The Federal Reserve raised a key interest rate by a quarter-point at its Wednesday meeting, the sixth time in three years rates have gone up. Though interest rates remain at historic lows, Fed officials have indicated more rate increases are all but certain, pushing credit unions to re-evaluate both their lending and investment strategies.
Deborah L. Rightmire, vice president-asset/liability management at Cornerstone Credit Union League and at CU Resources Inc., told Credit Union Journal that regardless of the interest rate environment, if priced correctly, loans always produce a higher rate of return than investment portfolios.
“This will not change in a rising-rate environment,” she said. “However, some credit unions have placed significant portions of their loan portfolio in historically low-yielding loans or extended investment terms in an effort to enhance yield.”
As a result, they will have to wait for these assets to mature and re-price at the higher interest rate. “We also know that asset durations tend to lengthen in a rising rate environment – members hold onto their homes and autos longer to avoid refinancing at the new, higher rates,” Rightmire added. “In general, loan portfolios tend to re-price more slowly than investments.”
Tom McCarthy, director of fixed-income trading at CUSO Financial Services in San Diego, told Credit Union Journal that rising interest rates are likely to negatively impact auto loan volumes at credit unions. “As rates rise, auto companies have more flexibility to continue to offer lower rates on vehicles, thereby potentially gaining an advantage over credit unions and likely taking away some of this business from them,” he said. “Indeed, credit unions have enjoyed a lot of success in the auto leasing/lending space the past couple of years as auto sales have skyrocketed — to about 17 million annually — and interest rates have remained low.”
Another potential problem: consumers have been trained to expect low rates because of how long the Fed tamped down on them.
“Consumers have been used to very low rates for a long time now,” McCarthy added. “Any increase in these rates produces a psychological effect that might lead to some consumers turning away.”
Frank Rinaudo, senior vice president at GrooveCar Inc., said when the Fed raises rates, it affects everyone who depends on consumer loan products.
“New vehicle sales [this year] are projected to be about half a million less than 2017 levels, but pre-owned vehicle sales are projected to increase over 2017 levels,” Rinaudo said. “Credit unions typically have a much higher percentage of pre-owned vehicles and should continue to dominate that area of the business.”
However, higher interest rates are unlikely to hurt mortgage loans at credit unions.
“Even if interest rates rise, credit unions will still be able to offer members mortgages with very low fees,” McCarthy suggested.
Jack Baker, director of CDCU Mortgage Center, agreed, noting that while he wouldn’t be surprised to see a brief slowdown in the mortgage marketplace overall, credit unions are in a good position to keep on lending. “We find that our member credit unions — as a result of their work with potential borrowers — can often offer better terms and conditions than would be available to them at more traditional lending outlets.”
There is less consensus on the investment side.
McCarthy of CUSO Financial Services noted that the bond markets fully expect the Fed to raise rates at the March 21 meeting by 25 basis points, but the Fed and bond markets disagree on further rate increases. “It is also important to note that a Fed rate increase does not affect all maturities equally,” he elaborated. “Two-year Treasury yields, which are sensitive to the Fed, are up only 10 basis points since March 2017. But 30-Year Treasuries, which are more reflective of long-term growth expectations, are up only 10 basis points for the since March 2017.”
There are several options for how credit unions may adjust their investment profiles, he suggests.
“A reasonable reaction to the Fed’s moves could be to shorten maturities where you give up income, but protect principal values,” McCarthy said. “Another tactic could be to use step-up coupon securities, a bond that allows coupon rates to rise under certain conditions.”
For credit unions that invest in mortgage pools, he added, they could use mortgage securities with more defined principal return schedules, thereby “reducing their exposure to investments in securities that have the potential to extend their maturity.”
Rightmire of Cornerstone cautions that there is probably no “right mix” of loans and investments that can be applied to all credit unions.
“Our advice is that credit unions loan as much as possible while maintaining sufficient liquidity (investments) to service the members’ needs,” she stated. “And, in addition, to have a tested contingency plan in place should liquidity needs change over the short term.”
Sam Taft, associate vice president of analytics at Callahan Associates, said that, broadly speaking, there have been some indications that credit unions are starting to feel the impact of the rate increases, on both sides of the balance sheet.
“Specifically, looking at yields, yield on loans has consistently declined for the last several years, yet they stayed flat year-to-year as of the fourth quarter of 2017, the first time in many years — indicating that credit unions are starting to see a small impact from the re-pricing of certain newly originated loans,” he said. “Looking at yield on investments, there has been steady increases over the last two years or so, which tracks well based on the rate environment.”
Finally, he noted, the cost of funds increased in the last year, albeit slightly — yet this is also consistent based on recent rate increases.
“Credit unions are feeling pressure both from consumers to increase rates, as well as from internal pressures as loan growth has consistently outpaced share growth in recent quarters and thus created more of a need to bring in deposits to fund future loan growth,” Taft explained.
Curt Long, chief economist and vice president of research at the National Association of Federally-Insured Credit Unions, noted that, on average, credit unions still earn more on loans than investments. “That isn't expected to change any time soon even though the spread has narrowed a little bit recently,” he added. “In determining the right mix between the two, there are of course other considerations like risk, operational capabilities, and membership needs.”
For most credit unions, Long observed, providing loans to their members is “at the core of what they do, and so prudent growth of their loan portfolio is always going to be a key goal.”
Mike Schenk, vice president of research and policy analysis at the Credit Union National Association, said that as regulators have long cautioned credit unions to effectively manage interest rate risk, most credit unions have done a “very good job” in mitigating such risks over the years.
“I think if you look at regulators’ reports on credit unions that have failed, you will not find any that failed, chiefly because they mismanaged rate risk,” Schenk said. “Looking forward, I think more credit unions are well prepared for this new environment of rising rates.”
However, Schenk said, it is difficult to offer “broad advice” to credit unions on what they should now do ahead of rising interest rates.
“A lot depends on their goals and overall strategy, which can vary from credit union to credit union,” he said.
McCarthy of CUSO Financial Services points out that while there is some market consensus that rates will rise in the near term, there is less agreement about the long-term course of rates. “The most obvious way to try to mitigate the effect higher rates would have on a loan portfolio would be to offer more adjustable-rate products, allowing the expected income of the portfolio to rise if and when rates rise,” he proposed.