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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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Budgeting During Times Of “Unusual Uncertainty”

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Creating a budget is always a challenging and uncertain process.  Developing the annual budget for 2011 may be unusually difficult as there is heightened uncertainty about loan demand, interest rates, investment yields and deposit trends.  Net operating expense concerns include share insurance assessments, threats to non-interest income and provision for loan loss trends—stable, declining, or, for some institutions, still increasing.

Due to this uncertain economic environment, credit unions should consider developing a base budget and then creating multiple scenarios identifying key vulnerabilities that could stress financial performance, such as:

  • What if loan demand continues to be anemic?
  • What if provision for loan loss increases unexpectedly?
  • What if mortgage originations decline materially?
  • What if cost of funds cannot be lowered enough to help offset other adverse scenarios?

Evaluating combinations of negative factors, while depressing, can provide valuable early warning information to management and the credit union’s board.  This process can also help manage key players’ expectations appropriately.

If the base budget is acceptable but there are several plausible scenarios that could create unsatisfactory financial performance, it is good to know this in advance so that decision-makers can begin to think about contingency plans.  This is particularly relevant if the credit union has a level of net worth with very little breathing room.

Identifying the potential problems early on will give your credit union a better chance at making 2011 a financially successful year.  Good luck!

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Annual Long-Term Financial Planning Process: Include A Deflation Scenario

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We strongly recommend that credit unions annually invest the time to forecast financial performance for at least three future years.  The baseline forecast should compliment the strategic plan and include the cost of major initiatives, as well as expected growth trends.  If the baseline does not produce satisfactory performance, determine what changes could be made.  Once a baseline is established, senior management should identify the issues they feel could have the biggest impact on future financial performance and then test each issue as a what-if.  Typical what-ifs include:

  • Provision for loan loss doubles from the baseline plan for 24 months
  • Non-interest income decreases 50%
  • Lending volume declines significantly
  • NCUSIF assessments are twice the level in the baseline
  • Interest rates increase to the credit union’s self-defined, worst-case scenario

We recommend that a deflation scenario be included as well.  Many management teams have not discussed the possible impact of a sustained period of deflation, and even fewer have taken the time to forecast the possible financial impact of such a scenario.  Following a structured strategic thinking exercise on deflation could be helpful to explore the issue.  Create the what-if forecast by evaluating the impact on all major components of the financial structure and updating assumptions.  Often these forecasts include lower long-term rates including loan rates and investment rates, an increase in loan and investment prepayments, decreased loan demand and an increase in deposits.  While this may sound similar to today’s economic environment, the magnitude of such conditions may be greater.  For example, long-term rates could fall to 2% or lower and loan growth could decrease materially due to accelerated prepayments and consumers postponing purchases.

Management teams are often surprised by the possible significant, negative financial impact of a deflation scenario.

As with all of the what-ifs tested in this process, if the financial performance is not acceptable, determine what actions could be taken and test the impact of these actions.  At the conclusion of the exercise, decide if any of the actions to address the risks in the what-ifs should be implemented in the baseline plan.