Stop me if you’ve heard this one before: interest rates are finally going to go up this year. I know, I know… we have all heard this, and have been talking about it for most of the past 2 or 3 years. And while rates were increased from historic lows in December 2015 and December 2016, those increases are comparative to starting a cross country road trip. That seems like a silly analogy, but the point is we may have started the journey, but there is still a long way before we reach the destination.
Recent chatter out of the Federal Reserve suggests that, even though rate hikes have come much slower than expected, 2017 is going to be the year where they really start to move. This all appeared to get started in March when the Fed Funds Rate was increased by 25 bps. This was the 2nd increase in 3 months, and was backed-up by Janet Yellen citing strong unemployment and economic growth indicators. Although the strength of economic indicators is up for debate, the writing appears to be on the wall: 2017 is finally the year where rates see a significant change.
Considerations for Credit Unions
So as always, with change comes risk and opportunity. There are loads of considerations Credit Unions will need to factor in when navigating an increased rate environment, but here a few that Twenty Twenty thinks are important:
To what degree will Adjustable Rate Products be affected?
Although the Fed’s actions are not a direct increase in retail rates, it remains that the rate increases will eventually filter their way down to the member at the loan level. Credit Unions will need to consider their portfolio segments that are driven by adjustable rates, and determine how increased rates are going to affect their members with such products. For a Credit Union that holds a large portfolio concentration in adjustable rate mortgages, it is important to know how the rate increase will affect member payments (particularly on high risk loans), and if a campaign incentivizing refinancing is a strategy that would be beneficial.
How long before Real Estate markets adjust?
As outlined in previous Twenty Twenty blogs, when interest rates go up, consumer purchasing power on mortgages goes down. That is, at a given payment amount, a consumer can purchase less home in a higher rate environment. In much of the country, real estate values are currently at post-recession highs and inventories are low. However, in the long term, as interest rates increase over the next few years, it is likely that values will come down in a free market economy. This could potentially lead to higher LTV’s on current portfolio loans, and the larger losses on real estate charge offs.
Will the recent trend of extended term length on Auto loans cause issues?
Auto loans have seen a trend over the past few years of extended term lengths. If rates go up, this could potentially lead to a large concentration of low rate loans that remain in the portfolio for years after rates have increased. Obviously, consumers will have little reason to re-finance or dive back into the market for a new or used car at a higher rate. In the longer term, this could affect originations in a segment that have been easy to come by (with a rebounding consumer base, and super low interest rates) over the past few years. At the very least, the Credit Union should understand their exposure to such interest rate risk on extended term consumer loans.
Will there be a lag in the increase to rates earned on savings?
Historically, when the Fed announces an increase, there is a lag in the timing of lenders adjusting savings rates compared to lending rates. As seen in the graphs at the bottom of this New York Times article, mortgage rates and auto rates, to a lesser extent, have already seen a response to the three Fed rate increases since the end of 2015, whereas CD rates have barely moved. Eventually, money market and CD rates will have to increase for Credit Unions (and all lenders) to stay competitive. It may be worthwhile to consider how a savings campaign would generate member engagement, and potentially lead to lending opportunities at matching rates.
What can Credit Unions do?
Although navigating an increasing rate environment is a tricky business, there is reason for optimism. One of the most persistent difficulties since the Great Recession has been uncertainty. Uncertainty in interest rates, unemployment, GDP growth, and, undoubtedly, uncertainty in politics and policy. The Fed strongly signaling where they are going with interest rates is a massive opportunity for those who are paying attention and proactively managing their lending policies.
Twenty Twenty Analytics offers solutions in proactively monitoring the interest rate performance of your portfolio. We explore interest rates at both a loan-level and concentration segment-level in our Multi-Dimensional Portfolio Analysis. In this analysis, we evaluate the interest rates for each portfolio segment, and each default risk rating.
From there, we use Credit Union specific charge-off rates to determine where yields stand after charge-off for each concentration segment. Further breaking down your portfolio, we are able to determine if you are adequately risk-grading your loan interest rates based on FICO tiers and compare different FICO tiers from different concentrations.
Finally, the most recent addition to our analytics tool kit, we are able to run your portfolio through our Profitability Calculator where we consider all the factors already mentioned along with a dynamic view of your cost of capital, origination costs, and even an unemployment stress factor. This module allows for interactive scenario analysis where you can model interest rate performance in almost any circumstance.
As with any changing situation proactively managing change is the best way to implement a sound strategy. So let Twenty Twenty be your map as you navigate the cross country road trip that is interest rate risk – maybe we will even chip in for gas.
If you are interested in learning more about solutions provided by Twenty Twenty Analytics, please reach out to Alan Veitengruber.