Four years ago, CUNA's CFO Council published a white paper that described a financial services landscape inhabited by an inverted yield curve, tight margins and an overabundance of providers.
Generating non-interest income was both the subject of the paper as well as a strategy to manage during those bleak days following the financial crash of 2008. One caveat was offered, though: there were few innovations in non-interest income, and instead creative variations on a theme.
The landscape has improved somewhat-but not as much as predicted or hoped-margins are still thin and while some of the providers have left, notably in the mortgage area, others have moved in. The recession that an inverted yield curve typically forecasts happened in 2008, of course, and for many Americans still lingers on like a bad dream.
Alternative revenue is the subject of a new white paper sponsored by CUNA's Operations, Sales & Service Council. The caveat offered in the previous paper is echoed here as well-there are no magic bullets that will generate revenue, notes CEO Steve Punch of the $1.1-billion Pacific Coast Credit Union, Walnut Creek, California.
"I haven't come up with any magic," he says. "The conflicting issues are the costs associated with adding new lines of business, the risks of not being able to generate sufficient scale quickly enough and the rate or credit risks associated with lending products.
"The big question is what's next and should I leap now?" he asks. "Or should I continue to conserve costs and wait for clearer indications in the economy. I think the answers depend on your market position and regional economy."
Both credit unions and the American public are learning to live with less and hard times. If we look at the return on average assets, as well as ROA minus fees shown in Figure A we note that ROA has recovered a bit from the lows of 2008 and 2009, but not to the earlier times when the accepted gold standard for performance was 100 basis points or more. That gold standard, like its namesake, is history.
The hard reality is that without fees and other non-interest income, credit unions would be overflowing in red ink and a losing proposition.
Hedging with Derivatives
Derivatives are being considered by a growing number of credit unions to cope with the volatility of the financial markets by serving as a hedge against interest rates climbing upward. No one knows the future or the precise date when interest rates will increase. The Fed suggests about two more years-2014, but there is a minority of economists and financial analysts who are pointing to a longer time span. Charley McQueen, CEO of McQueen Financial Advisors, Royal Oak, Michigan, breaks with conventional wisdom to predict that low interest rates will be with us for the next five to six years.
"People say rates can't stay this low; it hasn't happened before," he says. "This is true for the United States, but this has happened in Japan, which has a debt to GDP of 300%; the U.S. has a debt to GDP ratio of 101%. In Japan, rates have stayed low for nearly 14 years. Taxation is high in Japan and they are a nation of savers."
McQueen also predicts slower growth for the American economy for longer than many expect. "Many economists are predicting slower growth for the next six months to one year," he says. "I'm saying that we will have slower growth for the next five to six years. The tax code resets on Dec. 31, 2012 and the Bush era tax cuts will expire and the top marginal tax rate will revert to about 40% (President Obama has recently proposed certain extensions). If you are uncertain about taxes you are not going to hire people. Taxation will slow the economy."
When interest rates increase, it's likely the change will come quickly without time for reflection or planning. An interest rate swap is a derivative that allows a credit union to hedge against rising interest rates.
At this time, only 43 or so credit unions have the authority to participate with derivatives with the NCUA approved Derivatives Pilot Program with ALM First. NCUA could potentially grant credit unions the authority to apply for the use of derivatives outside the pilot program as early as a year from now, according to Emily Hollis, founding partner of the Dallas, Texas firm.
The current economic environment of low interest rates is a "great time to hedge, according to Hollis. "Using derivatives as a hedge is a form of insurance against interest rates rising," she says. "When rates fall, derivatives lose money, but when rates go up, you gain."
How A Swap Would Work
The following example shows how an interest rate swap would work for a credit union on a $10-million investment. Interest rate swaps have the potential advantage that rates won't get much lower and will most likely go up sometime, according to Hollis.
* The interest rate swap is based on $10 million, for the sake of this example.
* The credit union signs a contract with counterparty for 10 years and agrees to pay a fixed rate of 2% of the $10 million or $200K annually. This payment is constant and doesn't change.
* The counterparty agrees to pay a variable rate, based on the three-month London Interbank Offered Rate (LIBOR), starting at the current rate of 25 basis points or $25K annually.
* If rates move up to 10%, the counterparty would pay the credit union $1 million annually.
* If rates move down, which they currently lack the room to do; the counterparty would pay the credit union a lower rate. For example, 12 basis points would drop the counterparty's annual payment to the credit union to S12,000.
The use of derivatives can also be a workable option for credit unions since they aren't able to raise capital on the capital markets, according to Hollis. "Generating income by managing balance sheet risk is one of the few options to increase capital," she says. "Understanding and applying managing risk through duration mismatches can enhance returns, but it can also present risks if interest rates increase."
Jim Jerving is a freelance writer based in Madison, Wis. He can be reached at firstname.lastname@example.org.