No assessment of a credit union’s risk is complete without a macro outlook on the economy and interest rates. But how can a credit union best develop a forward view of economic factors? As the old joke goes, if you line up all the economists in the world end-to-end, they’ll never reach a conclusion.
Many years ago, when I served as Chief Economist of a large financial institution, I kept a crystal ball in my office as an artifact of my profession. My daughter, then eight years old, came to visit my office, and when she saw the crystal ball, she asked me what I used it for. Tongue in cheek, I told her, “I use it to see the future.” She looked at it for several seconds, noticing that images viewed through a solid glass sphere are inverted. Then she commented, “Well, it says your future is upside-down,” proving herself a more astute economic observer than most.
That experience provides an invaluable lesson for credit union professionals attempting to develop a forward view of the economy: oftentimes, the things we observe around us paint a clearer picture of what’s going on, and what’s to come, than the most sophisticated econometric models.
The recent unprecedented housing bubble and its disastrous aftermath are a case in point. Many esteemed economists – including then-Fed Chair Greenspan – admitted being taken by surprise by the bubble and what followed. And the Fed has some very sophisticated models at its disposal. But not everyone was surprised by the bubble.
In 2007, my neighbor was planning a move from Kansas City to Florida, where his two daughters had recently moved. His youngest daughter’s husband worked in construction management for a large homebuilder, and after graduation had bought a condo in the Bradenton area for $165,000, while his soon-to-be bride finished her degree. After six months, the condo was worth $230,000. They sold the condo, and used the proceeds to buy a new home, benefiting from the discount offered by the young man’s employer.
That was my first red flag. I’ve long held that since residential real estate doesn’t produce cash flows, it arguably shouldn’t return much more than the inflation rate, except in areas where demand is high and land is scarce, like Manhattan. When real estate does produce returns well in excess of the inflation rate on a widespread basis, a correction is inevitable. (Many of my friends have disagreed with me on this, based on their own experience. But after the housing bubble burst, they begrudgingly conceded the point.) So a 40% increase in the value of a condo in six months looked decidedly outside the norm.
My neighbor told me of his house-hunting trip to Florida, noting that he looked first in his daughter’s neighborhood. He noted that there were twelve homes on her cul-de-sac. All were builder spec homes, and all but his daughter’s were unsold and had been on the market for about six months. My immediate thought was, “Uh-oh – this is going to get ugly.” If it’s happening in one market, it’s likely happening in many others.
That, of course, turned out to be the case. A full discussion of what fueled the housing bubble could fill a book, and would date back to legislation first passed during the New Deal, exacerbated by many legislative and regulatory blunders since, plus a lot of lender, developer and borrower abuses. But the anecdotal evidence made it clear that a huge bubble was forming, and a sizeable correction was coming. Of course, what happened in 2008 and 2009 bore that out.
The upshot of all of this is that we can observe what’s going on around us, extrapolate it to the broader national macroeconomic environment, and develop a view of what’s coming. That will enable us to formulate a view of the current and projected economic environment, and its consequences in terms of employment, home prices, other economic activity, and interest rates. (One caveat is that we cannot necessarily forecast central bankers’ and regulators’ responses to these factors; to wit, the Fed’s unprecedented accommodation since the housing bubble burst, or the NCUA’s response to the resulting corporate credit union imbroglio.)
Peter Lynch, the former manager of Fidelity Magellan – the first super-fund in the mutual fund market – wrote a book titled “One Up on Wall Street.” In it, he advocated the practice of simply observing the world around you as you go about your daily life to determine what companies show promise as investments. The local Starbucks is always packed? Maybe that company is a good investment. The local K-Mart is always empty? Perhaps that’s a company to avoid. It worked for Lynch: from 1977, when he took over the Magellan fund, to 1990 when he stepped down, the fund’s average annual return was 29.2%, and assets grew from $18 million to more than $14 billion.
The point of all of this is that you can develop a forward view of the macroeconomic and interest rate factors that will impact the risks your credit union will face without relying on economists (who all too often have a bias) or developing complex econometric models, but instead observing the trends that you see occurring in your local market on a daily basis. It doesn’t have to be rocket science, and your future doesn’t have to be upside-down.