The financial health of credit unions depends on the financial health of their members. And the financial health of credit union members depends in large part on how the overall economy and individual local economies are faring. Through the middle of 2017, the overall economy performed well, though there have been a variety of serious localized challenges.
The U.S. economy continued to strengthen over the summer. The manufacturing and energy sectors are bouncing back after a two-year spell of weakness in 2015–2016, and conditions in the agricultural sector are brightening, with net farm income expected to rise this year for the first time since 2013. The national job market is in its best shape in years— the unemployment rate fell to a 17-year low of 4.1 percent in October and the number of job openings is near a record high. Household income is rising and household wealth is at an all-time high, even after adjusting for inflation, thanks to gains in the stock market and increases in house prices. Low interest rates are helping consumers keep their debt payments near a historically low level as a share of income, even as they continue to borrow.
Amidst these signs of economic strength, it is no surprise that consumers are more confident now than at nearly any other time in over a decade. Nor is it a surprise that overall credit union financial performance indicators remain solid. Through the end of the second quarter, credit union loan growth was strong, delinquency rates remained low, system-wide net worth ratios were in double-digit territory, and membership was steadily increasing.
Recent Hurricanes Will Have an Effect on Local Growth
However, some areas of the country and some industries have faced serious challenges. Earlier this fall, severe hurricanes dealt a blow to communities along the Gulf Coast of Texas and in Florida, Puerto Rico, and the U.S. Virgin Islands. Estimates from Moody’s Analytics suggest that in Texas and Florida alone, damages to homes, vehicles, businesses and public infrastructure could reach $200 billion. Economic disruptions may have cost the local economies another $20 to $30 billion in lost business.
The credit union footprint in these communities varies widely. According to second quarter 2017 Call Report data, in Texas, there were 158 federally insured credit unions headquartered in the counties hit hardest by Hurricane Harvey. These credit unions have 2.2 million members (accounting for 25 percent of the area’s total population), $26.6 billion in assets, $5.5 billion in real estate loans, and $8.8 billion in auto loans. In Florida, there are 102 credit unions in the areas hit hardest by Hurricane Irma. These credit unions have 4.8 million members (25 percent of the area’s population), $53.1 billion in assets, $14.9 billion in real estate loans outstanding, and $16.0 billion in auto loans. As of late summer, there were eight federally insured credit unions in Puerto Rico. Second-quarter Call Report data show that these credit unions serve 84,000 members (2.5 percent of the island’s population) with $761.7 million in assets. There are five federally insured credit unions in the U.S. Virgin Islands, with 16,000 members (15 percent of the population) and $105 million in assets.
It will take time for these communities to repair and rebuild. How long it takes will depend in part on the underlying strength of the local economy. Economic conditions around Houston and in Florida were relatively strong before the hurricanes hit, and the local economies were expanding. However, in Puerto Rico, the economy was struggling before Hurricanes Irma and Maria devastated the island, with the territory posting unemployment rates around 11 percent. To make matters worse, storm-related damage in Puerto Rico has been much more severe than in the southern U.S. As of this writing, 60 percent of Puerto Rico was still without power 50 days after Maria made landfall, and roughly, one-quarter of the island’s residents had no access to clean water.
Credit unions in all of the hurricane-affected areas will likely face a range of challenges. Members’ incomes will be disrupted, which will make it hard for members to repay mortgages and auto loans on time. At least temporarily, effects could include higher rates of delinquency and default on those loans, as well as a drawdown in deposit and share balances.
The effects of the hurricanes are showing up in a wide range of national economic indicators from the job market statistics to consumer prices. During the first eight months of the year, nonfarm businesses added an average of 176,000 jobs per month. However, in September, payroll growth slowed to just 18,000 as Hurricanes Harvey and Irma shuttered businesses along the Texas coast and in Florida. Job growth picked up sharply in October, as workers temporarily sidelined by the storms returned to their jobs, businesses resumed hiring, and additional jobs were created to help with recovery efforts. Altogether, nonfarm payrolls rose by 261,000 that month.
While the disruptions caused by these storms may continue to influence national economic statistics well into the fall, they are not expected to have a large, lasting impact on the U.S. economy. Strong labor market conditions, rising income, and low interest rates supported a healthy pace of consumer spending and borrowing before the hurricanes hit the U.S. These factors are expected to do so going forward.
Auto and Housing Markets Expected to Remain Strong
The biggest ticket items for most households are autos and housing—spending on these items are particularly important to credit unions. Vehicle sales have been strong for the past few years, running well above pre-recession levels. In 2016, sales of new cars and light trucks (including pickups, SUVs, and minivans) reached a record high of 17.5 million units. New vehicle sales have slowed since then, averaging 16.7 million units annualized in the three months before Hurricane Harvey made landfall in Texas.
Analysts estimate that Harvey damaged or destroyed between 300,000 and 500,000 vehicles in the greater Houston area in late August. Hurricane Irma, which hit Florida in early September, damaged or destroyed an additional 200,000 cars and trucks. Sales to replace vehicles helped fuel a surge in auto buying in September and October, lifting new vehicle sales to an average annual pace of 18.3 million units over the two months. Analysts predict annual sales will be 16.9 million vehicles this year, and sales are expected to slow only slightly in 2018 to 16.8 million units, the pre-recession average.
The high level of vehicle sales and strength of the underlying economy have been good for credit union auto loan demand. Credit union auto lending rose 13.6 percent over the year ending in the second quarter, and the delinquency rate was little changed over the year at 59 basis points. According to data from Experian, the credit union system’s market share in the auto lending space is growing. In the second quarter, credit union auto loan balances accounted for 27 percent of all open auto loan balances, up from 24 percent just two years ago.
The upbeat outlook for vehicle sales and the economy more generally suggests demand for auto loans at credit unions will remain healthy, and credit risk will remain relatively low. Moreover, some risks for auto lenders that emerged earlier in the year have started to fade. Concerns about falling used-vehicle prices, which affect the value of the underlying collateral for car loans, have recently eased as prices have started to stabilize. Used-vehicle prices are expected to get an additional—albeit temporary—boost from hurricane-related replacement demand over the next few months.
Rising home sales and house prices have also been good for credit unions as well. Real estate loan growth has exceeded 8 percent for the past three years and reached 9.7 percent over the year ending in the second quarter of 2017. Real estate loan quality has shown consistent improvement since 2010. The system-wide delinquency rate for fixed-rate real estate loans has fallen steadily and stood at 47 basis points in the second quarter of 2017, less than half its level just four years earlier.
There are some emerging signs that home sales are slowing, though the outlook for housing remains positive. Sales of new and existing single-family homes in the third quarter were up 0.5 percent compared with the third quarter of 2016. Around the start of 2017, sales were rising 6 to 7 percent on a year-over-year basis. Realtors report that a low supply of homes for sale, particularly in the most affordable price ranges, is largely responsible for the softer pace of sales. Low inventories combined with steady demand for housing has been driving house prices higher. According to the S&P/Case-Shiller Index, house prices rose nearly 6 percent across 20 major cities over the year ending in August. House prices in eight of those cities are now higher than at their peak during the height of the housing boom in 2005–2006.
Economy Looks Strong Going Into 2018
Surveys of economic analysts suggest they expect the current economic environment to be maintained in the near term. Economic growth is projected to remain steady at between 2 and 2.5 percent through the end of next year. Employment is expected to increase by roughly 170,000 jobs per month through the rest of 2017 and by about 150,000 jobs per month in 2018. Continued solid job growth will keep the unemployment rate near its current low level. Steady growth, rising employment, and low unemployment are expected to put upward pressure on wages and the price level more generally. This should boost inflation from its current level of around 1.5 percent to the Fed’s 2-percent inflation target by 2019.
In this environment, credit union membership and deposits are likely to rise, borrowing will increase, and credit risk should remain relatively low. However, a stronger economy with low unemployment and rising inflation also sets the stage for higher interest rates.
Short-term interest rates have already started to rise. Federal Reserve policymakers have raised the federal funds target rate in four moves, from a range of 0 to 0.25 percent in late 2015 to its current range of 1.0 to 1.25 percent. Market rates have moved higher in response—the 3-month Treasury rate has increased about 90 basis points since early December 2015 to around 110 basis points at the end of October 2017.
In their most recent set of economic projections published in September, Fed policymakers signaled that one more 25-basis point increase in the federal funds target rate may be appropriate before the end of this year. Looking ahead to 2018, their projections suggest three more rate increases will be appropriate, raising the median projection for the fed funds target rate at the end of 2018 to 2.1 percent. It is projected to rise to 2.7 percent by the end of 2019.
With short-term interest rates rising, credit unions face the prospect of paying higher rates for regular shares, short-term share certificates, and money market fund shares. Higher short-term rates could also lead credit union members to shift away from lower-yielding accounts, like share drafts, into higher-yielding share certificates. Some credit union members may choose to move funds across financial institutions. According to the Federal Reserve’s 2016 Survey of Consumer Finances, of the nearly 20 percent of households that use a credit union as their primary financial institution, 60 percent already also use a bank for some type of financial service.
Long-term interest rates are also expected to rise, pushing up credit union lending rates. Private forecasters think the interest rate on the 10-year Treasury note will increase 14 basis points from its October level to 2.5 percent by December of this year, and increase an additional 80 basis points over the next two years to 3.3 percent by late 2019. Some of the upward pressure on long-term interest rates is expected to come from the Federal Reserve’s efforts to shrink its $4.5 trillion portfolio of long-term securities. These holdings ballooned during three rounds of quantitative easing after the financial crisis. Some analysts expect the decline in the Fed’s balance sheet will lift long-term interest rates by less than 10 basis points, while others expect it to boost rates by as much as 80 basis points.
Higher long-term rates, if they result from a growing economy, likely won’t slow loan growth very much, but they might have a more discernable impact on the pattern of lending. For instance, when mortgage rates rise, refinancing activity—and the fees that go with it—typically falls. Higher mortgage rates could also lead to increased credit risk, particularly for borrowers with adjustable rate mortgages, which comprise more than one-third of all credit union real estate loans outstanding.
Interest Rate Uncertainty Remains
The bottom line for credit unions is that the interest rate environment is likely to continue to change. Current consensus forecasts suggest that, in the near term, short-term rates will rise more than long-term rates. That may mean credit unions will face a narrower term spread and, potentially, slower growth of net worth and income. Though the consensus is not always accurate, it seems reasonable for credit unions to consider how their income statements and balance sheets would look under the consensus scenario.
The current consensus forecasts provide a useful view, but as always, there are risks on the horizon that could alter the economy’s path. Particularly relevant upside risks for the economy include changes in fiscal policy, like lower taxes or increased infrastructure spending, which could lead to stronger economic growth. Global economic conditions also affect U.S. economic performance. Global growth is expected to pick up next year, and stronger economic conditions overseas should boost demand for our exports. Geopolitical developments can also affect the U.S. economy. For instance, rising tensions with North Korea could lead to increased financial market volatility, affecting equity and commodity prices as well as interest rates.
A turn in the economy for better or worse will have implications for interest rates and credit union performance. The Federal Reserve continues to indicate that it remains “data driven.” So, if the economy weakens or starts to show signs of faltering, it will likely shelve or delay its plans for future short-term rate increases. On the other hand, a stronger-than-expected economy could push the unemployment rate even lower than currently expected, and trigger higher inflation. In that case, Federal Reserve policymakers could raise short-term rates by more and at a faster rate than currently projected. While the outlook for the economy and credit unions is generally good right now, a smart strategy is for credit unions to be prepared for a range of economic outcomes.