CU Income and the Low-Rate Environment 

By Bridget C. Balesky
Vice President of Brick & Associates Inc.

In early 2007, many credit union balance sheets were not positioned well for falling rates due in part to concentrations in callable bonds and short investments that would reprice downward very quickly. Excess liquidity in overnight accounts was common because such accounts were paying 5% while bank CDs were generally paying between 4.75% and 5.25% depending on the maturity. Consequently, there was little rate incentive to ladder investments. Furthermore, there was little concern in the industry about the potential impact of falling rates. 

We recommended studying both rising and falling rate shock tests in ALM Reports using Income Simulation, a tool used to determine the directional sensitivity of earning power to changing interest rates. ALM is about measuring, monitoring and controlling interest rates risk in an attempt to avoid adverse income surprises from rising and falling interest rates. ALM is not about betting implicitly or explicitly on the direction of interest rates.

At the time, falling rate shock tests revealed that investments being called, mortgages prepaying, overnight investments and HELOCs repricing down would cause interest income to decline faster than dividend expense for many credit unions. When excess liquidity could not be used to make loans, we recommended laddering in investments without embedded options. A ladder spanning three to five ears would slow a decline in interest income if rates were to decline. 

As the Fed Funds Target declined 500 basis points from September 2007 to December 2008, short portfolios and those with heavy concentrations in callables experienced much more rapid turnover and in many cases faster erosion of interest income than laddered portfolios without embedded options. No one knew that interest rates would decline so dramatically and remain historically low for so long. Also, no one knew that the falling rate environment would still negatively affect credit union interest income nearly five years later.

The Fed plans to hold short term rates low for another 2½ years. This means that the bank CD ladder that served small- and medium-size credit unions very well for decades may not generate sufficient income during the next few years. The bigger the investment portfolio relative to the asset size, the bigger the problem the Fed’s plan will create. Attempting to increase the loans/assets ratio should be a goal if there is excess liquidity. In the meantime, continue the relentless task of investing for additional interest income. Excess liquidity has a high cost in the form of foregone interest income. If a balance sheet strategy is going to change materially, “What-If” ALM analyses should be performed to estimate the income and interest rate risk effects of the new strategy before implementation.

The Fed’s plan for low short-term rates through 2014 makes the Cost of Funds reaching a “floor” this year or early next year particularly problematic since returns on loans and investments will most likely continue to decline after that floor is reached. A multi-year income simulation analysis and a 0% shock test may project interest income declining much more than the dividend expense in the next few years. Such a 0% shock test should be a “What-If” ALM analysis today to show the potential impact that this historic rate environment may have on your income statement. 

Contrary to widespread belief, the projected income performance of many credit unions would improve if interest rates would rise sooner rather than later. This is becoming apparent in rising rate shock tests in many credit unions.