WEST PALM BEACH, Fla. -- Many within credit unions are drawn to the cooperative financial structure because of the unique intersection of numbers, finance and people's dreams. Credit unions help members finance a home, a car or a college education, and in a world ruled by ambiguity, numbers provide a degree of certainty and solace. But lately, the numbers provide little comfort. Credit union ROA and profitability are declining and membership growth is both stagnant and graying. Younger members are avoiding the credit union's doors.
The credit union financial engine is showing signs of wear and starting to sputter down the American highway, according to interviews by The Credit Union Journal with a group of 17 financial experts, CEOs and executives. They generally agree with the causes for the slowdown, but disagree as to whether the engine needs a tune-up or an overhaul.
In this report, we'll look at the reasons behind the uncertain performance, the evolving financial services industry and new profitability models. And we'll examine three credit unions that are bucking the trend with innovative services and healthy balance sheets.
First a word on profitability and philosophy. In the past, the word profitability was viewed by credit unionists as a dog regards a fire hydrant. A select few still consider profits as anathema to the philosophy of a financial cooperative. Many of the experts interviewed for this report consider the term apt as credit unions are evolving and need to ensure that all aspects of their operation are profitable to remain relevant. A profitable credit union can provide better rates as well as superior services and products to members. The words of Roy Bergengen in February 1928 gain purchase, "A credit union is first of all a business."
The return on average assets (ROA), which is one measure of a credit union's profitability, has been steadily declining since 2002. That year marked the last time the CU community's average ROA was above 100 basis points; in 2005 it dropped to 85 basis points. If fees and other income are subtracted from ROA, you are left with a negative 40 basis points for year-end 2005 as shown in the chart below.
Industry average ROA dropped to 81 basis points at the end of the first quarter 2006, according to Callahan & Associates (see chart, below). As of first quarter 2006, non-interest income was 1.19% of average assets so the difference dropped further to a negative 38 basis points.
The Current Slowdown
The current slowdown is a frayed mosaic that most credit unions would rather hang in their closet instead of the lobby. The malady starts with a flat yield curve that signals a decline in interest income and shrinking margins. The yield curve is the difference between short- and long-term interest rates that are tracked from one point in time to another.
As depository institutions, the traditional source of credit union earnings is the margin-the difference between the earnings received on loans and dividends paid on savings. The margin should pay for the operations of the credit union, but as the yield curve flattens, interest margins are shrinking and many credit unions are failing to make a sufficient margin to pay for operations. They are becoming dependent on fee income, which can be, well, addicting, according to Jeff Farver, CEO of the $1.9-billion San Antonio Federal Credit Union.
"Many credit unions are living on fee income," said Farver. "My concern is that we are addicted to fees-fees are the crack of financial institutions."
This report will discuss fee income later. In normal circumstances, long-term rates are substantially higher than short-term rates. An inverted yield curve-short term rates exceeding long term rates-has usually, but not always, been a bellwether for a coming recession. The current situation is unusual and likely temporary-a flat yield curve where the difference between short-term and long-term rates is minimal; short-term rates are higher than normal.
"In the last 10 years, the spread between two-year Treasuries and 10-year Treasuries has been as high as 250 basis points and averaged roughly 90 basis points; now the spread is two basis points," observed Todd Smith, SVP Client Services with CNBS, LLC in Lenexa, Kan.
The dilemma for credit unions is that they have failed to increase loan rates substantially, even though the highly competitive loan market is doing so. On the savings side, credit unions have been equally slow to increase rates. Members can go online and get from 4% to 5% APY on an Internet bank savings account without a required minimum balance. Historically, credit unions could trumpet the fact that their savings and loan rates were the best in the local market; that claim can no longer always be made.
Another reason for the slowdown is the end of the mortgage refinancing boom. Mortgage refinancing was a significant source of income through origination fees. In the recent past, credit unions that sold their 30-year mortgages on the secondary market experienced income gains. In today's climate, if a credit union sold a 30-year mortgage booked one or two years ago, it would likely experience a loss. Credit unions that hold 30-year mortgages at low rates are nervously watching their cost of funds inch up, further shrinking their margins.
"The cost of funds is up 36 basis points from 2004 to 2005; money is more expensive for credit unions," observed Dave Colby, CUNA Mutual Group chief economist.
Should the credit union community, regulators and others be worried about the declining ROA for the near future? This is a source of disagreement …
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