Why You Should Up The Ante In Your Stress Testing

Part of my strategic planning work with credit unions involves environmental scanning. We are fortunate as an industry to be blessed with numerous resources that help us assess the operating environment looking forward. We are heavily encouraged by our financial consultants and regulators to look at many different types of risk, and the penalties for not doing so can go well beyond a written rap on the knuckles.

Looking at the tea leaves for the rest of 2012 and into 2013 has left some of us with significant concerns related to what the environment might look like going into 2013. While I risk looking a bit like Chicken Little here, I believe CU leaders should up the ante on stress testing this year. While none of us really anticipated the collapse of the housing market beginning in 2006, another member of our firm, specifically Steve Williams, had been writing about his concerns about "out of control" mortgage securitization at least two years before the problem engulfed us.

I believe we face a significant number of current trends that could combine with several potentially damaging events scheduled for year-end that could lead to a period of true stagflation.


When The Music Stops

We are already seeing upward pressure on interest rates, which is worrying to a number of the more sober Fed governors. In 2011, the Fed purchased 61% of all U.S.-issued debt. Will the Fed be able to continue to balloon its balance sheet to obscure the fact that demand for U. S. Treasury securities is eroding abroad? We think not. What then happens when the Fed stops the music? There is only one way for interest rates to go.

Even given the extraordinary action by the ECB, World Bank and the IMF, the European crisis has not abated at all. We are now seeing increasing rates in Spain, Italy and France despite $1 trillion in new guarantees from the ECB. The banking system of the European Union is currently leveraged 26 to 1 (U.S. bank leverage is at 13 to 1). The European system is also much larger ($46 trillion vs. $12 trillion in the U.S.).

According to Mohammad El-Erian, the banking system in France has an overall capital-to-asset ratio of 1.5%, which pushes leverage to over 100 to 1. Many investment advisors continue to believe there will be a major corrective event in the EU that will force the Fed into another sizeable easing that will further devalue the dollar and cause interest rates to rise much faster..

While we all hope for a gradual pattern of rate increases, we know from the last several recessions that has not been the historical pattern. It is clear from recent messaging from the NCUA that their highest concern has now become interest rate risk. I am convinced by what I read that the Fed will be increasing rates far sooner than expected.

The regulators will be looking very carefully at rate shock assessments this year. We believe that prudent credit union leaders should take this seriously, even to the point of considering an increase over the next two to three years of as much as 500 BPs. Hope for the best but plan for the worst.


New Wave of Foreclosures?

Secondly, the folks that have been safe in making no mortgage payments for the past three years are about to be turned out. Now that the banks have reached a settlement with the Justice Department and have a clear path forward, we are likely to see another dramatic increase in foreclosures this year. While we believe that finally cleaning out the pipeline is a good thing in the long run, a rising rate environment and global disruption could actually cause yet another dip in housing.

Thirdly, the specter of much higher gas prices is always a threat to consumer spending and borrowing. Refining capacity continues to be curtailed in the U.S., especially in the Northeast, primarily because refiners are no longer willing to absorb large operating losses given the oppressive regulatory environment.

Given these three realities, there are also a number of year-end risks that cannot be ignored related to increasing tax rates and the threat of sequestration created by the last debt limit battle in Congress:

* The payroll tax holiday expires Dec. 31.

* The "Bush" tax cuts also expire, increasing the marginal tax rates for all taxpayers significantly.

Without Congress reversing itself, Sequestration begins to kick in Jan. 1st to the tune of $1 trillion in spending cuts-half from the defense budget and half from across-the-board cuts in domestic spending.

Each one of these events would have a negative effect on personal consumption. All three together would be quite a challenge. Mitigating these negative events will require bipartisan action from the Congress and Administration.


The Washington Track Record

Washington's track record in resolving differences and providing solutions, however, has not been a good one. Not many in Washington believe that anything will happen related to tax reform until after the election, which gives Congress and the Administration less than 60 days to address the estimated $500-billion tax hit that will occur on Jan. 1, 2013.

I am convinced that many high-placed officials in Washington would like to see at least some of these events come to pass. While many believe this type of painful correction is necessary and would benefit the country in the longer term, the short-term affect could be quite devastating.

Regardless of political leanings and the poor timing of these events vis-à-vis the presidential election, I would suggest that credit union officials take the potential for disruption seriously. While we all are required to complete regular rate shock analyses, I would encourage the completion of a thoughtful capital adequacy assessment this year. What happens to earnings and capital if we see another significant disruption in consumer spending, a further reduction in loan demand and delinquencies increasing dramatically-at the same time we see consumer prices and interest rates rising, potentially faster than we want them to? The result will be classic stagflation.

It is my belief that prudent CUs will make sure they assess what happens to earnings and capital under a much more potentially dangerous operating scenario than we have seen in a long time. I have always been under the opinion that the credit union industry is overcapitalized. Looking at all that is aligned against us in 2013, I'm not so sure.


What To Do Now

* Complete a capital adequacy assessment under multiple operating scenarios.

* Make sure that you do not allow assets to grow at a faster rate than capital.

* Make sure your operations are drop-dead efficient from a process perspective.

* Get help in negotiating contract renewals that come up this year, especially payments.

* Make a concerted effort to increase non-interest income.

* Make sure you have contingency plans that address a more negative operating scenario.

A recent interesting editorial in the Wall Street Journal reminded us that the Titanic had about half the lifeboats it needed to save all passengers and crew.

The reasons for this failure turned out to be that the builders were worried about the cost and were in compliance with the existing maritime regulations related to lifeboats-and the builders felt they could always add more if the inspectors raised an objection, which they did not.

They also made the assumption that if the boat did sink, it would sink slowly enough for rescue ships to arrive, and they could transfer all the passengers in an orderly fashion. As we know, it did not happen that way.

As it relates to our business, I'll be the first guy to cheer if the overall economy continues to improve and the coming rise in interest rates is manageable. But I say, let's hope for the best, but plan for the worst.



Ted Thames is a senior director with Cornerstone Advisors, Inc. He can be reached at tthames@crnrstone.com.