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Excess Liquidity Opportunities and Pitfalls

Now more than ever, CUs are looking to investments to reduce excess liquidity.

June 23, 2011
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Recently, while sitting in a credit union board meeting discussing our loan growth, the question was raised, “What are we going to do with our excess liquidity?”

This question has been a recurring theme for credit unions over the last couple of years. Now more than ever, credit unions are looking to investments to reduce excess liquidity.

It has been years since some credit union managers have thought about investments other than certificates of deposits or corporate notes, and they’ve discovered it has become more difficult to find good investments.

It’s easy to get overwhelmed by the time required to choose a quality security. So what can a credit union do with excess liquidity?

Opportunities

One sector to focus on is the agency market. Fannie Mae, Freddie Mac, and the Federal Home Loan Bank system are just three government-sponsored entities that issue debentures, callables, and step-up securities—all of which are permissible under state and federal charters.

Subscribe to Credit Union MagazineThe key benefit of investing in any of these securities is the vast investment profiles, including maturities and yields. Liquidity in these securities is very good—just below that of a U.S. Treasury.

Some of the options in the agency market include:

  • Three year callable agencies. Incremental yield pick-up to a comparable bullet maturity is substantial enough to take on the call risk. And a longer lock-out period before the first call date will smooth out a portfolio’s call schedule and may reduce turnover and transaction costs.
  • Fifteen-year mortgage-backed securities (MBS). These include pass-throughs and collateralized mortgage obligations (CMOs). They require significant time for analysis, but offer very good risk-adjusted returns.

These instruments replace stagnant or declining home loan cash flows. Lower dollar-priced CMOs are a great place to add incremental yield while protecting against duration extension risk.

Pitfalls

Let’s look at some common investing mistakes. One pitfall is selecting an investment because it has the highest yield. This is troublesome because higher yield typically equates to higher risk.

Risk can come in many forms: longer duration, embedded option, or frequency of coupon reset.

None of these are inherently bad. They simply add a layer of complexity to analyzing the investment and increase the analysis time.

Another danger is under-investing. This happens when someone expresses a personal negative bias toward an investment sector based on a lack of understanding or previous negative experience in the market.

CMOs and MBS are great examples of this psychological bias. Don’t let the events of the past lead to analysis paralysis. It’s important to understand those biases to move forward and embrace opportunities.

Resources are numerous and readily available when it comes to investing education. I’m happy to help facilitate a more robust investment understanding.

I can simply point you in the right direction or have a more in depth discussion. Just ask—I’m here to help.

For now, it appears the economy is recovering and people are willing to borrow again, albeit at a slow pace.

In the interim, diversifying excess liquidity by investing in the numerous types of securities offered in the agency market may provide much-needed income.

EDWARD MEIER is the director, senior portfolio manager, fixed income at CUNA Mutual Group. He also serves as a board member at Dane County Credit Union in Madison, Wis.

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