Strategic Risk-Based Lending for Shapiro

Credit UnionsCCUL AMC – October 29, 2013

DIANA MICHAELS, PRESIDENT & CEO

WESTERN HEALTHCARE FEDERAL CREDIT UNION &

RANDY C. THOMPSON, PH.D. TCT, INC.

What’s this all about?What’s NCUA telling us about risk-based lendingWhat are risk-based pricing and risk-based lendingIs tiered pricing all we needWhy is it so hard to turn a profitWhat is a “BAD” loanDoes knowing my costs really matter

What’s this all about?

Show a real-life success story because…

WE WANT YOU TO KNOW THAT YOU CAN DO THIS TOO!

Risk Based Lending - Definition

NCUA Guidance Letter - 174

“Risk-based lending allows credit union management to assess the risks involved in different types of loan products and price these products based upon the inherent risk associated with individual borrowers.

The end result is a more diversified loan portfolio mixing lower-yielding, lower risk loans with higher-yielding, but riskier loans.”

“Prior to beginning a risk-based lending program, it is important that the credit union board determine the parameters for the riskier loans based on the credit union's financial condition, business plan, lending and collection history, and asset liability management (ALM) program.”

August 1995

Risk Based Lending - Considerations

NCUA Guidance - Letter 174

“Credit unions should engage in risk-based lending, not as a means of re-pricing existing balance sheets, but as a tool to reach out to the under-served and take a risk that might otherwise be avoided.

Risk-based lending involves setting a tiered pricing structure that assigns loan rates based upon an individual's credit risk.

Through a carefully planned risk-based lending program, credit unions may be able to make loans to somewhat higher-risk borrowers, as well as better serve their more credit-worthy members.”

August 1995

What is Risk Based Lending? Risk Based Lending consists of two parts:

◦ Underwriting (Do you want to make this loan?)◦ Pricing (What rate must I charge to account for the risk?)

Risk Based Pricing We define risk, in relation to the loan portfolio, as the likelihood that money that has been

expended or extended by the credit union will not return.

Money expended includes cost of funds, loan operations and collections.

Money extended includes charge-offs of principle balances.

These items are identified as costs and as such can be statistically (stochastically) quantified and measured.

The consistent and complete measurement of these costs is foundational to an accurate and effective loan pricing system.

Types of Loan Pricing in Credit Unions

◦ 1. Tiered pricing – assumes a base rate and then stair steps in equal steps◦ Incomplete identification of costs causing a non-empirical measurement of costs◦ Results in imprecise costs and rates ◦ Looking over the fence at the rates across the street syndrome

◦ 2. Empirical Risk Based Pricing – identifies precise costs associated with each loan grade consistent with their costs and business model

Empirical, cost-based provides a precise, accurate measurement of costs

Assures that all loans provide equitable return on investment

Benefits of Empirical Risk Based Loan Pricing versus Tiered Pricing

Empirical risk based loan pricing offers these benefits to a credit union:

◦ Assures all loans provide a positive margin above costs

◦ Covers all risk/costs associated with the loan portfolio

◦ Expands ability to increase yield with higher risk loans

◦ Enhances earnings and builds equity (capital)

Tiered Pricing – Actual Effects

Over the past four years, credit unions have reduced rates on loans dramatically while they all compete for a diminishing share of A+ and A grade loans.

Survey of 75 credit unions◦ 2010 average A+ loan rate was 4.62%◦ 2013 average A+ loan rate is 2.01%

Drop of 2.61%

Tiered Pricing – Income Effects

Credit Union 2011 Yield 2012 Yield Change Loan Balance Interest Income Lost

1 5.57% 4.71% -0.86% $129,714,000 ($1,115,540.40)

2 7.28% 6.46% -0.82% $26,910,000 ($220,662.00)

3 7.54% 6.58% -0.96% $10,888,000 ($104,524.80)

4 7.43% 5.81% -1.62% $79,484,000 ($1,287,640.80)

5 6.45% 5.64% -0.81% $18,933,000 ($153,357.30)

6 8.16% 7.29% -0.87% $199,438,374 ($153,357.30)

7 5.76% 4.87% -0.89% $182,550,000 ($1,624,695.00)

8 6.29% 5.48% -0.81% $136,821,000 ($1,108,250.10)

9 6.28% 5.91% -0.37% $18,448,000 ($68,257.60)

Many Credit Unions are on a Collision Course with Disaster: by not pricing loans and deposits correctly, shrinking the margin resulting is eroding capital.

-1% Down-shock CU 1 CU 2 CU 3 CU 4Base Year Equity $3,552,117 $30,690,069 $6,392,026 $11,188,339 Year 5 Equity $2,861,356 $26,126,872 $4,730,003 $6,526,093Cumulative Equity Change $(690,761) $ (4,563,197) $ (1,662,024) $(4,662,246)

Base Year Equity Ratio 8.46% 8.97% 12.07% 9.66%Year 5 Equity Ratio 6.82% 6.60% 7.94% 5.63%Equity Ratio Change -1.64% -2.37% -4.13% -4.03%

NCUA Guidance - Letter 174“Risk-based lending philosophy does not intend for a credit union to grant "bad loans," however, it assumes that proper pricing and conservative terms may justify higher risk loans.

Credit unions offering risk-based lending should aim towards diversification and management of risk.

This can be accomplished by establishing policies, procedures, and pricing ranges broad enough to serve low-risk, average, and higher-risk borrowers.”

August 1995

Risk Based Pricing – Intent & Application

What is a “Bad Loan”?

A “Bad Loan” is one that results in a loss to the credit union.

• Loan with charge offs

• Loan priced below costs

Key Questions Related to Risk Based Pricing

Will the rates a Credit Union offers cover all loan related costs and provide a return?

or… Are rates set to simply attract a volume of unprofitable business?

Could pricing loans below cost qualify as an unsafe practice?

Fundamental Elements of Empirical Risk Based Pricing

A statistically valid pricing system requires:

Identification of costs Cost of Funds Loan Operations (Activity Based Costing) Collections Charge-offs

Accurate measurement of costs

Application of costs to loan volume

Set rates that will cover all costs and feed equity.

Quarterly Loan Operation Expense

Function: Consumer Loans Direct Expense Personnel $ 11,037 Operating $ 78,001

Indirect Expense Personnel $ 4,517 Operating $ 30,768 Sup/Admin $ 18,415

TOTAL CONSUMERLOAN COSTS $ 142,738

An empirical analysis of all loan related costs provides this picture of loan rates

Cost Breakout A+ A B C D E

Cost/Loan Booked 0.58% 0.58% 0.58% 0.58% 0.58% 0.58%

Collections 0.05% 0.08% 0.16% 0.18% 0.25% 0.29%

Charged-Off Loans 0.24% 0.40% 0.81% 0.93% 1.25% 1.47%

Total Mark-Up 0.86% 1.05% 1.54% 1.68% 2.07% 2.33%

Cost of Funds 0.56% 0.56% 0.56% 0.56% 0.56% 0.56%

Spread Margin 2.00% 2.00% 2.00% 2.00% 2.00% 2.00%

Anchor Rate 3.42% 3.61% 4.11% 4.25% 4.64% 4.89%

Interest Rate Differential 0.00% 0.19% 0.68% 0.82% 1.21% 1.47%

An empirical analysis of all loan related costs provides this picture of loan rates

Empirical Risk Based Pricing – More than a Model.

Empirical Risk Based Pricing – More than a Model.

Empirical Risk Based Pricing – More than a Model.

Empirical Risk Based Pricing – More than a Model.

Applying Risk Based Pricing methodology and its tools, multiple credit unions have turned their yields and income around:

CU 2012 Yield 2013 Yield Change Loan Balance Income Gained

1 6.46% 6.62% 0.16% $ 27,620,000 $ 44,192.00

2 6.58% 6.85% 0.27% $ 11,850,000 $ 31,995.00

3 5.50% 5.81% 0.31% $ 79,685,000 $ 247,023.50

4 5.64% 5.73% 0.09% $ 18,922,000 $ 17,029.80

5 5.48% 5.62% 0.14% $ 137,650,000 $ 192,710.00

Maintaining a Standardized Empirical Risk Based Pricing Metric

Quarterly updating of costs

Quarterly updating of rates and margins

Semi-annual validation reports consistent with NCUA requirements

Annual updating of loan distributions

This is not an ALM report. It is a pricing methodology!

Our Actual ExperienceInitial Considerations In order to improve yield we had to be prepared to increase certain

aspects of risk. This is not to imply that we would throw open the doors to all high

risk loans, in an effort to improve yield. On the contrary, our goal was to implement tools and techniques

in order to serve a wider spectrum of members and manage the risk inherent in this broader book of business.

Our Actual ExperiencePossibilitiesWe considered multiple options for expanding risk

Pricing for Risk GradePricing for LTVPricing for Term

Our Actual ExperienceFive elements to improve yields and sustain viability.

Comprehensive and consistently applied policies Effective risk mitigation technique and tools Empirically calculated Risk Based Pricing Consistent Credit Migration Analysis Concentration-risk monitoring and management

Policies that work◦Clarify acceptable loans◦Specify the percent for each grade◦Specify terms for each grade◦Specify maximum loan amounts for each grade◦Specify minimum rate spreads for each grade

Our Actual Experience

Tools to control risk◦Tools and techniques that mitigate risk of collateral loss

◦Allows greater flexibility in lending decisions◦Provides behavior modification to increase timely payments

◦Tracks collateral to marginalize loss of collateral

Our Actual Experience

Collateral Tracking Systems◦ Indicator light showing payment is due◦ Starter interrupt to prevent usage if delinquent◦ GPS locator to aid collection and repossession

Short-Term Financing◦ Minimum exposure ◦ Requires automated payment

Transformational Interest Rate ◦ Reinforces timely payments◦ Promotes long-term members

Effective Risk Mitigation Techniques and Tools

Identifying and Applying Costs to Loans

Perform regular and complete cost analyses◦ Cost of Funds◦ Processing/Maintenance◦ Collections◦ Charge-offs

Assure all loan grades and types are contributing equitably

Eliminate Cross-Grade Subsidies

Empirical Risk Based Pricing – More than a Model.

Empirical Risk Based Pricing – More than a Model.

Empirical Risk Based Pricing – More than a Model.

Empirical Risk Based Pricing – More than a Model.

Credit Migration Definition

◦ A measurement of changes in credit scores and risk for individual loans in the loan portfolio of the credit union.

◦ The composite of these changes provides a valid measure of the current risk inherent in the total portfolio.

◦This provides an early warning sign for potential losses

Credit Migration Understanding your Loan Portfolio

◦ Credit risk can Increase or Decrease◦ Which risk pools are improving impairing?

Identifying Potential Problems◦ Isolate impaired loans and react to them early◦ Understand the risk in your pools and adjust lending practices

Identifying Emerging Opportunities◦ Recognize Members that are making smart decisions◦ Proactively offer ways to help your members◦ Understand which pools of loans to take on more risk

Applying Precision in Allowance Calculation◦ Statistically based calculation◦ Complying to regulations

Using Credit Scores to Manage Risk

Monitor changing risk scores and then change:◦ Rates◦ Allowance◦ Credit limits◦ Limits on non-prime loans

Dollar Original FICO Grades

Grand TotalCurrent FICO A+ A B C D E Not Reported

A+ 740+ $ 33,886,855 $ 4,911,282 $ 1,696,945 $ 425,522 $ 105,543 $ 63,014 $ 3,184,419 $ 44,273,580

A 690-739 $ 7,886,015 $ 11,359,190 $ 5,212,544 $ 857,840 $ 146,917 $ 147,464 $ 1,828,060 $ 27,438,030

B 660-689 $ 1,857,191 $ 4,601,064 $ 10,527,101 $ 2,055,535 $ 1,333,417 $ 158,714 $ 537,630 $ 21,070,652

C 630-659 $ 910,286 $ 910,852 $ 2,541,847 $ 2,547,064 $ 886,367 $ 848,199 $ 268,658 $ 8,913,273

D 600-629 $ 17,970 $ 123,766 $ 1,503,642 $ 2,480,152 $ 715,706 $ 525,812 $ 526,391 $ 5,893,438

E <600 $ 91,237 $ 610,842 $ 1,026,951 $ 2,088,359 $ 717,708 $ 643,272 $ 563,043 $ 5,741,413

Not Reported $ 75,089 $ 29,047 $ 481,778 $ 189,437 $ - $ 300 $ 472,982 $ 1,248,632

Grand Total $ 44,724,643 $ 22,546,043 $ 22,990,809 $ 10,643,908 $ 3,905,658 $ 2,386,776 $ 7,381,182 $ 114,579,017

Identifying Opportunities Central mission of helping members

Targeted marketing

Increased loyalty

Up-sell opportunities

Dollar Original FICO Grades

Grand TotalCurrent FICO A+ A B C D E Not Reported

A+ 740+ $ 33,886,855 $ 4,911,282 $ 1,696,945 $ 425,522 $ 105,543 $ 63,014 $ 3,184,419 $ 44,273,580

A 690-739 $ 7,886,015 $ 11,359,190 $ 5,212,544 $ 857,840 $ 146,917 $ 147,464 $ 1,828,060 $ 27,438,030

B 660-689 $ 1,857,191 $ 4,601,064 $ 10,527,101 $ 2,055,535 $ 1,333,417 $ 158,714 $ 537,630 $ 21,070,652

C 630-659 $ 910,286 $ 910,852 $ 2,541,847 $ 2,547,064 $ 886,367 $ 848,199 $ 268,658 $ 8,913,273

D 600-629 $ 17,970 $ 123,766 $ 1,503,642 $ 2,480,152 $ 715,706 $ 525,812 $ 526,391 $ 5,893,438

E <600 $ 91,237 $ 610,842 $ 1,026,951 $ 2,088,359 $ 717,708 $ 643,272 $ 563,043 $ 5,741,413

Not Reported $ 75,089 $ 29,047 $ 481,778 $ 189,437 $ - $ 300 $ 472,982 $ 1,248,632

Grand Total $ 44,724,643 $ 22,546,043 $ 22,990,809 $ 10,643,908 $ 3,905,658 $ 2,386,776 $ 7,381,182 $ 114,579,017

So what did this do for WHFCU?Six MeasuresLoan BalancesLoan to ShareLoan YieldLoan Distribution (Non-Prime)Delinquent RatioCharge Off Ratio

So what did this do for WHFCU?

2009 2010 2011 2012 2013$0.0

$5.0

$10.0

$15.0

$20.0

$25.0

$30.0 $25.3$21.6 $19.0 $17.5 $19.2

Loan Balance

So what did this do for WHFCU?

2009 2010 2011 2012 20130.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

84.00% 81.00%67.00%

56.00% 59.00%

Loan to Share

So what did this do for WHFCU?

2009 2010 2011 2012 201319.00%

19.50%

20.00%

20.50%

21.00%

21.50%

22.00%

22.50%

23.00%

20.51%

21.36%

22.55%

21.07% 21.10%

Non-Prime Loan

So what did this do for WHFCU?

2009 2010 2011 2012 20135.40%

5.60%

5.80%

6.00%

6.20%

6.40%

6.60%

6.80%

7.00%

6.56%

6.87%6.68%

6.46%

5.89%

Loan Yield

So what did this do for WHFCU?

JAN FEB MAR APR MAY JUN JUL AUG SEP4.80%

5.00%

5.20%

5.40%

5.60%

5.80%

6.00%

6.20%

6.40%

6.22%

5.83%

6.12% 6.05% 6.04%5.91%

5.39%

5.73% 5.76%

Loan Yield

So what did this do for WHFCU?

2009 2010 2011 2012 20130.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

0.58%

4.28% 3.87%

5.76%

0.35%

Delinquent Ratio

So what did this do for WHFCU?

2009 2010 2011 2012 20130.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

2.33%2.85%

1.96%

1.21%0.69%

Charge Off Ratio

Were are we going?Continue with empirical risk-based pricingContinue with credit migrationExpand non-prime lendingExplore new lending optionsIncrease loan yield

Monitor, monitor, monitor and monitor some more

Questions?