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Niagara

Niagara Should Niagara Credit Union accept the Ontario Share and Deposit Insurance Corporation’s (OSDIC) proposed plan to merge with Pelham Credit Union as of November 1981? Provides basic banking services to the general public and commercial loans. It has a reputation of being an innovator in the field. Over the years it has developed a lending expertise in dealing with local farmers and small businesses, resulting in a near zero default rate (see Appendix A). It has experience in mergers as it merged with two small credit unions in the southern half of the peninsula in early 1981. It currently is the largest credit union in the area, with well-located branches throughout the region. The company is in good financial health and has consistently made money throughout the years. Started in 1957, it concentrates on making consumer loans. It has no commercial loans. In 1975 it merged with a financially troubled credit union resulting in a larger membership and deposit base. It merged again in 1980 with a small credit union resulting in 5 branches. However, it ended up closing two of the branches because it was not economical to run them. It is currently in financial distress, which has resulted in the proposed merger with Niagara. Its mandate is to protect the deposits of the members of Ontario’s credit unions. It monitors credit unions that are experiencing financial difficulty. If a credit union’s liquidity becomes jeopardized the OSDIC has three possible options:  Nurse the credit union back to health (very costly).  Facilitate a merger with another credit union (least costly).  Liquidate the credit union (negative image). It would prefer to try to broker a merger between credit unions, as this is the least costly option. Credit unions in the Niagara area used to be very community oriented with most credit union membership being based on bonds of association such as religious groups, employee association or ethnic background. However, credit union membership based on community association has weakened and a new trend has emerged based on competitive services and products rather than personal relationships. Credit unions operate in a competitive environment, characterized by slow population growth and a small population base (see Appendix B for market facts). Most of the credit unions of Ontario in the late seventies had assets and liabilities that were mismatched with respect to the term structure of interest rates. This caused spreads to shrink as interest rates rose from 1977 to 1981. Credit unions were especially hurt by the rise of interest rates: they were restricted by government regulation which stated that credit unions had to have less than 15% of their deposits in commercial loans (see Appendix C for explanation). Liquidation of a credit union was generally unpopular, as it would most likely generate a negative view of credit unions. 1. The merger has top management support. 2. Pelham’s assets and membership showed steady growth, implying that the underlying problem was it cost structure, not its ability to generate new business. 3. Strengthened competitive position in terms of geographical coverage: the merger would add 3 more branches and 13 700 members to Niagara. 4. Niagara has experience when it comes to mergers with other credit unions. This past experience could lessen possible transitional problems involved in combining the two credit unions. 5. The ODIC would pay off Pelham’s accumulated deficit of $1.7 million. 1. The poor financial and operational track record of Pelham is considerable (see Appendix D). 2. Niagara would have to pay $300 000 to renovate the Pelham’s Foothill branch. This is significant considering that Niagara’s 1981 net income was only $131 000. 1. Niagara could increase their reputation and competitive position within the region. 2. Turn Pelham’s assets into income generating assets by reducing costs such as data processing and salaries. 3. Niagara’s commercial loans are currently capped out at 15%. The fact that Pelham has no commercial loans gives Niagara increased room for growth within this promising area (see Appendix E). This would allow for better maturity matching and higher spreads, which ultimately reduces risk and produces larger profits. 4. Forecasts indicate significant positive contributions to Niagara’s bottom line. NPV calculations show a contribution of roughly a half a million in additional income (see 1. A failed merger may jeopardize not only the future success of Niagara but also its very survival: the merger has its risks. 2. Merger will produce a loss in the upcoming fiscal year of $71 000. 3. Agreement not to eliminate Pelham’s clerical staff may prove to be too restrictive in terms of how to operate the merged company. 1. Continue to operate as a profitable and successful company. 1. Miss out on a potentially excellent investment opportunity. 1. Merge with a more profitable company. 2. A refusal might result in more funding from the OSDIC being offered to complete the deal, along with better conditions. Negotiate a better deal than the existing proposal for the merger. 1. Niagara may face backlash from consumers not having faith in the credit union system if Pelham is liquidated by the OSDIC. There is potential for serious financial consequences. Given the facts of the case, we recommend a merger with Pelham Credit Union. We feel that the benefits of a merger are simply too great to ignore. The following highlights our key reasons: 1. Top management support and experience with mergers. 3. Opportunity to grow the less risky and more profitable commercial loan area (synergistic benefits). 4. Support from the OSDIC ($1.7 million in deficit relief). 5. Enhanced competitive position and presence within the region. However, due to the lack of information in the case we feel that Niagara may be in a position to negotiate a better deal. We would like to see the OSDIC pay for the renovation cost of the Foothill branch and remove the stipulation of having to retain Pelham’s employees. In order to properly assess Niagara’s negotiating power more case information is needed:  What stage of negotiations are they at, early or late, since proposals can be thrown back and forth?  What kind of costs are involved if the OSDIC was to pursue other alternatives such as liquidation or nursing the company back to health?  How much worse is a Pelham merger with Family Savings: is it only marginally worse or is it significantly worse? If one could put a dollar figure on these costs then we would have a much better idea as to the probability of negotiating a better deal. CALCULATION OF DEFAULT RATE ON LOANS (1945 – 1981): Default Rate = Bad loans / Total Loan Number of Competitors within the Region = 113  shows competitive environment Population as of 1981 = 386 288  shows small market Population Growth = 368 288 – 365 438 / 368 288  shows slow growth Reduction in New Homes Built = general down trend  shows reduced need for (1980-1981) mortgages which in turn reduces EXPLANATION OF WHY SPREADS INCREASE OR DECREASE: Interest on consumer deposits are paid out on a variable basis, depending what the prime rate of interest is. Interests on consumer loans are usually set for five-year intervals. Thus, if interest rates increase, as was the case in the late 1970’s, the consumer gets a higher rate on their deposits but the interest paid to the bank on loans remains the same. This results in a lower spread between the deposits and the loans. If interest rates go down the opposite occurs. Interest rates on commercial loans are different than consumer loans as they are set at a variable rate. This reduces the banks risk in terms of interest rate movement. Therefore, commercial loans are preferred over consumer loans. Rate=10% Rate=12% Rate=14% Rate=16% Rate=18% Variable DEPOSIT $10 $11 $12.32 $14.04 $16.29 $19.22 $10 $11.2 $12.54 $14.04 $15.73 $17.62 Rate=12% Rate=12% Rate=12% Rate=12% Rate=12% As you can see in the following example: As interest rates increase the margin between Deposits and Loans get smaller, eventually the margin becomes negative and the financial institution starts loosing money. As stated earlier, commercial loan lending rates are variable and are not exposed to this interest risk. KEY OPERATIONAL AND FINANCIAL FACTS FOR PELHAM:  Recorded losses of increasing amounts from 1978 to 1981; by 1981 the annual losses were in excess of 1.1 million.  Their spreads were smaller than Niagara’s: 1.87% of total assets at Pelham vs. 2.68 at Niagara.  Large data processing costs and non-interest expenses.  Poor matching of maturities, even by credit union standards.  In general Pelham’s poor financial position negatively affects Niagara’s capital base and financial flexibility. BREAKDOWN OF NIAGARA’S COMERCIAL LOANS: Niagara’s total assets: $ 155,704 Business & Farm Loans (commercial loans): $11,647,000 Business & Farm Loans / Assets: = 11,647,000/155,704,000 = 7.48% Business, Farm Loans and Other Loans / Assets: = 29,493,000/155,704,000 Assuming half “other loans” are commercial loans: = $17,846,000/2= $8,923,000 TOTAL COMMERCIAL LOANS: $20,570,000 Total commercial loans /Assets: = 20,570,000/155,704,000 Based on our assumption that half the “other loans” are commercial loans Niagara is just under the 15% regulation, leaving little room for expansion. Pelham has no commercial loans, which gives Niagara an immediate $3,852,000 of room for commercial lending. 15% of Pelham’s assets of $25,677,000 = $3,852,000 NPV OF THE PELHAM MERGER (ROUGH ESTIMATE): Using Opportunity Cost of 10% (average equity rate of return over last 50 years): NPV = -$484 000(exchange of share capital) + -$300 000(renovations) + -$199 000/1.1 + -$7000/(1.1)^2 + $169 000/(1.1)^3 + ($197 000/0.1)/(1.1)^4(assuming income = -$484 000 + -$300 000 + -$180 909 + -$5785 + $126 972 + $1 345 537 Using Opportunity Cost of 25% (being super conservative) NPV = -$484 000(exchange of share capital) + -$300 000(renovations) + -$199 000/1.25 + -$7000/(1.25)^2 + $169 000/(1.25)^3 + ($197 000/0.25)/(1.25)^4(assuming income = -$484 000 + -$300 000 + -$159 200 + -$4480 + $86 528 +$322 765 One could spend a whole paper on what the discount rate should be. In the short-term it should probably be around the 15% range but in the long run it should level out to historical level of around 10%. Our intuition tells us that the NPV of half a million is the best estimate. Bibliography:

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