Each March, the NCUA releases its Annual Report, summarizing the agency’s performance in meeting its strategic goals and objectives. As usual, this year’s report makes for an interesting read, particularly given the banking industry’s recent challenges around liquidity.
At the outset, the NCUA should be commended for putting together such a comprehensive, accessible, and intelligent presentation. Last year’s Annual Report won the prestigious Certificate of Excellence in Accounting Reporting award from the Association of Government Accountants. It would not be a surprise if this year’s presentation is a repeat winner. The document is laid out smartly and packed with information.
Overall, the NCUA’s focus in 2022 concerned five broad categories:
Responding to evolving economic and financial challenges;
Strengthening the credit union system’s capital levels;
Increasing cyber resiliency;
Supporting small credit unions and minority depository institutions; and
Fostering greater diversity, equity, inclusion and belonging.
Join this conversation today as Mike Macchiarola of Olden Lane who offers his analysis on the key takeaways from the NCUA Annual Report.
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Mike Macchiarola's Takeaways From The NCUA Annual Report
I'm excited to have Mike Macchiarola from Olden Lane. I know them well, but I pulled up their website in preparation for this show. I love the new summary on the homepage, which says, “A unique investment bank dedicated to the goals of our credit union partners.” His clients and I know him better as Mike Mac. Mike, I'm excited to have you here on the show.
Thanks. It's great to be with you.
We're both pretty active on LinkedIn. I saw you did a newsletter and a post on NCUA's annual report and it's called Eight Takeaways From NCUA's Annual Report. I thought it would be good to get you on here to talk through those eight. I know that you have some real thoughts on annual reports and what they mean.
It was cool for me having been at NCUA to see your take on the annual report because it gives me a little bit different perspective, but because of my 33 years at NCUA, I looked at it through one lens. I'm looking at it through a different lens and I like the lens you looked at it through here. Let's chat about the article and annual reports, and get started.
Thanks for having me. You bring up the annual report arena. It's interesting because, for me, it means two things. The first is it's a showpiece for the agency. You would appreciate this more than most. You can see how it gets passed around. There are plenty of folks who have input and have responsibility for a portion of this report. It hits all sectors, all divisions, lots of personnel, and lots of initiatives.
It's meant to be their summary piece of what they did in ‘22 and honestly more important for me, where they're going in ‘23. If you can read it with a little bit of an eye, you can see from the tea leaves where they think the world is going to be in ‘23. That's important when you're in the business that we're in, which is advising credit unions looking forward.
I have a couple of thoughts relative to my time at NCUA and I don't think a lot of people know this. Todd Harper, the chairman, started at NCUA as a political appointee and staff member in the Office of Public and Congressional Affairs. He worked for Paul Sarbanes and is a communication guru. He came to raise the bar of NCUA communications. As part of that, he raised the bar on the annual report under Debbie Matz, Rick Metsger, Mark McWatters, Rodney Hood, and all those board members he assisted.
He is now the chair, but he raised the bar. He got them applying and winning awards. It's a much better product these days. It hits the mark on the things that you mentioned. Some of my favorite people over at NCUA play a big role in this. When I saw what you had to say relative to your take on it, you nailed it and I thought it'd be kind of good to walk through the individual items. Anything before we jump into the eight items you wanted to say?
As a segue from that, another theme that's important for us here at Olden Lane where we've been beating the drum. If you look at the product and judge it, there are a couple of things that jump out. Most notably that the NCUA has been doing a fine job as a regulator. They seem to be ahead of the curve. They're forward-thinking, cooperative, and supportive and are accessible through this document.
The NCUA has been doing a fine job as a regulator. They seem to be ahead of the curve. They're forward-thinking, cooperative, and supportive.
If you read it the right way, certainly, there's going to be plenty that we that are deep in the weeds in the industry can quibble with. As an overall assertion, you have to say that the NCUA has been in front of a lot of things that are now going to be challenging. Here's where the rubber meets the road. What we have in front of us is certainly going to be a challenging period of time. This is when we see we're going to test the metal of the agency.
They've positioned well for this. They've got a lot of good guidance out, rules or scaled back certain rules, but we're entering likely a recession. Are we in a recession? Will we be in a recession? The statistics might already say that, but it's going to be an interesting challenge. They've been ahead of the curve.
The question will ultimately be how prepared are there staff as far as expertise because of turnover, different things because of The Great Resignation and the challenges agencies can have in that regard. It’s an excellent point. The first item that you identified is it says, “Interestingly, despite ample discussion of risks, the NCUA did not mention the potential for rising rates to create losses in the available-for-sale portfolios of credit unions.” What are your thoughts relative to that?
There's plenty of rate discussion and I don't want to short-shrift them, but it seems to me that where the rates caught up with everybody is not exactly where they were looking. Traditionally, we all were in the position to understand that rates were going to rise.
Everybody was looking at the pace of that rate rise and to understand whether they could work two sides of their book. Could they rerate their loans fast enough to pick up the cost of deposits that were going to hit them on the other side of the balance sheet?
While we were looking at that and we were talking so much about loan pricing, which frankly, honestly, the industry missed in Q3 and Q4 of ‘22, which we may get into. What got us more than anything else was the investment book. What's interesting here is you got to walk down memory lane a little bit and unpackage exactly why it happened. It's a little lazy to go after the Signature Banks and the SVBs of the world and say, “They didn't understand the asset-liability matching.” I'm not sure it's that simple because what we have here is a policy that is unlike any policy we've ever seen.
If you go back and understand what happened, we begin all the way at the beginning of 2020. We get hit with COVID. We're told to go home for two weeks and hide under our desks. We're also hit with 150 basis points of cuts right out of the gate in March 2020. What happens is everybody stays home and we get a lot of government stimulus onto the balance sheet of the credit union.
We have anomalous inflows of stimulus. Deposits balloon. Every credit union that we were talking to at the time asked the same question, “How sticky are these deposits?” I want to be responsible with what I'm doing here because if they're going to leave, I don't want to get myself in trouble. We had that conversation over and over again in 2020 and into 2021.
You reached a point where folks said, “I have a certain pain threshold. I can't hold these deposits on my balance sheet and earn nothing.” You were earning nothing. Folks went out, extended their investment mix, and picked up duration. They didn't necessarily do it as cowboys. They didn't get into crazy assets. We're talking about treasuries and agencies. We have a limited permissible investment universe, to begin with.
If you look at the numbers in 2020, investments into the 10-year-plus bucket doubled across the industry. From Q4 of 2020 to Q1 of 2022, those 5 quarters, the 5 to 10-year bucket doubled. If we have an extension of duration in the investment books of these credit unions, then what happens? We get the fastest rate hikes in history. I went back and looked at this. I don't think I've studied this hard since I was in law school. I looked at the rate hikes.
March 2022, 25 basis points. May, 50 basis points. June, 75. July, 75. September, 75. November, 75. December, 50. Feb ’23, 25. March, ‘23, 25. Altogether, 9 hikes in 1 year for 475 basis points. I will argue that it is not the hike that we all knew was coming. It is the pace and the aggressive nature of that hike. It's way above my pay grade to say whether it's appropriate or not, but it is very easy to say that folks who got caught whip sawed in that action because of two policy swings, the likes of which we've never seen in our history weren't doing their job. I wish they were all hedged and we didn't take losses like we did but this was a massive move in two directions, one after the other.
You have the pandemic, which was a black swan event. You have the unprecedented level of government stimulus, which was a black swan responding to the Black swan, which triggered the next event of an unprecedented rate hike. To be hypercritical of those, they sat on that money for the longest time as long as they could, and then eventually they had to do something. The world that they'd been in for many years would've shown that the range of things that they could do fell into reasonableness and then you get these rates going up.
The industry missed raising rates on loans. The loans took off on one side. They went long on the investments. You see these two scenarios where there was too much liquidity and you immediately went to not enough liquidity, which I'd like to jump. The number eight in your writeup was liquidity, but it's closely tied to the available for sale, the lack of share growth topic, and things like that.
Let's jump to that last one. Take them out of order. I'm trying to throw you off your game there. You pass the test. We'll go to number eight. I love the title of this. It's Liquidity. What I say here a lot is, “Liquidity doesn't matter until it matters, then it's the only thing that matters.” Let's chat about liquidity.
Unfortunately, there's not much to say here. You got caught in a very difficult circumstance and one of the things we keep an eye on here was how much of the liquidity, the deposits that the industry was relying on were the cheapest deposits and on demand. They were paying nothing for those. What's happening now is that portion of the deposit base had grown to its largest. It was the largest percentage ever of the overall deposit mix.
Not only are deposits hard to come by, but the internal mix at a credit union is also becoming more expensive as well as those on-demand now have a reason to shop. If you were telling me I can earn 0, 25, or 50, I'm going to be a certain level of stickiness. If you tell me I can earn 5%, you better have a pretty compelling conviction for me to stay.
One thing that the big bank failures alerted everybody to is maybe you were sitting on the sideline not paying attention to what you could get, and you see that people start moving. You have events and news stories that get you engaged and you go, “I didn't realize I could get those higher rates.” One of the things I do is look at my Schwab account and see what a 30-day CD is going for.
You can buy big chunks or $1,000, but you can get an over 5% on a 30-day CD. The Fed fund rates are pretty near that as well. It’s the interesting times on the liquidity piece. Looking at what you have here as well as the asset quality. One of the things Todd Miller, who is part of my team, talks about is, “The liquidity issues will resolve as long as your asset quality holds.”
Here's where it's interesting. Here's where you don't want to be a policymaker because you've got a difficult choice. What's interesting is they can step off of the pedal here and say, “We'll deal with a little bit of inflation, but we'll give the banks or the credit unions a respite so that they can breathe a little easier. We don't push the pedal on the deposit side.”
The problem with that is then you put more inflation on the back of the consumer. When you do that, it may be delayed, but it's likely going to express itself in higher delinquencies on the other big bucket of the assets of the credit union, which are its loans. What worries me about that is, I honestly believe that Q3 and Q4 of ‘22 were a whole batch of mispriced loans that came to credit unions.
Frankly, they were at the credit union. When the credit union thought they were taking shares, they were taking shares from the bank, but it's because the bank had stepped away from the market. Community banks were a little smarter and quicker to reprice exit. There's a lot of sorting that has to go on here. The credit box has to be redefined, and that's going to bring a slowdown.
At the same time, people are going to pull their sales in here and look for the price that they're being paid for their deposits. The cost of funds is going higher. As you said with liquidity, what we tell all the clients all the time is, “Have as many available sources. Test those sources. Use those sources. Take it when you can get it. Now is not the time to be real stingy on price.”
On the inflation side, before our show, I was on the phone with one of my clients getting an update on the West Coast. They've been getting hit hard on the deposit side because of inflation. They've pinpointed it down to the fact that people are spending more on a box of cereal. Instead of growing, that takes off again. That's going to have big ramifications.
On the credit side, there's another podcast I started listening to. It's a guy who's anonymous in a car dealership. He reports on Twitter and on his podcasts the different banks that are getting out of floor planning auto loans and the layoffs that are happening in different banks that are cutting all their junior lenders on their car loans because there's a storm brewing there and $50,000 Toyota Celica today are going to be worth $50,000 in a few months. If you start having those challenges, what might that do for your liquidity and your overall operation? I wouldn't want to be a policymaker that every lever pulled has consequences and unattended consequences.
The credit union mix is going to be autos and mortgages. You've got a batch of mortgages that you're holding that are struck with a three handle and have to run the term, then you've got a bunch of autos that we can argue about where they were struck and that they're mispriced in that whole capital intensive and credit intensive industry.
It is going to come under some significant pressure if it hasn't already. I watched the same thing about the dealerships that are closing and the banks that are exiting the market. To price that floor plan at the dealer is a capital-intensive effort. As people exit and as assets concentrate in larger banks, you're going to have issues. They're going to be geographic. They're going to be in places and times you might not see them coming.
I always have to find a silver lining. Here's the good news. The good news is that nothing brings clarity of thought is quite like a little existential risk. You'll think very clearly when your back is up against the wall. You are no longer in the benign interest rate and market environment that some of us have enjoyed for the last few years. It is not going to be smooth sailing. We are going to have choppy seas, but this is where the bold and the well-oiled machine are going to be rewarded.
Here’s the good news: nothing brings clarity of thought is like a little existential risk. You'll think very clearly when your back is up against the wall.
This is where there's going to be a great sorting. Those credit unions that have been doing their job consistently, understanding their risks, delivering for their members growing, but rationally, understanding the new buckets of loans into which they've been growing in the last several years are going to be rewarded. Those that have been a little bit lighter on risk, quicker to move to growth for growth's sake without a true strategy, it’s going to be exposed. As Buffett said, “Only when the tide goes out, do we see who's swimming naked.”
You reminded me of one of my other favorite quotes, which is from Napoleon Bonaparte. Napoleon allegedly said, “Hearing improves when the guillotine is near.” Scared straight. It’s fascinating. I'm going to jump around on one other topic: consolidations. For those that planned well, things will be bountiful. Those that didn't measure their risks much are going to have some challenges. You've got an item in here about consolidation. I'm not sure which item it is. That's something that we're going to see potentially pick up because of where we're at economically. Any thoughts on the consolidation likely to continue in number seven?
Consolidation is going to be a little different than what folks are used to. Not to do a commercial, but here is where good bankers or good advisors are going to be worth their weight in gold. I do not believe the next round of mergers is going to be as simple as the last round. I don't think it's going to be over coffee in the neighborhood and in the geography because one CEO was retiring and the other CEO knew him or her and said, “Let's get together and we'll take your business out.” Those transactional collegial mergers may still be there, but that's not where I'm interested.
Where I'm interested is I think the geographic bounds are going to break down. They're not as important as they once were you've seen some of this. You saw there was an Illinois credit union and a Maine credit union considering a merger. That deal did not work out. They broke it off, but that told you that geography doesn't matter as much. That makes sense in the mobile environment when customers are all about pricing and we've got an understanding of how to manage risks and work from home.
Credit unions in Michigan go for a bank in Florida. Those are the types of things you're going to see. People are going to do things more strategically to get their way into geographies that they desire, get themselves balance sheets that they like from a liquidity standpoint, business lines, or talent that they admire from afar. The merger box is going to open up, and it's going to be more about strategic mergers. I don't think credit unions to date have been as strategic as they could be.
My version of a merger goes all the way back when they taught it either law school or business school, and it was Goldman Sachs bankers who come in and they show the Ford Motor Company on a model and a PowerPoint why they should buy Nissan. It is driven by a bank and a bank's idea of why it makes sense for a credit union in this case. The credit union understands it and realizes that its choices are bigger than it might have realized. That's what's going to happen in the space.
Not only credit union to credit union, bank into the credit union, those types of acquisitions where there might be a bank. You touched on it. What's their asset mix? I'm 95% or 110% loaned out, and there's a bank that's available that's 50% loaned out. As a credit union, I could pay with cash as opposed to the guy down the street that the other banker has to pay with stock and maybe the stock is deflated and it's not a good time. There could be some acquisitions coming up in that vein as well.
The other thing that dawned on me was tied to SVB, Signature Bank, and other things, one of the articles I read tied to that talked about how there are few banks in many countries like Canada, but we still have almost 5,000 banks here and 5,000 credit unions.
We used to have many more. Part of that is tied to the fact that you couldn't cross state lines if you were a state charter. It was Illinois. Banks would be in Illinois. Illinois state-chartered credit unions would be Illinois. Not only do you see mergers of Federal credit unions across the country, but you'll see neighboring states where mergers many years ago wouldn't have been approved. It might need the state regulator in both states’ approval. It's now been an option for many years. That geography is expanding along with field memberships in both states and Federals, whether it's underserved rules or broad state rules. There are plenty of opportunities out there.