Why Deliberate Pricing & Efficiency Are Key to Future Lending

Today's lending environment is unique, with rates rising more quickly than many of us have experienced in our careers and inflation at 40-year highs. At the same time, longer-term trends such as automation and artificial intelligence are helping lenders use technology to make better credit decisions more efficiently. This specific moment in time presents both challenges and opportunities for credit union leaders and the members they serve.

A Full Throttle Challenge

One of the common challenges we've seen since COVID began is institutions opening all their lending valves and waiting for production. For much of the past two years, liquidity has been high across the industry and consumer borrowing was down. This caused many credit unions to chase consumer loans, and subsequently loan yields, down to the floor.

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After the Fed began raising rates in March 2022, those low loan rates began garnering more attention from consumers. With their lending throttles fully open, some institutions filled up their balance sheets quickly with below market rate loans. The lending volumes increased so quickly, and institutions were so hungry for loans, that some leaders may not have even recognized they were mispricing assets until after the fact. This creates a very challenging dynamic in the short run, especially if the institution is required to sell those mispriced assets at a loss to generate liquidity.

Trends in Mortgages, Autos and Unsecured Loans

At the beginning of 2022, first mortgages were the first to be impacted when the long end of the yield curve shot up and the market began to see the signs of the rising rate environment to come. A lot of institutions got stuck with mispriced first mortgages on their balance sheets early in the year and pivoted to variable rate home equity lines of credit as the mortgage refinance boom ended. HELOCs can benefit consumers as they don't have to disrupt the great low rate on their first mortgage and can affordably access the equity needed to make home improvements. From a lender's perspective, HELOCs are attractive because of their variable rates and the substantial amount of equity available due to several years of strong home value growth.

In the auto lending space, we've seen some big swings in risk-adjusted return on equity. Traditionally, ROE for autos was in the 15% range prior to COVID. During the pandemic, when there was scarcity, this was down to 10-11%. Now that there is a scarcity of liquidity, the ratio has moved in the other direction in the range of 16-18% to attract investors into the auto space. Historically high rate volatility has had a big impact on auto portfolios. For example, a loan priced at 1.99% in the old environment is now below a 2-year Treasury note at 3.00%. We think auto rates need to increase to make sense on credit union balance sheets.

Unsecured consumer loans, including credit cards, are where we've seen the biggest impact of fintech partnerships and originations in recent years. Some of the models and algorithms have done a better job at predicting loss than others, but new concerns about potential delinquencies and charge-offs are causing lenders to watch unsecured portfolios more closely and put greater emphasis on credit quality versus unsecured loan quantity. As a type of "canary in the coal mine," unsecured loans are often an early indicator of credit performance and have implications for other types of loans.

Shifting Expectations for the Short and Long-Term

In a normal environment, credit unions start planning for the next year in the fall. While we expect that structure will continue, we saw many 2022 plans get thrown out in March, April and May as lenders dealt with the rate shock. In the short-term, processing and internalizing the impact of rising rates on deposit gathering efforts, portfolios and organic loan originations took center stage. However, as Q3 winds down and we gear up for Q4, credit unions are refocusing on the specific actions they can take now to best manage their income statements and budgets. As lenders look to counterbalance and mitigate some of the negative impacts of rising rates on their loan portfolios, we expect to see increased loan transaction activity.

One of the longer-term trends we're seeing is credit unions developing scalable origination through new partners and platforms. Just as credit unions adapted their auto loan business to interface with indirect networks and offer financing at car dealerships, we're seeing the same type of integration and adaptation happening with unsecured loans and HELOCs through new technology platforms and fintech partnerships. We expect to see more integration and better coupling of high-performance user interfaces and APIs with credit unions' balance sheet knowledge and lending acumen to drive new efficiencies in loan origination.

A Consistent, Deliberate Pricing Strategy

We advise credit unions to have a consistent, deliberate, quantitative approach to loan pricing. Clearly understanding, and tracking, the economic value of what the institution is directly originating compared with what it could access in the secondary market is critical and will inform our decisions as lenders and balance sheet managers.

Credit unions that choose to pass along a better-than-market value to their members should do so consciously as a strategy to build loyalty or disrupt their marketplace. An intentional approach to pricing can help leaders pivot quickly as rate environments change and avoid unpleasant surprises, such as realizing too late that their cooperative can't sell loans because they were put on at below market rates.

Not Just an Academic Exercise

While performing rates up shock analyses may have seemed like an academic exercise in past years, the current environment is a clear reminder of why these exercises are so vital from both a safety and soundness perspective and to ensure our lending engine is prepared for the future. As the future of lending continues to evolve, driving efficiency in decision-making operations while managing risk appropriately will be key.

An Uncertain Future

Relative values are on the rise, but are they enough to bring loan buyers back into the fold? Economic uncertainty, along with internal loan demand, quickly transformed the environment from a sellers' market to a buyers' market. However, there comes a point in every bounce where participants view the rewards to be greater than the risk. How far, or close, we are to that point remains to be seen.