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Of Bulls and Bears – Margin Impact from Changing Yield Curves

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After the blog published on April 21, 2016, we have received a number of comments regarding why we were silent on the industry “conventional wisdom” that a wider yield curve can provide stronger net interest margin, and that a narrower yield curve can squeeze the margin. This can be true, but often is not. All else being equal, a wider yield curve would produce stronger margins. However, real life seldom results in an “all else being equal” outcome. Business, and the economic climate, are not static. There are constant changes to the regulatory, economic, and competitive landscape that can (and does) change consumer behavior – and the changes in consumer behavior result in changes and shifts in credit union financial structures.

Bear Flattener

If we were to apply “conventional wisdom” to the most recent “bear flattener,” which occurred from 2004 to the end of 2005, real world results are not what would be expected. In June 2004, the industry net interest margin was 3.26%. In June 2006, the industry margin had barely moved down, reaching 3.20%. This barely quantifiable movement in margin happened when the yield curve moved from roughly 350 basis points (bps) to about 20 bps – a reduction in steepness by more than 300 bps.

Using the “all else being equal” argument, margins may have been squeezed more. However, there was a mitigating factor that helped to preserve the margin – the loan-to-asset ratio for the industry increased more than 5% over that same time frame. The increase in the loan-to-asset ratio helped to offset margin pressures that could have been realized if “all else being equal” loan demand had not increased.

Bear Steepener

Applying the same conventional wisdom to a recent “bear steepener,” which occurred from 2012 to 2013 long-term rates increased more than 100 bps, translating to a yield curve that is roughly 100 bps wider than it was December 2012. However, net interest margin for the industry dropped from 2.94% to 2.80%. Comparing the end of 2012 to the end of 2015, the yield curve has been consistently steeper and loan-to-asset ratios jumped 7% (to 65%), but the margin of 2.86% has not rebounded to the 2012 level.

Now, some may argue that there were so many other variables and moving pieces in the broader economic climate, “all else being equal” or using an “apples to apples” comparison, margins should have increased. That may be the case. The same arguments are brought up in relation to static income simulation. Breaking it down into the fundamental components, everyone realizes that real life isn’t static – things change, member demands and consumer behaviors shift, and the competitive landscape has a significant impact on credit union earnings and risk profiles. The entire reason for the thought that wider yield curves bring stronger margins is a lack of change in the composition of assets and liabilities in static income simulation. This is antiquated thinking that has resulted in potentially misleading “conventional wisdom.”

Conventional Wisdom can be Misleading

As an industry, we have seen yield curves widen (steepen) and yield curves narrow (flatten), loan-to-asset ratios increase and loan-to-asset ratios decrease, with inconclusive correlations between changes in the yield curve in relationship to actual bottom-line net interest margins. Credit union management teams, boards of directors, and even regulators should be concerned with an assumption of static replacement regardless of the change in the environment, as it is often misleading. For decades we have been modeling a huge range of yield curves and environments, and this experience has taught us the importance of modeling how members may respond differently in these environments. Additionally, it has demonstrated that better business decisions can be made by first understanding the potential profitability (or losses) from the existing structure, prior to layering on guesses about what the new business may be able to do in all of the different environments.

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PLL and Managing Expectations

The most recent 2012 NCUA data shows that year-to-date, about 29% of all credit unions have run either a zero or negative provision for loan loss, due primarily to overfunding of the allowance.  The bulk of these credit unions were smaller in terms of asset size. Filtering to credit unions with assets over $500M, the answer is 5%.  Knowing that, it might be easy to infer that the abnormally low provision for loan loss is a small credit union phenomenon, but that is not necessarily the case. While the smaller institutions may have seen the more extreme swings in provision, recent data also shows that about 53% of credit unions over $500M have benefited from a provision for loan loss below 30bps (remember that in the exuberance prior to the credit crisis, PLL averaged 30-35bps).

The drop in PLL expense has helped offset the squeeze in margin that many credit unions are experiencing.  This leads to the question:  Can such a low level of expense be sustained in the future? Looking forward, credit expenses are likely to go back up as many institutions have delinquency and charge-off ratios that materially exceed provision for loan loss.  Managing board expectations in this regard is important.  Boards need to understand the impact of allowance overfunding and how it influences net income.  One simple step to address this would be to compare end-of-year provision for loan loss to actual charge offs.  Another option that could provide more detailed information would be to take your current level of charge offs and run out your budget with charge offs in place of provision for loan loss.  These analyses would help a credit union’s management and board to get a better feel for the sustainability of earnings once the ALL is no longer overfunded and PLL starts to rise.

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Interest Rate Risk Modeling—Do The Results Make Sense?

Many credit unions are increasing the number of “What-Ifs” they run. It is important that decision-makers do a gut check on the results being presented.  It is also important to understand that various modeling methodologies may need to be used to ensure appropriate evaluation of the decision.
Take, for instance, a decision to expand auto lending into lower credit tiers.  This decision may prove beneficial to help preserve shrinking margins.  However, taking this potential scenario and running it through a traditional net interest income simulation and NEV will show there is virtually no risk in making this type of decision, assuming the loans are priced near the effective discount rate.
Net interest income and NEV will not address the credit risk component.  In this case, the question that must be answered is, “how will earnings and net worth be impacted by the shift in assets?”  In this example, provision expense should also be adjusted to represent the risk of the shift in assets.  If applicable, collections, legal and other expenses should also be adjusted, to capture the economic reality of increasing credit risk.
Ultimately, any decision that could result in a material change to a credit union’s financial structure should be simulated and all potential financial impacts should be considered, including net operating expenses.  The results should be shared with decision-makers and all should be asking “does this make sense?” and “is there any other impact not captured by the modeling?” to ensure that modeling results do not lead decision-makers astray.
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Evaluating Investments

This post is a continuation of Investing At “Record” Low Rates… published February 10, 2012.

Investments with complex optionality are increasingly being added to credit union investment portfolios.  As such, it is critical that credit unions have a solid understanding of what they may be purchasing, before the transaction is executed.

First, make sure your broker is providing you with a complete picture of the characteristics of the investment in question.  In general, most brokers provide market value, and cash flow information for the current environment and a +300 basis point (bp) rate change.  However, some investments (in particular some CMOs) may look “okay” if rates go up 300bp, but have the potential for extreme extension risk if market rates go up 400 or 500bp.  Credit unions should ask their broker for cash flow and market value shock data for the +400 and/or +500bp rate change, particularly for investments with optionality.  Remember that short-term market rates were 500bp higher than they are today as recently as 2007.

In addition to cash flows, other optionality features can be very important as well.  For example, if the investment is variable rate, make sure that all of the repricing parameters are clearly understood: repricing frequency, margin, caps, floors, etc.  When the first repricing can occur is particularly important, especially with rates being so low.  For callables and step ups, consider call dates and potential repricing dates.  For step up investments consider if the future step protection warrants the lower starting coupon rate compared to a bullet or callable with the same final maturity.

Working with a trustworthy broker certainly helps in this process, but that does not absolve decision-makers of completing their own due diligence and ensuring an investment fits within their overall strategic objectives.  Keep asking questions until there is clarity on the investment and its structure, consider the other pertinent decision drivers (for example, policy, impacts to aggregate risk position, etc.) and consider the unexpected in the decision-making process.

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Perfecting The Process

Looking over the last 12 months, what has happened to your credit union’s net interest margin? If yours is like most credit unions, the answer is it has declined. Competition for loans and low interest rates continue to erode yield on assets.  Cost of funds has declined but (for most places) not enough to completely offset the reduction in asset yields.

If interest rates remain low throughout 2012, the yield on assets will continue to decline.  Can the cost of funds be reduced further?  For some, the answer is yes; however, others are at, or near, the floor.

Below the margin, many credit unions have made cuts to operating expenses over the last couple of years.  Most of the “low hanging fruit” has been picked.  Some credit union managers are feeling they have done everything they can do with operating expenses, yet earnings still aren’t where they would like them to be.  What can you cut after you’ve cut everything?

Sustainable expense reductions often come not from cuts, but from improving processes.  Have you examined and mapped out all the processes at your credit union? If so, were you surprised (shocked?) by what you learned?  We’re doing what!?!

Improving processes to remove unnecessary steps, to move members through the process faster and free up employee time, can both reduce expenses and increase revenue.  Remember that every minute a frontline employee spends completing a non-value-add step in a process is a minute less they spend interacting with members.