I’ve consulted with many large credit unions across the country over the past 18 months on ALL strategy, and we’ve learned some important lessons and developed some insightful strategies and methodologies for managing the ALL. The purpose of this article is to provide a high-level overview on these lessons learned.
In the waning days of 2009, the evidence is mounting that loan losses in credit unions have reached historic levels, and have contributed significantly to earnings degradation and capital erosion. Whether your credit union is in the sand states and has been impacted by the decline in residential real estate values, or just feeling the general effects of this severe recession, the vast majority of credit unions are being hammered not only by the financial impact of loan losses, but also by regulators and auditors demanding ever-increasing adjustments to the Allowance for Loan Losses (ALL).
I've consulted with many large credit unions across the country over the past 18 months on ALL strategy, and we've learned some important lessons and developed some insightful strategies and methodologies for managing the ALL. The purpose of this article is to provide a high-level overview on these lessons learned.
Lesson #1: "Just Because…"
Just because a loan is not delinquent does not mean the loan is not impaired. Just because the collateral value has disappeared on a real estate loan doesn't mean the loan is impaired. Just because the historical loss ratio is 1% doesn't mean this ratio is an adequate measure of impairment. "Just because" has become one of the phrases that I use most often with my clients when discussing ALL matters these days. What is clear to me is that the fundamental dynamics of this economic cycle are more severe than any cycle I've experienced in my 30 years in credit unions and therefore we have to look beyond the conventional ALL methods to properly account for loan losses.
Lesson #2: "We Need Updated Metrics…"
If we can capture updated loan to value information and combine that data with refreshed credit score data, identifying loan impairment becomes a much more achievable goal. Many credit unions have not updated their loan database to include these metrics, and therefore are unable to really assess the amount of impairment in their portfolio based on current conditions.
Lesson #3: "Loan Level Detailed Analysis is Paramount…"
For many credit unions, historical loss ratios are a worthless measure of impairment during these tumultuous times. The fact that last year's charge-offs may have equated to X% of loans provides little evidence of how much impairment exists in your loan portfolio today. If you accept this premise, then how do you quantify impairment in your loan portfolio? I would postulate that loan-level detailed analysis, on a statistically valid random basis provides compelling evidence of loan impairment.
Lesson #4: Kryptonite---A Strong ALL Policy …
As a former audit partner in a CPA firm, I grew up with the attitude that there was no such thing as too much when it came to the ALL. Be prepared to discuss your ALL balance with your auditors and examiners, and be prepared to be challenged as to the "not enough" attitude. The best way to defend your balance is to steer the conversation away from the "amount" of the ALL, and to discuss the approach and methodology utilized that produced the answer. If you focus the conversation on approach and methodology and if you have a well articulated ALL policy in writing and approved by the Board, you'll have a much better chance of winning the challenge. Consider asking your examiners and auditors to provide input and feedback on the approach and methodology in advance of their fieldwork.
Lesson #5: Some Interesting Perspective...
Important lessons on ALL adequacy can be ascertained from large public banking companies whose ALL balances are scrutinized by the SEC and investment community. Often, ALL adequacy is measured in terms of forecasted charge-offs for the next 12-month period. In a Wall Street Journal article on November 2, 20091, the following chart was published reflecting the relationship between the ALL versus estimated credit losses for the next four quarters:
|J.P. Morgan Chase
|Bank of America
Is this a metric built into your ALL analysis? How do your credit union's anticipated charge-offs compare to today's ALL balance?
Lesson #6: "TDR Accounting Can’t Be Ignored…"
Prior to the current economic cycle, it was rare for credit unions to have material amounts of TDR's. Not so today. Many credit unions have been approving restructured loans, but not appropriately accounting for these loans, and also not properly reporting these loans for regulatory purposes. The financial accounting impact of a TDR can be significant and therefore can't be ignored. And, if your credit union is routinely approving restructured terms on consumer (non real estate) loans, TDR accounting might be required.
Lesson #7: "It’s Not Just Your CFO’s Allowance…"
Too many credit unions have not involved their Chief Lending Officer and Chief Collection Officer in the ALL discussion and analysis. Their CFO's have accepted full responsibility and often these other management folks are not grounded in ALL theory. This is bad policy and will probably contribute to an ALL error. The best process will include extensive discussion among all the parties involved in the lending management. Further, a process should be implemented that provides an overview of the ALL methods and ALL outlook to the members of the Board of Directors and Supervisory Committee every year.
1Wall Street Journal, November 2, 2009, Page C8, “Investing in Banks? Check Loss Buffers”
About Mike Sacher:
As a CPA with over 30 years experience providing services to credit unions, Mike Sacher has earned a national reputation for his expertise in areas such as accounting & finance, internal control, ALM and governance issues of importance to credit unions. Mike has assisted numerous credit unions develop updated strategies and policies dealing with the Allowance for Loan Losses.