Peer Analysis and Balance Sheet Strategies Update November 2023

Peer Analysis and Balance Sheet Strategies Update

Well, good morning, everyone, and thank you for joining us today for our latest webinar.

And, once again, there is nothing going on in the world for us to talk about.

So, you know, as we go through here, give me just one moment as we try to get the slides to cooperate.

Here we go. So, if you don’t know by now, I’m Andrew, this is Sean.

And what we’re going to do today is walk through a couple of different areas. We’re going to talk about what’s happening in the markets and economy. We’ll take a deep dive into some call report trends, and then we’ll wrap things up with some balance sheet strategies for consideration.

As I think about what are the most important things taking up everyone’s attention and bandwidth these days. Maybe It’s just me, but it’s higher interest rates and Taylor Swift account for about 95% of the conversations I have at home and at work.

So, you know, there are actually some similarities between, you know what’s happening there and, as you can see, the quoted lyrics there, “Who is the problem?”

You know, I think interest rates are turning out to be a problem and a challenge for many here.

So, if you’re reading the sub-header above, there are seven Taylor Swift references there. So, you know, I’m going to move on to the next slide. But when you get the PDF after, you can see if you can count all seven. I think I got six. I think I got six OK. I’m a little surprised that in our new space, we don’t have a Taylor Swift room.

Yeah, We’ve got a Block Island room.

Well, you know. Maybe You need like a Gillette stadium-size one? Yeah. You know? Because she only plays the arenas. You know, you’re right.

So, let’s jump right into things.

So here, we’re going to look at what’s happening in short-term liquidity markets.

And we’ve touched upon this in previous webinars where, “OK, well, as depository institutions, we don’t participate in the Fed’s reverse repo. So why should we care about it?” And it’s important because money market funds do.

And as we’ve seen, it has been a common theme, you know, that is continuing to be a growing source of competition for client deposits.

And what we see is that when we go back to the summer, and we had the debt ceiling situation, that the Treasury General Account, which is essentially the, where the proceeds from Treasury issuance goes, and then it’s like the checking account for the Treasury. Those balances were getting very, very low, as issuance was modest.

And the balances in the reverse repo program were exceptionally high. So those money market funds couldn’t buy all the Treasuries, even if they wanted to, and there was a reason why they may be necessary, at that time, did not want to.

So, but once we cleared the debt ceiling issue, and, you know, that moved past, we saw an explosion in Treasury Bill issuance, and accordingly the balance in the TGA was going up. And at the same time, we saw declines in the reverse repo.

And in fact, I think the other day it just declined below one trillion dollars.

And this is important for twofold. One is that money market balances are still growing. So there’s, you know, the competition is still there, but we’re also seeing is that because of the greater willingness to buy Treasurys, there’s some extension out of the curve. And that ties into the expected future path of short-term interest rates, about why money market funds would be willing to incrementally move out the yield curve.

So, certainly, where short-term rates will be in the short, medium, and long term, is a focus of really, everybody right now, depository or otherwise, and I think, you know, the Fed is in a very difficult place between a rock and a hard place.

Because they’ve been tightening economic conditions as evidenced by one of their two primary tools, being the elevation of the Fed Funds rate from zero to over 5% in less than two years.
But the other mechanism that the Fed has to enact monetary policy is through the expansion or contraction of the balance sheet, the purchased Treasuries and mortgage-backed securities.

So, here, you know, that the area chart is looking at what is happening with the balance sheet.

We can see the explosion from the covert response in 2020, how they aggressively enacted a mortgage-backed security buying program.

And as they began to taper and contemplate the ability, the timing of, when they were going to start to raise short-term rates, they’ve allowed the purchases to slow and the balances to run off. But you can see that it really hasn’t made much of a dent. And for a reason that many of us are familiar with is that there’s not much prepay activity happening in those low-coupon mortgages that are in these pools.

So, you have this dilemma of should the Fed pause or start to lower interest rates. But, when you look at the size of the MBS holdings, that is still in a pretty accommodative position.

So, I think the Fed is probably inclined to let time in the calendar do some bidding. So, you know, that that is support for a potential pause.

When they get to interest rates, right? Not necessarily continued hikes to infinity but, or a cut immediately, but give some time and allow that runoff to occur before they get into a cutting cycle because then you have competing things, right?
You have a high level of bonds on the Fed’s balance sheet. But you also have an easing stance if and when they move towards short-term interest rate cuts.

So, it’s been an interest rate risk and liquidity risk story over the last year and a half.

But, again, you know, similar to why we want to pay attention to what’s happening in short-term liquidity markets, from the money market side of things, corporate credit can be useful for us to track and monitor, as well, even if corporate bonds don’t make their way onto your balance sheet.

Because they can be an early warning sign for any large-scale scale stress that may be occurring in the capital markets.

And what we saw through the first phase of the hiking cycle in 2022, was that credit did not perform particularly well. And we’re looking at here is interest rate hedged corporate bond performance. So, it takes out the component of what’s happening with interest rates.

And so we saw declines of 6-7% for both investment grade and high-yield corporate bonds.

But that has changed over the last year plus, where we have seen credit interest rates, hedged credit, be a strong performer.

And, you know, really, when you look at the whole landscape of markets, that’s probably been the only thing that is, that has been in the black. Right? We know interest rates have continued to rise, and they stress our bond portfolios and tangible capital ratios.

So, at least in regards to corporate credit, not just the best of the best investment grade, but even high yield, which does tend to cut and run for the exits at the sign, at first signs of economic weakness. Things are looking pretty good there.

So, you know, staying on the topic of asset spreads, and this is something a little closer to home, is that mortgage spreads continue to be at historically wide levels at the same time that nominal interest rates are at high levels.

So here we’re just looking at where mortgage rates have been, as well as where the spread versus 10-year Treasurys have been. And we’re looking at it going back to 2017, and we’re bucketing it. And you may not be able to see it, but in the top right-hand corner.

And it’s come down in the last couple of weeks, both in terms of the rate and the spread, but we’re at very high nominal levels.

Now, the practical challenge is the volume isn’t there, you know, on the origination side, or the liquidity and capital conditions may be on the investment side to take full advantage of that. And that’s going to be a common theme as we go through the rest of the webinar today.

So looking at what the yield curve is telling us, you know, oftentimes in the financial press, you’ll see the slope of the yield curve, talking about the twos versus tens and, I think, from a depository perspective.

You know, there are other parts of the yield curve, maybe that can tell us a little bit more and be a little more useful. So here or here are three versions of that that we’d like to look at, one being, SOFR, the overnight rate, versus the five-year Treasury. So that gives us a good proxy for “Can I borrow short, and can I lend long?” Right? And then the three-month and the one-year gives you a short-term perspective on where the overnight rate may be going. And the one-year, three-year gives you more of a medium-term look as to what is happening there.

And what we’ve seen is that over the last few months, we’ve seen an inversion or a re-steepening of the yield curve here where things aren’t as deeply as inverted as they were.

And the prospect of higher-for-longer has been seeping into markets and, you know, the, the bond market has been on a ripping rally yesterday, excepted for the last couple of weeks. So, nominal level rates are down, but really, when we look at the spreads, the spreads haven’t changed too terribly much, such that the different parts of the yield curve have more or less moved in tandem, but we still are in inverted yield curve territory.

And, you know, shifting from the capital markets side of things, you know, looking to, you know, to assess the health of our customer base.

Because that’s going to be a big driver for, you know, the core components, loans, and deposits that make their way onto our balance sheet.

So here is a multi-decade look at the personal savings rate.

And after that, we saw an extraordinary spike that we saw in 2020, where there was nowhere to spend your money, so, yeah, you had nothing to do, but save it.

We’ve seen a normalization of the personal savings rate, and really kind of plateaued it at very low rates.

And the thing that I’ll emphasize here is that the previous low was at 2.1% at about mid-2005.

Now, you know, this is a good example of one of those indicators that just because it gets to a certain level doesn’t mean that the world is going to end tomorrow.

If we remember back to 2005, that really that, that, the cracks in the markets, whether we’re talking about equities, fixed income, that lending portfolios from a credit perspective, really start to happen until about two years later. Right?

So, sometimes, being early on something it can be the same as being wrong. So, you know, as we see this, this is lower levels of the savings rate, which obviously, in fact, affects the ability for deposits to come in the door that we may see some lingering at the soft levels for a period of time.

So, we’re going to switch to the call report analysis here, and, you know, we’re going to take a look at what’s happening in earnings, and, you know, we have some, some new ways of, looking at, things, I think, you know, something that we all can appreciate.

We’re going to look at some of the deposit outperformers relative outperformers, and Sean’s going to show us what the special sauce has been and how they’ve been able to do it. And I say the word relative because, you know, that is key. Because, you know, there certainly are some challenges when we look at margin and growth.

Over the last few quarters.

Thanks, Andrew. So, you know, I want to do something a little bit different. I wanted to take a look and say, you know what we saw in 2022.

We saw three quarters in a row there of expanding NIM for our depositories.

Pretty significant expansion. And then, in 2023, we’ve seen just the opposite.

We’ve seen a number of different declines quarter after quarter. And we’ll show some of those numbers in a second.

But what I wanted to try to examine was what’s driven outperformance. How have some folks been able to perform better?

There has been sort of a negative convexity, I guess we could say, of NIM over this past year.

Where a year ago. I just looked at these numbers in Q3 of 2022 actually, we had no depository members that had a NIM below 2%.

And in this quarter, we had 27 different depositories who had a NIM below 2%.

And we’ve generally seen a shift down.

Most banks, at this point, are actually lower on their NIM then they were a year ago, credit unions are kind of holding serve more or less.

So what’s really driven that change? You know, our, our lowest NIMs right now are just above 1%.
The median has been shifting down.

What’s been the factors that have really affected NIM performance for folks?
And so I tried to take a look at analysis by saying, “Let’s regress NIM against a couple of different discrete variables.”

So the three that I really wanted to take a look at were, the frequency of asset re-pricing — is the fact that you are more asset-sensitive, allowing you to have that better NIM?

Is it managing the cost of funds?

Is that the fact that you’re a lot tighter on managing those deposit costs that’s affecting the NIM?

Or is it using derivatives, you know, derivatives increasingly part of a big part of depository management in the industry?

Which one of these factors is actually resulting in the best performance for NIM, and we get it across 183 different member banks that we have.

And so here’s a chart to try to take a look at this. And so, if we think about it, let me go back to sort of maybe a college stats class we had a long time ago.

Correlation ranges from to positive one.

And positive 1, 1.0 would be perfect correlation. Completely correlated and -1 would be completely inversely correlated.

And then R-squared is just the square of that correlation, and it identifies the amount, the percentage of which the variance in one variable can be explained by the other.

So with that sort of pointy-headed statistical, quick explanation behind us, let’s take a look which one of these actually affected things. Well, what’s really interesting is derivatives didn’t actually affect it at all. They weren’t correlated hardly at all.

In fact, very slightly inversely correlated, really not statistically significant in any way.

So, derivative use was no solution in and of itself for managing them over this timeframe. Asset pricing has some correlation to it. About 25% of the variance in NIM can be explained from asset pricing.

But the big winner here is the cost of funds.

It’s managing deposit costs and costs of funds. And that was about 40% of the variance, and then it was from that one single variable.

So, it’s very interesting to kind of see which one of these things has actually resulted in the best NIM outperformance. It’s managing the cost of funds and deposit costs.

That was a really striking way to outperform peers.

OK, so if managing deposit costs and cost of funds was the most important variable, what drove that?

So, how did you outperform on deposit costs?

And again, I take a look at the same type of analysis to say, “Let’s regress one variable against the other to try to figure out what’s the single biggest driver of deposit cost?” Is it asset size?

Maybe bigger, bigger banks have the ability to command better pricing.

Is it deposit volumes themselves?

So if you’re outperforming on deposit volumes, that’s allowing you to lag on deposits or just the reverse. Is it, again, asset repricing?

So, if you’re, this is sort of a way to get to NII management.

I do think a lot of folks try to back into different levels on NII – manage an NII budget for themselves, and then think about pricing deposits within that scheme about where they’re trying to manage their ultimate profitability. Or is it lending choices?

Is it how much of a liquidity demand is being conditioned by the lending choices that you’re making on the balance sheet?

Which one of these is actually affecting your deposit cost performance the most?

We did it against 181, and a couple of banks fell out here just because there were in business combinations, or they had had some noise that kind of muddied the waters that wasn’t…that was kind of muddying this analysis.

And so, again, sort of like derivatives, we found out size didn’t really matter.

In this particular analysis — size, whether you’re a bigger or smaller, didn’t really seem to affect what the cost of deposits was.

Asset repricing, and the actual amount of change in deposits themselves have a little bit, have a little bit of correlation, a little bit of explanatory power towards figuring out the overall costs of deposits – that is to say, probably something here around expense management and managing an NII budget is actually affecting deposit changes.

But the jackpot in trying to figure out what drives deposit costs is ultimately loans-to-deposits.

And loans-to-deposits, in and of itself, was, you know, R-squared here, 0.2467, 25%, basically, of the variance in overall deposit costs for your institution versus another institution, can be explained by loans-to-deposits.

And if we make that a little bit more granular by saying…excuse me…let’s exclude brokered and listing deposits from that overall deposit numbers, so it’s just loans and client deposits, that R-squared goes up to almost 50%, which is really a really big result.

And I think it is a really interesting finding.

Loans to client deposits was the single best variable to try to figure out the cost of deposits, which in and of itself is the single biggest variable in figuring out NIM performance relative to peers over the cycle.

So the more loaned up, the more commercial heavy, the higher the cost of deposits tends to be versus other factors.

OK, so now let’s take a look at, sort of, what were the most striking underperformers and overperformers on costs of deposits. What has their experience been with volume?
Because it’s one thing to say, “Hey, we’re managing NIM” but it’s another thing to say, “Well, there’s a volume cost” Andrew alluded to that along the way to say, you know, something like mortgages and bonds in this environment right now.

Very high levels, very high spreads, but nobody has liquidity to buy them, which is sort of the necessary irony I think of a lot of financial markets and of depository management.

When you have the money, the spreads are tight, and when you don’t have it, the spreads are wide, and the opportunities are all over the place.

So what happens here if we have, in this case, take a look at the 20 lowest deposit payers.

The lowest paying banks in our membership. And what you see here is that all the dots represent where they are relative to the growth they’ve experienced since the cycle started back in the spring of 2022.

And of these nineteen out of twenty, have had negative growth – only one had kind of had, sort of that old-fashioned seven, seven-ish percentage point annualized growth.

And the vast majority of actually underperformed the industry in general.

So, keeping a very tight lid on deposit costs has actually been correlated with lower volumes over time.

And so I think that’s sort of the bargain that those folks are making.

Now let’s take a look at the highest paying.

What has happened with the highest-paying depositors?

And again, let’s take a look at the 20 highest. What is their deposit growth experience?

Well, it is positively correlated with growth.

So, paying more in deposits has actually had some higher growth, but it is no sure thing.

That’s really the big thing to find here is that of these 20, nine actually still had deposit outflows, 11 had growth.

And you can see that there’s a wide range of outcomes here.

Some had very, very big growth, and clearly paying up on deposits resulted in big volume for them, but a lot were on the opposite side.

And so, I think what we see here is that we’ve kind of put these two slides together here — keeping a really tight lid on deposit costs is almost a surefire way to actually have lower volumes.

But paying up is not necessarily a solution actually resulting in higher volumes along the way, too.

So, keeping costs low is a sure way to kind of underperform on volume.

Pricing in and of itself is not necessarily the best path toward growth. And something else to kind of think about here is the degree to which pricing and volume are affecting one another.

It’s not just pricing affecting volume; it might be volume affecting pricing.

That is to say, I do think a lot of folks have seen outflows and then price up to try to recover them.

And I suspect when you look at these, these higher paying places, some of them are doing and re-capturing that. And some of them aren’t.

They’re losing those volumes, then try to price up and they’re not coming back. They’re still losing those folks.

So again, paying help isn’t necessarily a path toward growth.

All right, let’s take a look at, sorry about that whole, the whole spread of dispersion around NIM for our entire membership base. So on the left-hand side, we have banks on the right-hand side credit unions. And these are on the same scale.

And each one of these bars represents how many institutions were within a 10-basis point range on NIM.

What you can see on the bank side, relative to the credit union side, is that there’s a really high central tendency. That is to say, banks were much tighter this quarter than we’ve seen in a while. The overall performance on NIM across the membership was really moderated.

We use this — we’ve seen a very, very wide dispersion over the past year.

I talked about the fact that we didn’t have anybody with an NIM below 2%, now, we have something like 15% of members are actually below 2%.

And so that dispersion this quarter started to come back together for banks in a very significant way.

75% of banks still had declining NIM. The median was -7 basis points, the average was about -4 basis points. But you see that the vast majority of folks are in that sort of tight, you know, mid-single digit sort of NIM decline and contraction.

Credit unions are a little bit of a different story. Again, still outperformed banks. It’s been a consistent theme over the course of this whole cycle, so far is that credit unions on NIM have outperformed banks. Median was -3 and what you see here is a much flatter distribution than we see with banks. So, what is that showing you?

The experience across credit unions is starting to branch out in the way we say banks branch out earlier this year, It’s starting to come into credit unions.

And again, it’s about 50/50 more declines in credit unions than increases, but it’s a lot, it’s a lot more spread out than banks.

What drove it?

So banks, again, on the left, credit unions on the right.

And so what drove it is we see it’s overwhelmingly liability rate offsetting the asset pricing, but it’s not as big a change as we’ve seen in the last couple of quarters.
So, in this quarter, banks, on average, are down four basis points different from the median, and again, it depends on size and overall levels.

But liability pricing is up 20 basis points for banks this quarter versus the asset pricing, about 16. Credit unions — this is the first quarter where we saw liability prices increase more for credit unions than banks and I think the way to kind of interpret this is credit unions are starting to catch up.

They’re starting to pay out more.

Banks have already taken a lot of the pain, so to speak, and credit unions are starting to do more of that pricing up to try to catch up in this cycle.

Overall, on average, credit unions were only down about one basis point, and we’re seeing that spread now start that we saw in banks earlier this year, start to come to credit unions where, more and more, institutions are starting to separate themselves as being under or outperformers over time.

So, when we think about the changing liquidity conditions that we’ve seen for a lot of balance sheets over the last year+, going from the most liquid we’ve ever been to being at very narrow levels, it hasn’t just been a deposit story.

The growth in loans in the latter half of 2022 was exceptional.

So, on the bottom table, you can see the mid-double-digit growth that credit unions and banks experienced during that time.

So that was right as deposit growth was plateauing. And in many cases, turning negative for folks.

And we actually settled back into a mid-single-digit range right now in terms of median loan growth.

But when we look at the parts up top — the very noisy and colorful charts here — we’re now at a more balanced exposure when we bucket what the growth looks like, so in terms of the negative loan growth, zero to 5%, these are all annualized numbers by the way, five to 10% or greater than 10%.

So when we look at, you know, the ranges between those four categories, of 16 to 33% on banks, and even at narrower range credit unions, between 21 and 31%, that’s kind of what you would expect to see, right?

Some folks have a lending franchise that is their flagship, right? That they’re fantastic in bringing in loans, in certain types, or are really, across the board and, and the structure to do so. Others have done a little bit better on the deposit side.

So, know, this is the big thing right now: the conditions as, as we’ve outlined, and we’ll get into even further for positive growth, are still going to be challenging.

But, really, in terms of the liquidity, if loan growth is still humming along at mid-single digit levels while deposits are either very tough or very expensive or both to come by.

Then that’s further going to put pressure because most community institutions, if they have loans to make and they want to make them, and you know, the $64,000 question is, is there going to be a turn in credit? Right, and that is the, you know we’re math guys, so credit is the least math-y thing that we do right? Interest rate risk is the most math-y?

That’s going to be fun for the automatic transcription there to see how they take “math-y.” But so, you know, as we look at that, you know, thinking about it, we’ve been through multiple cycles here, right?

We went from double-digit loan growth for many at the same time as the cycles were normal and then normalized loan growth where deposit growth was negative. Now, what if we get into a situation where loan growth is slightly negative and deposit growth is even slightly more negative? Right?

So, it’s, it’s, it’s different skillsets in different parts of the playbook that we have to tap into when we’re when we’re actively growing and have the capital to do so, or if we’re retrenching a little bit, either by choice or because of client and customer demand.
So, you know, when we think about asset repricing, Sean mentioned that as one of the variables that we looked at in terms of driving NIM pressure, and we’ll have some things in the following charts here.

Is that slowly but surely, asset yields are going higher, but they’re not obviously going to move up at the same pace that market yields are moving, and it has to be frustrating, right?

Because we see these mortgage rates in the 7% and we see investment yields in comfortably in the 6s with very, very wide spreads, and you have the flexibility to move at any part of the curve with the amount of prepay protection that you want.
a
But you’re kind of handcuffed, and you’re not in this position of being able to say, “Hey, we would love to start putting on more six and 7% assets versus the legacy 2 and 3 and 4%.

And gradually pull the portfolio’s yield up.”
But it can be tricky.
So, you know, here we’re comparing what happened quarter over quarter, 9/30 versus 6/30, as well as 9/30/23 versus March of 2022 – so call that the start of the rising rate cycle.

And as you might expect, the move in portfolio yields has paled in comparison to what has happened for those market rates.

So that the payoff and the lack of prepayments has certainly been the driver there.

Interesting. And this aligns with the NIM decomposition that Sean had gone through when you look at the change in yields for loans for credit unions versus the more granular look that we have on the bank side, that the asset repricing has been a little bit better for credit unions.

And, I think, you know, the big contributor there is probably the auto loans, which tend to be short, shorter, and have more principal coming back on a regular basis versus whether it’s CRE or even residential loans.

The thing that the other thing to call out here is the investment yield change cycle to date for credit unions has been rather exceptional, almost 200 basis points, but there’s a caveat there. Is that a credit union investment yields were so low going into the cycle and so cash heavy, and so front-loaded to the front end of the curve that they’re still not. They’ve only reached, you know, 275, approximately, so it’s, you know, think about it for your own experience if you were sitting on high levels of cash or short-term investments.

In the spring of or summer of 2022, you were having a great time because you are taking those investments that were at zero and 1% handles, and without doing much, you were able to get to 2, 3, 4%.

So, there is that gradual repricing effect.

Again, as it says up top, slowly but surely.
So, back to deposit costs for a second.

So, this is where a lot of challenges lie right now in terms of both the path of rates but also the cost.

And I think one of the things that has to be on our radar is the potential for, even if we do see some, some flatlining, or even a downtick in, in short-term rates, I think there’s still going to be pressure for, for short-term interest rates to rise.

So, really, what we’re focusing on here is, on the left-hand side, look at all that blank space between the three-month T bill yield and the rates that are being paid on credit union shares and deposits.

That was another Taylor Swift reference for anybody paying attention there. When I said blank space, I’ll pause there and just see if anybody caught that.

So, you know, if we used a three-month T bill yield as a proxy for deposit for the incremental deposit cost.

And, again, everybody is well aware of this, that they’re competing against treasuries among the money market complex. And the institution next door who has the loan demand on fire and is willing to pay up for that 5.5% CD.
So when you look at where you are, your yields are, so the 75th percentile of high-paying credit unions right now is at 150.

We move over to the right-hand side and look at the bank deposit cost.

Certainly, as you might expect, the time deposits are the most costly right now.

But even the bank in the 75th percentile is not even paying 4% on the deposit rate.

And, you know, one of the great things that we have, and I’ve mentioned this before, is we do a lot on that, the analytics and the call reports.

But our positioning and combining that with the qualitative side and the conversations we have with all of you is that nobody’s having a great time or having a great experience on the deposit promotions that the ones who are paying high rates, they admit that cannibalization is really eating into a lot, that there’s migration from the non-low-cost non, non-maturity deposits.

And the folks who are trying to be a little bit more disciplined on the time deposit cost are still in that you say, they are out there with 4% CDs, they’re just not bringing in the money there. So, I think there’s probably more room to run in all of those categories. Irrespective of where rates go in the very, very near term.

So, I said that word deposit migration, and here’s a couple of things.

So the top chart is good news. The bottom chart is not as good news.

So, on top, we’re looking at the best deposits we have.

So for banks, the non-interest bearing, and for credit unions, share drafts.

And there’s been a lot of talk about, oh, we got all those surge deposits in during COVID, and now, they’re coming, and now, they’re going away.

Well, what we see is that the level of noninterest-bearing and share drafts hasn’t gone past where they were in March of 2020.

So here is a little bit of a glass-half-full glimmer of hope that really, that, that, the bedrock of your liability side, of your balance sheet, these low-cost sticky deposits, have been sticking around a little bit more.

Looking towards the bottom, Here’s where the challenges lie.

So, we’re looking at the percentage of members who increased in these particular buckets, and the color portrait is a little different. So banks segregate inside of three months and credit unions inside of one year.

We’ve seen a big jump for who has the most exposure for the shorter CDs. Now, I don’t think there are many banks out there doing two and three months. CDs, we tend to see more. 5, 7, 9-month type offerings, but what happens is if you did a nine-month CD seven months ago, or now it’s naturally rolling into that category.

And you have this dynamic where maybe, you know, you put that CD on it, three or 4%. It’s coming due again, and what’s going to happen. That’s rate-sensitive money. That you’re going to have to price closer to the incremental rate, which is 5, 5.5%.

So, that shortening of the time deposit portfolio. It’s creating pressure on them.

Turning over to non-interest expense, we’ve talked a lot about margin and what’s going on with ALM, but non-interest expense. You know, as we think about margin pressure is coming in for a lot of people, where to where do we really start to see the pain?

This is, you know, a look at all of our member banks and what their non-interest expense as a percentage of assets is.

And it’s a little bit different than the kind of traditional efficiency ratio a lot of people are used to looking at that efficiency ratio, but with the dispersion you see in NIM now, I think it provides less information than it used to historically.

And so, if we just kind of isolate it as non-interest expense as a percentage of assets, I think we have a clearer baseline for folks. What you see is we create a classic S curve. And we just plot every bank that we have.

We have folks below one, and we have folks well above three, but the median is 2.54%. So, 2.54% is kind of a big level for a lot of folks where if they ever get to that point or below, it would really start to cause a lot of pressure.

And if we look at credit unions structurally higher, structurally higher – going from 2.54% to 3.03%.
And if you saw the shift in the curve as we went from slide to slide there, the overall book is a lot higher for credit unions and structurally a higher cost of business.

You know, it’s interesting, and I kind of elided over this on the banks, but on the credit union side, we see it here.

Size, again, is not correlated really ultimately to what that non-interest expense is. You might reasonably say, “Hey, big banks have economies of scale.

Bigger credit unions have some economies of scale. Maybe there’s an opportunity there.”

Well, if we just bloodlessly, you know, regress the two variables against each other, we find out there isn’t.

And, in fact, that credit unions, there’s a very slight inverse correlation that the bigger credit unions actually have more expense.

So, expense management, here, or something else, is probably going to come into focus for a lot of people.

So, let’s shift to some strategic things, and I tease this a little bit. So when we go look at this next chart here, you know, we did an exercise to say, OK, you know, look at the next 12 months.

So this is similar to what everyone is doing with their net interest income projections, and we looked at an institution by institution level and the composition of the balance sheets and said, “If higher for longer is the pain point for NIM and earnings, you know, how can we quantify that?”

So, the dashed lines are the potential asset repricing.

So we’re assuming some levels of runoff on the various portfolios and replacements at market yields — the same thing on the deposit side.

Then what we see is that everybody is more liability sensitive, at least in the near term here, where the deposit repricing pressure is coming, uh, and, you know, to the point where the median is 82 basis points for banks and 121 for credit unions. And the asset repricing potential is a fraction of that.

And, you know, this is, as Sean alluded to before, that credit unions have thus far done better than banks in managing deposit costs and overall NIM. But we see this with the conversations we have the folks who have done a little bit better — they’re not taking a victory lap or patting themselves on the back.

They know that their time is coming, that the challenges are, you know, going to be that much more challenging.

So, you know, here’s a strategy that, you know, we think has an awful lot of value to us, you know, really specific to credit unions because managing the NEV supervisory test it certainly something that is in focus.

And then, for the banks that are not familiar, this is similar to the economic value of equity calculation.

And so, you know, I won’t go into the whole detail because I know what it makes us a little frustrated in terms of the standardized premiums on the non-maturity deposits in the rate shock scenarios. But, you know, one of our advanced solutions that is tailor made for this type of scenario is our member option.

So, you know, in this example, a 10-year, one-year, one-time member option allows you to get the liability duration benefits of the 10-year, which is going to be very NEV test friendly.

But by incorporating that option that you own and you have the ability to prepay that advance at the one-year mark, that you don’t have to carry that for the full duration of 10 years, right? You know, you’re getting through this first year, getting that interest rate protection of the 10 year because you own the option, and then paying it off. Maybe you have some asset repayments.

Maybe you have an expectation that deposit growth is going to be a little bit better as we roll forward the calendar then, and so on.

And you can see on the bottom table here, we just did a little analysis of the difference in the post-shock capital ratio, as compared to those standardized premiums of 96 for the non-maturity deposits, and what that does to the capital ratios.

We can see that you’re talking 16 basis points if you were to do 1% of assets and 48 basis points at a 5% asset level.

And compare that to even the five-year classic, where we have seen a lot of long-term borrowings. You know, the NEV benefits are considerably more, using this product without the obligations for years two through five, right?

So, you still retain that flexibility, and then it blows away the one-month classic.

And even the one-year classic, which actually is, is worse for the NEV calculation.

So margin relief that’s been, that’s been a common theme. We’ve talked about this before. The HLB-Option Advance is a very popular advance, continues to be, so for the ability to get some interest rate savings.

And, you know, there’s a couple of use cases here on the right-hand side, whether it’s remaining disciplined on the marginal cost of funds, funding those assets that have less prepayment risk.

If you are in the position where you can take advantage of investment spreads.

But I will point out that, you know, the last one there, the soft-landing scenarios, right? You know, the last two times rates have gone down, they’ve gone down to zero.

That’s not always the case. You know, so I’m sure, as you’re looking at the various scenarios, that if we do go down, off of where we are right now, and settling down three to 4% range, that your balance sheet is going to perform differently. And if they go back down to zero very suddenly, like they did in 2020 or 20, 2008, excuse me. So, you know, we won’t go into all the details here, but the ability for the cost savings in that three to 4% coupon range.

If we do settle into a marginal rate of 4%, then these would be some of the outperformers, but you will see here the Classic Advance curve, you know, still is inverted. And that is going to segue into some ideas that Sean has. Yeah, so, I mean, one thing to think about, as we think about different funding strategies and asset liability management, overall, is always sort of operating both against risk limits that exist at your institution.

But you’re also operating against the forward curve at any given point in time, Which is just showing you what the market’s implied path of rates is over time.

So here’s just a quick look at, derived from our own advance curve over the next couple of years, what’s the implied path of short-term rates?

Basically, what this is saying is, what is going to be the one month rate, month by month, along the way?

And what you see is, you know, today, a lot of folks know that our short-term rates are about 5.55% or so.

And what the forward curve is implying, we’re probably gonna stay there until next spring.

And then you start to see the possibility of cuts coming in sort of in the summer and Q3 of 2024 and continuing slowly, gradually, into 2025.

And a way, maybe, to think about this is not necessarily that there’s going to be cuts every time along the way, but the odds of the cuts are increasing all along the way.

And so you start to bottom out around 4%.

And if you go extend this out, it really implies that rates are never going to get meaningfully below 4% ever again over the horizon.

And so that bloodless expectation of the market should really factor into the thinking, as we think about the overall cost of different strategies.

So Andrew talked about, you know, some of the option products we have.

I want to take a look at some of the just sort of old-fashioned bread and butter, bullet type products.

And thinking about how does rolling short-term advances versus laddering out a little bit longer terms perform under different environments?

And what’s the overall sort of difference in the rate that you end up paying? So, how can we manage expenses by thinking about risk relative to what the market’s expectations are?

All right, so if rates are static, and we have the rolling short-term advance strategy, sort of on the top above the fold, so to speak, and then the laddering long-term strategy below.

If rates are static, which strategy ends up winning?

We see at the bottom here that the long-term ladder strategy actually wins, and by the tune of 52 basis points pretty significant, and why? Because the curve is baking in the idea that there’s already going to be cuts. If those cuts don’t materialize what Andrew was talking about, what if we have a higher for longer environment?

Then, the long strategy will win because the long strategy was taking into account the expectation of those cuts that never materialize. Ok, what if we take a look at the forward curve in the middle?

Which one will win? Well, the long strategy wins again in Year 1, in 2024.

Why? Because it’s baking in that curve change. And so it’s continuing to bake that in past 2024.

At which time the short flips over, it starts to wane in the second year.

Basically, that long term was already baking in the things that were going to happen in the second year, and so it takes a full year and a half in order for the roll short to outperform the long.

So, going long, you can see in both these strategies, actually outperformed over the next year entirely because the curve is already starting to anticipate potential cuts. Ok, what if there are deeper cuts?

What if we have a situation — you know UBS was out a couple of days ago saying that Fed Funds is going to be cut 275 bps starting next fall – ok, what if something like that materializes?

What if we end up in a situation where cuts are a lot more significant than going to just 4%? What if they go to 3%, is what I assume in this.

Instead of going to 4%, we go to 3% by the end of 2025.

Which strategy wins? Well, you can see.

Even with that scenario, the long actually still outperforms by two basis points — basically breaks even in the first year.

But in 2025 the rolling short really starts to shine.

And so, it’s something to think about if you’re constrained by things like NEV or having really difficult IRR simulations in the longer term, the bullet strategy in Year 1 wins on sheer expenses, irrespective of the fact that it’s helping the risk tolerances.

On the other hand, if you’re more convinced that there is a chance of deeper cuts coming in the, you know, intermediate sort of horizon, then the rolling short strategy actually could end up being outperforming once you get past that 2024 horizon.

And one last point that we, I always try to highlight is the, is don’t forget the value of the dividend.

As rates have risen, the relative value of our dividend compared to advance prices continues to increase. Our dividend, I think a lot of folks saw, was, I believe, 8 31% in Q3.

It’s based on whatever the average SOFR rate plus 300 basis points is — or has been in recent quarters.

That’s not necessarily the case, but it has been what’s been going on, and so if you do the math on, what does that dividend worth relative to the advance rates you’re paying?

It’s gone all the way from 8 to 25.5 these days.

So, as you think about that advance pricing and those short-term advances at 5.55%, it’s really like 5 30% when you start factoring in the value of the dividend as well.

And that’s, that’s something that I don’t think necessarily is at the top of mind for everybody, but it’s increasingly valuable.

So before we wrap things up, there was one question in the queue that I wanted to address, asking about some of the deposit analytics in relation to any mergers that have occurred.

So, you know, in some of this analysis, we take the approach where it’s looking at existing members today.

So if someone was merged out two quarters ago, and we’re looking at, you know, over the last six or eight quarters, then that wouldn’t necessarily flow up into the, into the calculations. Yeah. And I’ll just quickly add, there’s one or two names in there that the reason they were excluded is because they basically doubled in size, because they were part of a merger, and I just said, we’re going to take that out of the analysis and not muddy the water.

So, all right, well, that, that brings us to the end. Again, hopefully, everyone appreciated, you know, our walk through what’s happening in the industry, and, you know, as always, if there are any questions or anything that we can be supportive for you with, please reach out and we’re happy to do what we can.

Thank you, everyone, and have a great rest of your day.