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Qualified Mortgages, More Than Just a Compliance Issue…

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As of January 10, 2014, the “Ability to Repay and Qualified Mortgage Standards under the Truth in Lending Act (Regulation Z)” went into effect. Beyond the added compliance burden this will have, consider how this rule could impact strategy, interest rate risk and earnings at individual credit unions, and for the financial services industry as a whole.

There are many facets to the regulation, including limits on points and fees, caps on debt-to-income and limits on loan term. An additional requirement is that, on variable-rate mortgages, the originator must verify that the borrower can still make the payment assuming the maximum increase in rate over the first five years. For those credit unions that make and hold significant 1/1, 3/1 or 2/2 ARM, this could have a major impact. Many credit unions make these variable-rate loans in order to offer members another mortgage option, typically at a lower rate. A benefit of this is that it also provides some interest rate risk protection; yet under this new rule, the ability to originate and keep these loans may be severely diminished.

Take the example of a 1/1 ARM originated today with a starting rate of 2.5%, a 2.0% annual periodic cap and a 6.0% lifetime cap over the original rate. Given the requirements of the new Qualified Mortgage rule, the borrower would have to qualify for this loan at a rate of 8.50% (see table below):

Qualified Mortgages Table

Many members who could have previously qualified for a 1/1, 3/1 or 2/2 ARM may no longer qualify under this new rule. Now, while it could be argued that this could have the impact of reducing potential credit risk down the road, it also means that some adjustable rate mortgage products are likely to go away, or change materially. Consider, will credit unions switch to offering exclusively fixed-rate mortgage products or offering ARMs with initial lockouts of five years or longer? Either of these alternatives will add increased interest rate risk. The shift may not dramatically change interest rate risk profiles over 2014, but what happens after several years of a shift like this?

There is no doubt there are many other questions that credit unions should consider. Beyond the shift in risk that may occur, it can also be good to consider the longer-term strategic consequences credit unions could face.

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Linking Strategy With Desired Financial Performance

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The strategic planning season is right around the corner. At the end of their overall strategic planning process, many credit unions believe they have linked strategy with their desired financial performance. Some credit unions decide on targeted financial ratios and believe they are linking strategy with financial performance, but not high-functioning credit unions. They simulate the long-term earnings and risk to earnings of their strategy to understand if it is positioned to produce the credit union’s desired financial performance.

High-functioning credit unions focus on what it will take to keep a business model fine tuned, not allowing it to get stale. They make sure they are more stellar than their competition at one, two or three things. They also make sure they are delivering a unique value proposition for the markets they are targeting. They dig into the data that is at their fingertips because, for example, they know how many approved loan applications were actually funded and they do everything possible to not let approved loan applicants slip away. High-functioning credit unions also know what percentage of transactions happen in branches, the call center and electronically – and they consider those transaction trends in their strategic planning process.

They also focus on creating and maintaining a sustainable ROA, long term. With margins in the 2s for the overall industry, figuring out how to do this is tough work – but critical. For example, high-functioning credit unions are constantly on the lookout for additional sources of non-interest income without taking advantage of members. They make sure their limited resources are being allocated appropriately. In other words, they make sure there is an ROI for every expense.

There are a number of other things high-functioning credit unions habitually do, but what we have included here should help credit unions focus on the right questions to be asking – and answering.

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One Of Many Ways For Management To Add Value To The Strategic Planning Process

Front-line staff members are the first line of defense with an unsatisfied member, and are also the first line of offense with respect to communicating the credit union’s marketing messages. Routinely, credit unions identify themselves as “member-focused” or “service-oriented”—both of these identifiers lean very heavily on member experience, which is in turn influenced by the experience those members have with your front-line staff.

As the second calendar quarter is closing, and credit unions are beginning to formulate plans for next year’s strategies and goals, gathering input from the front-line staff can enhance the process.
Consider brief, but direct, surveys of those employees who deal with member concerns every day.  Some valuable questions include:
  • What is the top member complaint that you receive?
  • How does this complaint typically get resolved?
  • If it were up to only you, how would you solve it?
  • What three things take up the majority of your time during the day?
  • Of those three things, which do you think provides the most value to the membership, and why?
However these surveys are conducted, ensure that controls are in place that promote candid feedback.  Set a participation goal for your staff, such as 95% response, and tie the goal to a credit union sponsored pizza lunch some Friday during the summer.
Most importantly, take steps to ensure that the participating staff realize that their responses were heard by management, and did not disappear into some “survey vortex” where there is no perceived value from their time filling out the surveys.  It is amazing what information a couple slices of pizza and a receptive management team can elicit from front-line staff, and their input could be invaluable in spurring discussion on plans for the future.
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Bits And Bites For The Board

NCUA’s new rule on interest rate risk emphasizes board-approved policy and oversight by the board.  The board is also responsible for setting strategic direction.  With the speed of change the industry has experienced lately, keeping board members apprised of all that’s happening has become more challenging than ever.

Board meetings typically focus on the day-to-day business of the credit union and review of financial results with very little time spent looking forward or learning about industry issues.  Why not take a bit of each board meeting and purposefully devote some time to strategic issues and education?  While formal board education and planning sessions are crucial, regular discussion on these topics can help keep the board moving in the direction that NCUA requires.

Boards share the ultimate fiduciary responsibility for credit unions and equipping them with the tools they need to make informed decisions is critical.  It’s a little bit like sneaking vegetables into the spaghetti sauce, but small, regular doses of education and strategy can go a long way toward healthy boards and credit unions.

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Investing At “Record” Low Rates…

The Fed’s first 3-year “forecast” revealed that almost half of the Fed Governors believe the Fed will keep short-term rates very low through 2014.  Coupled with continued weak loan demand, many credit unions feel like they are forced to do more with investments.  These two factors may cause more credit unions to extend investments moving forward into 2014.  Here are a couple of things to consider:

  1. Ask yourself, does that make sense? Regardless of what your broker tells you, it is always a good idea to apply the “reasonableness test” to any new investments that your credit union is evaluating.  Honest mistakes can be made.  A recent example is a broker showing a credit union a 13% market devaluation in a +300 basis point (bp) rate change on a 15-year final maturity callable.  The mistake was made because the market value model that was used showed the callable being called at the 5-year point, even in a 300bp rate increase.  In reality, a 15-year final maturity callable should devalue by roughly 30% in a 300bp rate change.  Callables will NOT get called if rates rise.   Make sure your credit union is evaluating the risk to final maturity if you consider investments with optionality, like callables, or mortgage-related products.  Buying long maturity callables with the expectation that they will be called can be a risky strategy
  2. How does this fit within policy? All investment decisions of relevance should be examined from an overall risk perspective, to ensure the new purchases still fit within policy limits.  Not just investment concentration limits, but overall aggregate risk policy limits (calculating impact on overall financial results)

There are many other areas that could be considered, such as overall credit union strategy and how new investments fit within this strategy.  Is the credit union positioned for long-term success if rates stay low and loan demand remains weak?  Lengthening investments can provide some revenue relief in the short-term, but will not provide relief from the long-term structural and operational challenges that many institutions are facing in this environment.