Portfolio Risk analysis
-
Upload
mentor-muhaxheri -
Category
Documents
-
view
219 -
download
0
Transcript of Portfolio Risk analysis
-
7/29/2019 Portfolio Risk analysis
1/30
2000-2009 Prime Alliance Solutions, Inc. All Rights Reserved.
PortolioRiskAnalysisPrime Alliance Solutions, Inc.January 2009
Tracy AshfeldExecutive Vice PresidentStrategic Mortgage Solutions
Nizar HashlamonExecutive Vice PresidentLoan Servicing
David MendelsonSenior Training ManagerPrime Alliance Training
-
7/29/2019 Portfolio Risk analysis
2/30
Portfolio Risk Analysis
Prime Alliance Solutions, Inc.
January 2009
Tracy Ashfield
Executive Vice President
Strategic Mortgage Solutions
Nizar Hashlamon
Executive Vice PresidentLoan Servicing
David Mendelson
Senior Training ManagerPrime Alliance
-
7/29/2019 Portfolio Risk analysis
3/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 2 of 29
EXECUTIVESUMMARY..........................................................................................................................3
INTRODUCTION ......................................................................................................................................4
Background.........................................................................................................................................................................................4
Scope of the Analysis .................................................................................................................................................................5
Staff Assignment ............................................................................................................................................................................5Stakeholders ......................................................................................................................................................................................5
Characteristics of Loans Analyzed ....................................................................................................................................6
Number of Loans Analyzed for Each Type .................................................................................................................6
METHODOLOGY ......................................................................................................................................7
Tools Utilized .....................................................................................................................................................................................7
Process Used in Conducting the Analysis ...................................................................................................................7
RESULTS ....................................................................................................................................................8
ACTIONSTAKEN .................................................................................................................................. 11
Member Reaction ........................................................................................................................................................................ 12
CHALLENGES ......................................................................................................................................... 13
CONCLUSION ......................................................................................................................................... 14
Executing a Collateral Risk Portfolio Analysis ......................................................................................................14
Project Scope .................................................................................................................................................................................14
Methodology ....................................................................................................................................................................................14
Taking Action ..................................................................................................................................................................................14
ACKNOWLEDGEMENTS ..................................................................................................................... 15
APPENDIX .............................................................................................................................................. 16
Sample Line Decrease Notification Letter sent to members: .................................................................16
Supervisory Letter......................................................................................................................................................................17
-
7/29/2019 Portfolio Risk analysis
4/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 3 of 29
Executive Summary
Real Estate Lending is becoming the principal business activity for most credit
unions. The loan portfolio is typically the largest asset and the predominate source of
revenue. As such, effective management of the real estate loan portfolio is
fundamental to credit union safety and soundness. Loan portfolio management is the
process by which risks inherent in the credit process are managed and controlled.
This risk is exaggerated when considering the historical decline in home values andthe substantial increase in defaults.
For decades, good loan portfolio managers have concentrated their efforts onprudently approving loans and carefully monitoring loan performance. Although
these activities continue to be crucial to portfolio management, it falls short in the
current lending environment. It does not address the needed lead-time for corrective
action when there is a systemic increase in risk. The risk elevates because such
analysis does not take into consideration the current value of the underlying
collateral (property).
To manage their portfolios, credit unions must understand not only the risk posed byeach loan but also how the risks of individual loans and portfolios are interrelated.These interrelationships increase risk exponentially. Until recently, few credit unions
used portfolio management concepts to control credit risk by obtaining a credit scoreon the entire portfolio. Better technology and easier access to information have
opened the door to better risk management methods. A portfolio manager can now
obtain early indications of increasing risk by taking a more comprehensive view ofthe loan portfolio. Currently, many credit unions view the loan portfolio in its
segments and as a whole and consider several factors in addition to the traditional
credit scoring in determining the risk. During the current decline in home values its
evident that a good evaluation of the underlying collateral plays an integral part in
assessing the overall portfolio.
The results of assessing the risks associated with the credit union portfolio can have
many implications on lending practices. The credit union highlighted in this paper hastaken steps to better manage the risks associated with their HELOC portfolio. More
specifically they are identifying potential risks associated with current home values
and adjusting the credit unions exposure while continuing to meet their membersneeds for home financing.
-
7/29/2019 Portfolio Risk analysis
5/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 4 of 29
Introduction
Evaluating credit unions real estate loan portfolios is more important now than ever
in todays changing economic climate. Conducting a comprehensive analysis of the
loan portfolio is a key component to sound risk management. Such analyses provides
credit unions with early indications of increasing portfolio risk and allows them to
take appropriate steps to ensure a healthy and sound financial position.
Knowing what data to collect and review and how to evaluate and act on such data
can be a daunting task. The objective of this paper is to provide credit unions with abest practice approach. Our analysis included a thorough review of BECUs process in
conducting their portfolio risk assessment. This analysis includes the scope,
methodology, results, and actions taken. We also identified challenges the credit
union faced in implementing the program.
BECU was selected because of their unique approach to portfolio analysis.
Furthermore, the program has been reviewed by independent third parties that
found the analysis and actions taken to be sound.
We hope reviewing this case study will provide credit unions a good understanding of
the steps essential to completing a portfolio risk review and better prepare them toperform these important steps. We reviewed all aspects of the project including the
methodology, selection of tools and vendors and assignment of staff resources
needed for the project completion.
Background
In August 2008 the NCUA issued letter No. 08-CU-20 to Federally Insured Credit
Unions. It encouraged credit unions to view risk management in terms of the entire
loan portfolio. The letter (attached in the Appendix) identified several elements that
should be part of a loan portfolio management process. These elements complementother fundamental credit risk management principles such as sound underwriting,
comprehensive financial analysis, adequate appraisal techniques, loan documentationpractices, and sound internal controls. These elements include:
Setting individual and aggregate loan limits based on net worth and the
overall risk profile within the balance sheet.
Updating credit risk scores periodically on all borrowers.
Monitoring home values by geographic area.
Obtaining updated information on the collaterals value when significant
market factors indicate a potential decline in home values, or when theborrowers payment performance deteriorates and a greater reliance is placed
on the collateral.
Analyzing whether increasing loan-to-value (LTV) ratios necessitate reducing,
suspending, or discontinuing existing credit lines (e.g., HELOCs).
Obtaining updated information on the collaterals value when significant
market factors indicate a potential decline in home values, or when the
-
7/29/2019 Portfolio Risk analysis
6/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 5 of 29
borrowers payment performance deteriorates and a greater reliance is placed
on the collateral.
While the above elements are all important for a sound risk assessment practice, we
chose to focus on managing HELOCs for our case study. This decision was based onthe current decline in home values and the increased exposure to losses. We believe
reviewing HELOC portfolios allows credit unions to take actionable steps to limit orprevent potential losses.
Boeing Employees Credit Union, Tukwila, WA
Scope of the Analysis
Boeing Employees Credit Union made the decision in late 2007 to proactively
evaluate their First Mortgage and Home Equity portfolio risk in light of the then
developing economic crisis. Historically the credit union conducted a quarterly credit
review of existing borrowers by obtaining and reviewing current credit scores. For
this analysis, BECU chose to expand the review to include collateral valuation with a
focus on their mortgage and equity advantage program (HELOC).
Staff Assignment
BECU understood that commitment of senior management and providing staffresources were essential for the success of such a project. The project was conceived
by the Executive Vice President COO. The project was headed up by their Senior
Vice President of Member Operations. A project team was assembled that included
Vice President of Lending and the Manager of Model Management. Other resources
were included at different stages as the project progressed, such as Marketing, ITand others.
Stakeholders
Because of the high importance of the project and its impact on the credit unions
financials, lending policies and culture, BECU identified the Executive Management
Team and the Supervisory Committee of the Board of Directors as the main
stakeholders in this process.
The decision was made to review only the HELOC (Equity Advantage) portfolio. BECU
felt these lines posed the greatest risk and a review of the first mortgage loanportfolio would be performed at a future time. The analysis focused first on all Equity
Advantage loans with 100% LTV and all out of state loans. In the second round theyincluded the remaining HELOC loans in the portfolio.
-
7/29/2019 Portfolio Risk analysis
7/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 6 of 29
Characteristics of Loans Analyzed
The Equity Advantage loans were first broken down using the following criteria:
Current value of the home vs. original value at time of origination
Current Loan to Value vs. original LTV at time of origination Age of loan - 2005 to 2007 was determined the greatest risk since homes
were valued during the peak of the housing bubble
Current Credit Score of the member vs. credit score at origination
The three data types used in the assessment were:
Risk Determination - Collateral risk measurement that predicts the potential
of an early payment default and/or the likelihood of an overvalued property.Risk levels are identified as Minimal, Intermediate or Elevated. A proprietary
risk analysis model derives these indications. The model analyzes multiple
relationships between key collateral elements. Property characteristics,
location influences and characteristics, sales activity information, and
property values and trends are all evaluated to produce credible risk
indication.
REO Percentage A foreclosure activity measurement that identifies the
percentage of sales in the subject market area that have transferred with aTrustees Deed, which typically indicates a foreclosure, within the past three
years.
Price Volatility Percentage - Sales price increase measurement that identifiesthat average percentage increase on properties in the subject market area
that had sold two or more times over the last three years.
The pool for the credit limit suspension and reduction was active Equity Advantage
(EA) accounts only. BECU decided there was not much benefit to getting the valueson the fixed rate/fixed term home equity loans as limited action could be taken on
those accounts. From a macro standpoint BECU wanted to assess the decline in value
the portfolio was exposed to. This would quantify the overall collateral value as ameasure against current balances. This measure would help quantify risk and
identify potential losses.
Number of Loans Analyzed for Each Type
The analysis covered 7,271 Equity Advantage loans, of which only 748 or 10.3%
were determined to be at risk. Loans at risk were determined by the following
criteria:
A FICO score drop of 40 points or more since loan origination A FICO score lower than 720 50% or more drop in net equity
-
7/29/2019 Portfolio Risk analysis
8/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 7 of 29
Methodology
Tools Utilized
BECU chose Prime Valuation Services (PVS) to provide the risk evaluation on
collateral in the portfolio. Additionally, Sagent data mining software was used toextract data from the different systems at the credit union. TransUnion was used to
pull the current FICO scores on each loan in the analysis through BECUs quarterly
account monitoring run.
Process Used in Conducting the Analysis
PVS required the following fields to conduct their analysis:
Member ID Number Street Number
Street Name City
State Zip Code Loan Number Original Value
Original Value Date Original Loan Amount Current Loan Balance
-
7/29/2019 Portfolio Risk analysis
9/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 8 of 29
Results
748 accounts were identified as potentially at risk of 40,959 loans.
These accounts had the following characteristics:
Average original FICO score - 698 Average FICO score as of 8/27/2008 - 651 Average decline in property value 13%
Out of the 748, 73.3% had a risk level considered to be minimal, 25.8%intermediate, and 0.9% had a risk level considered to be elevated.
REO Findings:
The analysis returns an REO Percentage, an indicator of foreclosure activity
measured by the percent of sales in the subject market area that transferred with a
Trustees Deed within the past three years1. Subject market areas with an REO
Percentage greater than 35% are considered to present a significant foreclosure risk.
The analysis returned the following results, which are also illustrated in Graph I:
96.5% had anREO Percentage
less than 25%; 2.1% had an
REO Percentage
of 25%; and 1.5% had an
REO Percentage
greater than
35%.
1 According to USLegal.com, a deed is the written document, which transfers title(ownership) or an interest in real property to another person. A trustee's deed is a
deed to be executed by a person serving as a trustee in their appointed capacity. A
trustee's deed is often used, for example, by a trustee in bankruptcy to sell real
property of the debtor.
-
7/29/2019 Portfolio Risk analysis
10/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 9 of 29
Price Volatility Percentage Findings:
The Price Volatility Percentage is a measure of the average percentage increase in
sales price of those properties within the subject market area that were sold two or
more times in the last three years.
A Price Volatility Percentage was returned on 7,271 loans. The analysis returned the
following results, which are also illustrated in Graph II:
38.2% had a price
volatility of less
than 25%; 15.1% had a price
volatility of 25% -
35%; and 46.7% had a price
volatility
exceeding 35%.
-
7/29/2019 Portfolio Risk analysis
11/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 10 of 29
Value Relationship Changes:
In addition to the three previous analytics, BECU also used Pass/Index Automated
Valuation as well as a review of current Loan-To-Value ratios 40, which is discussed
in the following section. The Pass/Index Model provides a view into property value
changes, from point of loan origination to present day. Of the loans reviewed, values
declined on 3,847, as described here, and in Graph III:
95.6% of loans less than
20% decline; 2.2% with a decline of
20% - 25%; and 2.3% with a decline
greater than 25%.
The final data point used in this analysis was Current Loan-to-Value. Current LTV
was returned revealing 77.5% of loans had a ratio below 90%, 5.4% fell between
90% and 95%. The final 17% exhibited an LTV of 95% or more. Graph IV illustrates
this segmentation.
Using all the above information, BECU decided to focus the analysis on loans thathave seen the most declines in property value. To identify those loans, they put
together a template using current and original credit score and combined it with the
current and original home values to determine which lines of credit would be reducedor closed. Members who had deterioration in both credit score and property value
were recommended for reduction in their lines of credit. Members with extremely
poor credit had their lines of credit closed, regardless of their home value.
-
7/29/2019 Portfolio Risk analysis
12/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 11 of 29
Actions Taken
BECU identified different actions to be taken depending on various FICO, LTV and
loan amount combinations. If the current FICO was less than 720, the LTV
greater than 80%, and the credit line greater than $25,000 the following
actions were taken for each product:
EA 85 Product1
Reduce the line when there is a 50% or greater decline in available equity and
there is less than $5,000 in available credit. Suspend the line if there is greater than $5,000 in available credit, or if there
has been a 40-point drop in the FICO score.
EA 100 Product
Reduce the line only when the current LTV at 100% will accommodate all
balances, and when there is greater than $5,000 in available credit. Suspend the line for all accounts with a current LTV greater than 100%, or if
there has been a 40-point drop in the FICO score.
BECU reviewed their Equity Advantage credit limits and in some cases those limits
were reduced or suspended. This was a due diligence measure to protect the safetyand soundness of the Credit Union. They recognized that the housing market has
changed and values are lower and time on the market is longer. Given the
circumstances, BECU carefully assessed its position relative to their members andthe collateral provided.
A line reduction or suspension only occurred if there had been a material change in
the conditions under which the loan was granted. BECU had defined a material
change as either a 50% decline in available equity or a 40-point or greater
decline in the FICO score. There is concern about member retention and the Net
Promoter Score2. The criteria for line review or suspension are designed to help
members who have lost value in their property from becoming overextended and totarget at risk members based on a decline in credit.
1The EA 85 Product refers to an Equity Advantage with 85% LTV or lower. The EA 100 Productrefers to an Equity Advantage loans with an LTV of 85.1% to 100%.
2Fred Reichheld developed the Net Promoter Score after more than a decade of research. This
research has shown that companies with a higher NPS have stronger relationships, profit andgrowth.
The BECU Board of Directors has set a three year Strategic Objective for NPS with a target of75% as of 12/21/08. This is calculated using a member survey. In the Net Promoter surveymembers are asked, How likely are you to recommend BECU to a friend or colleague? using ascale of 0 to10. Members who answer with a 9 or a 10 are Promoters; those who answer with a 7or an 8 are Passives and are not included in the final calculation because they could go eitherway; and those who answer in the 0 6 range are Detractors. There is an additional question thatBECU asks their members, What is the primary reason for your score?
The NPS is calculated by subtracting the number of Detractors from the number of Promotersdivided by the total number of responses.
-
7/29/2019 Portfolio Risk analysis
13/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 12 of 29
All reduced limits have met one or both of the material change provisions. In
addition, BECU did not look to change credit limits less than $25,000, with a currentFICO score greater than 720 or with a current LTV greater than 80%. If the member
has good credit, equity in the home, or a small credit line their BECU equity line will
be the same.
Applying the stated criteria resulted in the following changes to credit limits andaccounts:
Suspended limits = 700
Reduced limits = 48
Overturn on appeal = 14
o Change in credit score = 3o Appeal on property value and/or was suspend when it could have been
reduced = 8
o Cover check that were written in good faith = 3 $70,552,892 in total limits, $61,428,550 in balances.
For loans targeted for a limit reduction a letter of explanation was sent with
instructions to contact Member Risk Assessment with any questions. A copy of this
letter is attached in the Exhibit I.
Members who had their limits closed were sent a standard adverse action letter
containing the same contact information.
In order to prepare staff, copies of both letters along with an explanation of BECUsactions were communicated to all frontline employees via BECUs knowledge
management system which displays daily updates to BECU operations, policies and
any other important news. The update included instructions on how to assistmembers who may wish to dispute the decision and gave Rheba Cottles contact
information.
Member ReactionOverall the members who contacted BECU were concerned about their situation, yet
the majority understood why BECU was taking such action. To date there have been
approximately 125 calls from members. Below is a breakdown of those calls:
The majority of the calls were to discuss the reason for suspension or
reduction (i.e., Drop in Equity or Credit Score). Most of the members were able to understand the basis for credit unions
decision. The most common comment is they were disappointed that the lineswere suspended before they got the notification. Many were concerned that
the note was being called due.
Two members threatened to close accounts. As of 11/21/08 those accountswere still open.
There are three appeals on value where appraisals are in progress.
The remainder of the calls varied from members asking for advice or askingwhere and how to get help.
-
7/29/2019 Portfolio Risk analysis
14/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 13 of 29
Information was placed on each affected members profile to explain why his or her
limit was reduced or closed. Contact information was included on the letter andexamples distributed to the Member Service Call Center and Neighborhood Financial
Centers in a communication. This helped Member Service Representatives properly
address the situation should a member make an inquiry.
Challenges
Timing was an issue for BECU regarding when to send the letters explaining the line
of credit decrease or closure. They did not want to appear insensitive and the
holidays were approaching. Philosophically credit unions are not used to taking
things away from members, which made this a difficult task.
As a counter measure, BECU created an appeal process for members who felt their
equity was valued incorrectly. The members were given the opportunity to ordertheir own appraisal (as an out of pocket expense to the member) and present it to
BECU for review. BECU also implemented their own self-audit that took place before
the letters were sent. If a value appeared to be incorrect another Home Valuation
Explorer (Automated Appraisal) was pulled to double check.
Another challenge was knowing whether or not lowering credit limits of at risk
loans or closing the limits all together was cutting BECU losses or cutting potential
income. Ultimately BECU felt that their actions would benefit the membership as awhole by protecting against potential loss.
The final challenge occurred at the time the letters went out. BECU ran a marketingcampaign through online e-statements, paper statement inserts and on their website
encouraging members to apply for the Equity Advantage product. BECU felt that a
credit union-wide communication plan would avoid this from happening in the futureand recommend that any credit union who may choose to follow a similar program
should consider a plan to meet with marketing and other departments who may havean effect on such a mailing.
-
7/29/2019 Portfolio Risk analysis
15/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 14 of 29
Conclusion
Executing a Collateral Risk Portfolio Analysis
The following steps are meant as a guide to assist you in getting started with a
collateral risk portfolio analysis.
Project Scope
Determine who will be responsible for the project Identify your stakeholders
Identify products to be analyzed (First Mortgages, Seconds, HELOCs) Identify which loans, if any, you wish to exclude
Methodology
Identify which tools to utilize and what vendors (property valuation, credit
score, etc.) Outline a process to conduct your analysis
o Identify data elements to be pulled
o Decide if there will be any special focus on certain product lines, hometypes, demographics, etc.
Taking Action
Identify loans that may be at risk
Decide what action will be taken (Adverse Action Letter, reduce or close limitson HELOCs)
Identify if changes are needed to your lending policies Create a communication plan for staff and members
This has to be done regularly to be effective, once a year or less
-
7/29/2019 Portfolio Risk analysis
16/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 15 of 29
Acknowledgements
We would like to thank the credit union executives and staff who provided
information for this paper. Special appreciation is given to:
Joe Brancucci
Executive Vice President and COO
BECUTukwila, Washington
Scott StrandSenior Vice President of Member Operations
BECU
Tukwila, Washington
Aaron Bresko
Vice President of Lending
BECU
Tukwila, Washington
Will Gix
Manager, Model ManagementBECU
Tukwila, Washington
-
7/29/2019 Portfolio Risk analysis
17/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 16 of 29
Appendix
Sample Line Decrease Notification Letter sent to members:
FullName Date of Notice: Date
AddressLine1 Account Number:
Account_NumberAddressLine2
CityName, StateCode ZipCode5
Dear Member: FullName
BECU periodically reviews our loan portfolio to determine if there have been any
significant changes since a loan was granted. We are contacting you with important
information regarding your Home Equity Line of Credit. After reviewing your Home
Equity Line Account, on Date we have reduced your Credit Limit to $ Limit
Our decision was made in accordance with terms of the Credit Agreement(s) and was
based primarily on a decline in the value of the property securing your Home Equity
Line, which resulted in a significant decrease in your available equity. In order todetermine this, we obtained an updated home value assessment for this property.
Please note that your account is not closed and will not be reported to any of the
credit bureau agencies as such. You can continue to make new advances on your line
up to the new Credit Limit and be reported in good standing as long as you continue
to satisfy the terms and conditions of the Credit Agreement.
Once the circumstances, that led to this action has been corrected, you may request
BECU to reevaluate your account for reinstatement of the credit limit.
Please note that all of the other terms of your Credit Agreement(s) remain in effectuntil you have repaid all amounts due under that agreement.
If you have any questions, please call Rheba Cottle at 206-XXX-XXXX, or toll-free at1-800-233-2328 x0000 if you are calling from outside the local Seattle calling area.
-
7/29/2019 Portfolio Risk analysis
18/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 17 of 29
Supervisory Letter
Evaluating Current Risks to Credit Unions
Risk in the credit union industry continues to evolve and requires NCUA to
continually evaluate our risk monitoring and supervision procedures. This
Supervisory Letter (Letter) discusses several of the emerging risks, particularly thoserelated to the current economic climate, and provides guidance for addressing the
issues. The specific topics covered in this Letter include:
The changing credit union business model and balance sheet composition andthe challenges it creates;
Present mortgage and real estate market and the related expectations for
credit unions and examiners; and
The Risk Focused Examination (RFE) supervision program with an emphasis
on district management and off-site monitoring.
Recent failures show the results when credit union management does not prudently
plan, pursues aggressive and unchecked growth, and fails to properly diversify.These failures also demonstrate the consequences associated with declining real
estate markets coupled with higher levels of credit risk. Not fully understanding the
risks of a new program coupled with not limiting exposure to gain experience was amaterial flaw in the management of these failed credit unions.
One of the key lessons learned is the need for credit union management to gain
adequate experience with any new product or service in order to understand and
manage the related risk. The core lesson regarding new programs is to limit
exposure until management has a complete understanding of the potential risk.Even after gaining an adequate understanding, the ongoing measuring, monitoring,
and controlling of the risks is essential to ensure long-term success in meeting the
credit unions strategic goals.
The remainder of this Letter addresses the current risks credit unions are facingalong with guidance to staff. While this Letter primarily addresses the risks in real
estate lending, many of the principles discussed can and should be applied to other
loan products and services.
-
7/29/2019 Portfolio Risk analysis
19/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 18 of 29
Evolution of the Credit Union Business Model
As of June 30, 2008, there were 7,972 federally insured credit unions reporting $291billion in real estate loans. However, just as an individual credit union can have a
concentration of assets, the National Credit Union Share Insurance Fund (NCUSIF)
has a growing concentration risk with 7.7 percent (or 614 credit unions) of federally
insured credit unions holding 78 percent (or $227 billion) of the credit unionindustrys outstanding real estate loans. These 614 credit unions all are in excess of$250 million in assets. As the majority of real estate loans reside in these credit
unions, so does the majority of the credit and interest rate risk discussed in this
Letter.3
Balance Sheet Structure
The structure of the credit union
industrys balancesheet andincome statement materially
changed over the past 10 years.
As Chart 1 shows, assets shiftedfrom traditional consumer loans to
real estate loans, with the latter
comprising over 53 percent oftotal loans.
During the same period, membershares shifted from regular shares
to more rate sensitive share
certificate and money market
accounts as shown in Table 1. In
addition to greater reliance on rate sensitive shares, credit unions increased the use
of borrowed funds and the reliance on fee income.
Table 1
Dec 1997 June 2008
Real Estate Loans to Total Loans 35.0% 53.3%
Net Long-Term Assets to Assets 20.2% 32.1%
Regular Shares + Share Drafts to Total Shares +Borrowings
49.4% 36.5%
Certificates + Money Markets to Total Shares +Borrowings
38.4% 49.3%
Borrowings to Total Shares & Borrowings 0.4% 4.3%Fee Income to Net Income 57.7% 163.2%
3Credit unions with assets less than $250 million can also demonstrate elevated risk levels
discussed in this Letter. Examiners should apply the guidance provided to all credit unionsexhibiting high risk characteristics, not only those with assets greater than $250 million.
-
7/29/2019 Portfolio Risk analysis
20/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 19 of 29
Credit unions with a balance sheet exhibiting the growing concentration in real estate
loans funded by more volatile shares requires a high level of oversight and moreadvanced risk modeling systems. Examiners must closely scrutinize the risk systems
and models employed by credit unions exhibiting these characteristics.
Earnings
The credit union industrys income structure is being impacted by changes in thebalance sheet composition, the interest rate environment, and economic conditions.
An increase in the operating expense ratio and compression of the net interest
margin has occurred since 2005. As Chart 2 illustrates, the industry balance sheet
would be unprofitable without fee income as the historical core share and loan
products no longer provide sufficient spread to cover operating expenses. Creditunions not able to find additional efficiencies in operations found other ways to boost
income, such as increasing loans or offering other fee-generating products or
services. This trend pointsto a significant change in
credit union operations, one
that is untested in thecurrent economic
environment.
Lower levels of earnings can
be acceptable depending on
the level of net worth,4
quality of assets and
liabilities/shares, and thelevel of control exerted over
the earnings structure. An
overly simplistic focus ongrowth to increase earnings
in the current environment isvery likely to involvestrategies that necessitate excessive risk-taking and could drive unsafe and unsound
behavior.
Examiners must evaluate credit union earnings relative to the financial and
operational risk exposure, strategic plans, and net worth needs based on current andpotential risks. Lower levels of earnings should continue to be viewed positively if
they result from a sound and well-executed strategy to balance risk exposure or to
position the credit union to achieve long-term growth, financial stability, andmember service objectives. Any unsafe and unsound concentration risks affecting
earnings must be addressed with the management of the credit union and
adequately reflected in the CAMEL and risk ratings.
4 Thus, credit unions need not engage in reactive or extraordinary measures simply becauseearnings levels decline as a result of broader economic conditions when net worth levels meet orexceed their needs. In fact, such measures likely involve significant risks, either in terms ofaccepting greater risks to generate higher returns, and/or in terms of short-sighted trade-offs(e.g., increasing fees, selling less profitable business lines, engaging in high risk lending)affecting the longer-term strategic positioning of the credit union. NCUA Letter to Federal CreditUnions 06-FCU-04, August 2006
-
7/29/2019 Portfolio Risk analysis
21/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 20 of 29
Reliance on Third-Party Providers
The methods credit unions use to obtain the assets and liabilities/shares changed
dramatically in recent years while the use of third-parties to facilitate lending
services increased significantly. These third-parties could be credit union serviceorganizations (CUSOs), mortgage brokerage firms, other financial institutions, or
other third-parties. Loan participations and outright purchasing of real estate loansoriginated by other parties has also increased. Third-party risk is addressed in
Supervisory Letter No. 07-01, October 2007 - Evaluating Third Party Relationships.
Letter 07-01 provides a good reference for examiners to use when evaluating a
credit unions due diligence process.
Assessment of Risk Management Systems forMortgage Portfolios
Since 2002, real estate values have cycled from historical increases to historical
declines in certain geographic areas. As real estate valuations were dramatically
increasing, mortgage loan originators expanded beyond the traditional mortgage
products. Although the credit union industry does not report large amounts of non-
traditional mortgage lending,5 there is some exposure to this lending type. These
loans amount to $7.2 billion, or 3.7 percent of all first mortgages, which indicates a
low level of industry-wide risk. In addition to new types of mortgages, many
mortgage originators demonstrated willingness to lower credit underwritingstandards, including:
Low-doc or no-doc loans;
Relying on stated income without verification;
Determining capacity to repay solely on the initial payment for interest only
hybrid adjustable rate mortgages (ARMs) or payment option ARMs;
Risk layering6
through simultaneous second mortgages; and,
High loan-to-value ratios for first or second lien loans.
The vast majority of credit unions followed traditional mortgage underwriting
practices consistent with the characteristics of their field of membership. However,
due to the prevalence of high risk underwriting practices in the mortgage industry
over the past several years, any credit union with real estate loans on their books islikely to have increased risk exposure. For instance, if the credit union holds a
second mortgage behind a senior lien underwritten using the practices mentioned,
these loans are at a higher risk of default.
5NCUA Call Report data for non-traditional mortgages is limited to Interest Only or Optional
Payment first mortgage loans.6
Risk-layering refers to loans that combine multiple nontraditional features, such as interest onlyloans, with reduced documentation and/or a simultaneous second-lien loan. Management shoulddemonstrate that mitigating factors support the underwriting decision and the borrowers capacityto repay. Mitigating factors could include higher credit scores, lower loan-to-value and debt-to-income ratios, significant liquid assets, mortgage insurance, or other credit enhancements. Whilehigher pricing is often used to address elevated risk levels, it does not replace the need for soundunderwriting.
-
7/29/2019 Portfolio Risk analysis
22/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 21 of 29
While the weakened mortgage market is causing increased delinquency and loan
losses across nearly all types of lending, real estate loan categories demonstrate thegreatest increase. Other real estate loans (those not in a first lien position) show a
higher degree of credit risk as evidenced by the significant increase in delinquency
and losses during 2007 and through the first six months of 2008.
Table 2
Range for
1997-2006 2007
June 2008
(annualized)
First Mortgage Delinquency 0.26% - 0.49% 0.64% 0.78%
Other Real Estate Delinquency 0.24% - 0.41% 0.73% 0.78%
Non-Real Estate Delinquency 1.01% - 1.30% 1.21% 1.19%
First Mortgage Charge-off 0.01% - 0.02% 0.02% 0.07%
Other Real Estate Charge-off 0.04% - 0.06% 0.19% 0.53%
Non-Real Estate Charge-off 0.67% - 1.00% 0.93% 1.25%
In some areas of the country, property values have declined in excess of 20
percent,7 which puts even well underwritten, conventional mortgages at some risk.
An article titled Hybrid ARMs: Addressing the Risks, Managing the Fallout, included
in the summer 2008 edition of FDICs Supervisory Insight, begins with the followingstatement:
Recent turmoil in U.S. residential mortgage markets has shattered the
long-held belief that home mortgage lending is inherently a low-risk
activity.
This observation is important when evaluating the risks faced by every credit union
granting or holding real estate loans. The dramatic changes in the credit marketsand in real estate valuations affect nearly all credit unions, even the vast majority
that adhered to conventional real estate lending practices and products. What was
once the safest loan a credit union could grant now carries with it thepotential forincreased credit risk, even when prudent underwriting standards are followed.
Evaluating Mortgage Portfolios
When a credit union has a large mortgage portfolio or a portfolio with high-riskcharacteristics, examiners need to ensure risk managementpractices arecommensurate with the risk assumed and management clearly identifies and
measures the risk taken. Examiners should determine whether risk managementprocesses include:
Setting individual and aggregate loan limits based on net worth and the
overall risk profile within the balance sheet;
Updating credit risk scores periodically on all borrowers;
Monitoring home values by geographic area;
7Based on reports produced by the Office of Federal Enterprise Oversight and the National
Association of Realtors.
-
7/29/2019 Portfolio Risk analysis
23/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 22 of 29
Obtaining updated information on the collaterals value when significant
market factors indicate a potential decline in home values, or when theborrowers payment performance deteriorates and a greater reliance is placed
on the collateral;
Ensuring that appraisals obtained reflect realistic values based on currentmarket conditions and comply with regulatory and industry requirements,
especially if related to a loan underwritten by a third-party where theyselected the appraiser;
Monitoring transactional volume and activity on home equity lines of credit
(HELOCs); and
Analyzing whether increasing loan-to-value (LTV) ratios necessitate reducing,
suspending, or discontinuing existing credit lines8 (e.g., HELOCs).
Management should be producing periodic reports for the portfolio management
process, including:
Origination and portfolio trends by product, loan structure, originator channel,credit score, LTV, debt-to-income ratio (DTI), lien position, documentation
type, property type, appraiser, appraised value, and appraisal date;
Delinquency and loss distribution trends by product and originator channel
with some accompanying analysis of significant underwriting characteristics,
such as credit score, LTV, DTI;
Vintage tracking9 (i.e., static pool analysis);
The performance of third-party (brokers and correspondents) originated
loans; and
Market trends by geographic area and property type to identify areas of
rapidly appreciating or depreciating housing values.
High Loan-to-Value Loans
In some cases, examiners will find the existence of high loan-to-value (HLTV) loans,
especially in the markets with declining home values and in product lines designed to
serve low-income members. When HLTV loans are present, management should
monitor such loans closely. In reviewing HLTV loan portfolios, examiners should
review:
The existence and reasonableness of the board policy limit on HLTV loans tonet worth;
The repayment terms and structure of the senior liens as the risk of the
senior liens impact the subordinate liens;
The tracking of all LTVs in excess of 80 percent, including factors such as theexistence of mortgage insurance;
8Letter 05-CU-07, Managing Risks Associated with Home Equity Lending, outlines the
circumstances when credit lines can be reduced or discontinued under Regulation Z.9
Risk Alert 05-Risk-01, Specialized Lending Activities Third-Party Indirect Lending andParticipations, and the accompanying supplemental guidance whitepaper on static pool analysisdiscusses how such analysis can be used to track the performance of most loan pools. Thisguidance can be applied to all non-traditional products or other loan products, not just indirectlending.
-
7/29/2019 Portfolio Risk analysis
24/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 23 of 29
Inclusion of unfunded commitments such as available unused lines of credit in
LTV computations; and
The reporting of the aggregation of HLTV loans to the board of directors at
least monthly.
Mortgage Loan Workouts
During an economic downturn, credit unions are more likely to offer mortgage loanworkout programs to their members. Examiners must closely evaluate these
programs to ensure management exercises the proper level of due diligence in
developing and monitoring these inherently higher risk programs. When the credit
union originated and holds the distressed loan, management should be encouraged
to take appropriate actions to rework the loan as necessary to reduce the credit
unions loss exposure.10 At the same time, examiners must ensure the program
does not cause unintended consequences such as masking delinquency or delaying
the timely recognition of loan losses.
When reviewing loan workout programs, examiners must ensure the credit union
adheres to the following minimal controls:
Strict aggregate program limits in terms of total loans and net worth;
A requirement for the borrower to meet traditional underwriting standards interms of the credit score, employment stability, etc;
If HLTVs are accepted, a documented assessment showing the current
property value and anticipated value over the next 12-24 months (consider
using nationally recognized real estate valuation sources), as well asthe LTV at the end of that period;11 and
Monthly reporting to their board of directors on the loans originated under theprogram, including the risk profile of theportfolio related to current LTV,delinquency, losses, and credit quality.
If the credit union offers a loan workout program to members with distressed
mortgages held by another institution,12 the level of oversight and control should be
equally diligent and based on time-tested sound lending practices. In addition to thecontrols above, there should also be a requirement for the member to obtain
concessions from the originating lender so the credit union is not fully absorbing the
risk of the distressed mortgage and accompanying collateral.
10Letter to Credit Unions number 07-CU-06 Working with Residential Mortgage Borrowers.
11This control is intended to guide credit unions making HLTV loans both to consider the current
property value and to exercise caution in light of potential future declines in the property value,not to make lending decisions based on forecasted higher property values.12
These would be mortgages in which the credit union does not have a direct interest. In thoseinstances where a credit union attempts to help their member out of a problem loan with anotherinstitution they should apply traditionally proven and sound underwriting guidelines.
-
7/29/2019 Portfolio Risk analysis
25/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 24 of 29
Risk Focused Supervision and Monitoring
There are several pillars to the RFE program including examinations, supervision,and district management, each of which contributes to the programs overall
effectiveness. Given the current ability of credit unions to rapidly change the
composition of their balance sheet and risk profile, coupled with their growing
complexity, a responsive and results-oriented supervision program is essential.
Identifying a potential problem early provides credit union management and NCUA
with the best chance of resolution without requiring assistance from the NCUSIF.
One of the key parts of the supervision program is off-site monitoring. However, thereview of numbers by themselves often does not provide the depth of an issue.
When signs of increased risk are present through off-site monitoring, the review may
lead to a phone contact or an on-site contact to gain an understanding of thechanges and risks.
District Management
Off-site review of the quarterly call report, financial trends, regional risk systems,and national risk reports are essential pieces of district management and the RFE
process. These reviews provide insight into the impact from changes to the balance
sheet structure related to a new product or service, or provide the first indication ofa material change in strategic direction. The review of data must be coupled with
consistent communication between the credit union and examiner for effective
district management.
During on-site or off-site contacts, examiners should become aware of any new
products or services, changes in strategic direction for each credit union in the
assigned district, and changes in key management positions. This knowledge allows
the examiner to put the financial trends in perspective and adequately evaluate the
credit unions risk profile.
Where feasible, it is a good practice to address shortfalls in the planning or riskmanagement of a new product/service or a change in strategic direction before
implementation. Examiners typically become aware of these situations through the
review of board minutes or other credit union documents, quarterly call reports, orthrough conversations with management and the officials of the credit union.13
Among other things, plans should address prudent limitations to manage the risk to
net worth, the projected costs and income, interest rate risk impact (if applicable),long-term strategic goals, and on-going monitoring.
Off-Site Contacts
Off-site supervision and timely identification of risk trends is a critical component ofthe overall supervision process. Ensuring growth trends are in line with strategic
planning and risk management strategies is essential in determining whether there is
undue potential risk to the credit union. Periodically reassessing existing asset orliability concentrations based on changes in internal and external factors is also a
valuable supervision step.
13These reviews and/or conversations could be through off-site or on-site supervision.
-
7/29/2019 Portfolio Risk analysis
26/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 25 of 29
Examiners should consider the following questions when conducting off-site reviews
of quarterly data, reports, and other information provided by credit unions:
Do call reports, financial performance reports, historical warnings reports,
or risk reports reflect any unusual trends, possible data errors, or
anomalies warranting further review?
Is the growth in any asset or liability category unusual or inconsistent withthe credit unions strategic plan or established risk thresholds?
Is the growth rate excessive, when all factors are considered (e.g.
compared to the credit unions own historical trends, geographic, or
industry trends)?
Is the volume or concentration of any loan product or asset category
excessive when measured against net worth, particularly in light of
existing economic conditions?
How is the credit union funding loan growth? Is it through current
liquidity, borrowed funds, brokered deposits, or some other source or
combination of sources? Does the funding source(s) create other risk
considerations? Is loan growth from the credit unions use of a third-party? Does this
represent a new vendor relationship or a change in relationship not
previously reviewed?
Are the earnings, liquidity, and net worth levels consistent with the creditunions current plans and strategies?
Can management adequately explain their growth strategies? Do they
have a solid understanding of the potential risks, and are adequate plans,systems, and controls in place to manage those risks?
Has there been a substantial change in senior management? What is the
background of the new management staff and is their tolerance for risk
consistent with historical information?
Examiners should contact credit unions in a timely manner when there is asubstantial change in the balance sheet composition or trends. This is particularly
critical when the product or service may have unique risk characteristics or when
there is concern that a concentration is developing that could create an undue level
of risk not considered by management. This may necessitate an on-site contact to
address the questions or concerns.
On-Site Contacts
Examiners may determine an on-site visit is necessary to review the trends and to
ensure management has a full understanding of the risks associated with theirstrategy. It is important to remain vigilant when assessing managements strategicvision and risk management processes, especially when there appears to be a shift in
strategic direction.
Open and clear communication with senior credit union management is a key
element of a successful on-site contact and effective supervision. Senior
management should be forthcoming with answers and support for areas of potential
risk and provide examiners unrestricted access to documentation and staff members
-
7/29/2019 Portfolio Risk analysis
27/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 26 of 29
to facilitate the contact and understanding of the credit unions practices. A lack of
candor or limiting access to records or staff are red flags examiners should notaccept. Examiners should discuss problems involving lack of cooperation with their
supervisor, communicate with the credit union officials to obtain required cooperation
and/or records, and document the issues in the administrative record.
When performing on-site assessments and monitoring the risks outlined in thisLetter, whether through routine examinations or interim on-site supervision contacts,
examiners should constantly evaluate managements capabilities including whether:
Short-term decisions and strategies are based on a sound business model,that all risks have been fully considered, and potential short-term gains
are not being pursued to the detriment of long-term risk exposure;
Risks being taken are commensurate with the expertise of credit unionstaff and with the level of available net worth;
Potential risk to the institution is within board established risk parameters;
Processes and procedures are appropriate in light of the risks taken; and
Third-party vendors have been thoroughly reviewed prior to entering intosuch relationships and adequate controls over the product/servicingprocess are maintained.
Problem Resolution
When a contact discloses elevated levels of risk without prudent risk management
practices, examiners must take appropriate supervisory action.
It is important to remember there does not have to be an imminent risk of loss to be
a safety and soundness concern. While there is no finite list of concerns, examplesinclude: (1) A credit union growing a program rapidly without prudent risk
management practices in place; (2) A credit union with a significant mismatch in the
asset/liability structure and lacking proper interest rate risk management; or (3) Acredit union failing to perform initial and on-going due diligence when using a third-
party.
Examiners must evaluate the situation based on their own experience, assess the
individual credit unions management of risk, and determine whether corrective
action is required. When elevated risk is present and management of the risk is not
sufficient, examiners must consider a credit unions ability to continue offering a
program and the potential impact to net worth using a worst-case scenario.
Supervisory actions may include requiring the cessation or moderation of growth in a
program until proper risk management practices are in place. As always, examiners
should consult with their supervisor prior to initiating such action .
Conclusion
Diligence in NCUAs examination and supervision efforts is of paramount importance
to help ensure the continued success of the industry and maintain public confidence
in the credit union system. Flexibility in the examination and supervision approach isneeded to match the changing credit union business model, as well as deal with the
challenges presented by the current real estate market.
-
7/29/2019 Portfolio Risk analysis
28/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 27 of 29
NCUA has issued numerous letters to the credit union industry regarding the
associated risks given various economic, interest rate, or credit cycles. The coremessage and guidance in these letters represent sound risk management practices
and are applicable today, including:
Applying prudent policies, realistic limitations, and business strategies for allasset, liability and share categories;
Considering carefully the risk to net worth and the level of earnings requiredto sustain strategies under various economic and interest rate environments;
Employing proper diversification strategies in order to avoid excessive
concentrations in or reliance on any asset, liability or share category;
Evaluating and clearly understanding the risks involved before implementing
new strategies, introducing member products, or materially increasing any
loan or asset holding;
Performing initial and on-going due diligence when using a third-party to
provide services, loan underwriting, or purchase/manage assets or liabilities;
and
Measuring, monitoring, and controlling the risks from all strategies andmaking operational adjustments as necessary.
-
7/29/2019 Portfolio Risk analysis
29/30
2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 28 of 29
Resources
1. NCUA Letters to Credit Unions No. 57, June 1981 Diversification in theInvestment Portfolio
2. NCUA Letters to Credit Unions No 60, October 1981 - Deregulation of Share,
Share Draft, and Share Certificate Accounts
3. NCUA Letters to Credit Unions No. 124, June 1991 - Real Estate Secured Credit
by Credit Union Members
4. NCUA Letters to Credit Unions No. 130, February 1992 - Changes in Interest
Rates During Examinations
5. NCUA Letters to Credit Unions No. 146, August 1993 - Yields on Assets
6. NCUA Letters to Credit Unions No. 154, April 1994 - Credit Unions' Lending
Policies
7. NCUA Letters to Credit Unions No. 174, August 1995 - Risk-Based Loans
8. NCUA Letters to Credit Unions No. 99-CU-05, June 1999 Risk-Based Lending
9. NCUA Letters to Credit Unions No. 99-CU-12, August 1999 - Real Estate Lending
and Balance Sheet Risk Management
10.NCUA Letters to Credit Unions No. 00-CU-13, December 2000 - Liquidity and
Balance Sheet Risk Management
11.NCUA Letters to Credit Unions No. 01-CU-08, July 2001 - Liability Management Highly Rate-Sensitive & Volatile Funding Sources
12.NCUA Letters to Credit Unions No. 03-CU-11, July 2003 - Non-Maturity Sharesand Balance Sheet Risk
13.NCUA Letters to Credit Unions No. 03-CU-15, September 2003 - Real EstateConcentrations and Interest Rate Risk Management for Credit Unions with Large
Positions in Fixed-Rate Mortgage Portfolios
14.NCUA Letters to Credit Unions No. 04-CU-13, September 2004 - Specialized
Lending Activities
15.NCUA Letters to Credit Unions No. 05-CU-07, May 2005 - Risks Associated with
Home Equity Lending
16.NCUA Risk Alert No. 05-RISK-01, June 2005 - Specialized Lending Activities
Third-Party Subprime Indirect Lending and Participations
17.NCUA Letters to Credit Unions No. 05-CU-15, October 2005 - Increasing Risks in
Mortgage Lending
-
7/29/2019 Portfolio Risk analysis
30/30
18.NCUA Letters to Federal Credit Unions No. 06-FCU-04, August 2006 - Evaluation
of Earnings
19.NCUA Letters to Credit Unions No. 06-CU-16, October 2006 - Interagency
Guidance on Nontraditional Mortgage Product Risk
20.NCUA Letters to Credit Unions No. 07-CU-06, April 2007 - Working withResidential Mortgage Borrowers
21.NCUA Letters to Credit Unions No. 07-CU-09, July 2007 - Subprime MortgageLending
22.NCUA Letters to Credit Unions No. 07-CU-13, December 2007 - SupervisoryLetter-Evaluation Third Party Relationships
23.NCUA Letters to Credit Unions No. 08-CU-05, March 2008 - Statement onReporting Loss Mitigation Efforts of Securitized Subprime Residential Mortgages
24.NCUA Letters to Credit Unions No. 08-CU-09, April 2008 - Evaluating Third Party
Relationships Questionnaire
25.NCUA Letters to Credit Unions No. 08-CU-14, June 2008 - Consumer Information
for Hybrid Adjustable Rate Mortgage Products
26.FDIC Supervisory Insights Summer 2008, Volume 5, Issue 1
http://www.fdic.gov/regulations/examinations/supervisory/insights/sisum08/inde
x.html