How Mispriced Loans Are Fueling a Liquidity Crisis

Credit union leaders typically celebrate record loan volumes. However, when below market-rate loans are driving unprecedented growth in areas like indirect auto loans, it’s time to recognize the reality that record volumes can be a very bad thing for cooperatives and the members who depend on them.

Over the past several years, many credit unions couldn’t originate enough loans. The industry was awash in liquidity as deposits increased. However, after a brief pause in the early days of the pandemic, consumers have continued to borrow, credit unions just weren’t always their preferred lender.

According to the New York Fed’s latest report on household debt, a $33 billion increase in auto loan balances in the second quarter of 2022 is simply “continuing the upward trajectory that has been in place since 2011.” In fact, elevated originations in both auto loans and mortgages “remained elevated in the second quarter of 2022, continuing the high volumes seen in dollar terms since 2020 Q3.”

So why are so many consumers suddenly turning to credit unions for loans?

As rates have risen, banks have been quick to adjust their offerings, making some credit union loans, particularly in the indirect auto market, the cheapest game in town. Competing solely on price – specifically below-market price  – is a dangerous game. This is especially true in the indirect auto space where cooperatives are also paying dealer premiums, making that mispriced loan, or in our view “purchased asset” from the dealership, even more expensive for the financial institution.

Couple that with the well-known fact that the conversion rate of an indirect borrower to use any other product or service at their new credit union is typically in the single digits, and it’s easy to see how credit unions are draining vital liquidity to fund mispriced assets and attract notoriously unprofitable members.

How can credit unions avoid mispricing loans?

For years, credit unions have looked at their local competitive marketplace to set their loan rates as opposed to looking at how a broad asset class is priced. One simple way to evaluate whether a loan rate is reasonable is to see what the clearing rate in a participation would be for that type of loan or, in periods when the participation market is not transparent due to a lack of volume, compare your offering rate to that of an asset-backed security.

The securitization market for auto asset-backed securities is active and, as a forward-thinking institution, it’s important to ensure that if you needed to sell loans, you could. Unfortunately, for institutions that chased yields down in 2021 to drive volume and were slow to raise their rates in 2022, the result is often balance sheets filled with below-market rate loans on a risk-adjusted basis that can never be sold.

How can cooperatives balance their mission to serve members with the need to generate sustainable income?

Credit unions are not investment clubs, and they all share a common mission to serve their members. To strike the right balance between offering affordable loans, higher savings rates and fewer fees to responsibly benefit all member-owners, leaders should start by asking whether markets such as indirect auto loans really represent the institution’s core membership. Attracting new members via indirect channels who are unlikely to actively participate in your cooperative beyond their mispriced auto loan is likely not going to contribute to the long-term health of the organization.

It may also prevent you from serving your active members, including depositors looking for better savings options. Paying below market rates on loans creates an environment in which you can’t pay market rates to depositors, or worse yet, where your institution may be forced to slow or even halt profitable lending activities in a liquidity crunch. Measuring overall economic value and clearly defining how the organization will provide benefits for its member-owners is a strong first step for any organization. This should include what you give back to members overall in terms of loan rates, deposit rates, investments in technology, mobile apps, branches, call centers and more.

Instead of simply celebrating today’s record loan volumes, let’s look ahead and ensure that our cooperatives will still be able to serve members effectively 20 years from now and beyond.

What steps should credit unions take now?

Credit unions should start by taking a hard look at the economic benefits and costs of their current assets. Is your loan pricing structure offering your institution more economic benefit on a risk-adjusted basis than a risk-free asset such as a Treasury? If the answer is no, then it’s time to reassess your options and find ways to increase your return and benefit your membership over the longer-term.

Next, consider your liquidity position and what the next few months could look like if you run out of borrowing capacity and the below-market loans you’re adding are illiquid. If you’re in a borrowing position to fund new loans, make sure those new loans are priced correctly by using a disciplined approach and evaluating rates in a risk-adjusted framework.

Liquidity risk is one of the most severe risks for credit unions and other depositories. When you couple that with credit risk or interest rate risk, it’s not difficult to see why a disciplined approach to pricing loans is vital for the health and sustainability of any financial institution. This is true in any environment, but comes into sharper focus as potential recession worries or other economic challenges pop up.

As a silver lining, for those institutions that do have liquidity, now could be a great time to take advantage of a buyers’ market in terms of loan participations. Buying assets at higher returns now could provide forward-looking cooperatives with more profitability and a bigger capital cushion in the future.

Travis Goodman is Principal of ALM First Financial Advisors in Dallas.