Short-Term Certificates May Buffer Blow from Declining Fed Rates, Extend Asset Duration

But that cautious approach could spell danger if the fed fund rate should decline, said Brad Cunningham, WesCorp senior director, financial consulting services.

"Credit unions have responded with very small rate increases for their administered accounts while for the most part maintaining balances in these accounts, that is, with very little attrition [or] disintermediation," Cunningham said. "Therefore, when interest rates start declining, these accounts will start from a much lower level than in previous declining rate cycles. This will make it more challenging for credit unions to lower interest expense in conjunction with declining asset yields [declining revenue]." The Federal Reserve's tightening has resulted in an increase in the fed fund rate of 325 basis points or 3.25% from June 2004 through December 2005. The fed fund rate has actually increased 400 bps through May 10, but NCUA 5300 call report data was only available through Dec. 31, 2005, Cunningham pointed out. In anticipation of these declining rates, credit unions might want to consider altering their mix and pricing of certificates while at the same time extending asset duration, Cunningham suggested. Three or six-month certificates are a good start and as rates come down, a reliable rate has already been established. Credit unions can also use "specials" or offers of a higher rate certificate at a premium price with odd maturity dates. "A lot of times, three-month and six-month certificate holders are less rate sensitive. If you come out with a special for a four-month or eight-month, you can price it higher than you normally would, test the market and see how it works," Cunningham said. Other considerations with shorter-term certificates are offering automatic renewal into the next most common term, like a three-month or six-month, "which are less expensive" and may result in a decline in interest expenses. "Initially, someone might say by offering specials, expenses might go up and that might be true, but the increase is at the margin," Cunningham said. "If you have to offer a premium to attract money, you're increasing all your expenses." Credit unions may also worry that by offering specials, they will only get "hot money," not long-term relationships. Cunningham said automatic renewal can extend those relationships. The fed funds rate is predicted to peak at 5.25% or 5.50%, Cunningham said. The next move would be a decline in interest rates. When rates do go down, MMAs and similar accounts are going to be at a much lower level than in the last declining environment. It will also be difficult for credit unions to lower expenses and yield on assets. Whether short-term certificates are a good fit for credit unions really depends on their individual interest rate forecasts, Cunningham said. Once interest rates start declining, credit unions may have a difficult time moving members in that direction. WesCorp has already forecast that a rate decline is imminent and rates may come down next year. "If you have money available to invest in four- or five-year securities or loans, you can lock in the money," Cunningham said. "If you have variable rate assets on the books, make sure the minimum rate is set at a fairly high level." For instance, a home equity line of credit tied to the prime rate or even something more sophisticated like a derivative, might be options, Cunningham said. Historically, various competitive landscapes dictated whether credit unions raised their rates after a Fed move. Cunningham said in the late 1990s, there were five years of 20%-plus returns on the stock market. By 2000 to 2002, the stock market delivered negative returns and at the same time the Fed started to ease. An influx of funds came into the system and stayed there, he added. "The bottom line is when rates come down, how are you going to get that rate reduction," Cunningham said. "That's the main thrust. A lot of it will depend on the credit union's rate forecast."