This Saturday we had the AGM (followed by the 60-year Gala which I did not attend;by the way, 61 is a nice Fibonacci number). Nothing too exciting other than a few immaterial tweaks in the by-laws and the usual financials. There was a guest speaker in the person of Arkadi Kuhlmann of ING fame, he advocates the lean and mean approach which Duca does not live by having increased the boards remuneration by 50% in just two years. Also , in his interview with Forbes, he said that he liked hiring “difficult” people as they drive innovation. Duca likes like-minded people. He also reminded people in that interview that if you want a friend, get a dog which for some members of management may be the only option. Regulators were never Mr Kuhlmann’s closest allies whereas Duca pretends to worship them.
To get to the point, there was not much out of the ordinary. For years now the numbers have not changed that much. Interest income 50 mln, interest expense 20 mln, gross margin 30 mln and expenses about 20 mln. leaving a net profit of about 10 mln Due to fine tuning as in loan loss provisions etc.etc. the actual profit fluctuated from last years “amazing” 12 mln. year to this year’s 98% achieved goal 7 mln. year. What has changed is the size of the balance sheet. The philosophy applied is one of grow-or-die. As residential loans grow organically more or less in proportion to the the real estate market (the bread and butter and the “knitting” of credit unions), growth is accomplished in good part by deviating from the “knitting” and going into commercial lending. This now constitutes almost 40% of the loan book. If history is a guide Duca does not have a particularly strong credit evaluation ability.
Over and above this higher level of risk intrinsic to engaging in a business that, using their own numbers is arguable 17x more risky, the real time bomb is the colossal size of their mismatched book. The mismatch in the 2-5 year maturities is now running at $455 mln., this after making all the proper adjustments for capital, swaps and so on, this is a net number! Also, virtually all liabilities have a duration of less than two years so very little will change in the course of the next two years.
Here is where the above chart enters into the equation. It represents the overnight (technically there is no daylight) interbank rate. It is very much manipulated by the supply of balances and consequently tends to fluctuate less than say, a one month BA. Due to a lack of choices we use this as a reasonable proxy for funding costs, the absolute level of which is less important than the change. At a glance you will see that there are 15 incidents where the rate changed by 3 to 5 %, on average once every 2.7 years. For the past 5 years or more nothing much has happened.
A move any time now or in the next two years, would cause the gross interest margin to shrink by possible as much as 13.5 mln. A bigger move, which is very possible given the quite state of the market (quite before the storm?), could push this number up to well over 20 mln. Yield-curve flattening or inverting could make that outcome more complex.
Risk adjusted the commercial loan book may not be as attractive as it seems at first blush, growth at all costs resembles the good old variable cost accounting, a method of doing your business in such a way that you lose on every deal but make it up with volume. This is becoming evident when you see that the longer duration assets earn the lowest percentage of 3.97% (they are the newest?) and if they were to be funded the cost of 5 year money is quoted in the papers at 2.80% leaving a spread of a little more than 1% for highly risky business. The responsibility for the mismatch risk lies with the board, and judging by the rapidly maturing swaps, the degree of engagement as well as sophistication is not encouraging. This is a time bomb akin to playing Russian roulette with 3 bullets in the chambers or not taking Doris Day to heart.
P.S. A 5% sustained change in interest rates, any time in the next two years, assuming a linear distribution over the 3 years of the 455 mln exists, could lead to a loss of income to the tune of about $38 million by the end of the 5th year
We also recommend reading up on the causes of the Savings and Loan debacle in the US, there are quite a few similarities.