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.
