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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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Intermediate And Long-Term CDs – Interest Rate Risk Protection?

Rates are low and, given news from the Fed, expected to stay low for the time being.  Some members are taking the Fed at their word and are beginning to move their funds into intermediate and longer-term CDs.  Before assuming this can help provide interest rate risk protection credit unions should answer a few questions.

CDs come with an early withdrawal penalty, but are your penalties enough to keep members from withdrawing their funds if rates move up? Consider the following example:

A credit union is offering a 5-year CD at 2% with a 6-month early withdrawal penalty.  One year after a member takes this CD, rates have increased.

Question:  How high would rates have had to increase over this year to put the member in a position to take the early withdrawal penalty and break even?

Answer:  Rates would have had to increase just 25 basis points (bps).

If the member takes the CD out early, they are charged a 1% penalty.  However, the member still has a 4-year investment horizon, which, if they can earn an extra 25 bps per year, equals the 1% penalty taken to pull their funds out early.  If rates increase more than 25 bps then it is a “no-brainer” for the member.  Some say that their members won’t early withdraw because they are fee adverse, but after years of pent up demand for more yield, it is hard to bet that the member won’t withdraw.  If there is a small fee to get a mortgage, does it stop someone from refinancing to a lower rate?

If the credit union is happy that it at least got the funds from the 6-month penalty, consider that the 2% rate minus the 6-month penalty results in a net cost to the credit union of 1% for what wound up being a 1-year CD.  1% for a 1-year CD is rather expensive for the credit union if there is not corresponding loan demand.

If rates don’t change, the member will continue to receive 2%, costing the credit union more than most investments would yield without taking substantial risk.

Credit unions do a lot of great things for members.  The key in this difficult environment is to make sure that the areas of giveback are intentional and understood.  Without such understanding, costs and risks can unintentionally increase.

What can be done if you decide that it isn’t in the credit union’s best interest to add an additional giveback?

Consider not trying to be top of the market on intermediate and longer-term CDs.  Some credit unions have increased the penalties on intermediate and longer-term CDs.  Eighteen months or half of the term are examples.  You could have the stiffer penalties for your current CD rates and offer lower rates for members that want the flexibility of a lower penalty.

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Auto Lending: The Concerning Slow Decline

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Traditionally, auto loans have been the “bread and butter” of credit union loan portfolios.  However, 1st mortgages have claimed that honor with short- and long-term trends showing continued declines in auto loans as a percent of total loans for the credit union industry’s balance sheet.  Auto loans have been consistently decreasing from roughly 40% of total loans in 2000 to 29% as of June 30, 2011.  The green trend lines reflect distribution changes since 2000 (long dash) and since 2007 (short dash)—which show little fluctuation in trend.  If the trend since 2007 is realized, auto loans will be down near 24% by December 2014.

Keep in mind that year-to-date auto sales in 2011 are up by 10.4% compared to 2010 according to Ward’s Auto Group.  Also, according to the Wall Street Journal, Chrysler Group LLC said recently its sales leaped 31% in August, while General Motors Co. and Nissan Motor Co. each reported increases of just under 20%.  Ford Motor Co. posted an 11% gain.

While some meager growth in used auto lending has occurred for credit unions from Q1 to Q2, the industry’s auto portfolio overall is on track to shrink another 1.6% in 2011.  Consider that the banking industry (FDIC-insured institutions) is on track to grow autos around 13.6% in 2011 according to FDIC data.  While overall non-revolving loan market share for commercial banks has traditionally been around 3 times that of credit unions per the Federal Reserve’s G19 release, the difference in growth rates and the downward trend is still quite concerning.

What’s The Point?

Some credit unions may have lost their focus on one of the primary things that made them great in the first place—auto loans.  Additionally, the continuing trend of increased 1st mortgage balances (which could be significantly extending balance sheets) is somewhat alarming in light of interest rate risk concerns; 1st mortgage balances are positioned to grow almost 4% in 2011 for the credit union industry.  While Bernanke is on record “forecasting” an extended period of a low target rate, we know that forecasts do not always come true.  Consider this past quote:

Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.

Fed Chairman Ben Bernanke
Semiannual Monetary Policy Report to the Congress
July 18, 2007

Each credit union is unique and must be armed with the right decision information in order to focus resources appropriately.  Understanding local demand trends and being positioned to take advantage will be even more critical going forward as banks and captive auto finance companies continue fighting for (and dominating) this piece of the consumer pie.  As we see it, it may be time for credit unions to take up the fight to more aggressively attract some of the auto market back.