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Is NEV Capturing The Risk Of Declining Asset Yields?

Short and long-term market rates have been at—or near—record lows for almost 3.5 years.  This has resulted in credit unions continually replacing higher-yielding assets with lower-yielding assets.  This is creating earnings challenges at many institutions, particularly as the cost of funds is nearing a “floor.”

So, is your NEV analysis reflecting this risk?  The answer for most credit unions is no.  Loan yields have decreased steadily, but offering rates (often used to discount loans in NEV) have decreased much faster.  In many cases this has resulted in loan valuations improving from an NEV perspective, even as the yields and revenue are decreasing.

Consider a credit union auto portfolio that yielded 6% in 2010.  Lower-yielding loans have been booked since then, and have taken the yield down to 5%.  If the NEV discount rate being used is 3.5%, an economic value gain today of ~3% would be produced (a different gain could be generated depending on principal cash flows, prepayment assumptions, etc.).  The credit union might be happy that they are holding autos at a gain, but since they don’t plan to sell them anyway, the reality of lower yields and less revenue is a very unappealing prospect.  NEV does an inadequate job of capturing the risk of declining asset yields (along with ignoring net operating expenses and earnings).  Credit unions should be cautious if NEV is used in the decision-making process, and make sure they are aware of the limitations of NEV.

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Budgeting During Times Of “Unusual Uncertainty”

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Creating a budget is always a challenging and uncertain process.  Developing the annual budget for 2011 may be unusually difficult as there is heightened uncertainty about loan demand, interest rates, investment yields and deposit trends.  Net operating expense concerns include share insurance assessments, threats to non-interest income and provision for loan loss trends—stable, declining, or, for some institutions, still increasing.

Due to this uncertain economic environment, credit unions should consider developing a base budget and then creating multiple scenarios identifying key vulnerabilities that could stress financial performance, such as:

  • What if loan demand continues to be anemic?
  • What if provision for loan loss increases unexpectedly?
  • What if mortgage originations decline materially?
  • What if cost of funds cannot be lowered enough to help offset other adverse scenarios?

Evaluating combinations of negative factors, while depressing, can provide valuable early warning information to management and the credit union’s board.  This process can also help manage key players’ expectations appropriately.

If the base budget is acceptable but there are several plausible scenarios that could create unsatisfactory financial performance, it is good to know this in advance so that decision-makers can begin to think about contingency plans.  This is particularly relevant if the credit union has a level of net worth with very little breathing room.

Identifying the potential problems early on will give your credit union a better chance at making 2011 a financially successful year.  Good luck!