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Callables and Low Rate Environments

Trying to get any kind of yield on investments is tough when rates are this low. Some credit unions are reaching for yield by purchasing longer-term callables with the justification that “we don’t have to worry much about the risk because they are going to get called.” But consider this, if rates move up even a little bit, most callable bonds will not get called, and the credit union could be stuck with material losses. The example table below demonstrates this potential risk.

The example assumes that a $1M 1/5 callable (callable in 1 year, final maturity in 5 years) is purchased today at 80bp. It shows that, compared to Overnights earning 25bp, this investment would yield an additional $6K in revenue over the course of 1 year, at which point it would be called. However, when you layer on industry-average cost of funds, operating expense and fee income, it reveals that from an ROA perspective this investment loses $19K in year 1. If rates go up at all, the bond will stick around for the full 5 years, and in a +300bp rate environment the bond would lose about $147K over its lifetime when the credit union cost of funds, operating expense and fee income are factored in. If rates returned to levels seen in 2007 (5%), this bond would lose $190K over its lifetime.

Note that for simplicity sake it is assumed that rates move immediately.

Some credit unions can afford to take this risk, some cannot. In any case, the decision to buy longer-term callables should NOT be based solely on the expectation that they will be called; the consequences of being wrong could have a very negative impact on a credit union’s risk profile and future earnings.

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Do You Have A Clear Philosophy On Fees?

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With fee income under fire, it is becoming more important than ever for credit union boards and managements to be able to articulate their philosophies on fees.  Simply saying, “We don’t like to fee our members” is not enough.  Most credit unions are already considering, if not implementing, new fees and fee increases—not because they want to fee their membership, but because they feel that replacing lost fee income and/or offsetting increasing expenses is a financial necessity.

Consider the following when discussing fees and fee pricing:

  • Cover Costs—Fees can be implemented to put the burden on the party that is incurring the costs rather than making the entire membership carry the costs.  Take the example of check-cashers.  Check-cashers typically are not contributing members but use a lot of credit union resources.  One answer to this dilemma is to decide that it’s okay to cash checks as long as the costs are covered with a fee.  In this case, it must also be okay to have the check-cashers go elsewhere if they decide that they don’t want to pay the fee
  • Strategy—The fee structure and pricing must support the credit union’s strategy.  A credit union that is building its mortgage business may choose to charge mortgage fees that do not cover all costs.  The rationale could be that the costs will be covered with future interest income while charging more fees today could drive potential borrowers away.  The important thing is that the fees align, and are not in conflict, with the strategy
  • Member Behavior—Some fees are intended to change member behavior.  An example is paper statement fees.  The purpose of these fees is to encourage members to get statements online, enabling the credit union to reduce expenses directly attributable to paper statements.  In addition, the credit union may hope members will shift to using more electronic services, reducing branch and phone transactions
  • The Bottom Line—Fees are sometimes instituted to improve the bottom line, although this is often only part of the reason.  Improving the bottom line often goes hand-in-hand with covering costs and altering member behavior
  • What the Market Will Bear—As a practical matter, fees that most institutions charge are included on many credit unions’ fee schedules simply because the market expects to pay them.  This approach is also used in deciding fee pricing as opposed to pricing to cover costs.  However, it is important to understand the hard costs.  It should be a conscious decision to charge a fee that does not cover the cost

This is the perfect time to discuss and clarify the credit union’s fee income philosophy.  Having decision-makers on the same page will help align upcoming fee structure changes with the credit union’s philosophy and strategy.

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Threats To Interchange—More Than Just An Income Issue

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The financial services industry is still holding its breath awaiting the repercussions of the Durbin Amendment reforming debit interchange.  The initial threat for which many are preparing is a material reduction in non-interest income.  Although the amendment exempts financial institutions with less than $10 billion in assets, opponents argue that merchants will (of course) coerce consumers by any means necessary to use lower-interchange payment forms.  But what operational expenses might be involved?  While many are focused on the direct impact to the bottom line, there is also the challenge of implementation and the associated cost.

A recent statement from William Sheedy, a Group Executive for Visa Inc., noted that:

The Durbin Amendment will be expensive and challenging to implement and will likely require changes by all stakeholders from the point-of-sale through to the issuer.

The statement also mentions that the two separate interchange structures are compounding the issue—noting that the degree of difficulty in implementation will depend upon actions by all stakeholders in the system and, of course, the details of the final regulation.

This is just one more threat facing decision-makers.  Uncertainties that could result in significant financial pain can impact product offerings, service levels and strategic direction.  Our suggestion is to turn these high-level threats into opportunities to reevaluate your business model by test driving how life might be if a particular threat were to become a reality.  If the threats don’t materialize, the worst that happened is decision-makers invested more time to think deeply and strategically about their business.

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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.