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How credit unions can mitigate loan portfolio risk

Apr 27, 2023

How confident are you in your credit union’s ability to mitigate loan risks? A March 2023 webinar from the National Credit Union Administration (NCUA) highlighted the need for credit unions to have sound policies and procedures in place to manage credit risk, including underwriting and monitoring of loans.

The presenters also emphasized the importance of interest rate risk management, including monitoring market trends and having contingency plans.

Here is a roundup of emerging risks, key concerns and best practices for loan portfolios covered in the presentation:

Residential real estate

  • Inflated credit scores: Because of government stimulus efforts and increased consumers saving during the peak COVID-19 years, credit scores rose approximately 20 to 30 points. These scores are starting to decrease, signaling potential issues.
  • Rise in monthly payments-to-income ratios: Although FNMA and FHLMC are purchasing loans with payment-to-income ratios of up to 35%, NCUA recommends a safe gauge of 25%.
  • Inadequate construction and development monitoring: Credit unions may not be prepared for home construction not finishing on time due to supply chain issues and worker shortages. It is important to stay on draw schedules and proactively work with the borrower as issues arise.
  • Significant increases in homeowner’s insurance: Some states, including Florida and California, have faced increased contractual monthly payments.
  • Absence of private mortgage insurance (PMI): NCUA has seen a lack of PMI on loans with high loan-to-value.
  • Falling home values: In certain geographic areas, declining home values pose a risk with collateral values.
  • The return of student loan payments: The end of deferments through COVID-19 will increase borrower’s payment-to-income ratios.

Indirect lending

Similar to the elevated risks with residential real estate, declining credit scores and increased payment-to-income ratios pose risks in the indirect lending sector as well.

Credit unions should avoid high volumes of loans with new dealer relationships.

Subprime loans to borrowers with credit scores below 660 are not performing well and loans that were priced based on credit scores may not have been priced appropriately due to these inflated scores.

Other trends impacting borrower income, cash flow and collateral values:

  • Costs associated with going back to the office
  • Inflated auto prices due to the low supply of vehicles, both new and used, and microchip shortages
  • Vehicle shortages also resulted in higher prices on older vehicles that require more repairs and maintenance
  • Increase in rolling negative equity into new loans, inflating the loan-to-value.
  • NCUA recommends rescoring portfolios to identify credit trends with existing borrowers

Commercial lending

Following these recommendations can reduce risk in commercial lending at your credit union:

  • Step up your construction and development loan monitoring to ensure budget overages are addressed.
  • Be proactive when commercial loans are showing early delinquencies (at least 30 days past due) and track the slow payers.
  • Keep the board of directors, or at least the commercial loan committee, apprised of trends and risks.
  • Cash flows must meet debt service specifically for the project financed as lenders may turn down global guarantor support.
  • Be aware of the false sense of security with SBA 7A guarantees. The slightest error could result in a rejection.
  • Pay attention to credit unions buying into credit union service organizations and participating in loans across the tcountry, without knowledge or understanding of the risks and challenges in those geographic areas.

It is important for credit unions to maintain good risk management processes in evaluating the loan portfolio and to avoid following market leaders who can better afford losses.

The NCUA stressed the need for accurately calculating cash flows and setting reasonable payment-to-income limits. Be sure to proactively watch for trends through collection efforts and regular rescoring of credit scores. Report risks and trends to the board of directors regularly so they can appropriately respond if needed.

How Wipfli can help

Wipfli professionals are prepared to step up with a range of services from regulatory compliance exams, risk assessments and general consulting to assist your credit union. Our complimentary strategic risk management consultation can pinpoint areas of risk in your institution and discuss recommendations for how to mitigate that risk and strengthen your institution’s overall stability. 

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Alison J. Herrick, CPA
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