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Does Your NEV Analysis Really Capture Fair Value Of Assets?

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If your credit union runs a Net Economic Value (NEV) analysis as part of the A/LM process, how do you determine the credit union’s loan discount rate assumptions?

Sometimes we hear credit unions say that their current loan offering rates are used as the discount rates in their NEV models.  We do not believe this is the best method.

While current offering rates reflect what a specific credit union is willing to accept in terms of yield on new volumes, they do not necessarily reflect what an investor looking to purchase an existing portfolio may demand.  For example, if the credit quality of a credit union’s auto loan portfolio has materially degraded since the loans were made—a situation many credit unions are experiencing—then an investor is going to require a return that exceeds today’s low rates to compensate for the risk.

Additionally, there may be times when a credit union is intentionally pricing a portfolio above or below market to affect growth in that portfolio.  Many credit union executives would say that their loan rates are better than banks—in other words, they are “below market rates.”

As far as the credit risk component is concerned, lately we have heard comments suggesting that credit risk should not be factored into an NEV analysis.  This is simply not true.

In Letter to Credit Unions 99-CU-12, the NCUA says “NEV equals the fair value of assets minus the fair value of liabilities.”  What is the definition of fair value?  According to 12CFR NCUA, Section 704.2, fair value is defined as “the amount at which an instrument could be exchanged in a current, arms-length transaction between willing parties.”  The definition further states, “Valuation techniques should incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility.”

If you have gone through the process of having a third party value your portfolio, this can be helpful.  Note, in many cases such as mortgages, the price will only be for a portion of the loans, not for 100% of the portfolio.  Often, a material portion of the portfolio will not receive a price since there is not an efficient market for mortgages made several years ago that now have high LTVs.

If you do not have market values then for each portfolio, as you set assumptions, consider if you would have to take a loss selling all of the parts (the good and the bad).  Not only should your unique credit experience play a role in this answer, but so should the geographic region in which the loans were made.  A credit union selling loans from any of the sand states will typically take larger losses.

Once you establish an assumed price, you can use that price to calculate the assumed discount rate.  Once the base simulation is done, run alternate sets of assumptions to calculate the sensitivity to your results.

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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.