Higgins: Rising Rates Don’t Lift All (Credit Union) Boats

Rapidly rising interest rates have created a new world for credit union members and managers who weren’t thinking about deposits and loans before the Great Recession.

But for credit union consultant Mike Higgins, it’s banking as usual.

Higgins said the 1929 tune “Happy Days are Here Again” set the mood before the 2007 financial crisis as credit unions and banks earned overnight and short-term rates of about 3.5% to 4%.

“So if I was not good at lending, I could bring in deposits and earn enough investment spread to survive, and probably do well,” he said.

When the music stopped and the Fed lowered interest rates to near zero, net interest margins were compressed, and earnings often suffered.

Higgins said financial institutions generally do better in a rising interest rate environment, but that it depends how they’re situated. He described four groups.

The first group is well-run credit unions that need to make no changes.

“Those are going to be the credit unions that are probably your top performers,” Higgins said. “They’re good at lending. They’re good at bringing in deposits. They probably have ancillary products and services that generate a decent amount of non-interest income.”

“They’re really not desperate for earnings or income, so they don’t have to take unnecessary risks,” he said. “They’ve got a robust, well rounded revenue stream that when one area is doing well another one will offset it.”

Moreover, because they have high loan-to-asset ratios they have little excess cash they need to invest.

“They just have some overnight cash,” he said. “That’s really the difference between what their deposits are on their loans are they don’t really have an investment strategy because they don’t have any investments.”

The second group of credit unions is cranking up the Victrola to play “Happy Days are Here Again” — again.

That’s because back when interest rates were low, these credit unions chose to invest in bonds and other instruments with relatively short terms, like three to five years. They might have more investments than the first group, but they’re relatively liquid.

“They’re benefiting because they’ve got all this short-term cash or short-term investments. As those mature, they can redeploy immediately and get a higher rate of return,” he said. “Those are the ones that are in a good spot for that reason.”

Then there is the group Higgins describes as “liability sensitive.”

“These credit unions are better at attracting deposits than they are at lending,” he said. “As a result, they’re going to have a lot of surplus funds, a lot of cash left over that they either can put in overnight funds or they can invest.”

These credit unions might have invested aggressively: Buying bonds with terms of five to 10 years. They got higher returns by going long — ”reaching for yield.”

“The problem is when you reach for yield like that in this low-interest-rate environment that we’ve been in, you might be reaching for a 1.75% yield versus a 1.50% yield,” he said.

And the strategy bites those credit unions in their income statements when rates rise.

For example, if a credit union invested in 5- to 10-year bonds at 1.75% over the past few years, it now finds the overnight rate is 2%. “You’re stuck holding all those bonds until they mature,” he said.

And, finally, there are the most unfortunate of credit unions: That fourth group that Higgins said has a “forecast for pain.”

“They’ve got a fundamental weakness in that they are bad at lending and they went long on the investment portfolio to make up for it,” Higgins said.

“They’re going to be in some pain,” he said. “They’ve tied up all their money in long-term fixed-rate investments and they can’t unwind those. They could try to sell those investments at a loss, but the problem is it would hit their capital and their capital would go down.”

Higgins said credit union CFOs should be sharpening their pencils running scenarios to figure the best way out. They’ll take a hit by selling them at a loss, but it might be worse to hold them.

And credit unions with, say, an 8% or 9% net worth ratio, “might not be able to stomach” taking a big loss if it would drop their ratio below 7%.

A CU Times analysis showed an unusually high number of mid-size credit unions reporting substantial losses in the second quarter. There were 20 credit unions had losses exceeding $1 million in the three months ending June 30, compared with three in the first quarter. The group included 12 mid-sized credit unions (those with assets between $1 billion and $4 billion), one large credit union and seven small credit unions.

Higgins’ observations on credit union performance in the second quarter are available in a report published by the Filene Research Institute. Key items included:

• In the second quarter the net income margin was an annualized 2.71% of average assets, up from 2.57% in the first quarter and 2.53% in the second quarter of 2021. “Net interest margin finally showed some improvement,” Higgins said, which he attributed to higher loan-to-asset ratios and higher yields on surplus funds.
• Non-interest income (fee income plus other operating income) declined for a third consecutive quarter.
• “There was a massive amount of loan growth this quarter, but no major improvement in loan yield – just up 1 basis point,” he said.
• Unrealized losses on available for sale (AFS) securities shot up significantly, again. “This reflects elevated interest rate risk (IRR) in rates up,” he said. “If the securities are held to maturity, there is no loss, but it shows their market value is dropping with each rate hike.  Effectively, they are fixed-rate loans right now for IRR purposes.”