The truth about effective lending strategies is in the numbers. Too often, assumptions are made about credit quality, loan-to-value ratios, loan terms and loan types based upon anecdotal data. Credit unions may miss out on loan opportunities or suffer high losses due to an overreliance on accepted risk assumptions rather than actual performance data.
Consider point-of-purchase lending. Credit unions sometimes choose not to participate in point-of-purchase lending because they have heard about peers experiencing trouble with loans originated at the dealership. Yet many credit unions have been participating for years in this type of lending and have healthy, profitable portfolios as a result. The fact is that point-of-purchase lending does have risks, but it is the ability to manage risk that enables credit unions of all sizes to participate in long-term, profitable programs.
Perceived safety is not guarantee. Ten years ago, few credit unions thought they would experience huge losses in their real estate loan portfolios. Yet, that is exactly what happened over the last few years.
If a credit union limits its portfolio to just low risk loans, it can be difficult to generate the returns needed to maintain profitability. Fortunately, there are steps a credit union can take to manage risks, provide more loans to its members, and maintain healthy and stable returns.
Consider the information that is collected in the loan decision process. Typically, application data includes factors such as the applicant’s time on the job, time at their current residence, and their income. Collateral valuation information is also collected, and in the point-of-purchase environment, certain information is collected about the originating third party.
The real question is what to do with this information after the loan is made. If this information was central to making the loan, why wouldn’t it remain important in analyzing the loan performance as it matures? Here are a few key data points that should be collected and stored in the credit union host system and can be useful for later analysis.
All credit scores used to make the loan decision or price the loan
The cost to originate the loan if those costs are specific to that loan type, including dealer origination fees
The loan-to-value ratio for all collateralized loans
Dealer information for auto loans, whether they are indirect loans or not
Dealer finance director information for auto loans, if available
Vehicle manufacturer information
Vehicle warranty and payment protection product information, whether the credit union sold the warranty or not
Values of real estate property
The total value of all liens against real estate property
Credit unions should look to employ technology that enables them to do ongoing, regular analysis of their loan portfolio. Typically, on-board host system reports are not sufficient for providing the necessary consistent analysis and host systems’ data architecture does not allow for tracking historic trends. Although some credit unions rely on spreadsheets for tracking, they can become very difficult and tedious to manage after several months. The marketplace offers a variety of tools to credit unions that are designed to track historic trends, including specialized software like Lending Insights’ LPMS. Any solution used should be robust and employ Multi-Dimensional Portfolio Analysis (MDPA), which allows the credit union to slice and dice the loan portfolio by multiple dimensions.
Example of MDPA analysis could include isolating real estate loans and evaluating losses by year of origination and credit tier at origination, or assessing loss severity by vehicle brand and loan underwriter. All of the information collected at origination can assist in evaluating loan portfolio performance from a seemingly infinite number of perspectives, all contributing to a more refined lending strategy that reacts to conditions and offers the prospect of predictability.
Below are a few standard analysis reports the credit union should include in a comprehensive, ongoing portfolio analysis.
Monitoring Risk Concentrations – Credit unions should establish risk thresholds for certain loan products and monitor portfolio growth to ensure that these thresholds are not exceeded. Additionally, when entering new loan markets it is important to start small and use performance analysis to determine how fast the credit union should increase concentration thresholds.
Risk Based Pricing and Interest Rate Risk – Credit unions can use pricing tiers, changes in portfolio yields and loss data to determine if they are charging the right rate for each risk tier.
Static Pool Analysis – Credit unions can pool loans together by origination characteristics, most often by date, to view how loans originated under the same circumstances perform over time. This will enable them to detect lending strategies that have a negative impact on loan performance.
Credit Score Migration – Often it is helpful to know if the credit scores of members with unsecured lines of credit are going down. But credit score migration analysis can also help predict future loan performance by tracking credit score volatility after origination, and may actually provide the opportunity to curtail certain lending activities as downward trends are indicated in the population.
Reacting To Analysis
It’s important that credit unions not only gather and analyze this data, but react to the trends exposed by the analysis. Even if the analysis disproves assumptions, it’s important to not ignore the facts. FICO advises that if lenders had reacted to the downward trend in credit scores 12 months before the real estate bubble burst, fewer real estate loans would have been originated, saving lenders millions of dollars in losses. Experience led many to believe that real estate values never fall, but the facts proved otherwise.
Credit unions are encouraged to react cautiously without overreacting. In some lending environments, volatility in lending strategies can cause disruptions in loan growth, which can also have a negative impact on lending. Portfolio analysis takes practice and can be difficult to get started. However, properly analyzing loan performance is worth the time and money spent to start the process.
This was an excerpt from an article that appears in the upcoming Spring/Summer issue of CU Direct’s Credit Union Lending magazine.
Lending Insights provides key analytics and reporting tools that help credit unions make more profitable loans, while meeting regulatory requirements. Lending Insights helps credit unions easily view and understand all aspects of their loan portfolios for timely and strategic decisions.