The NCUA’s warning on interest rate risk: Crying wolf? Don’t bet on it

Credit unions have been hearing dire warnings about impending rising interest rates from all manner of huffing and puffing pundits for the last few years. But what has happened? Nothing. Rates haven’t risen as expected. And the sky didn’t fall either. So should we dismiss these warnings as a bunch of people simply crying wolf? The NCUA doesn’t think so. In fact, the NCUA is so concerned about the potential affect of rising rates on credit unions that they released an Economic Update video on October 1, 2014 featuring their chief economist, John Worth. In the video, Mr. Worth re-emphasized the NCUA’s focus on the risks to CUs presented by the inevitable rising interest rates and the importance for CU’s to fully understand and prepare for it.

In the NCUA’s video, Mr. Worth said that in the second quarter of 2014, credit unions in general performed well – partly as a result of the improving U.S. economy. But, he reminded us that this improving economic environment poses a downside in the form of possible changes in interest rates. His clear implication is that as the economy improves, credit unions should expect rising interest rates and prepare for it. Mr. Worth then highlights some recent economic developments that may act to boost interest rates, including signals from the Federal Reserve. For example, at the end of one of its recent Federal Open Market Committee meetings, the Fed confirmed that it would continue to wind down its quantitative easing program (e.g., continue tapering its purchases of Treasuries and Mortgage Backed securities) and that the program would end before 2015 if the economy remains on track. Sure enough, the Fed did, in fact, end its securities purchasing program in late October just after this NCUA video was released. Mr. Worth acknowledged that long term interest rates are affected by many factors and the end of its quantitative easing program does not alone mean that interest rates will jump. But, the Fed believes that if the economy continues to improve as the Fed expects, short term interest rates will probably rise. The Fed also believes that the unemployment rate will be at 5.5% by the end of 2015, which most economists define as “full employment” (although this headline measure does not typically consider underemployment and the participation rate, both of which have been unusually and chronically high following the economic crisis). Fed policy makers, according to Mr. Worth are telling us that if the economy proceeds as expected and when we reach or approach full employment, expect to see short term rates increase in 2015. But, the Fed has continually reminded us that all this is “data driven.” In other words, if the economy improves faster than expected, rates will likely rise faster and higher and vice versa. Regardless, Mr. Worth says that based on the improving economy and the Fed’s statements, it appears that short term rates will be rising.

So what does all this mean for credit unions in the view of NCUA? Mr. Worth says it means rising interest costs in 2015 and into 2016 but uncertainty as to how fast those costs will rise. If the increase in short term rates is greater that that for loan rates, the yield curve would flatten and CUs would suffer a cut in net interest margins. Non-interest income has already recently moved lower and if that continues, Mr. Worth warns that the added decline in net interest margins could cause many CUs to realize declining net income or even losses. This prompts Mr. Worth to express the main point of the video in the following quote near the end of his talk:

Here at NCUA, our chief concern is that credit unions are aware and prepare for this possibility. Credit unions should have a firm idea of how their income statements and balance sheets are affected by a rapid rise in short-term rates and they should have a plan for dealing with the potential consequences.

The moral of this story? Persistent warnings of imminent rises in interest rates have been echoing in our ears for a few years now, but so far rates have not risen. But don’t let this desensitize you to the issue. Understanding and preparing your credit union’s loan and investment portfolios for rising interest rates is imperative because interest rates have no where to go but up. And when they do, you want to ensure your sheep don’t get shorn.

Heber Fuger Wendin, established in 1934, is a fee-only, independent SEC-registered investment advisory firm (not a broker) to credit unions and other depository institutions. Mr. Barnes leads the Heber team in helping to manage $4.8 billion for nearly 100 community depository institution clients, including credit unions. Mr. Barnes can be reached at dbarnes@hfw1.com or www.HeberInvestments.com or www.linkedin.com/in/davidgbarnes