Balance Eases Interest Rate Risk
When Mike Hambrick arrived at Envision Credit Union in April 2011, the $260 million Tallahassee, Fla., institution was still struggling under the weight of the previous administration's strategies.
The subsequent steps taken by Hambrick, the new senior vice president and chief financial officer, and Darryl Worrell, the new president/CEO hired in 2010, put the credit union on a stable course while setting the stage to better manage interest rate risk in preparation for what will one day be a changing rate environment.
At the time, Envision was burdened with high overhead and had too many 30-year fixed-rate mortgages on its books. Long-term assets topped out at 43% of the overall portfolio with little to balance the risk on the short-term side. By 2009, losses from real estate loans and other long-term assets had taken a $2.4 million bite out of credit union earnings, Hambrick said.
“We spent two-and-one-half years changing the portfolio, buying $42 million in SBA securities,” said Hambrick. “They are immediately re-priceable, but you pay a pretty good premium for them.”
Envision set out to reduce its long-term debt from 43% to 23%, selling off $12 million in prime loans, a move that cost the credit union $1 million in earnings over two years. Despite the loss, NCUA examiners understood and approved of Envision's new sensitivity to a better-balanced portfolio that effectively reduced risk.
“I’m not getting busted by examiners for interest rate risk,” said Hambrick. “Examiners are more accepting when you can give them a reason for what you’re doing. It's the deer-in-headlights look some credit unions have that they don't much like.”
Envision's survival strategy created a financial stability that will keep the credit union buoyant amid changing rate scenarios. By all accounts, the NCUA is happy with the change, as well as Hambrick's penchant to work up close and personal with his examiners.
“We don't take the attitude that examiners are a bad thing,” said Hambrick. “Our attitude is that the sooner you get here and see what we’re doing, the better for all of us.”
Hambrick's position is one from which many credit unions could learn as the promise of rate hikes glimmers on the horizon. Private and public sector financial experts anticipate nothing much will happen before mid-2015 and the Federal Reserve Bank may wait even longer for employment, consumer spending and other economic factors to improve before taking definitive steps.
In the meantime, they say, credit unions should take their own steps to balance their portfolios and better protect themselves from interest rate risk.
“If risk exposure is created by a cash flow mismatch between earning assets and variable funding, then the balance sheets most affected will be those for credit unions with greater allocations of longer-term assets, such as fixed-rate mortgages, that are funding themselves through tiered money market accounts,” said Brian Turner, chief strategist for Catalyst Strategic Solutions, part of Catalyst Corporate Federal Credit Union in Plano, Texas.
J. Owen Cole, NCUA's director of capital and credit markets, offered similar advice and some insight on how this issue is viewed through a regulator's lens.
“Examiners look for credit unions to have risk measurement metrics in place with prudential limits on how much risk to income and capital each credit union can absorb,” said Cole. “They also look for compliance with those board-established limits as well.”
In addition to achieving balance, greater liquidity of assets on a credit union's books helps hedge potential losses in a rising rate environment, Turner said. Credit unions with inadequate liquidity can face significant shortfalls as rates rise and the assets’ worth declines in the face of changing market values.
“Liquidity is not only a strategic balance sheet account, but also acts as a short-term asset that hedges interest rate risk,” Turner added.
David D’Annunzio, chief financial officer and vice president of finance at the $845 million South Florida Educational Federal Credit Union in Miami, agreed with Turner's assessment.
Liquidity plays a key role in shielding long-term loans and investments from turning a paper loss into an actual loss, he explained. It's a strategy that has worked at South Florida Educational, a credit union he's served since the beginning of the new year.
“It comes down to managing the duration of assets,” said D’Annunzio, formerly CFO of $475 million Heritage Trust Federal Credit Union in Charleston, S.C. “When you look at our credit union and the asset side of our balance sheet, the average life is around three years for most investments and loans, so we would not be overly sensitive to a rising rate environment.”
South Florida Educational has long enjoyed the benefit of a conservative asset management strategy, according to D’Annunzio. Shorter-term mortgages make up just $32 million of the credit union's $195 million loan portfolio, with the balance comprising of auto loans, credit cards, lines of credit and other short-term vehicles.
Factor in $600 million in investments governed by a “barbell strategy” that balances long- and short-term instruments and you wind up with a credit union in good position to weather economic change.
“With nearly $200 million in loans compared to $650 million in deposits, we have a low loan-to-share ratio,” D’Annunzio said. “We have a very strong capital position capital which helps support the asset side of the balance sheet.”
A conservative strategy with an eye toward maintaining a balanced approach is a good prescription for many credit unions, according to the NCUA's Cole. It's also necessary given future rate changes.
“Credit unions should be evaluating their current and prospective risk positions and determine whether earnings and capital at risk is tolerable for plausible rate scenarios,” he said “If not, credit unions should be instituting risk mitigation strategies as appropriate.”
D’Annunzio and other CFOs welcome a rise in rates. In fact, they see it as critical to industry survival. Credit unions that have been cutting costs in an attempt to save their way to profitability may soon be out of low-hanging fruit to pluck, D’Annunzio said.
“The longer we’re at these low interest rates, the harder it will be for credit unions to sustain profitability going forward,” D’Annunzio added. “Credit unions are running out of levers to pull.”