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Do Lower PLL Ratios Mean The Credit Crisis Is Over?

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On the surface, recent credit union provision for loan loss (PLL) trends seem encouraging; industry-wide through second quarter 2010, the ratio of PLL to average assets has declined by 31 basis points to an annualized ratio of 0.81%.  However, delinquencies and charge-offs as a percent of loans have only decreased by 11 basis points and 5 basis points respectively for the same period.
Of course every situation and institution is unique, but as we look toward 2011, credit unions might want to consider:

  • Is the improvement in PLL sustainable?  Or, could it be a function of allowance accounts being over-funded?  As noted above, recent delinquency and charge-off trends do not look as positive as the industry PLL trend
  • Do the unemployment outlook, real estate values and the trends in member credit scores support the assumption that PLL will continue to decrease through 2011?
  • What if many of our usually dependable borrowers lose their jobs and, at a certain point, run out of savings?
  • What if strategic defaults become more commonplace?  Consider that strategic defaults are currently blamed for as much as 25% of foreclosure activity
  • Could commercial real estate woes trickle down to further impact the economy and cause broader loan losses?

Is 2011 the year that we’ll see sustainable improvements in PLL?  Hopefully it is, but with all of the uncertainty out there, we may not want to count on it just yet.

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Hope For The Best, Budget For Reality

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Recently, during The Economist’s Buttonwood Gathering, Raghuram Rajan, current professor at the University of Chicago’s Booth School of Business and former chief economist at the IMF, expressed concern over our government’s need to address the deficit.  Rajan stated that, “We need to have a path which brings [the deficit] under control.  It’s very important to tell the bond market and the public what that path is.”

Laying out a path to show how we will recover is important.  Not doing so prevents us from addressing the problem which may cause markets to respond poorly, leading to further disaster.

The same logic applies for the credit union world at budget time.  A realistic view of the situation and a path for handling it is the single best tool for dealing with what has been a difficult time for many credit unions.  For example, in some regions loan demand has been very low.  If that same level of loan demand continues, it could make for a tough 2011 for some institutions.

While unfortunate, that is the reality and credit unions shouldn’t “pretty it up” by making assumptions that next year will be better, unless there is reliable data that shows a change in trend.  It is better to present the ugly reality and then identify a series of triggers that can be pulled to make the financial picture bearable.  Only when the board is presented with the reality of the situation can they begin to make the tough decisions that are required.  It may mean settling for losses in 2011 or difficult cuts in expenses but meeting the situation head-on is by far a better alternative than showing a happy budget that will only disappoint in the end.

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Good News! NCUSIF Premium Is ONLY 0.2582% For 2010

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The NCUSIF premium was set by the NCUA Board as 0.1242% on September 16, 2010.  This brings the total NCUSIF refunding cost for 2010 to 0.2582% when the 0.1340% for corporate stabilization is included.  This is in the middle of the 15 to 40 basis point (bps) range originally projected by the NCUA in November 2009.  Before you pass out party favors at your next board meeting, however, consider some of the comments made by the NCUA upon releasing this information:

  • CAMEL 4 and 5 federally insured credit unions (FICUs) increased to 366 from 291 in June 2009 for an increase of 25%.  Total assets for these credit unions increased $20 billion or 74%.  This indicates some larger credit unions have entered this group¹
  • The combined 0.2582% premium will cost FICUs $1.9 billion or 2.3% of their net worth²
  • “…NCUA is stepping up enforcement actions – to control the costs of troubled credit unions before those charges must be passed on to all credit unions³

Considering these comments and the state of the economy, it isn’t time to have a party just yet.  In fact it is even more important now to consider various possible scenarios as you work on your 2011 budget and longer-term financial plans.  Those of you who are regular readers of this blog (we thank you) know we are great proponents of scenario testing.  This has not changed—the use of 26 bps of insured shares would be a prudent base forecast; we also suggest that you consider scenarios at both ends of NCUA’s 15 to 40 bps projection for NCUSIF refinancing costs.  In addition to identifying the potential impact on your earnings, this will help you begin to think about possible contingency plans if the higher end of the range comes to pass.

¹NCUA Board Meeting Minutes 09/16/10

²IBID

³NCUA Chairman Debbie Matz Statement, Share Insurance Fund Premium, 09/16/10

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Are Your Second Mortgages Secured?

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As we discussed in our April post, Bankruptcies on the Rise and the Evolving U.S. Debt Burden, bankruptcies have been rising at an alarming rate this year. The trend is likely to continue—it will be interesting to note how the situation evolves (since 1st quarter) when the U.S. Judiciary releases second quarter figures in the coming weeks.

In the meantime, more and more consumers are taking advantage of a loophole in Chapter 13 bankruptcy proceedings to effectively remove the debt of their second mortgages. Bankruptcy courts can reclassify 2nd mortgages as unsecured if the appraised value of the home is less than the amount owed on the 1st mortgage—in essence, when there is no value securing the 2nd.

For example, a borrower has a $200K first mortgage and a $40K second mortgage; the borrower’s home only appraises for $180K. Thus, since there is no equity, or value, to secure the second mortgage—the borrower can file suit to have it removed.

With unprecedented decline in home values across the nation, one lawyer estimates at least 20% of his clients would qualify for a reclassification (Liening on banks: Second mortgages are next housing crisis, New York Post, 7/11/10).

If you have a significant portion of assets in second mortgages, we recommend stress testing what could happen to your risk profile should a significant amount be charged off due to continued credit risk and bankruptcy proceedings.

Furthermore, everyone should consider what could happen to the broader economic landscape should 20% of the nation’s $1 trillion second mortgage market be put at risk of reclassification.

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When Will This Be Over?

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It’s natural to wonder when things will get back to “normal.”  But week after week, the only thing consistent in the economic indicators is that they are not consistent.  So how do we plan for the future?

Most credit unions are designed to thrive in a different type of economic environment─one we may not see again for a long time.  Yet opportunities exist in every environment.  The key is the ability to alter our mindset and look for ways to take advantage of the current reality.

Try test driving the scenario:  “It is 2015 and we are thriving.  The economy is about the same as it was in 2010.”  What did you do to thrive?  How is your strategy different than it was in 2010?  Instead of looking for a “magic bullet,” consider staying true to your core business and improve areas of expertise.  For example, there may not be much loan demand at the moment, but by truly understanding what your target market needs and values, you can work toward getting more of the loan demand that currently exists.

Also, many institutions are focused on cutting costs; according to NCUA’s aggregate FPR for March 2010, there was a 36% decline in the industry’s average operating expense ratio from March 2009 to March 2010.  However, keep in mind that some cuts are not sustainable, such as pay cuts and leaving critical positions vacant.  While they may be necessary in the short term, work toward sustainable cuts like improvements in processes and strategic changes in product offerings.  Consider the following statistics from the Harvard Business Review’s July-August 2009 readers’ survey, How Bleak is the Landscape?

  • Only 27% of businesses surveyed are streamlining product or service offerings
  • Only 34% are reengineering processes
  • Only 37% are improving current products, services or customer support

Rather than hunkering down and waiting for the storm to pass, meet the storm head-on.  Stay focused on strategy and never stop thinking about ways to improve your business.