U.S. Economic Outlook & Its Impact on Financial Institutions

Transcription

1 CUNA CFO Council Mandalay Bay Hotel, Las Vegas :-: & :-: noon, Tuesday, May th, U.S. Economic Outlook & Its Impact on Financial Institutions Steven W. Rick Senior Economist Credit Union National Association PO Box 3 Madison, Wis. 3, USA Telephone: -3- Facsimile: srick@cuna.com

2 Investment Factors:. The Federal Reserve announced that interest rates will remain low until the labor market improves. Financial markets indicate short-term rates will rise in the first half of. This is forcing a reevaluation of the duration of investments.. Rising loan growth will reduce investment portfolios in. 3. Financial institutions are sitting on record levels of excess reserves ($. trillion) earning.%.. Excess liquidity is punishing earnings with short-term investment yields lower than deposit interest rates.. The U.S. is overbanked (, banks and credit unions) who have low loan-to-savings ratios. This excess liquidity will lead to hyper competition to loan out the surplus funds driving down net interest margins. Annual Growth Rates CU Balance Sheet Assets (% of 3 Assets) Liabilities + NW Investments (3%) Deposits (%) Deposit Factors:. Members preference for liquid funds will buoy core deposits and limit time deposits.. Large interest rate differentials between loans and savings will encourage households to pay down debt rather than save any surplus funds. 3. Households using existing savings balances to pay down debt will reduce the size of financial institution balance sheets.. Rising oil prices will reduce savings balances.. Inflation rates higher than deposit rates will produce negative returns on savings deposits.. The national savings rate is back down to % from % during the financial crisis.. Rising home prices will discourage thrift. Annual Growth Rates Loans (%) Net Worth (.3%) Annual Growth Rates Annual Growth Rates Loan Factors:. Economic recovery and accompanying job growth will encourage borrowing in.. Rising consumer confidence will encourage spending. 3. A % increase in home prices in 3 and should increase demand for second mortgages and home equity loans.. Rising stock prices will produce a wealth effect fostering increased consumption.. Deleveraging should fade in.. Low spending in - has created much pentup demand for durable goods. Auto loans, credit card loans and purchase mortgage loans will be strong growth areas.. The recession has created a large pool of potential borrowers with sub-prime credit scores.. Rising auto sales to over million in may reduce % financing offers and boost new auto loans. Net Worth Factors:. Rising return on asset ratios in will raise return-on-equity ratios.. Capital contributions will outpace asset growth raising net worth-to-asset ratios. 3. NCUA s Risk-Based Capital proposal will encourage some CUs to boost capital levels.. Alternative capital (subordinated debt) is a top CU legislative priority.. Credit unions are building their capital levels and ratios today in case they lose their tax exempt status sometime in the future. Its easier to build capital with pretax rather than post tax earnings.. CUs are unable to lower deposit rates further and therefore are unable to discourage an excessive surge in deposits which would result in lower capital ratios. So CUs are building a capital cushion well above the well capitalized threshold.

3 Yield on Assets Cost of Funds = NIM Fee/Other Income Operating Expenses Provision for loan losses = Net Income The Federal Reserve s QE- program (print money to buy MBS and Treasury bonds) will end at the end of, increasing long-term rates term premium, and increasing long-term interest rates.. Banks/CUs are weighing the marginal risk (credit/interest rate) versus marginal return (additional YOA) of alternative assets to boost NIMs. 3. Rising YOA due to rate and mix effect.. Aggressive loan pricing will limit YOA increases.. Rising loan growth will raise YOAs.. Rising short-term interest rates in will raise yields on short-term investments.. Rising short-term interest rates in will increase COFs.. Continued repricing of maturing CDs is lowering COFs today. 3. Excess liquidity will allow Bank/CU deposit rates to lag increases in market rates in.. Ultra-low market interest rates are preventing the pricing of deposits below market, reducing earnings opportunities.. NIM expected to rise in as YOA rise faster than COFs.. A steeper yield curve in will put upward pressure on NIMs by making ST borrowing and LT lending more lucrative. 3. Banks/CUs are reevaluating their GAP strategy due to changing interest rate forecasts.. The mortgage refinance boom has ending, reducing loan origination fees and gains on sale of mortgages.. The interchange fee cap rule (October, ) capped the maximum fee charged per debit card transaction to cents (plus an additional -3 cents for fraud prevention) for institutions greater than $ billion. 3. Interchange income may decline in if interchange rates fall more than the increase in card transactions. Merchants have incentives to move customers to new alternate low-cost payment systems, reducing the market power of the card networks.. Rising compliance costs for new Dodd-Frank Act regulations and new Consumer Financial Protection Bureau rules.. NCUSIF premiums expected to be - bps in due to a build up of reserves for insurance losses and less CU failures. 3. Corporate stabilization assessments are expected to be zero in. The combination of corporate capital written off ($. billion) and total assessments paid to date ($. billion) is close to what the losses are likely to be.. Asset growth of over % will lower operating expense ratios and improve economies of scale and efficiency.. Many banks/cus have over funded allowance for loan losses. leading to provisions lower than net chargeoffs.. Job growth will improve credit quality and lower provisions. 3. Home prices are expected increase % in, reducing the number of mortgages at risk of foreclosure.. It is difficult to generate adequate earnings without adversely increasing interest rate and liquidity risk.. Deficit reduction talks threaten the CU taxation exemption (and other tax expenditures) which would lower CU earnings and therefore asset growth ROA remains below its long-run average and questions remain whether this will be the new normal.

4 The Heart Vs Bank/CU Analogy How the Heart Works: Blood Flow Diagram How Blood Flows Through a Healthy Heart. Banks/CUs are to the economy what the heart is to the body Money Blood Deposits Deoxygenated (blue) Blood Loans Oxygenated (red) blood (Loans like blood lead to productive outcomes) Loan departments collect information Lungs collect oxygen Capital Heart Muscle Aorta artery Allocates Blood Banks/CUs Allocate Capital (to Most Productive Use) Toxic Assets/Loans (MBS) Plaque (Mortgage Backed Securities) Banking Crisis Heart Attack Government Intervention Defibrillator

5 Economic Growth = 3.%. Housing market recovery (% growth). Rising home prices (-%) 3. Rising auto manufacturing ( million units). Rising business investment spending. Strong energy sector. Strong medical care sector. Easing credit conditions. Rising consumer confidence. End of deleveraging. Less imported oil will reduce current-account deficit Is there a recession in our future? Recession Causal Factors: High Inflation High inventories Financial imbalances or excesses Exogenous/External influences No recession is expected over the next years. The only surprise would be for disappointment.

6 Quarterly % Change in U.S. Economic Output (Real GDP - Chainweighted $) % % % % % % % 3% % % % -% -% -3% -% -% -% -% -% -% -%.%.% 3.%3.3%.%.% 3.%.%.%.%.%.%.% 3.% 3.%.%.3% : : : : : : -.% : : : 3: : : Falling Potential Growth Rate 3.% to.% Less investment spending Lower leverage in post-credit era Suppressed demand Negative demographic trends Lower total factory productivity growth Maximum Sustainable Growth Rate =.% -.% -.% -.3% -.%.3% 3.%.% 3.%.%.% -.3% 3.%.%.% 3.%.%.% Recession Factors: Loose monetary policy Poor regulation Lax bank supervision Opaque derivatives Shadow banking system Lax investor diligence Poor governance Misaligned incentives fraud.%.%.%.%.%.% 3.%3.%3.% 3.%3.%3.%3.% Source: Department of Commerce. The output of goods and services produced by labor and property located in the U.S rose.% in Q,. Positive contributions came from personal consumption expenditures, Negative contributions came from lower federal government spending, private inventory investment and residential fixed investment. Final sales of domestic product GDP minus change in inventories grew.% annualized. Inventories subtracted. percentage points from growth as firms decreased the pace of inventory accumulation. Stronger aggregate demand will lead to job growth, rising confidence and further spending (a self-sustaining expansion). A balance sheet recession is the process whereby households and companies pay down debts rather than embark on new spending. The lack of demand for loans is due to the debt-strapped private sector. Economic growth during - relied too much on consumption spending and house buying, both financed by foreign savings channeled through an undercapitalized financial system. Today s sluggishness stems from pre-crisis excesses and the misshaped economy it created. Recoveries from debt-driven busts always take years as households repair balance sheets. st Quarter GDP Spending = C + I + G + X M % of total = (.) (.) (.) (3.) (-.) Growth rate = (3.) (-.) (-.) (-.) (-.) Contribution = (.) + (-.) + (-.) + (-.) + (.) =.%

7 Thousands US Payroll Employment Monthly Changes SA 3 Recession Payroll, Target Payroll employment grew, in April, above the, long-run target and above the, needed to meaningfully lower the unemployment rate (private payrolls rose 3,, government payrolls rose,). Housing-related employment, directly and indirectly, will account for /3 of all private sector job gains during the next few years. Improved consumer balance sheets will also stimulate job creation in. Average workweek remained at 3. hours. A greater workweek and more payrolls lead to.% rise in total hours worked. Average hourly earnings ($.3) rose by.% m/m and.% y/y, indicating little evidence of wage pressures and slightly above the. inflation rate. Forward looking indicators (temp hiring and average weekly hours) suggests additional hiring in coming months. (Percent) Unemployment Rate 3 Recession 3 Unemployment Underemployment (U-) Full Employment (NAIRU) 3333 Source: Department of Labor. 3 3 The unemployment rate fell to.3% in April, which corresponds to. million unemployed workers of which 3. million have been unemployed for more than weeks. Underemployment fell to.3%. The labor force participation rate decreased to.%. Employment-to-population ratio remained at.%. The labor force fell -,: employed fell 3,, unemployed fell -33,. Structural Unemployment Disease: Joblessness is becoming chronic with the average unemployment at weeks. Longterm unemployment is harder to cure because workers skills atrophy (human capital degradation) and they become detached from the work force. High long-term unemployment decreases future economic growth, raises future deficits and decreases social order. the theory of hysteresis argues that a recession can permanently affect the labor force, leading to an increase in long-term unemployment.

8 Unemployment Rate Vs CU Delinquency Rate.. (Percent) Recession Unemployment (LHS) Delinquency (RHS) Every percentage point change in U.R =>. change in delinquency rate Credit Risk ( types). Default Risk borrowers willingness and ability to repay debt (unemployment rate). Collateral Risk market value decline of the asset securing the loan. (home price changes) % 3% % % % % % % % % % 3% % % % Unemployment Rate (LHS) Net Chargeoff Rate (RHS).3%.%.%.%.%.%.% Unemployment Rate Versus CU Net Chargeoff Rate.%.%.%.%.%.%.3%.%.%.%.%.3%.3%.%.%.%.%.%.3%.%.%.% : : : : : : 3: :.%.3%.%.%.%.%.%.%.%.%.%.3%.%.%.% Source: Department of Labor, NCUA,CUNA Every percentage point change in U.R =>. change in NCO

9 3 3 - Annual Percentage Change Consumer Price Index to Present % Target Inflation =.3% m/m,.% y/y (higher food and gas prices) Core inflation =.% m/m,.% y/y (below Federal Reserve s.% threshold for reversing monetary policy) Subdued overseas economic growth and excess capacity is depressing U.S. consumer prices. Expect slightly rising consumer inflation in due to:. Rising commodity prices as the global economy rebounds. Rising economic growth should increase producer prices Low inflation => Federal Reserve QE- (print money to buy assets) Federal Reserve taper of Q.E. => dollar exchange rate => import prices and oil prices % Inflation (CPI) (year over year % growth) % % 3% % % % 3 3 -% -% -3% Headline Core (excludes food and energy) Forces Pushing Inflation Lower:. Negative output gap => idle capacity => prices. Unemployment Rate > U.R. Natural => wages 3. value of $ => import prices. Commodity super cycle => commodity prices. Bond markets are not pricing in higher inflation. (Nominal rates TIPS rates)

10 3 Interest Rates and Recessions Recession Baa Fed Funds -yr Treas Short-term Interest Rate Forecast: When, pace, new normal? Fed will raise short-term interest rates % per year for 3 years starting in mid. : 3 percentage points in first year : percentage points in first year : percentage points in first year Interest rates in will normalize at levels below previous plateaus due to lower real interest rates and lower expected inflation. Long-term Interest Rate Forecast: -year treasury below 3.% through Demand for Money (Supply of Bonds): Treasury issuance is below long-run average Deficit-to-GDP ratio =.% Post-debt-crisis borrowing aversion Supply of Money (Demand for Bonds): Fed s Forward Guidance ; market expects short-term rates to be lower for longer. Aging population shifting assets towards bonds Slow long-term economic growth % Trade dollars recirculated back to U.S. bond market Rising income inequality Struggling emerging market countries,.brita Interest rates (price of money) balance the desire for savings with the demand for investment. Savers are cautious and investors are reluctant to invest in new projects. The Federal Reserve has pushed down interest rates to discourage savings and boost consumer demand and to encourage business borrowing, investment and employment. The Fed has forced the - year Treasury interest rate to the lowest in history because of the incredibly weak economy. The low interest rate is a sign from the bond market that they expect years of stagnation and deflation or are terrified of imminent danger. Asset-Shortage Theory: U.S. Government bond yields are low because of a worldwide shortage of safe assets (MBSs and PIIGS sovereign debt are no longer considered safe assets) and a glut of global savings (business parking surplus cash and consumers savings more). Is the savings glut temporary? We could go from fretting about scarce assets to about scarce capital and the accompanying rising interest rates.

11 Household Debt (As a Percent of Disposable Household Income) % 3% % % % % % % % % % 3 % 3% % % % % % % % % % Source: BEA & Federal Reserve. 3 Credit Categories (Based on How Funds are Spent). Provident and Productively: Business, student, auto, new home loans Increase the supply of goods and services along with the demand. Increases both the numerator and denominator of the debt-to-income ratio. Economy grows with no inflation.. Wastefully: Consumption loans or misconceived investments Increase the demand for goods and services with no increase in capacity to produce. This increases the debt-to-income ratio. Inflation with no economic growth 3. Speculatively: Loans that are spent on existing assets real or financial Credit and asset prices can chase each other higher This increases the debt-to-income ratio. No direct impact on inflation and/or GDP The debt-to-income ratio fell over the last years because a lot of mortgage debt has been written off and new debt is hard to get. Consumers are also deleveraging to work off this mountain of debt. The debt-to-income ratio reached.% in Q3, 3, down from.% in Q3. The debt ratio rose to. in Q 3 as disposable income fell faster than debt. Economists believe a ratio of % is sustainable in the long run. Rising debt ratios: Households using future income to fund current consumption. Falling debt ratios: Households using current income to pay for past consumption. Source: Flow of Funds, D.3 Debt Outstanding By Sector, Total Household. BEA, Disposable Personal Income, $ billions.

12 The Virtuous Cycle of Banking Faster Asset Growth Higher Return on Equity ROE Economies of Scale Self-reinforcing spiral Feedback Loop Higher Return on Assets ROA Higher Profit Margin

13 Capital-to-Assets Growth Rate Analysis The growth rate of a ratio is the difference between numerator and denominator growth rates, (for small growth rates). %D (C/A) = DC/C DA/A % growth. = ========>. =. 3 3% growth % growth % = % - 3% If (ROE) DC/C = DA/A Then %D (C/A) = If DC/C = DA/A (multiply both sides by C/A) Then ROA = DA/A x C/A

14 Return on Equity Decomposition ROE = Asset Growth Speed Limit (given a constant Capital-to-Asset ratio) Return on Equity Leverage Return on Assets R E A E R A A E R GR GR A Profit Margin Asset Utilization R = Return (net income) E = Equity (reserves + undivided earnings) (beginning of period) A = Assets (beginning of period) GR = Gross Revenues (interest revenue + noninterest revenue) - # of Banks < mil:, $-$, mil: > $, mil: Banks Return on Equity (by Asset Size) < $ Million $-$, Million > $, Million

15 Banks Equity Multiplier (Leverage) (Assets to Equity) (by Asset Size) < $ Million $-$, Million > $, Million Banks Return on Assets (basis points) (by Asset Size) < $ Million $-$, Million > $, Million

16 Banks Profit Margin (Net Income to Gross Revenues) (by Asset Size) < $ Million $-$, Million > $, Million Banks Asset Utilization (Gross Revenues to Assets) (by Asset Size). < $ Million $-$, Million > $, Million

17 % % Commercial Bank Yield on Assets & Cost of Funds Yield on Assets Cost of Funds % % % % % 3% % %.%.%.%.%.%.%.%.%.%.3%.%.%.%.%.%.%.%.%.%.%.3%.%.%.%.%.%.%3.%3.%3.%.%.%.3%.% 3.%.% 3.%3.% 3.%.%.%.%.%.%.%.%.%.%.% 3.%3.% 3.%3.%3.%3.3% 3.%3.%3.%3.%.%.%.%.%.%.%.%.%.%.%.%.%.%.%.%.%.%.%.3%.3% % % % 3% % % % Source: FDIC : : : : : : : : : 3: : % YOA is at record low levels due to: historically low interest rates, price competition for good loans, excess liquidity, weak loan demand, low investment yields and abnormally high risk aversion..% 3.% 3.% 3.% 3.% 3.%.%.%.%.%.% Commercial Bank Net Interest Margin vs Operating Expense Net Interest Margin Operating Expense : : : : : : : : : 3: :.% 3.% 3.% 3.% 3.% 3.%.%.%.%.%.% Source: FDIC Net interest margins are falling as YOAs fall faster than COFs. COFs are asymptotically approaching %. The Great Recession led to over bank failures which reduced capacity and improved margins in an overcrowded market. Banking woes include anemic economic growth, piles of new regulation, waves of housing related litigation and exposure to European banks and the Euro-zone debt crisis.

18 .% 3.% 3.% Overall Net Chargeoffs - Family st Mortgage C & I Commercial Real Estate Commercial Bank Loan Net Chargeoffs.% 3.% 3.%.%.%.%.%.%.%.%.%.%.%.% Source: FDIC : : : : : : : : : 3: :.% High unemployment and falling property prices levied a heavy toll of bad debts. Credit quality has improved leading to easier lending standards. Banks need to deal with the large amounts of distressed assets that remain on their balance sheets..%.%.%.%.%.%.%.%.%.%.%.%.%.% -.% -.% -.% -.% -.% Return on Assets Loan Loss Provisions Commercial Bank Loan Loss Provision & ROA : : : : : : : : : 3: :.%.%.%.%.%.%.%.%.%.%.%.%.%.% -.% -.% -.% -.% -.% Source: FDIC Falling provisions for loan loss has led to bank return on assets, ROA, to climb above % in 3. Bank capital ratios are now some of the highest in the world over %. During the boom many banks boosted earnings simply by levering up, masking poor returns on assets with the magic of debt. New banking rules (BASEL 3) require banks to hold more capital (against potential losses) and bigger pools of liquid assets and more long-term debt (if funding markets dry up) which will depress returns on equity. New bank regulation will make banks safer at the cost of decreased supply of credit at a higher interest rate. Dodd Frank Act compliance costs will increase operating expenses.

19 Credit Union Savings Growth Annual Percent Growth A slow economic recovery over the next year will make balance sheet growth difficult. CUs need to focus on sales management and programs designed to increase deposits. For individual CUs, mergers may be a viable strategy for growth. New regulations will pressure smaller CUs to merge. Mergers can produce cost efficiencies in the long run. Large banks are driving customers to CUs. 3. Credit Union Loan Growth (Annual Percent Growth) Credit union loan balances are expected to rise.% in and % in, as credit unions see record loan originations (see chart). These growth rates will be the fastest pace since the.% set back in. Auto loans, credit card loans and purchase mortgage loans will be strong growth areas.

20 Net Income to Average Assets Basis Points High-performing CUs are doing the following: clearly articulating the member value proposition for each demographic segment, transforming the cost base, improving the credit portfolio, attracting more core deposits, increasing fee income, improving the risk management culture and process, aligning the operations to the strategy, improving methods to retain human capital. Net Capital to Assets Percent U.S. PCA Well Cap'd CUs are increasing their capital-to-asset ratios to absorb potential loan or asset losses. This will reduce leverage ratios (asset-to-capital) and therefore reduce return on equity ratios for any given return-on-asset ratio. This will reduce how fast CU assets can grow. Higher interest rates in mid will reduce the value of investments and long-term loans and will cause other troubled assets to appear. This will have a negative impact on capital ratios.

21 .3. Yield on Assets (Percent of Average Assets) Credit union loan growth of -% in - will shift assets away from low yielding investments and into higher yielding auto and mortgage loans. This will push credit union assets yields above the record low of 3.% set in 3. The Federal Reserve s Quantitative Easing program (print money to buy MBS and Treasury bonds) will end at the end of, pushing up longer term interest rates to 3.% by the end of. Faster economic growth in will keep the upward pressure on interest rates with the -year Treasury crossing over 3.%. This will push mortgage rates up and boost earnings. The Fed will raise the fed funds interest rate in the spring of raising the yields on short-term credit union investments. Aggressive loan pricing by banks returning to the consumer lending arena will, however, lower net returns on some loans. Cost of Funds (Percent of Average Assets) Rising short-term interest rates in will increase credit union cost of funds from the record low mark of.% set in 3 The rise will be modest as excess liquidity will allow deposit interest rates to lag increases in market interest rates. With almost all member certificate of deposits repriced to today s low interest rates, the funding cost increase will come sooner than it did during the last rising interest rate cycle of. Rising interest rates will encourage members to shift funds out of core deposits and into higher yielding money market accounts, a liability mix effect. We expect the pace of interest rate increases to be slower than the last episode of rising rates in July to July when the Fed raised rates 3%.

22 Fee Income (Percent of Average Assets) Fee income as a percent of average assets will continue its year decline as the economic recovery lowers penalty fees. Fees from checking accounts serves as the single largest source of credit unions fee income. The average percentage of fee income derived from nonsufficient funds (NSF), overdraft, and courtesy pay fell to 3% in 3, down from % during the worst of the Great Recession. Credit unions continue to charge lower and fewer fees than banks for financial services. And by offering bank customers a low-fee alternative to high-fee banks, many credit unions experienced a surge in membership growth over the last few years.. Other Income (Percent of Average Assets) The end of the mortgage refinance boom will reduce loan origination fees and gains on sale of mortgages over the next years. Interchange income may decline in - if interchange rates fall more than the increase in card transactions. Merchants have incentives to move customers to new alternate low-cost payment systems, reducing the market power of the card networks. The interchange fee cap rule (October, ) capped the maximum fee charged per debit card transaction to cents (plus an additional -3 cents for fraud prevention) for institutions greater than $ billion.

23 Operating Expenses (Percent of Average Assets) Operating expense ratios will fall over the next years because the Corporate stabilization assessments are expected to be zero in -. The combination of corporate capital written off ($. billion) and total assessments paid to date ($. billion) is close to what the losses are likely to be. Moreover, NCUSIF premiums are expected to be zero in - due to a build up of reserves for insurance losses and less CU failures. However, credit unions will experience rising compliance costs for new Dodd-Frank Act regulations and new Consumer Financial Protection Bureau rules. Low asset growth of around 3.% will limit the reduction in operating expense ratios and therefore also limit the improvement in economies of scale and efficiency metrics. Provisions for Loan Losses (Percent of Average Assets) Falling loan net charge-offs, tighter underwriting standards, an improving labor market, rising home prices and a still overfunded allowance for loan loss account will keep loan loss provisions at below normal levels for -. Many credit unions still have over-funded allowance for loan losses. leading to provisions lower than net chargeoffs over the last few years Job growth will improve credit quality and lower provisions. Home prices are expected increase % in, 3 reducing the number of mortgages at risk of foreclosure.

24 Provisions for loan Losses Equilibrium Condition Provisions = Net Charge-offs Allowance for Loan Losses Net Charge-offs $ $ $ $ $ $ $ $3 $ $ $ CU Provisions, Allowances & Net Chargegoffs ($ Billions) Provisions Allowance for Loan Loss Net Chargeoffs $ $ $ $ $ $ $ $3 $ $ $ The allowance for loan loss (ALL) account is a credit union s estimate of the dollar amount of bad loans currently held on the balance sheet. Credit unions are reducing the ALL account by reducing loan loss provisions below the rate of net chargeoffs.

25 .%.%.%.%.%.%.%.%.%.%.%.% Loan Loss Provisions Allowance for Loan Losses Net Charge-offs Credit Union Credit Quality (As a % of Loans) : : : : : : : : : 3: :.%.%.%.%.%.%.%.%.%.%.%.% Source: NCUA The coverage ratio (allowance for loan losses divided by net charge offs) averaged.3 during the years before the great recession. Today the coverage ratio is.. The ALL-to-Loan ratio is a function of loan composition, inherent loss rate, the state of the economy, loan age, etc..%.% CU Net Chargeoff Rates (Loans Charged Off Net of Recoveries as a Percent of Average Loans).%.%.%.%.%.%.%.%.%.%.%.%.%.%.%.%.%.3%.%.%.%.%.%.%.%.%.3%.%.%.%.%.% The CU net charge off ratio averaged.% in the years prior to the Great Recession. Expect the charge off ratio to fall to.% in, 3 basis points above its long run average.

26 Yield on Assets % 3 YOA vs -year Treasury Rate Yield on Assets.% Spread - Year Treasury 3 Percent Falling YOA to record low levels is due to: historically low interest rates, price competition for good loans, excess liquidity, weak loan demand, low investment replacement yields, deleveraging, debt aversion and abnormally high risk aversion. Returns for mortgages and other loans tied to dollar-based LIBOR were depressed because rates had been suppressed by banks manipulating LIBOR. Repositioning of assets towards unsecured loans should help offset the downward pressure on YOA. COF vs Fed Funds Rate -3 Cost of Funds % 3 3 Percent Cost of Funds Fed Funds The Federal Reserve s exceptionally low interest rates for an extended period is causing CU cost of funds, COF, to asymptotically approach %. Focusing on core deposits and the stickiness of deposits will increase the opportunity for higher interest margins when short-term interest rates begin to rise in.

27 Basis Points DIDEMCA Garn-St. Germain CU Net Interest Margin - Recession Interstate Banking Act NIM Financial Modernization Act Deregulation over the last 3 years has increased competition in the financial services arena, resulting in lower net interest margins. Banking competition will increase as survivors of the Great Recession reduce their risk aversion. For an individual CU, margins will also be determined by local market demographics: population growth, median household income, local industry, age trends. Margin compression is forcing credit union to boost efficiency and productivity. Net Interest Margin vs Operating Expense to Average Assets Basis Points NIM Operating Expense Net interest margins are falling as YOAs fall faster than COFs. Credit unions have been underwater for the last years as operating expenses have been greater than net interest margins. Mergers will accelerate as a means to reduce operating expense ratios. Cost containment and reorganization efforts are also a high priority: enhance the distribution system, evaluate the product menu, optimize business processes, improve vendor relationships.

28 Income Household Budget Constraint + Chg Debt = Taxes + Debt Interest + Spending + Savings CU Loan Growth vs Personal Income & Consumption Expenditures [Year Over Year % Change] Recession Consumption Annual Credit Union Loan Growth Income

29 Household Budget Constraint Income + Chg Debt = Taxes + Debt Interest + Spending + Savings Consumer Credit Outstanding (monthly change & annual growth rate) Percent Recession Consumer Credit Monthly Change (RHS) Year-over-Year Growth (LHS) Deleveraging = /3 Charge-off = / $ bil (SA)

30 Household Budget Constraint Income + Chg Debt = Taxes + Debt Interest + Spending + Savings Household Debt Service Ratio % % Recession Debt Service Ratio % % 3% 3% % % % % % % % 333 Source: Federal Reserve. % The household debt service ratio is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The debt service ratio fell to.% in the fourth quarter of, the lowest level since Q3 of. Falling interest rates and debt levels both caused the decline. Low debt payments are freeing up disposable income for additional consumption or savings. The financial obligations ratio adds automobile lease payments, rental payments on tenant-occupied property, homeowners' insurance, and property tax payments to the debt service ratio. The financial obligation ratio fell to.% in the fourth quarter of, down from.% in Q3 of. 3

31 Household Budget Constraint Income + Chg Debt = Taxes + Debt Interest + Spending + Savings 3 - National Savings Rate [3-month moving average (Personal Savings/DPI)] Greater economic stability Equity capital gains Foreign savings/capital inflow New Mortgage Products Low interest rates Financial Stress Saving rate (savings / disposable personal income) =.%, down from.% one year ago In the environment of low savings, spending gains will be highly dependent on income growth and consumers preferences for additional savings. Paradox of Thrift Everyone increasing their savings leads to a recession 3

32 CUNA s Economic and Credit Union - Forecast As of March ECONOMIC FORECAST The U.S. economy is expected to grow 3% in and 3.% in. The economic headwinds experienced over the last years will abate and turn into tailwinds to push the economy s growth to over 3%. We expect a surge in housing construction, rising home prices, rising auto sales, stronger business investment spending and a robust energy sector. Inflation will remain below the Federal Reserve s inflation target of % in and. Core inflation (excluding food and energy prices) will remain below.% in due to a large output gap and low capacity utilization rates. Low core inflation will keep inflation expectations low and therefore also keep long-term interest rates low. The unemployment rate will fall below.% by the end of. The Federal Reserve has set a.% unemployment rate threshold for when it will consider raising the fed funds interest rate target. Even so we do not expect them to raise the fed funds rate in. The fed funds interest rate will stay in the -.% range through due to the economy operating below potential. The U.S. economy is currently producing a level of output of goods and services % below its potential level of output. The Federal Reserve will wait until the economy closes that gap before exiting its extraordinarily easy monetary policy. The -year Treasury interest rate will end below 3.3%. The Federal Reserve s QE program (monthly purchases of Treasury bonds and MBSs) will end in as the Fed reduces their monthly purchases by $ billion at each of their FOMC meetings. This will cause bond investors demand for longer-term bonds to decline, resulting in higher interest rates. The Treasury yield curve will steepen in as long-term interest rates rise faster than shortterm interest rates. This will increase credit union s net interest margins as borrowing short term and lending long term becomes more lucrative. Credit union yields on assets will rise in (reversing a year decline) due to rising interest rates and faster loan growth. CREDIT UNION FORECAST Credit union savings balances are expected to grow 3.% in and 3% in. Saving growth will slow to 3% in due to the Fed raising short-term interest rates which will cause some members to transfer funds to MMMFs. Nevertheless, fast membership growth of around.% (twice as fast as the % growth in population ) will help buoy savings growth. Credit union loan balances are expected to rise.% in and % in. Loan growth of.% will be the fastest pace since the.% rate set back in. Expect households to release pent up demand for autos, furniture and appliances over the next years. New auto loans, credit card loans and purchase mortgage loans will be strong growth areas. Credit quality will improve in and. The overall loan delinquency rate will fall below. in, but remain above the long-run average of.%, as job growth continues. Provisions for loan losses as a percent of assets will rise above the.% reported in 3 as loan growth picks up. Credit union return on assets will rise.% in and.% in. Rising yield on assets will increase net interest margins and the elimination of the corporate assessment will lower operating expenses. Nonetheless, a drop in mortgage refinancing will reduce gains on sale of mortgage income. Capital-to-asset ratios will rise to % in. Capital growth will outpace asset growth over the next two years, increasing the capital-to-asset ratio. Credit union capital ratios will approach the record level of.% set in, the year before the beginning of the great recession. 3

33 Economic Forecast March, Actual Results Quarterly Results/Forecasts Annual Forecasts Yr Avg 3 : : :3 : Growth rates: *Economic Growth (% chg GDP).%.%.% 3.% 3.% 3.% 3.% 3.% Inflation (% chg CPI).%.%.%.% Core Inflation (ex. food & energy).%.%.%.% Unemployment Rate.%.%.%.%.3%.%.%.% Fed Funds Rate.%.%.%.%.%.%.%.% -Year Treasury Rate.%.3%.%.% 3.% 3.%.% 3.% * Percent change, annual rate. All other numbers are averages for the period Credit Union Forecast March, Actual Results Quarterly Results/Forecasts Annual Forecasts Yr Avg 3 : : :3 : Growth rates: Savings growth.% 3.% 3.% -.% -.3%.% 3.% 3.% Loan growth.%.3%.3%.%.%.%.%.% Asset growth.% 3.% 3.%.% -.%.% 3.% 3.% Membership growth.%.%.%.%.%.%.3%.3% Liquidity: Loan-to-share ratio** 3.%.%.%.3%.%.%.%.% Asset quality: Delinquency rate.%.%.%.%.%.%.%.% Net chargeoff rate*.%.%.%.%.%.3%.%.% Earnings Return on average assets (ROA)*.%.%.%.%.%.%.%.% Capital adequacy: Net worth ratio**.3%.%.%.%.%.%.%.% * Annualized Quarterly Data **End of period ratio See also our MCUE website If you have any questions or comments send an to srick@cuna.coop 33