Economy Hitting Some Areas Harder

MIKE SCHENK, CUNA VP of Economics and Statistics,
April 21, 2009 | COMMENTS

CUNA's outlook calls for slower economic growth with substantial deterioration in labor markets over the forecast horizon. The economic weakness will mean that short-term interest rates will remain low through 2009, and the resulting fairly steep yield curve should ease some credit union bottom-line pressures.

— CUNA economic forecast, November 2009

Ceteris paribus (“all things equal”) has been the case throughout most of our economic history. Federal Reserve rate cuts result in higher interest margins at the nation's credit unions.

That's because most credit unions—actually most financial institutions—are liability sensitive, with deposit costs that change more quickly than asset yields. Deposit costs tend to decline more quickly than asset yields when the Fed cuts market interest rates, and conversely, deposit costs increase more quickly than do asset yields when the Fed increases interest rates.

In any case, CUNA economists' notion that the Fed easing rates in 2009 would ease some bottom line pressures recently prompted one credit union manager to ask us “what planet are you living on?” In his view, Federal Reserve rate cuts would NOT ease credit union bottom line pressures. On the contrary, pressures will be significantly increasing. Why? Several reasons in his view:

• Many credit unions are suffering with a burden of high fixed costs and rapidly increasing operating expenses. The credit union operating expense ratio averaged 3.01% in 1993 but rose to 3.38% in 2007. This occurred even though credit unions grew substantially—from an average size of $22 million in 1993 to an average of nearly $100 million in 2007.
• Loan portfolios are stressed. Loan demand is low, denials are high and increasing, and borrower “quality” is declining and will continue to do so, particularly with expectations of further deterioration in labor markets.
• Product pricing and portfolio mix-related effects are taking a toll. With little demand for consumer loans most loan portfolio growth is in the real estate lending arena. Credit unions cannibalize themselves by lowering rates to market and ignoring portfolio management issues—specifically whether we can really afford to offer a 30-year fixed-rate real estate loans at 4.50% with operating costs over 4.50%. More focus on maintaining interest margins is in order or credit unions will soon take “not-for-profit” to new levels.
• Overall downward pressure on asset yields is magnified in the current environment because weak loan demand can translate into low loan-to-share ratios and fast-growing investment portfolios while short-term investment yields are very close to zero. On several occasions recently some short-term investment yields actually turned negative!

Each of these observations is true, if not in the aggregate, certainly among large numbers of individual institutions. An economist's construct of a world where “all else” is equal isn't the real world. While the Federal Reserve is cutting rates, lots of other things are happening. Member behavior IS changing in fundamental ways. Non-rate-related costs ARE rising in many cases. So despite Federal Reserve easing, bottom line results may be declining for many credit unions.

Location, Location, Location

Another interesting observation related to this is historically, credit union operating results tended to be fairly uniform. Most observable variation could be traced to credit union asset-size differences, with smaller institutions reflecting relatively large overhead burdens, lower loan-to-savings ratios, and generally slower growth and lower earnings than their larger counterparts.

In today's environment operating results are not nearly so homogeneous. Credit unions are operating in different worlds—maybe even living on different planets. That's due almost entirely to the fact that the recent economic dislocations vary substantially depending on which area of the country you're looking at.

Credit unions in some states, most notably those with agricultural- and energy-related economies are holding up fairly well (so far). They reflect fairly low unemployment rates, and continue to experience decent economic growth and fairly strong credit union operating results. Prime examples include Wyoming and North Dakota, each experiencing unemployment rates below 3.5% and credit union ROA exceeding 90 basis points on average assets.

Other states, especially states with substantial real estate dislocations and heavy reliance on manufacturing—auto manufacturing in particular—are showing signs of extreme stress. Michigan's 9.6% November 2008 unemployment rate leads the nation, but California and South Carolina aren't far behind with rates of 8.4%, while Nevada posted an 8% rate.

The bursting real estate bubble has been felt most keenly in California, Nevada, Florida, and Arizona, though others have suffered as well. Not surprisingly, the ten states experiencing the most pronounced real estate adjustments are home to credit unions that have reported the lowest bottom-line results.

For example, all but one of the ten states listed on the graph reported credit union ROA of 0.40% or less in the year ending September 2008. In contrast, only two states (Nebraska and Utah) outside of this group reported aggregate ROA below 0.40% and one-half of all states reported earnings above 0.65% in the 12-months ending September 2008.

The four states with the most severe real estate declines logged aggregate earnings of just 1 basis point on average assets in the year ending September 2008. That's a 43 basis point decline over full-year 2007 results. Provisioning for loan losses is the most obvious reason for the steep earnings declines in these states.

The four states with the most severe real estate stress also have been experiencing low loan growth. The 4.2% annual increase in loans in these states is less than one-half the 8.9% increase among credit unions in non-stressed states. As a group, Arizona, California, Florida, and Nevada credit unions saw declines in most relatively high yielding loans. Both new and used automobile portfolios declined, and personal unsecured loans increased by only 3.5% in the 12 month period ending in September.

What's a credit union manager to do? One thing is clear: there is no magic formula, no panacea. No single event—such as a Federal Reserve rate cut—will turn things around.

Advice

The manager who wrote to remind us economists that all things are never equal helpfully also offered some valuable advice:

Redouble efforts to price effectively. What we need to do is make sure we know what we can truly price our products at (for the markets we are in) and stop playing this game of “we'll make it up in volume”; it hasn't ever worked before and won't in the future.

Re-examine those attempts to grab more market share and do what you can to reign-in operating expenses. He suggests that there are too many financial providers in the marketplace and everyone trying to capture market share that it should come as no surprise that there is contraction in the financial services industry. While the competition has been (short-term) good for the consumer the overall results have been a drain on the economy, because there have been too many financial institutions offering rates that couldn't support the operational costs of their operations.

Use more care in lending. Financial institutions, including credit unions, he thinks, were dipping way too far into the lending “gene pool” and then surprised when these folks defaulted on loans they couldn't afford to begin with.

Think twice about loss leader products and services. We keep shooting ourselves in the foot, according to this manager, when the industry keeps bringing to market products that are loss leaders, such as “almost any of the electronic products.” He says “we're a bunch of techie addicts and feel a need to have all the bells and whistles, whether we can afford it or not because we'll make it up in volume!”

The reality is that just because Wells Fargo doesn't charge for a service isn't a reason for us not to charge, he says. They have a strategy to bundle products that are loss leaders with other money making products in order to secure relationships. They have much deeper pockets and can actually raise capital via investors. As a credit union we follow the market and say to ourselves we won't get anybody to use our product unless its free because they can get it free at Bank of America. While that may be true to an extent, we also need to have a good idea of how adding on more cost in an environment where we are earning less makes any sense at all.

In short, he says, going forward we need to look at our industry differently. If not, we will become irrelevant in the consumer's view. With any luck, that will remain an alien concept for most credit unions.