By Ray Birch
WASHINGTON—The current rising rate environment in which spreads are slim demand credit unions take additional risk to manage the bottom line, says Evan Clark.
Clark, CEO of the $504-million Department of Commerce FCU here, has managed his CU through several rising rate environments during his 15 years at the helm. He spoke with CUToday.info about strategies credit unions can take to be successful when rates are climbing.
After a decade of flat and near-zero rates, the insights are being shared as part of a series in CUToday.info dedicated to sharing the perspective of credit union leaders who have experienced periods of rising rates in the past with newer CEOs and CFOs.
The Biggest Concern
“In this latest round of rising rates, the biggest concern I have is not rising rates it’s spread compression,” explained Clark. “What’s happening is the short end of the yield curve is rising but the long end of curve is not rising nearly as fast. So we are seeing spread compression.”
Clark said every morning he looks at two Treasury numbers.
“One is the 10-year Treasury and the second is the two-year Treasury,” said Clark. “I look at the difference between the two, which is known as the two-ten spread.”
Clark described the two-year Treasury as a “kind of surrogate” for financial institutions’ cost of funds.
“If you look at everyone’s cost of funds, if you combine core deposits with timed deposits, you’ll see the average life is around two years,” said Clark.
Much of the asset side of most credit unions’ balance sheets is made up by mortgages, noted Clark, with the average life of most mortgage loans is seven to ten years, given refinancings and loans and early payoffs.
In mid-January, the 10-year Treasury stood at 2.74% and the two-year 2.54%, Clark noted.
“That’s 19 basis points difference. And over the last 40 years the average spread between the two-year Treasury and the 10-year is 94 basis points. So, right now we are dealing with a very narrow spread,” he said.
It’s the Federal Reserve’s moves to raise rates that is compressing the spread, noted Clark, with the two-year Treasury closely tied to federal funds rates.
Influenced by Inflation
“But the 10-year is more influenced by inflation, or the perception of inflation in the market,” Clark said. “So, if there is no inflation perception in the market, the 10-year won’t rise nearly as rapidly as the two-year. We have the drop in oil prices, the market slowing down, the tariffs…and because of any numbers of other reasons we don’t see a lot of inflation in the system—at least not as much as the Fed originally anticipated.”
When the spread tightens, Clark insists the credit union must inject more risk of some kind into the balance sheet.
“There are all sorts of flavors of risk you can do, one is transaction risk. That is putting something new on your balance sheet,” said Clark.
Clark explained this often leads to credit unions putting something on the balance sheet with which they are not familiar. He stressed a credit union must understand the new addition inside and out.
“If you can’t explain what you are doing to your 10-year-old daughter, then you should not be doing it,” he said. “For example, medallion loans. People thought they understood medallion loans, but they didn’t understand the impact of cell phones and the resulting ride-sharing services that turned the taxi industry upside down.”
The other option is to add credit risk, he said.
“And a lot of credit unions are doing this now, and I am happy to see that, as reaching down deeper into lower credit scores to put more loans on the
books is helping people of more modest means,” Clark said. “The entire financial services industry is doing this now.”
If the credit union accepts greater credit risk, it must first make sure its underwriting and collections processes are very strong, emphasized Clark.
“Again, this is good for consumers and good for the credit unions, as loans to riskier borrowers are more profitable than A and B paper, if you control delinquencies.”
The CU can also take on additional interest rate risk, reminded Clark.
“You can go further out on the curve on your assets and try to keep your liabilities really short. But the problem there is you get a very strong economy and all of a sudden you see your deposits—deposits you thought were core deposits—go right out the door,” said Clark.
Clark pointed to what several economists have stated in previous CUToday.info reports—consumers have been stockpiling money in checking accounts due to the ultra-low rates that had been paid on CDs and money market funds. But now, as rates on CDs and money markets are rising to the point where they are more attractive, money from liquid accounts is flowing.
“So you are starting to see disintermediation of credit union core deposits,” said Clark, who also said those funds are leaving because consumers are spending more money due to a strong economy.”
Strong ALM Testing Needed
If the CU takes on additional interest rate risk, it must first have strong ALM testing, insisted Clark.
“You have to have a strong ALM process in place, and there are a number of very good ALM providers,” said Clark. “But it’s not so much the provider that’s key, it’s the credit union’s understanding of what its ALM software is producing, and that can be a bugaboo for a lot of credit unions if they don’t have a strong ALCO process. We have very strong ALCO process—we meet with our board twice a month and one of the meetings is strictly about ALCO and ALM issues.
“We have a big issue at our credit union from the high loan demand—we grew loans by 33% last year,” continued Clark. “Because loan demand has been so strong, we are trying to figure out what to do with our balance sheet to keep capital where we want it to be and keep our net economic value—a measure of interest rate risk in the balance sheet—in balance with our ALM policies. So we are considering things like extending some of our liabilities. You can do that cheaply now since the spread is so narrow. We can move from one-month borrowing to five-year borrowing at the home loan bank for 25 BPs. It’s just unbelievably cheap now to go long on the liability side. And another thing we will do is sell some of our loans because loan demand is so crazy.”
Regulators Are ‘Very Aware’
Clark emphasized regulators are looking closely at all of the strategies he described.
“We have a great relationship with our regulators,” said Clark. “And I know they are very aware of the all the additional risks I pointed out. They are really looking at these things because they are equally concerned now with the spread being so narrow and what strategies credit unions are using to maintain bottom line.”