NEW YORK -In the eyes of brokerage firms, where should credit unions be divvying up their investments in this low-rate, high liquidity environment? Credit Union Times talked strictly to brokerage firms to get their take on the myriad of directions available for credit unions during this liquidity surge. Given flush liquidity, historically low interest rates and the rapid growth of fixed-rate mortgage activity, general advice leans toward keeping an adequate level of short-term assets, such as cash, overnight balances and loans and investments expected to mature within one year in a credit union's portfolio. At least once a year, a realistic assessment of a credit union's liquidity needs for the coming year is critical, including the amount generated or used due to changes in demand and share balances, most analysts would agree. Before any decisions are made, the starting point, said Peter Duffy, senior vice president at Keefe, Bruyette & Woods, Inc., a securities broker/dealer, is to look at the competition and ask `am I losing money to my competitor because he's getting a better yield.' "Then you look at the makeup of your balance sheet to see how the investment portfolio can play an effective role in reducing your interest rate risk," Duffy said. "Because interest rate risk is a function of things the credit union can not control, if the member wants a mortgage loan, he will go elsewhere for a better rate." After those factors are addressed, the credit union CFO has planned for what will be loan demand and the "proper ideal of duration" has been determined, only then can portfolio fine-tuning come into play, Duffy said. In today's market, Duffy likes 15-year mortgage-backed pass throughs because of their shorter extension rate. When homeowners slow down on refinancing, the cash flow slows on mortgage-backed securities. "Credit unions want the cash flowing in," Duffy explained. "The 15-years are reliable, there's uninterrupted monthly cash flow and they continue to pay until maturity." Duffy said another `perfect world' investment is the hybrid adjustable rate mortgage (ARM) because of its generally short duration, uninterrupted cash flow and "pretty good yield." "After three, five or seven years, they become a one-year ARM security and every year the coupon sets to a reset to a margin above the one-year Treasury," Duffy said. "A homeowner who walks in the door after taking a hybrid ARM is more than likely thinking about refinancing. These hybrids work for credit unions because the bonds continue to refinance in a higher rate environment." The downside to the hybrid is if an investor pays too much of a premium and the homeowner gets the refinancing, the credit union has less time to amortize that premium because "refis have a shorter duration." "It's great that they're getting the cash but the results are a lower yield," Duffy said. "The key is to not pay 1.02 and a half more than the premium." The beauty with callables is when rates go up, the agency doesn't call the bond, Duffy said. A five-year callable with a one-year call, the agency, at its sole discretion, can send the money back, keep the money or keep it until the five-year maturity. But if the agency keeps the money, it's a cheaper source of funds for them than reissuing the bond. This option works against credit unions because they use the money for loans but they're not going to see the money unless they sell the bond, Duffy explained. "Callables have bad market value performance in a rising rate environment," he said. "In 2000, part of the liquidity problem had to do with credit unions buying too many callables. Generally speaking, the typical credit union should not have more than 15% of their portfolio in callable bonds." Duffy further warned that because we're "coming off 50-year lows in rates, they're going to go up at some point and the danger is those callables are not going to get called." "Credit unions are going to be stuck with callables with very low yields," Duffy said. Like most of his `perfect world' investments, sequential collateralized mortgage obligations (CMO) offer uninterrupted cash flow, decent yields and "with the right kind of collateral, very little extension risk." Dangers of `Emotional' Investing The fear of rising rates can slow down or even shut down the decision making process, said Leo Triolo, senior vice president of investments for First Empire Securities, Inc. That fear often drives credit unions to think that "keeping one's hand on massive amounts of liquidity could be better than making investments in rising rates." "Assuming we are at the bottom and that rates will rise from now on, is no way to run a credit union," Triolo said. "If it were, you would be turning away members who were applying for loans. Credit unions are here to serve the members, regardless of the rate environment and regardless of where rates are going." Triolo said due to past experience of false assumptions, some credit unions compare fixed income investing to equity investing. "Unfortunately, this is one of the worst mistakes of all," he said. "Equities are emotional. They are driven by expectations and fear." Bonds on the other hand, are mathematical, Triolo said, explaining they should be bought methodically, mechanically and regularly. "One sure way to time the market is to buy on regular intervals, the portfolio should be diverse," he offered. When the Federal Open Market Committee (FOMC) recently discounted many of the threats of deflation to the economy, Triolo said, "rates rose tremendously." Indeed, the five-year Treasury yield rose 123 basis points in a three-month period ending Sept. 11 "Mortgage bankers who were hording mortgage-backed securities after securitizing them for months in the hopes of further price increases, dumped those securities into the open market with tidal force," Triolo said. As a result, credit unions should look within the MBS sector because "the prices dropped precipitously as portfolio managers and total return players decided to sell into the wave." Triolo said above any other investment choice, diversity should be present in product, coupon, collateral, issuer, structure and duration. "Product choice should be made on the basis of the balance sheet and the risks therein, not the hot bond of the day," he said. The Real World is Rough The current interest rate environment places a great deal of pressure on the management of credit unions to seek the highest possible yield on investment portfolios to accommodate the dividend rates necessary to remain competitive in the marketplace for members' funds, most industry analyst agrees. More than 20 years ago, former NCUA Chairman Lawrence Connell wrote "as a result of the liquidity pressures placed on financial institutions in recent years, credit unions should move to more efficient funds management techniques to match asset and liability maturities to effectively manage their liquidity position." Further, safety and yield must be addressed in written investment policies and evaluated jointly, Connell wrote. His suggestions are more pressing today as some credit unions steer towards investments with higher risk factors and greater price volatility in order to reap larger yields. "We don't live in a perfect world," said Tim Dougherty, senior vice president, brokerage services, Corporate Network Brokerage Services, Inc. "In order to invest anywhere, one would need to look at credit risk or liquidity risk and then examine the choices that exist." Dougherty said a snapshot of consolidation trends reveals that "a lot more credit unions have invested away from corporate to bond markets." Indeed, according to June 2003 figures from Callahan & Associates, credit unions invested only 38.7% of their investments through corporate credit unions. A paltry slice of the portfolio pie, most industry watchers would agree. Of those reporting, at 39%, agency securities continue to be the primary investment instrument. Since July, the market has continued to sell off and yields have increased around the curve, Dougherty said. Because the two-year Treasury has increased 70 basis points the three-year increased 82 bp, and the five-year increased 94 bp, "the market sell-off has created a supply of secondary callable securities that are out-of-the-money." "Over the past year, the market has not had a supply of secondary callables due to the fact that most issues were called or in-the-money at the next call date," Dougherty said. The resulting sell-off has created the low coupon callable, a solid choice in a rising rate environment, he added. Because low coupon callable securities have coupons that are below current market levels and are priced to maturity, prevailing market conditions indicate the bond will have a low likelihood of being called, Dougherty said. Likewise, in a rising rate environment, Dougherty said mortgage-backed securities, CMOs and some callables will perform because the prepayment rates should slow and cash flow will slow down and become more stable. "In the real world, credit unions need to be sure that if there is a rise in loan to shares, that there is enough liquidity in their portfolio to have the ability to sell out of positions to fund any future liquidity demands," Dougherty said. -

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