Understanding the Unusual, Unprecedented and Uncertain Economic Environment

Widespread stimulus was provided to individuals and businesses. Government stimulus money was re-invested 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. 

Asset Appreciation and Inflation

As a result of the supply demand imbalance, prices rose. Auto values increased 28.7% in 2021, unprecedented for what is normally a depreciating asset class. 

Median home prices increased 18% in 2021 and of 30% from Q4 2020 to Q4 2022. 

Inflation eclipsed the Federal Reserve’s 2% target in Q1 2021 and peaked at a whopping 9.1% in Q2 2022. 

Interest Rates

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%, 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’ Impact on Banks and Credit Union

Increasing interest rates decrease the value of fixed rate assets and liabilities. This impact is called interest rate risk. Credit unions and banks have asset liability management (ALM) processes in place to keep interest rate risk in check, but most scenario analysis peaks at 300 or 400 bps. Rates increasing over 450 bps led to the collapse of Silicon Valley and Signature Banks 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.

Increasing Interest Rates’ Impact on Members

Raising 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 dollar does not go as far as it 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 can be noted from the table above, vehicles appreciated 28.7% in 2021 and depreciated 22.9% in 2022. BlackBook 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. 

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 to those more affluent.

Positioning Your Credit Union for Success

Rapidly increasing interest rates make it more likely that members will opt to add-on or renovate their existing homes as compared to purchasing a new home and losing their irreplaceable low interest rate. Making competitive home equity products available positions credit unions well 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.