Even with interest rates at lows not seen since the 1950s; there has never been a better time to begin developing an improved portfolio structure. One that delivers consistent, competitive results now and as rates move back up. Yes, the Federal Reserve has lowered the Fed Funds rate 10 times since January 2001 and the current yield on overnight funds is somewhere in the 1.25% area (which is one of the reasons to begin, now). As we approach the end of a rather tumultuous year in the markets and with the economy showing little in the way of vigor, more Fed easing is possible. The housing sector, until now the brightest light in the economy, may finally be showing signs of fatigue as some areas of the country report inventories growing and "some" price erosion. Detroit meanwhile, is discounting cars and continuing 0% financing to prop sales as they anticipate a slowdown in 2003. The consumer still holds the trump card. If they feel good about their employment prospects, they'll probably continue to spend. Watch for how the holiday season unfolds in the stores, to get an early read on how the consumer feels. The point is we can expect rates to stay low for a while and therefore the yield on CU investments is dependent partly on how much is being left in overnights. And since the last Fed move of 50 basis points, most lending institutions feel their margins are at risk because there doesn't appear to be much flexibility in funding costs while loan and investment funds keep pouring in. Dollars versus Percentages The penalty for keeping too much in overnights is greater when rates are low versus when rates are high. For one thing, almost all CU's are asset sensitive meaning earnings are at risk when rates go down (and stay down) not when rates go up. Just look at ROA's since January 2000 (all data is derived from call reports and Bloomberg). True, ROA staged a slight comeback in the second quarter (due mostly to a precipitous drop in cost of funds) but most analysts believe income will come under pressure in the months ahead as the latest Fed move accelerates earning asset erosion while funding costs have less elasticity for downward movement. So while rates are low, not only are a lot of CU loan dollars maturing, but the reluctance to invest funds exacerbates the situation with the paltry returns in the overnight account. Here's the real rub. The dollars of income "lost" by not investing is greater when rates are low. The best way to illustrate this point is to compare our current rate environment with the higher rates of February 2000. Take a look at the comparable yields.. The dollars of lost income (the penalty for not investing) is greater today. The decision to leave funds in overnights today at 1.25% costs the CU 340 basis points versus 135 basis points in a higher rate environment. For perspective, the 205 basis point difference is equal to $25,000 on an annualized basis. Where else are we going to find that kind of pure profit income? So, why aren't more CU's putting funds to work? There are many answers to the question, but few good reasons. Most seem concerned, rightfully, about the next risk.which is rates moving back up. Fair enough. The next risk is for rates to move up. Since none of us know when the economy and rates will rise, let's review the logic for staying active with the members' funds, while we prepare cash flow for an uptick in rates. Portfolio Structure with a Purpose Some CUs have begun to realize the benefits of developing the cash flow of the investment portfolio in a manner that doesn't leave so much income on the table. For perspective, take a look at the balance sheet and portfolio mix of the typical CU and Bank. Note, too, that the average bank is yielding significantly higher in the investment portfolio (5.80% vs. 4.0%) and therefore has a higher ROA (1.28 vs. .97). A growing legion of CUs are investing in the right mix of the right type of mortgage-backed securities and federal agency securities in order to realize an increase in income while providing for sufficient monthly cash flow. Those CUs that have done so have yields similar to the banks. Those that haven't are leaving too much income on the table and eventually will put the CU's loan offerings at a competitive disadvantage. The easiest way to illustrate why this strategy works is to describe for you the monthly cash flow characteristics of a Sequential CMO mortgage back security. Along with the yield pick up versus overnights of 340 basis points, the CU that invests 1mm in such an investment receives an estimated half the principal and interest income by the 36th month ($627,000). As rates rise, the monthly cash flow can be reinvested in higher yielding loans or investments, thus helping to protect margins. Think of these investments as loan substitutes. They are another lender's loans, packaged in an AAA wrapper. Yes, the payments will slow as rates rise because fewer households will refinance. Most of the CU's and Banks that have evaluated this through many rate cycles have come to the conclusion that the cash flow is still more than adequate and the yield on portfolio is better off. Otherwise, they would have dropped the strategy many years ago. This isn't to say that the only investments that make sense are mortgage back securities. Referring again to the chart, some combination of MBS, Agencies, Corporate Certificates can go a long way to improving yield while setting up appropriate monthly cash flow. Why not? If the CU can improve earnings without undue risk, then the CU can fund the new branch, ATM, technology improvement that the member is demanding. Clearly the member isn't going to become less demanding, nor is the competitor going to stop trying to take your business. At the same time, improved earnings can help fund the salary needs of your top employees. The need for more income wills only increase going forward as the business continues to become more competitive. Another tactic some CUs and banks are employing is selling selected pieces of the loan portfolio. Done right, loan portfolio sales can reduce interest rate risk while helping to maintain adequate levels of capital.