to consumers.  This does lead to more credit risk exposure, given the higher loan amount.

Table: Average New Loan Amount

Graph showing average new loan amount in FinTechs study

However, when looking at the distribution of originations by credit score, FinTechs’ credit risk is right in line with credit unions.

Table: Risk Distribution of Originations

Graph showing risk distribution of origination at t in FinTechs study

In combination, these two charts suggest that while FinTechs are willing to lend more money, they are not focused only on the near prime and lower credit scores.  This again may challenge credit unions’ view as it suggests competition from FinTechs is not isolated in the lower credit risk tiers and in fact, FinTechs are competing across all credit scores and age ranges.

In light of this information, it would be good for decision-makers to have strategic discussions about how this could impact the credit union and its strategy.  This is a great topic to discuss during a board or ALCO meeting.  Participants can read the study beforehand, and come ready to discuss the impacts – positive and negative – to the credit union, and consider if any changes to the credit union’s strategy need to be discussed.