Case Study: What to Think about When You’re Thinking about Inflation
By Bill Brooks, CEO, $403M Mid-Atlantic FCU
“Paranoia runs deep” is the start of a verse in the Buffalo Springfield 1966 song of that title. Inflation is a very complex subject with multiple views, creating a level of paranoia across America, and particularly among those in financial services and their regulators. Again, to quote from the song, “nobody’s right if everybody is wrong.” You can truly get a lot of resistance for speaking your mind on the subject.
The view I have is that inflation is here and it is almost at the runaway level. Remember, most of the youngsters who volunteer at credit unions and the staff think of the 70s and early 80s as ancient history. My experience working in the credit union industry is not really good because the industry has changed so much. Back then, 36 month auto loans were the bread and butter of a credit union. Those going out 42 months on an auto loan was considered risky.
Inflation is here and it is almost at the runaway level.
Mid-Atlantic FCU CEO Bill Brooks
Our balance sheet is considerably more complex and extended. There are valid concerns if inflation spikes. Our biggest challenge is that we are getting mixed signals from the Federal Reserve and financial markets. In March the 10-year Treasury was 1.72%. Presently, it is 1.35%. Reported inflation rates are at historic percentages. Efficient markets are not doing their job predicting interest rate adjustments.
My best guess is that interest rates will have to go back to pre-COVID levels. I believe that they will go back up sooner than later.
This will not be a disaster for us, but it will cause us to make decisions based on the options available at that time. We are not going to be totally screwed, but need to inform Houston that we have a problem. Like Apollo 13 and the flight engineers, we will have to figure out how to get home safely with all the tools at hand.
Mid-Atlantic FCU will have options. We are in the process of seeking approval to use the new authority granted by NCUA to hedge our portfolio. Not sure how long it will take us to get the approval.
1. If we could hedge our low-yield mortgages for one year, this is approximately $49 million at a cost of about $343,000. We would earn revenue of $1,347,000 by holding the $49 million at average 2.75%. We would get a fee income of about $490,000 by having to deliver the mortgages for sale a year later.
2. If we just dumped the $49 million, we would earn $833,000. Plus, we could invest the $49 million and earn not much. With a variable rate SBA, we would get about 1%. We would have upside protection. We would get the sales fee of $833,000 plus $490,000 investment income in year one. Year 2 income would be the coupon of the investment only. Depending on a lot of unknowns, year two would be about $800,000 in lost income.
I guess this is where paranoia is real if it is true.
Until the situation becomes clear, we have to take the Federal Reserve at their word. We need to believe there is not going to be an interest rate increase for another year.
This is only one part of the multitude of concerns we will have to face when the debilitating effects of inflation on our balance sheet. I believe the challenges will be greater than COVID. With preparation and luck we will address them successfully.