portfolio risk analysis prime alliance solutions

©2000-2009 Prime Alliance Solutions, Inc. All Rights Reserved.

Portfolio RiskAnalysisPrime Alliance Solutions, Inc.January 2009

Tracy AshfieldExecutive Vice PresidentStrategic Mortgage Solutions

Nizar HashlamonExecutive Vice PresidentLoan Servicing

David MendelsonSenior Training ManagerPrime Alliance Training

Portfolio Risk Analysis

Prime Alliance Solutions, Inc. January 2009

Tracy Ashfield Executive Vice President

Strategic Mortgage Solutions

Nizar Hashlamon Executive Vice President

Loan Servicing

David Mendelson Senior Training Manager

Prime Alliance

© 2000 – 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 2 of 29

EXECUTIVESUMMARY..........................................................................................................................3INTRODUCTION ......................................................................................................................................4

Background .........................................................................................................................................................................................4Scope of the Analysis .................................................................................................................................................................5Staff Assignment ............................................................................................................................................................................5Stakeholders ......................................................................................................................................................................................5Characteristics of Loans Analyzed ....................................................................................................................................6Number of Loans Analyzed for Each Type .................................................................................................................6

METHODOLOGY ......................................................................................................................................7Tools Utilized .....................................................................................................................................................................................7Process Used in Conducting the Analysis ...................................................................................................................7

RESULTS ....................................................................................................................................................8ACTIONSTAKEN .................................................................................................................................. 11

Member Reaction ........................................................................................................................................................................ 12CHALLENGES......................................................................................................................................... 13CONCLUSION ......................................................................................................................................... 14

Executing a Collateral Risk Portfolio Analysis ...................................................................................................... 14Project Scope ................................................................................................................................................................................. 14Methodology .................................................................................................................................................................................... 14Taking Action .................................................................................................................................................................................. 14

ACKNOWLEDGEMENTS ..................................................................................................................... 15APPENDIX .............................................................................................................................................. 16

Sample Line Decrease Notification Letter sent to members: ................................................................. 16Supervisory Letter...................................................................................................................................................................... 17


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 and the substantial increase in defaults. For decades, good loan portfolio managers have concentrated their efforts on prudently 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 by each 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 score on 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 of the 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 it’s 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 has taken 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 union’s exposure while continuing to meet their members’ needs for home financing.


Introduction Evaluating credit unions’ real estate loan portfolios is more important now than ever in today’s 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 a best practice approach. Our analysis included a thorough review of BECU’s 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 to perform 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 complement other fundamental credit risk management principles such as sound underwriting, comprehensive financial analysis, adequate appraisal techniques, loan documentation practices, 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 collateral’s value when significant

market factors indicate a potential decline in home values, or when the borrower’s 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 collateral’s value when significant

market factors indicate a potential decline in home values, or when the


borrower’s 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 on the 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 or prevent 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 staff resources 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, IT and others. Stakeholders Because of the high importance of the project and its impact on the credit union’s 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 loan portfolio 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 they included the remaining HELOC loans in the portfolio.


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 a Trustees Deed, which typically indicates a foreclosure, within the past three years.

Price Volatility Percentage - Sales price increase measurement that identifies that 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 values on 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 a measure 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


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 to extract 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 BECU’s 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


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 Trustee’s 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 an REO 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.


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%.


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 that have 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 reduced or 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.


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 safety and 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 and the 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 to target “at risk” members based on a decline in credit.

1 The EA 85 Product refers to an Equity Advantage with 85% LTV or lower. The EA 100 Product refers to an Equity Advantage loans with an LTV of 85.1% to 100%. 2 Fred 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 and growth. The BECU Board of Directors has set a three year Strategic Objective for NPS with a target of 75% as of 12/21/08. This is calculated using a member survey. In the Net Promoter survey members are asked, “How likely are you to recommend BECU to a friend or colleague?” using a scale of 0 to10. Members who answer with a 9 or a 10 are Promoters; those who answer with a 7 or an 8 are Passives and are not included in the final calculation because they could go either way; and those who answer in the 0 – 6 range are Detractors. There is an additional question that BECU 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 Promoters divided by the total number of responses.


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 current FICO 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 and accounts: Suspended limits = 700

• Reduced limits = 48 • Overturn on appeal = 14

o Change in credit score = 3 o 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 BECU’s actions were communicated to all frontline employees via BECU’s knowledge management system which displays daily updates to BECU operations, policies and any other important news. The update included instructions on how to assist members who may wish to dispute the decision and gave Rheba Cottle’s contact information. Member Reaction Overall 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 union’s decision. The most common comment is they were disappointed that the lines were 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 accounts were 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 asking

where and how to get help.


Information was placed on each affected member’s profile to explain why his or her limit was reduced or closed. Contact information was included on the letter and examples 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 order their 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 a whole by protecting against potential loss. The final challenge occurred at the time the letters went out. BECU ran a marketing campaign 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 future and 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 have an effect on such a mailing.


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, home

types, demographics, etc. Taking Action

• Identify loans that may be at risk • Decide what action will be taken (Adverse Action Letter, reduce or close limits

on 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


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 BECU Tukwila, Washington Scott Strand Senior Vice President of Member Operations BECU Tukwila, Washington Aaron Bresko Vice President of Lending BECU Tukwila, Washington Will Gix Manager, Model Management BECU Tukwila, Washington


Appendix Sample Line Decrease Notification Letter sent to members: «FullName» Date of Notice: «Date» «AddressLine1» Account Number: «Account_Number» «AddressLine2» «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 to determine 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 effect until 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 at 1-800-233-2328 x0000 if you are calling from outside the local Seattle calling area.


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 those related 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 and the 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 a material 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 union’s strategic goals. The remainder of this Letter addresses the current risks credit unions are facing along 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.


Evolution of the Credit Union Business Model As of June 30, 2008, there were 7,972 federally insured credit unions reporting $291 billion 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 union industry’s 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 industry’s balance sheet and income statement materially changed over the past 10 years. As Chart 1 shows, assets shifted from traditional consumer loans to real estate loans, with the latter comprising over 53 percent of total loans. During the same period, member shares 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%

3 Credit 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 unions exhibiting high risk characteristics, not only those with assets greater than $250 million.


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 more advanced risk modeling systems. Examiners must closely scrutinize the risk systems and models employed by credit unions exhibiting these characteristics. Earnings The credit union industry’s income structure is being impacted by changes in the balance 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. Credit unions 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 points to a significant change in credit union operations, one that is untested in the current economic environment. Lower levels of earnings can be acceptable depending on the level of net worth,4 quality of assets and liabilities/shares, and the level of control exerted over the earnings structure. An overly simplistic focus on growth to increase earnings in the current environment is very likely to involve strategies 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 and potential 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, and member 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 because earnings levels decline as a result of broader economic conditions when net worth levels meet or exceed their needs. In fact, such measures likely involve significant risks, either in terms of accepting 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 Credit Unions 06-FCU-04, August 2006


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 service organizations (CUSOs), mortgage brokerage firms, other financial institutions, or other third-parties. Loan participations and outright purchasing of real estate loans originated 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 union’s due diligence process.

Assessment of Risk Management Systems for Mortgage 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 underwriting standards, 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 is likely 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.

5 NCUA 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 only loans, with reduced documentation and/or a simultaneous second-lien loan. Management should demonstrate that mitigating factors support the underwriting decision and the borrower’s capacity to 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. While higher pricing is often used to address elevated risk levels, it does not replace the need for sound underwriting.


While the weakened mortgage market is causing increased delinquency and loan losses across nearly all types of lending, real estate loan categories demonstrate the greatest 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 FDIC’s Supervisory Insight, begins with the following statement:

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 markets and 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 the potential for increased 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-risk characteristics, examiners need to ensure risk management practices are commensurate with the risk assumed and management clearly identifies and measures the risk taken. Examiners should determine whether risk management processes 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;

7 Based on reports produced by the Office of Federal Enterprise Oversight and the National Association of Realtors.


Obtaining updated information on the collateral’s value when significant market factors indicate a potential decline in home values, or when the borrower’s payment performance deteriorates and a greater reliance is placed on the collateral;

Ensuring that appraisals obtained reflect realistic values based on current market conditions and comply with regulatory and industry requirements, especially if related to a loan underwritten by a third-party where they selected 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 to net 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 the existence of mortgage insurance;

8 Letter 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 and Participations, and the accompanying supplemental guidance whitepaper on static pool analysis discusses how such analysis can be used to track the performance of most loan pools. This guidance can be applied to all non-traditional products or other loan products, not just indirect lending.


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 loan workout 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 union’s 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 in terms 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 as the LTV at the end of that period;11 and

Monthly reporting to their board of directors on the loans originated under the program, including the risk profile of the portfolio 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 the controls 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.

10 Letter to Credit Unions number 07-CU-06 “Working with Residential Mortgage Borrowers.” 11 This 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 those instances where a credit union attempts to help their member out of a problem loan with another institution they should apply traditionally proven and sound underwriting guidelines.


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 program’s 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, the review 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 the changes 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 of a 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 union’s risk profile. Where feasible, it is a good practice to address shortfalls in the planning or risk management 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, or through 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 of the 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 or liability concentrations based on changes in internal and external factors is also a valuable supervision step. 13 These reviews and/or conversations could be through off-site or on-site supervision.


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 with the credit union’s strategic plan or established risk thresholds?

Is the growth rate excessive, when all factors are considered (e.g. compared to the credit union’s 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 union’s 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 credit union’s 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 a substantial 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 their strategy. It is important to remain vigilant when assessing management’s strategic vision 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


to facilitate the contact and understanding of the credit union’s practices. A lack of candor or limiting access to records or staff are red flags examiners should not accept. 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 this Letter, whether through routine examinations or interim on-site supervision contacts, examiners should constantly evaluate management’s 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 union staff 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 into such relationships and adequate controls over the product/servicing process 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, examples include: (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) A credit 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 NCUA’s 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 is needed to match the changing credit union business model, as well as deal with the challenges presented by the current real estate market.


NCUA has issued numerous letters to the credit union industry regarding the associated risks given various economic, interest rate, or credit cycles. The core message and guidance in these letters represent sound risk management practices and are applicable today, including:

• Applying prudent policies, realistic limitations, and business strategies for all asset, liability and share categories;

• Considering carefully the risk to net worth and the level of earnings required to 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 and making operational adjustments as necessary.


Resources 1. NCUA Letters to Credit Unions No. 57, June 1981 – Diversification in the

Investment 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 Shares

and Balance Sheet Risk 13. NCUA Letters to Credit Unions No. 03-CU-15, September 2003 - Real Estate

Concentrations 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


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 with

Residential Mortgage Borrowers 21. NCUA Letters to Credit Unions No. 07-CU-09, July 2007 - Subprime Mortgage

Lending 22. NCUA Letters to Credit Unions No. 07-CU-13, December 2007 - Supervisory

Letter-Evaluation Third Party Relationships 23. NCUA Letters to Credit Unions No. 08-CU-05, March 2008 - Statement on

Reporting 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/index.html

portfolio risk analysis prime alliance solutions

Documents

member reaction