Razor Thin Loan Margins: Does your pricing make sense?

Bill Vogeney
July 25, 2011 | COMMENTS

Regardless of what part of the country your credit union is located, you’re probably in the middle of a historically vicious rate wars for auto loans. There are a variety of reasons for this rate war, including:

1. Historically low investment rates. The fact the corporate credit unions have had to return to sound pricing doesn’t help you generate a reasonable return on your excess funds.
2. Low mortgage rates have forced many lenders, including banks, to sell their production flow. So both banks and credit unions are looking for shorter-term loans to offset this factor.
3. Excessive amounts of liquidity from depository lenders. That means the banks and our credit union friends.
4. The captive finance companies have come roaring back to the market since early 2010 with 0% financing. The lack of trust in the financial markets in 2009 would have made that kind of financing offer impossibly expensive.
5. Continued uncertainty about the housing market has left both lenders and borrowers feeling bearish about home equity loans. Lenders really don’t want to make them, and borrowers are preserving what equity they have.

Thus, many of us feel like auto loans are the only game in town and we’re willing to almost give the funds away, as rates as low as 2.99% for 60 month loans have become commonplace. I’ve talked to credit unions that have lowered their rates and still have not generated any additional loan volume. Why do we want the volume? We want to increase earnings over investments, of course. But what combination of events result in REDUCED earnings?

Years ago, I decided to put to use some of the economic principles I learned in my MBA program, and decided loan pricing was a logical candidate. The concept of marginal production and pricing intrigued me-what were the implications of making one more loan, what would it cost on the margin, and would the loan be profitable?

Opportunity cost also had to be part of the analysis. If I’m not making loans, my credit union has to invest the money. With most credit unions investing at rates that are probably 1%  or less, there’s a lot to be gained from making loans at 3%-potentially.

After a lot of trial and error, I developed this model for answering the question: “If I lower loan rates from current levels, and I have a given amount of loan volume today, how much additional volume do I need to generate incremental income over my existing mix of loans and investments?”

To understand the concept, let’s use a simplified model of a credit union. ABC credit union has exactly $10 million in cash rolling in from new deposits, loan payments, and investments maturing every month. The manager, Jane, has one loan product-an auto loan-to generate loan volume. She also has one investment opportunity allowed by her board of directors. She has to make loans throughout the month, and then invest the excess at month end.

For the last six months, Jane has been making about $6 million in auto loans at a rate of 4%. She has been investing the rest of the funds at 1%. Let’s assume the average life of the auto loans is about the average life of her investments. For simplicity purposes, now let’s look at the first full month of return on Jane’s lending and investment activity:

$6 million in loans at 4%= $240,000 in interest income, divided by 12 = $20,000 in loan income

$4 million in investments at 1% = $40,000/12 months = $3,333 in investment income

Total income $23,333

Let’s say Jane decides to lower loan rates to generate some more loan volume. If she lowers rates to 3.5% and makes $7 million in loans next month, here’s her first month results:

$7 million in loans at 3.5% = $245,000, divided by 12 = $20,416.67 in loan income

$3 million in investments at 1% = $30,000/12 months = $2,500 in investment income

Jane just made the credit union $22,916.67 in income, a REDUCTION from the previous month. Not good. In addition, she had some marginal costs. That $1 million in additional loans is going to generate additional loan losses. In addition, she had to pay staff incentives for the production. Jane is now costing her credit union money.

Back to my trial and error efforts to build a marginal pricing model; after a few attempts, I realized that ultimately, you never know how members will respond to changes in loan pricing. Any model you could build could only help you evaluate the end results. I also knew I had to account for these marginal costs-loan losses, staff incentives, overtime, etc., to properly account for all of the marginal costs. Your CFO might tell you this is a flawed model, because it does not take into account your expense ratio. Many of my peers have recounted conversations with their CFO that went something like this:

“We can’t make auto loans at 4%. Our cost of funds is 1.5%. Our expense ratio is 3%. We need a .50% ROA, and we have loan losses of .50%. Our minimum auto loan rate should be 5.5%.”

Most of that is true. However, shouldn’t your entire management team, CFO included, want to improve the financials of your credit union? Shouldn’t you want to increase net income? Assuming you don’t want to layoff staff and close branches, your facilities and payroll costs are somewhat fixed. That’s why a marginal approach to pricing is necessary.

Stay tuned for part 2

Bill Vogeney is Senior Vice President and Chief Lending Officer for $3.1 billion Ent Federal Credit Union in Colorado Springs. He can reached at bvogeney@ent.com