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Despite all the buzzwords we throw around, the economy is relatively simple.
Supply and demand influence price. Changes in purchasing power influence demand. Improvements and availability of technology influence supply. If there’s a supply shortage/demand surplus, inflation will follow.
While the economy is cyclical, the catalysts pushing us from one phase to the next are often different. Credit unions should be in tune with the pulse of the economic environment to position themselves favorably across a range of economic outcomes.
Let’s look at this business cycle’s story and the factors impacting credit unions most significantly.
With individuals effectively trapped in their homes, there was little demand for goods and services as consumer spending slowed dramatically. Families were saving money preparing for the worst.
People and businesses received widespread stimulus. Government stimulus money was reinvested into what was unexpectedly a growing workforce, and incomes rose
Interest rates were low and purchasing power was high. Demand rebounded quickly, but supply chains did not, with pandemic-restricted bottlenecks created across manufacturing sectors.
Industries hardest hit were motor vehicles, coke and petroleum products, basic metals, and machinery and equipment.
As a result of the supply/demand imbalance, prices rose. Auto values increased 28.7% in 2021, unprecedented for what’s normally a depreciating asset class.
Annual auto depreciation ranged from 8.3% in 2011 to 22.3% in 2022. The forecasted depreciation in 2023 is 18%.
Meanwhile, median home prices increased 18% in 2021 and 30% from 2020 to 2022.
Inflation eclipsed the Federal Reserve’s 2% target in Q1 2021 and peaked at a whopping 9.1% in Q2 2022.
To keep inflation in check, the Fed began raising interest rates in Q2 2022. As of the time of this writing, the fed funds rate sits at 5.25%, with a pandemic-era low of 0.07%.
Rapidly increasing interest rates bring pressures across the financial spectrum. Let’s explore these pressures.
Increasing interest rates decrease the value of fixed rate assets and liabilities. This impact is called interest rate risk.
Credit unions have asset/liability management processes in place to keep interest rate risk in check, but most scenario analysis peaks at 300 or 400 basis points. Rates increasing more than 450 basis points led to the collapse of Silicon Valley Bank and Signature Bank, and put many financial institutions in a liquidity crunch
In this rising-rate environment, credit unions must consider options for maintaining strong liquidity by identifying members in need of deposit accounts and making competitive products available.
Rising interest rates generally cause businesses to decrease spending as the cost of funds increases. Members have already adjusted their spending habits for income growth during the pandemic, but inflation-adjusted median household income has fallen to pre-pandemic levels.
Not only are members seeing that their dollars don’t go as far as they did two years ago, many are experiencing payment shock as their variable-rate loans reprice, increasing default risk.
A breakdown of bankcard delinquency by vintage year highlights newer vintage year cards are becoming delinquent at a rate much faster than prior vintage years
Quantitatively, this is a result of financial institutions loosening underwriting standards moving away from the pandemic. Qualitatively, we expect there was likely lower predictive value in credit quality indicators used in underwriting as a result of the unusual circumstances of the pandemic.
Not only will charge-offs rise, expect fewer recoveries moving forward on vehicle repossessions. As noted earlier, vehicles appreciated 28.7% in 2021 and depreciated 22.9% in 2022. Black Book expects auto values to continue to depreciate faster than normal in 2023.
Home affordability is approaching all-time lows. In 2021, with mortgage rates at 3%, a median earner could afford to service a $413,000 home. That same earner can only afford to service a $306,000 loan with rates at 7%.
It’s hard to imagine a scenario where this doesn’t impact home prices. Today’s median home price is $377,406, up from $351,994 in 2021. During that time, the average 30-year fixed mortgage rate rose from 3% to 7%, creating a substantial decline in purchasing power.
With a high level of uncertainty in the economy, credit unions must understand their current loan portfolio and how it might react in the event of adverse economic scenarios. Some metropolitan areas are more volatile than others, and studies have found that economic downturns impact lower credit quality borrowers disproportionately.
Rapidly increasing interest rates make it more likely that members will opt to add-on or renovate their existing homes instead of purchasing new homes and losing their irreplaceable low interest rates.
Making competitive home equity products available positions credit unions to capture this changing demand.
And what goes up must come down. While increasing interest rates have dried up short-term demand for refinancing, credit unions should have a plan to capture the renewed demand as rates inevitably fall.
While it’s likely that members will see some struggles ahead, credit unions have historically been empathetic in times of need. Empathizing with members and proactively finding amicable solutions creates loyal members.
DAN PRICE is vice president of prescriptive analytics at Trellance.