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Pay Attention to Liquidity

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As we conclude our budget and forecasting work with many credit unions, we continue to see expectations for loan growth to exceed share growth in 2017. Combining this trend with an assumption for higher interest rates could squeeze liquidity positions in 2017.

Callable bonds may no longer get called and mortgage related assets will extend if rates increase. In addition, deposit growth could slow or shift to more expensive deposits.

While we recently posted a blog on liquidity, we felt it was important to give another reminder to do advance planning in this arena.

Test your liquidity position under various scenarios. If you see pressure beyond your comfort zone, now is the time to have the strategic conversations about how the credit union will be prepared to respond without sacrificing longer-term strategic objectives.

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Fed Indication on Bond Buying

On June 19, Chairman Ben Bernanke indicated that the Fed may slow its bond purchases later this year. Since that statement, the 10-year Treasury yield has increased 35bps from 2.20% on Tuesday, 6/18, to 2.55% on Wednesday, 6/26 (Treasury.gov), while the Dow Jones Industrial Average (DJIA) has dropped 408 points over the same period (Bloomberg.com). Keep in mind, the Fed only made a statement.

This raises some interesting questions for decision makers to consider, including:

If the rate increase is sustained…

  • How might this impact loan volumes in the short and intermediate term? Could volumes increase in the short-term for fear of loan rates increasing? What impact would it have on longer-term loan demand?
  • How might non-interest income be impacted?
  • If you were counting on your callable bonds to be called, and now they may not be called, should you hold them or fold them?
  • Could you experience another flight to safety if the stock market continues to be volatile?

Treasury rates could come back down and the stock market will hopefully “right” itself at some point. Nonetheless, decision makers should consider the impact to financial performance if current trends continue. Running through different “what-if” scenarios of how the institution would react and testing them in forecasting and risk models can help decision makers be better prepared.

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Weighing Credit Union Investment Strategies

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Given the flight to safety combined with sustained low loan demand, threats to non-interest income and NCUSIF assessments, many credit unions are reevaluating their investment strategy.

The problem is not enough credit unions are evaluating their investment strategy in light of their entire financial structure and strategic objectives.  They are evaluating one investment at a time. In other words, this investment seems to be a good deal today. But how long will it be a good deal?  And, if/when the decision needs to be unwound, what will be the viable options?  How does it fit with the credit union’s strategic objectives and financial structure?

Let’s take an example using callable bonds.  We are seeing credit unions purchase callable bonds with final maturities of 10 and 15 years.  The reasoning too often is, we need to do something, and they are going to be called anyway, so we may as well get the extra yield today.

Typically, people say they will sell it before rates become unfavorable, 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.

Some say that if rates go up they won’t need to sell low-yielding investments because loan demand will be so good, the yields on new loans will offset the risk of the lower-yielding investments.  This could happen.  However, it is important to keep in mind that rates can go up without economic recovery.

Stating the obvious, there is a tremendous amount of uncertainty—there always has been.  Yet decisions have to be made.  Just make sure your decision framework is sound.  Stick with the basics:

  • Make decisions in light of your entire financial structure.
  • Agree on how long you are willing to live with your decision if things don’t go as planned.  In the above example, answer:  are we willing to live with this decision for the next 10 or 15 years?  If not, how are we going to know it is time to unwind before it results in unacceptable risk for our credit union? This thought process should be followed when making any decision with potential long-term consequences.
  • Don’t assume that the future will be brighter or more forgiving than the present.  Isn’t that part of the mindset that got us here in the first place?
  • Document the rationale for major decisions.  Memories are short, so it’s important that key players remember why the decision was made in the first place.  Especially if the changes in the environment result in unfavorable financial performance.
  • Test drive your investment strategy before you implement it by using your A/LM model.  Don’t just look up +300 basis points either.  Remember, rates were 500 basis points higher just three years ago.  By rehearsing tomorrow today, you can understand the potential risk of what you are buying and can decide if that risk is worth today’s reward.
  • Agree on your appetite for risk for your entire enterprise, stick with it and manage to it.

This writing is not intended to say that callable bonds are bad, we are using them for example purposes only.  Our philosophy is that every decision has a trade-off; it is critical to understand the trade-off before implementing decisions.  It is up to decision makers to understand how each investment they purchase works not only today, but as the environment changes.  Decision makers must also understand how investments complement or compound issues in their entire financial structure and risk profile.