Weathering the Storm: Rates, Recession, and Risk

Size: px

Start display at page:

Download "Weathering the Storm: Rates, Recession, and Risk"

Alaina Newman
5 years ago
Views:

1 Weathering the Storm: Rates, Recession, and Risk

2 Presenters: Charles McQueen Ed Lis Greg Gibson President VP of Finance & Compliance Chief Financial Officer McQueen Financial Adv. First Choice Financial FCU Georgia s Own CU Moderator Assets = $105 million Assets = $2.5 billion

3 Outline: Current Interest Rate Environment CFO Concerns Ed Lis Viewpoints Greg Gibson Viewpoints Wrap up Q&A Session

4 Charles N. McQueen Founder of McQueen Financial SEC Registered Investment Advisor Asset Liability Management Merger Valuation Services

14 Concerns: Cost of funds is going up Delinquency and loan losses will return Both actions will hurt earnings

15 Outline: Current Interest Rate Environment CFO Concerns Ed Lis Viewpoints Greg Gibson Viewpoints Wrap up Q&A Session

16 Thus far, the recovery has lasted 113 months, making it the second longest in history. Adding in the roughly the year-and-a-half-long recession, the total cycle is in its 132 nd month. During the 113 months of recovery, the economy has grown 18.5% from its previous peak, making it one of the weakest during the modern Fed era. The yield curve is currently flat relative to the historical norm. This generally occurs mid- to late economic cycle. The expansion is approaching its end. Expect more flattening of the yield curve. Source: Vining Parks

17 Inverted yield curve has historically been a reliable predictor of impending recessions. Every recession since 1957 has been proceeded by a yield curve inversion with the average lag between inversion and a recession being 13-months. We have benefited from higher yield opportunities while at the same time not having to pay extra on non-maturity shares. Short-term rates have increased 200 bsp and our cost of funds has not fundamentally increased. We expect short-term rates will continue to react of Fed expectations while the long-end of the curve should be influenced by global conditions and inflation. We project share betas to continue to place pressure on our funding costs.

18 Balance Sheet Management Maintaining NIM Tactically continue to place and reemphasis a renewed focus on operating expenses looking for ways to increase efficiency. What-if scenario modeling with our ALM provider. Exposure to earnings at risk and capital at risk. What-if we have to increase money market rates higher than otherwise expected? What-if regular shares and money market withdraw or shift to more expensive rate sensitive options? What-if a certificate promotion or higher certificate rates in 2019 cannibalizes some of our regular shares? What-if short-term rates and the cost of funds increase while the yield curve flattens, putting additional pressure on margins? Monthly back testing of both NII and NIM budget to actual being able to explain variances.

19 Balance Sheet Management IRR Profile: EAR and NEV Our primary exposure is to declining rate scenarios from both an earnings and economic value standpoint. While rising rates are the focus don t forget about falling rates. Loans Purchase Auto Loan Participations Pre-purchase Analysis Improve earnings and offset a lack of organic loan demand in the auto sector Competitive yield opportunities Invest excess liquidity Manage interest rate and concentration risk profile Investments Our strategy Invest based on the overall balance sheet A/L position. Invest throughout the economic cycle. If overly exposed to rising rates, invest super short or in variable rate. If overly exposed to falling rates, invest longer. If relatively neutral, then look at the market to see what things look like. When rates are rising, stay defensive, keep duration low, work in variable rate securities, short ladder, short cash flows with higher premiums to cushion slowing prepays. Callable are OK. When rates look like they are falling, invest longer, with locked out cash flows, bullets are preferable, longer cash flows near par or discount price to protect against higher prepays.

21 Deposits Liquidity Have a workable Contingency Funding Plan with primary and secondary funding sources Early Warning Indicators Cash Flow Forecasting Rolling 12-month forecast Back test of forecasted cash flows to actuals Stress Testing of Liquidity Scenarios Deposit runoff Additional haircuts on pledged securities Members access unfunded commitments

22 Regardless of the economic or interest rate cycle monitor the aggregate exposure of different risks to net worth. In addition to understanding traditional threats such as interest rate risk (IRR) and credit risk, considering new strategic threats. This tool established a minimum net worth the credit union never wants to fall below in a worst case scenario. The established net worth is not a target ratio or goal but it represents a worst case floor. If anything, the last recession clearly demonstrated that risk needs to be quantified and understood in the aggregate as bad things do not happen in isolation.

23 Outline: Current Interest Rate Environment CFO Concerns Ed Lis Viewpoints Greg Gibson Viewpoints Wrap up Q&A Session

24 Bear Market Traps As the Bears take over the bond market, the result is a flat, flatter, flattest curve until boom the market awakens to a recession. Historically this scenario has preceded virtually every recession in the modern era. 4 UST Yield Curve Comparison 3.5 in 10 Year UST 74 bps in 1 Month UST 177 bps in 30 Year UST 34 bps mo 2 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr 11/9/ /31/ /30/2016

25 Bear Market Traps The 2 Year to 10 Year UST spread is widely viewed as an exceptionally reliable indicator of recessionary onset. However, the Fed funds to 2s is frequently an inflection point in the curve that acts as an early indicator. The trap this scenario produces is that it is easy to remain in cash as the short end of the curve rises and continue to add to this position. This cash position poses no risk of increasing the unrealized losses piling up in the existing bond portfolio. But as the cash position increases the exposure to falling interest rates increases. So as protection against rising rates is realized in larger short lived assets, the inevitable next leg of the interest rate cycle, a rapid fall of rates, exposes the vulnerability to interest income. So how is this mitigated? Fight the compelling logic to shorten the average life of the bond portfolio and continue to manage the duration of the balance sheet and bond portfolio normally. Educate your management and Board that unrealized losses are exactly that, unrealized, and bonds will ultimately mature at PAR.

26 Credit Crunch As if Bond Bears taking over the market is not enough, the slowing of the economy impacts credit performance in greater or lesser degrees depending on numerous variables. To understand this impact you only need to remember the Great Recession and the Santayana quote of warning, Those who cannot remember the past are condemned to repeat it. And who wants any part of that. So what can we possibly do now that may mitigate existing risk in credit portfolios? The first step is to remember it is better to make changes a year too early than a day too late. Look closely at the past performance for different sectors of your loan portfolio and then consider what has changed since then to increase or decrease risk in those particular portfolio components. Evaluate portfolio concentrations and assess the possible performance of each scenario in mild, moderate or severe recession scenarios. Follow that with stress testing of your portfolio by segment/asset class and identify the most susceptible to credit degradation so as to evaluate the adequacy of your ALLL and capital base under varying levels of stress. Consider the appropriateness of overall credit exposure. Credit unions loan to share ratio, at nearly 83% is at its highest level since 4Q08. When you analyze, remember the old adage, bad loans are made in good times.

27 Credit Crunch A couple of other ideas you may want to explore for strengthening the credit risk position of your institution: If you become concerned about any concentrations, consider selling a portion of that concentrated asset class and purchasing a different asset class that has a differing credit profile. Look to the economy and observe potential bubbles that well may perform poorly in the next recession and evaluate such impact on your current portfolios. Such bubbles and/or concentrations could be geographic, industry, credit score, LTV or a number of other variables. Some obvious general domestic areas include: Student Loans Student Loan debt now exceeds $1.5T compared with $56B in Real Estate Yes real estate, many markets are now at levels that exceed the pre-great Recession levels. MBLs, is you CU new to commercial lending since If so look very carefully at construction, A&D and any speculative commercial CRE your lenders may have collected over the past ten years. Credit card and unsecured portfolio segments almost always come under stress in economic downturns, again look at prior performance and what has changed over the last several years with these assets.

28 Liquidity Sufficiency Having sufficient liquidity in a severe economic downturn is critical. In times of severe stress, adequate liquidity is at least as important as adequate capital if not more so (seen the movie It s a Wonderful Life lately?). A few timely considerations regarding liquidity include: Make sure you have a comprehensive liquidity contingency plan that is TESTED! This includes on-balance sheet, off-balance sheet, internal and regulatory reporting, PR etc. Consider ways to gain liquidity from concentrated asset classes: For instance, consider creating a large pool of loans from a concentrated asset class on your balance sheet. Then sell portions of that pool to several investors leaving a significant portion of the pool on your balance sheet. In the event of a liquidity need you then have the option of going to the third party owners and offering more of that pool to them as they will already understand the performance of the pool. Don t forget to include in your stress testing the increasing haircuts you ll likely see from your collateralized lines of credit. Consider a small tranche of Treasuries in case nothing else is trading as in November of 2008.

29 Outline: Current Interest Rate Environment CFO Concerns Ed Lis Viewpoints Greg Gibson Viewpoints Wrap up Q&A Session

30 Comments: 113 month recovery Flat Yield Curve inversion/ recession? Balance sheet management and capital limitations Liquidity Trapping a bear, or bear market trap? Credit Liquidity (another view) very important today

31 Final Comments: It is tough to have a recession when everyone has a job The FOMC is discussing a 3.00% neutral Fed Funds rate Inflation is currently under control Deposit Costs are rising quickly Loan losses will return

32 Outline: Current Interest Rate Environment CFO Concerns Ed Lis Viewpoints Greg Gibson Viewpoints Wrap up Q&A Session

Balance Sheet Strategies For Changing Rate Environments

Balance Sheet Strategies For Changing Rate Environments Moss Adams 2017 Credit Union Conference Portland, OR June 22 nd, 2017 Ryan W. Hayhurst Managing Director ryan@gobaker.com 800 962 9468 Credit Union