Preparing for the Bond Bubble Pop
The bond price bubble will eventually pop as rates rise, creating potential for the next crisis: a one-two punch of deposit withdrawals and negative spreads as hundreds of credit unions fall short of the earnings needed to compete on deposit rates. The cost of funding will overwhelm asset yields and punish even the strongest balance sheets due to the interconnectedness of credit unions that leads to a phenomenon we call the growth tax.
Although we believe it is premature to say the U.S. has recovered from the credit bubble, important financial trends indicate that credit unions should start planning for the inevitable end of Federal Reserve rate accommodation now, while there is still time.
For perspective, take a look at the nearby table.
With interest rates at or near record lows in recent years, credit unions have extended asset duration significantly while also experiencing core deposit shrinkage of 12% of total savings. At historic low interest rates, credit unions have extended to record duration.
The NCUA has issued a letter to credit unions identifying the areas of supervisory focus for 2013, which include liquidity and interest rate risk, and is reported to be considering expanding the number of credit unions eligible to hedge. This would be welcome news. Sandler O’Neill has been analyzing and modeling various strategies for its bank and credit union clients to help mitigate liquidity and interest rate risk, and many large credit unions would benefit from the flexibility provided by adding these hedging tools.
The vulnerability of the credit union industry to rising rates is exacerbated by inadequate backstop liquidity measures.
September 2012 NCUA call report data indicates there were 6,888 federally insured natural person credit unions. Of those, only 1,149 are members of a Federal Home Loan Bank, which, as proposed in the new liquidity regulations, is not a recognized liquidity backstop for credit unions.
What counts for liquidity backstop is access to the Federal Reserve discount window and ownership of Central Liquidity Facility stock (used as collateral for borrowing from the CLF). Using the most recent data available from the NCUA’s website, 380 credit unions (43% of industry assets) have access to the Fed window and 95 own CLF stock. We don’t know how many of the credit unions with FHLB membership also have access to the window and own CLF stock, but there is plenty of overlap, based on our discussions with large credit unions. Thus, thousands of CUs appear unprepared for the bond bubble to burst.
Credit unions that are healthy and prepared for the bond bubble collapse will still be adversely affected by others’ vulnerabilities. In a rising rate environment, thousands of credit unions will likely need to encourage disintermediation to occur on a large scale because they will lack the earnings to meet the higher deposit rate requirements of their members.
Over the last few years, between 26% and 47% of all credit unions have not generated a positive ROA, and without fee income, the industry in the aggregate has a negative ROA. When this shrinkage occurs, healthy and growing credit unions will shoulder a larger share of the industry’s assessments for the bailout of natural person and corporate credit unions.
We have called this phenomenon a growth tax in previous discussions regarding the huge swath of credit unions that aren’t growing and passing on part of their assessment responsibility to healthy credit unions. The growth tax is poised to accelerate when the bond bubble bursts. Healthy credit unions considering capital outlays and special dividends should keep the growth tax in mind as well as the potential for higher capital requirements in sympathy with the Basel III accord and the Dodd-Frank Act.
Credit unions should apply for access to the Fed window immediately and consider FHLB membership as well.
Using the precedent in the NCUA’s 2012 proposal for liquidity requirements that considers Basel III liquidity measures for credit unions with assets greater than $500 million, perhaps the larger credit unions should seek formal training on hedging techniques from advisers experienced in the business, particularly if the NCUA allows more credit unions to hedge interest rate risk.
Some credit unions are already adjusting their balance sheets. Selling longer duration assets is an income forfeit now but should be explored and perhaps implemented if interest rate risk analysis projects problems as rates rise or when harvesting gains makes sense. Perhaps all new mortgage originations should be conforming and sold off. Deleveraging strategies should also be considered where high-cost borrowings exist on the balance sheet.
Consider reducing reliance on callable agency securities in the investment portfolio, especially with final maturities greater than three years.
Meet with an outside adviser or two to analyze and model various tactics and investment strategies that could reduce erosion of margin, liquidity and capital. Getting one or two opinions is not a bad idea given that we are experiencing such an extended period of record-low rates.
Although many credit unions are flush with cash now, history suggests that won’t last. How cash is deployed today will be a determining factor in how, or if, an institution weathers the bursting of the great bond bubble.
Peter F. Duffy is managing director with Sandler O’Neill & Partners LP.
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