What Rises Must Also Fall (Eventually)

Three signs of pending improvement that impacts the allowance for loan losses.


According to several macroeconomic factors, the economy is stabilizing. Real estate values are firming, unemployment is holding steady, residential construction starts are picking up, and delinquency is starting to decline. The worst seems to be behind us. Yet we keep hearing from auditors and regulators (and maybe even consultants like me) that Allowance for Loan Loss balances are never adequate and there is still inadequate coverage in the Allowance, especially in the Sand States and for those credit unions with large member business loan portfolios.

I, for one, am seeing the light at the end of the tunnel, and here are a few compelling reasons why.

1. Net Charge-Off Trends

At the end of 2007, net-charge offs (annualized) started exceeding the prior year ALL balance and continued this trend until beginning to decline in the second quarter of 2009. Even the Sand States are now tightly aligned with the other geographic regions. This is a good sign; it is an indication that Allowance balances were not only increased to cover worsening credit conditions but also that charge-off levels are slowing down. I’d like to see the ALL able to absorb approximately 125% of current year net charge-offs. Or said differently, the ALL should be able to easily absorb one year’s worth of prospective net charge-offs. 

Net Charge-Offs as a % of Prior Years' Allowance – June 30, 2010

Click graph to view larger size. |  Source: Callahan & Associates' Peer-to-Peer

2. Delinquency Trends

The Allowance for Loan Losses is less encumbered by delinquent loans as of June 30, 2010 as compared to the past few years. The Sand States and the western region have the most favorable ratios of all the peer groups noted; the central region has the most unfavorable level as noted in the chart below. Also the Sand States have the greatest amounts of TDR loans, which tend to overstate delinquency until six months of performance under the restructured terms. Once the six month meter has elapsed, we could see a significant decline in delinquency. Also, many credit unions haven’t been able to charge-off residential real estate loans because of judicial backlogs and administrative processes. This build-up of real estate delinquency could also be having an overstated effect on these ratios. I’d like to see this ratio decline to less than 100% as the economy continues to stabilize.

Dq. Loans as % of ALL – June 30, 2010

Click graph for larger version.

3. Delinquency & Charge-Off Ratios

Delinquency and charge-offs appear to have hit their peak and will hopefully reflect significant declines on a go-forward basis. These are critical trends, as both of these ratios are thought of as lagging indicators. 

Dq. & C/O Ratio – June 30, 2010

Click graph for larger version.

Join me on Thursday, September 30, for a discussion of important Allowance for Loan Loss topics. I’ll provide important perspective to help you recognize when the time has come to begin reducing your Allowance for Loan Losses.

Graph source: Callahan’s Peer-to-Peer software