portfolio risk analysis

7/29/2019 Portfolio Risk analysis

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2000-2009 Prime Alliance Solutions, Inc. All Rights Reserved.

PortolioRiskAnalysisPrime Alliance Solutions, Inc.January 2009

Tracy AshfeldExecutive Vice PresidentStrategic Mortgage Solutions

Nizar HashlamonExecutive Vice PresidentLoan Servicing

David MendelsonSenior Training ManagerPrime Alliance Training


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Portfolio Risk Analysis

Prime Alliance Solutions, Inc.

January 2009

Tracy Ashfield

Executive Vice President

Strategic Mortgage Solutions

Nizar Hashlamon

Executive Vice PresidentLoan Servicing

David Mendelson

Senior Training ManagerPrime Alliance


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2000 2009 Prime Alliance Solutions, Inc. All Rights Reserved. Page 2 of 29

EXECUTIVESUMMARY..........................................................................................................................3

INTRODUCTION ......................................................................................................................................4

Background.........................................................................................................................................................................................4

Scope of the Analysis .................................................................................................................................................................5

Staff Assignment ............................................................................................................................................................................5Stakeholders ......................................................................................................................................................................................5

Characteristics of Loans Analyzed ....................................................................................................................................6

Number of Loans Analyzed for Each Type .................................................................................................................6

METHODOLOGY ......................................................................................................................................7

Tools Utilized .....................................................................................................................................................................................7

Process Used in Conducting the Analysis ...................................................................................................................7

RESULTS ....................................................................................................................................................8

ACTIONSTAKEN .................................................................................................................................. 11

Member Reaction ........................................................................................................................................................................ 12

CHALLENGES ......................................................................................................................................... 13

CONCLUSION ......................................................................................................................................... 14

Executing a Collateral Risk Portfolio Analysis ......................................................................................................14

Project Scope .................................................................................................................................................................................14

Methodology ....................................................................................................................................................................................14

Taking Action ..................................................................................................................................................................................14

ACKNOWLEDGEMENTS ..................................................................................................................... 15

APPENDIX .............................................................................................................................................. 16

Sample Line Decrease Notification Letter sent to members: .................................................................16

Supervisory Letter......................................................................................................................................................................17


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Executive Summary

Real Estate Lending is becoming the principal business activity for most credit

unions. The loan portfolio is typically the largest asset and the predominate source of

revenue. As such, effective management of the real estate loan portfolio is

fundamental to credit union safety and soundness. Loan portfolio management is the

process by which risks inherent in the credit process are managed and controlled.

This risk is exaggerated when considering the historical decline in home values andthe substantial increase in defaults.

For decades, good loan portfolio managers have concentrated their efforts onprudently approving loans and carefully monitoring loan performance. Although

these activities continue to be crucial to portfolio management, it falls short in the

current lending environment. It does not address the needed lead-time for corrective

action when there is a systemic increase in risk. The risk elevates because such

analysis does not take into consideration the current value of the underlying

collateral (property).

To manage their portfolios, credit unions must understand not only the risk posed byeach loan but also how the risks of individual loans and portfolios are interrelated.These interrelationships increase risk exponentially. Until recently, few credit unions

used portfolio management concepts to control credit risk by obtaining a credit scoreon the entire portfolio. Better technology and easier access to information have

opened the door to better risk management methods. A portfolio manager can now

obtain early indications of increasing risk by taking a more comprehensive view ofthe loan portfolio. Currently, many credit unions view the loan portfolio in its

segments and as a whole and consider several factors in addition to the traditional

credit scoring in determining the risk. During the current decline in home values its

evident that a good evaluation of the underlying collateral plays an integral part in

assessing the overall portfolio.

The results of assessing the risks associated with the credit union portfolio can have

many implications on lending practices. The credit union highlighted in this paper hastaken steps to better manage the risks associated with their HELOC portfolio. More

specifically they are identifying potential risks associated with current home values

and adjusting the credit unions exposure while continuing to meet their membersneeds for home financing.


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Introduction

Evaluating credit unions real estate loan portfolios is more important now than ever

in todays changing economic climate. Conducting a comprehensive analysis of the

loan portfolio is a key component to sound risk management. Such analyses provides

credit unions with early indications of increasing portfolio risk and allows them to

take appropriate steps to ensure a healthy and sound financial position.

Knowing what data to collect and review and how to evaluate and act on such data

can be a daunting task. The objective of this paper is to provide credit unions with abest practice approach. Our analysis included a thorough review of BECUs process in

conducting their portfolio risk assessment. This analysis includes the scope,

methodology, results, and actions taken. We also identified challenges the credit

union faced in implementing the program.

BECU was selected because of their unique approach to portfolio analysis.

Furthermore, the program has been reviewed by independent third parties that

found the analysis and actions taken to be sound.

We hope reviewing this case study will provide credit unions a good understanding of

the steps essential to completing a portfolio risk review and better prepare them toperform these important steps. We reviewed all aspects of the project including the

methodology, selection of tools and vendors and assignment of staff resources

needed for the project completion.

Background

In August 2008 the NCUA issued letter No. 08-CU-20 to Federally Insured Credit

Unions. It encouraged credit unions to view risk management in terms of the entire

loan portfolio. The letter (attached in the Appendix) identified several elements that

should be part of a loan portfolio management process. These elements complementother fundamental credit risk management principles such as sound underwriting,

comprehensive financial analysis, adequate appraisal techniques, loan documentationpractices, and sound internal controls. These elements include:

Setting individual and aggregate loan limits based on net worth and the

overall risk profile within the balance sheet.

Updating credit risk scores periodically on all borrowers.

Monitoring home values by geographic area.

Obtaining updated information on the collaterals value when significant

market factors indicate a potential decline in home values, or when theborrowers payment performance deteriorates and a greater reliance is placed

on the collateral.

Analyzing whether increasing loan-to-value (LTV) ratios necessitate reducing,

suspending, or discontinuing existing credit lines (e.g., HELOCs).


market factors indicate a potential decline in home values, or when the


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borrowers payment performance deteriorates and a greater reliance is placed

on the collateral.

While the above elements are all important for a sound risk assessment practice, we

chose to focus on managing HELOCs for our case study. This decision was based onthe current decline in home values and the increased exposure to losses. We believe

reviewing HELOC portfolios allows credit unions to take actionable steps to limit orprevent potential losses.

Boeing Employees Credit Union, Tukwila, WA

Scope of the Analysis

Boeing Employees Credit Union made the decision in late 2007 to proactively

evaluate their First Mortgage and Home Equity portfolio risk in light of the then

developing economic crisis. Historically the credit union conducted a quarterly credit

review of existing borrowers by obtaining and reviewing current credit scores. For

this analysis, BECU chose to expand the review to include collateral valuation with a

focus on their mortgage and equity advantage program (HELOC).

Staff Assignment

BECU understood that commitment of senior management and providing staffresources were essential for the success of such a project. The project was conceived

by the Executive Vice President COO. The project was headed up by their Senior

Vice President of Member Operations. A project team was assembled that included

Vice President of Lending and the Manager of Model Management. Other resources

were included at different stages as the project progressed, such as Marketing, ITand others.

Stakeholders

Because of the high importance of the project and its impact on the credit unions

financials, lending policies and culture, BECU identified the Executive Management

Team and the Supervisory Committee of the Board of Directors as the main

stakeholders in this process.

The decision was made to review only the HELOC (Equity Advantage) portfolio. BECU

felt these lines posed the greatest risk and a review of the first mortgage loanportfolio would be performed at a future time. The analysis focused first on all Equity

Advantage loans with 100% LTV and all out of state loans. In the second round theyincluded the remaining HELOC loans in the portfolio.


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Characteristics of Loans Analyzed

The Equity Advantage loans were first broken down using the following criteria:

Current value of the home vs. original value at time of origination

Current Loan to Value vs. original LTV at time of origination Age of loan - 2005 to 2007 was determined the greatest risk since homes

were valued during the peak of the housing bubble

Current Credit Score of the member vs. credit score at origination

The three data types used in the assessment were:

Risk Determination - Collateral risk measurement that predicts the potential

of an early payment default and/or the likelihood of an overvalued property.Risk levels are identified as Minimal, Intermediate or Elevated. A proprietary

risk analysis model derives these indications. The model analyzes multiple

relationships between key collateral elements. Property characteristics,

location influences and characteristics, sales activity information, and

property values and trends are all evaluated to produce credible risk

indication.

REO Percentage A foreclosure activity measurement that identifies the

percentage of sales in the subject market area that have transferred with aTrustees Deed, which typically indicates a foreclosure, within the past three

years.

Price Volatility Percentage - Sales price increase measurement that identifiesthat average percentage increase on properties in the subject market area

that had sold two or more times over the last three years.

The pool for the credit limit suspension and reduction was active Equity Advantage

(EA) accounts only. BECU decided there was not much benefit to getting the valueson the fixed rate/fixed term home equity loans as limited action could be taken on

those accounts. From a macro standpoint BECU wanted to assess the decline in value

the portfolio was exposed to. This would quantify the overall collateral value as ameasure against current balances. This measure would help quantify risk and

identify potential losses.

Number of Loans Analyzed for Each Type

The analysis covered 7,271 Equity Advantage loans, of which only 748 or 10.3%

were determined to be at risk. Loans at risk were determined by the following

criteria:

A FICO score drop of 40 points or more since loan origination A FICO score lower than 720 50% or more drop in net equity


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Methodology

Tools Utilized

BECU chose Prime Valuation Services (PVS) to provide the risk evaluation on

collateral in the portfolio. Additionally, Sagent data mining software was used toextract data from the different systems at the credit union. TransUnion was used to

pull the current FICO scores on each loan in the analysis through BECUs quarterly

account monitoring run.

Process Used in Conducting the Analysis

PVS required the following fields to conduct their analysis:

Member ID Number Street Number

Street Name City

State Zip Code Loan Number Original Value

Original Value Date Original Loan Amount Current Loan Balance


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Results

748 accounts were identified as potentially at risk of 40,959 loans.

These accounts had the following characteristics:

Average original FICO score - 698 Average FICO score as of 8/27/2008 - 651 Average decline in property value 13%

Out of the 748, 73.3% had a risk level considered to be minimal, 25.8%intermediate, and 0.9% had a risk level considered to be elevated.

REO Findings:

The analysis returns an REO Percentage, an indicator of foreclosure activity

measured by the percent of sales in the subject market area that transferred with a

Trustees Deed within the past three years1. Subject market areas with an REO

Percentage greater than 35% are considered to present a significant foreclosure risk.

The analysis returned the following results, which are also illustrated in Graph I:

96.5% had anREO Percentage

less than 25%; 2.1% had an

REO Percentage

of 25%; and 1.5% had an

REO Percentage

greater than

35%.

1 According to USLegal.com, a deed is the written document, which transfers title(ownership) or an interest in real property to another person. A trustee's deed is a

deed to be executed by a person serving as a trustee in their appointed capacity. A

trustee's deed is often used, for example, by a trustee in bankruptcy to sell real

property of the debtor.


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Price Volatility Percentage Findings:

The Price Volatility Percentage is a measure of the average percentage increase in

sales price of those properties within the subject market area that were sold two or

more times in the last three years.

A Price Volatility Percentage was returned on 7,271 loans. The analysis returned the

following results, which are also illustrated in Graph II:

38.2% had a price

volatility of less

than 25%; 15.1% had a price

volatility of 25% -

35%; and 46.7% had a price

volatility

exceeding 35%.


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Value Relationship Changes:

In addition to the three previous analytics, BECU also used Pass/Index Automated

Valuation as well as a review of current Loan-To-Value ratios 40, which is discussed

in the following section. The Pass/Index Model provides a view into property value

changes, from point of loan origination to present day. Of the loans reviewed, values

declined on 3,847, as described here, and in Graph III:

95.6% of loans less than

20% decline; 2.2% with a decline of

20% - 25%; and 2.3% with a decline

greater than 25%.

The final data point used in this analysis was Current Loan-to-Value. Current LTV

was returned revealing 77.5% of loans had a ratio below 90%, 5.4% fell between

90% and 95%. The final 17% exhibited an LTV of 95% or more. Graph IV illustrates

this segmentation.

Using all the above information, BECU decided to focus the analysis on loans thathave seen the most declines in property value. To identify those loans, they put

together a template using current and original credit score and combined it with the

current and original home values to determine which lines of credit would be reducedor closed. Members who had deterioration in both credit score and property value

were recommended for reduction in their lines of credit. Members with extremely

poor credit had their lines of credit closed, regardless of their home value.


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Actions Taken

BECU identified different actions to be taken depending on various FICO, LTV and

loan amount combinations. If the current FICO was less than 720, the LTV

greater than 80%, and the credit line greater than $25,000 the following

actions were taken for each product:

EA 85 Product1

Reduce the line when there is a 50% or greater decline in available equity and

there is less than $5,000 in available credit. Suspend the line if there is greater than $5,000 in available credit, or if there

has been a 40-point drop in the FICO score.

EA 100 Product

Reduce the line only when the current LTV at 100% will accommodate all

balances, and when there is greater than $5,000 in available credit. Suspend the line for all accounts with a current LTV greater than 100%, or if

there has been a 40-point drop in the FICO score.

BECU reviewed their Equity Advantage credit limits and in some cases those limits

were reduced or suspended. This was a due diligence measure to protect the safetyand soundness of the Credit Union. They recognized that the housing market has

changed and values are lower and time on the market is longer. Given the

circumstances, BECU carefully assessed its position relative to their members andthe collateral provided.

A line reduction or suspension only occurred if there had been a material change in

the conditions under which the loan was granted. BECU had defined a material

change as either a 50% decline in available equity or a 40-point or greater

decline in the FICO score. There is concern about member retention and the Net

Promoter Score2. The criteria for line review or suspension are designed to help

members who have lost value in their property from becoming overextended and totarget at risk members based on a decline in credit.

1The EA 85 Product refers to an Equity Advantage with 85% LTV or lower. The EA 100 Productrefers to an Equity Advantage loans with an LTV of 85.1% to 100%.

2Fred Reichheld developed the Net Promoter Score after more than a decade of research. This

research has shown that companies with a higher NPS have stronger relationships, profit andgrowth.

The BECU Board of Directors has set a three year Strategic Objective for NPS with a target of75% as of 12/21/08. This is calculated using a member survey. In the Net Promoter surveymembers are asked, How likely are you to recommend BECU to a friend or colleague? using ascale of 0 to10. Members who answer with a 9 or a 10 are Promoters; those who answer with a 7or an 8 are Passives and are not included in the final calculation because they could go eitherway; and those who answer in the 0 6 range are Detractors. There is an additional question thatBECU asks their members, What is the primary reason for your score?

The NPS is calculated by subtracting the number of Detractors from the number of Promotersdivided by the total number of responses.


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All reduced limits have met one or both of the material change provisions. In

addition, BECU did not look to change credit limits less than $25,000, with a currentFICO score greater than 720 or with a current LTV greater than 80%. If the member

has good credit, equity in the home, or a small credit line their BECU equity line will

be the same.

Applying the stated criteria resulted in the following changes to credit limits andaccounts:

Suspended limits = 700

Reduced limits = 48

Overturn on appeal = 14

o Change in credit score = 3o Appeal on property value and/or was suspend when it could have been

reduced = 8

o Cover check that were written in good faith = 3 $70,552,892 in total limits, $61,428,550 in balances.

For loans targeted for a limit reduction a letter of explanation was sent with

instructions to contact Member Risk Assessment with any questions. A copy of this

letter is attached in the Exhibit I.

Members who had their limits closed were sent a standard adverse action letter

containing the same contact information.

In order to prepare staff, copies of both letters along with an explanation of BECUsactions were communicated to all frontline employees via BECUs knowledge

management system which displays daily updates to BECU operations, policies and

any other important news. The update included instructions on how to assistmembers who may wish to dispute the decision and gave Rheba Cottles contact

information.

Member ReactionOverall the members who contacted BECU were concerned about their situation, yet

the majority understood why BECU was taking such action. To date there have been

approximately 125 calls from members. Below is a breakdown of those calls:

The majority of the calls were to discuss the reason for suspension or

reduction (i.e., Drop in Equity or Credit Score). Most of the members were able to understand the basis for credit unions

decision. The most common comment is they were disappointed that the lineswere suspended before they got the notification. Many were concerned that

the note was being called due.

Two members threatened to close accounts. As of 11/21/08 those accountswere still open.

There are three appeals on value where appraisals are in progress.

The remainder of the calls varied from members asking for advice or askingwhere and how to get help.


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Information was placed on each affected members profile to explain why his or her

limit was reduced or closed. Contact information was included on the letter andexamples distributed to the Member Service Call Center and Neighborhood Financial

Centers in a communication. This helped Member Service Representatives properly

address the situation should a member make an inquiry.

Challenges

Timing was an issue for BECU regarding when to send the letters explaining the line

of credit decrease or closure. They did not want to appear insensitive and the

holidays were approaching. Philosophically credit unions are not used to taking

things away from members, which made this a difficult task.

As a counter measure, BECU created an appeal process for members who felt their

equity was valued incorrectly. The members were given the opportunity to ordertheir own appraisal (as an out of pocket expense to the member) and present it to

BECU for review. BECU also implemented their own self-audit that took place before

the letters were sent. If a value appeared to be incorrect another Home Valuation

Explorer (Automated Appraisal) was pulled to double check.

Another challenge was knowing whether or not lowering credit limits of at risk

loans or closing the limits all together was cutting BECU losses or cutting potential

income. Ultimately BECU felt that their actions would benefit the membership as awhole by protecting against potential loss.

The final challenge occurred at the time the letters went out. BECU ran a marketingcampaign through online e-statements, paper statement inserts and on their website

encouraging members to apply for the Equity Advantage product. BECU felt that a

credit union-wide communication plan would avoid this from happening in the futureand recommend that any credit union who may choose to follow a similar program

should consider a plan to meet with marketing and other departments who may havean effect on such a mailing.


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Conclusion

Executing a Collateral Risk Portfolio Analysis

The following steps are meant as a guide to assist you in getting started with a

collateral risk portfolio analysis.

Project Scope

Determine who will be responsible for the project Identify your stakeholders

Identify products to be analyzed (First Mortgages, Seconds, HELOCs) Identify which loans, if any, you wish to exclude

Methodology

Identify which tools to utilize and what vendors (property valuation, credit

score, etc.) Outline a process to conduct your analysis

o Identify data elements to be pulled

o Decide if there will be any special focus on certain product lines, hometypes, demographics, etc.

Taking Action

Identify loans that may be at risk

Decide what action will be taken (Adverse Action Letter, reduce or close limitson HELOCs)

Identify if changes are needed to your lending policies Create a communication plan for staff and members

This has to be done regularly to be effective, once a year or less


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Acknowledgements

We would like to thank the credit union executives and staff who provided

information for this paper. Special appreciation is given to:

Joe Brancucci

Executive Vice President and COO

BECUTukwila, Washington

Scott StrandSenior Vice President of Member Operations

BECU

Tukwila, Washington

Aaron Bresko

Vice President of Lending

BECU

Tukwila, Washington

Will Gix

Manager, Model ManagementBECU

Tukwila, Washington


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Appendix

Sample Line Decrease Notification Letter sent to members:

FullName Date of Notice: Date

AddressLine1 Account Number:

Account_NumberAddressLine2

CityName, StateCode ZipCode5

Dear Member: FullName

BECU periodically reviews our loan portfolio to determine if there have been any

significant changes since a loan was granted. We are contacting you with important

information regarding your Home Equity Line of Credit. After reviewing your Home

Equity Line Account, on Date we have reduced your Credit Limit to $ Limit

Our decision was made in accordance with terms of the Credit Agreement(s) and was

based primarily on a decline in the value of the property securing your Home Equity

Line, which resulted in a significant decrease in your available equity. In order todetermine this, we obtained an updated home value assessment for this property.

Please note that your account is not closed and will not be reported to any of the

credit bureau agencies as such. You can continue to make new advances on your line

up to the new Credit Limit and be reported in good standing as long as you continue

to satisfy the terms and conditions of the Credit Agreement.

Once the circumstances, that led to this action has been corrected, you may request

BECU to reevaluate your account for reinstatement of the credit limit.

Please note that all of the other terms of your Credit Agreement(s) remain in effectuntil you have repaid all amounts due under that agreement.

If you have any questions, please call Rheba Cottle at 206-XXX-XXXX, or toll-free at1-800-233-2328 x0000 if you are calling from outside the local Seattle calling area.


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Supervisory Letter

Evaluating Current Risks to Credit Unions

Risk in the credit union industry continues to evolve and requires NCUA to

continually evaluate our risk monitoring and supervision procedures. This

Supervisory Letter (Letter) discusses several of the emerging risks, particularly thoserelated to the current economic climate, and provides guidance for addressing the

issues. The specific topics covered in this Letter include:

The changing credit union business model and balance sheet composition andthe challenges it creates;

Present mortgage and real estate market and the related expectations for

credit unions and examiners; and

The Risk Focused Examination (RFE) supervision program with an emphasis

on district management and off-site monitoring.

Recent failures show the results when credit union management does not prudently

plan, pursues aggressive and unchecked growth, and fails to properly diversify.These failures also demonstrate the consequences associated with declining real

estate markets coupled with higher levels of credit risk. Not fully understanding the

risks of a new program coupled with not limiting exposure to gain experience was amaterial flaw in the management of these failed credit unions.

One of the key lessons learned is the need for credit union management to gain

adequate experience with any new product or service in order to understand and

manage the related risk. The core lesson regarding new programs is to limit

exposure until management has a complete understanding of the potential risk.Even after gaining an adequate understanding, the ongoing measuring, monitoring,

and controlling of the risks is essential to ensure long-term success in meeting the

credit unions strategic goals.

The remainder of this Letter addresses the current risks credit unions are facingalong with guidance to staff. While this Letter primarily addresses the risks in real

estate lending, many of the principles discussed can and should be applied to other

loan products and services.


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Evolution of the Credit Union Business Model

As of June 30, 2008, there were 7,972 federally insured credit unions reporting $291billion in real estate loans. However, just as an individual credit union can have a

concentration of assets, the National Credit Union Share Insurance Fund (NCUSIF)

has a growing concentration risk with 7.7 percent (or 614 credit unions) of federally

insured credit unions holding 78 percent (or $227 billion) of the credit unionindustrys outstanding real estate loans. These 614 credit unions all are in excess of$250 million in assets. As the majority of real estate loans reside in these credit

unions, so does the majority of the credit and interest rate risk discussed in this

Letter.3

Balance Sheet Structure

The structure of the credit union

industrys balancesheet andincome statement materially

changed over the past 10 years.

As Chart 1 shows, assets shiftedfrom traditional consumer loans to

real estate loans, with the latter

comprising over 53 percent oftotal loans.

During the same period, membershares shifted from regular shares

to more rate sensitive share

certificate and money market

accounts as shown in Table 1. In

addition to greater reliance on rate sensitive shares, credit unions increased the use

of borrowed funds and the reliance on fee income.

Table 1

Dec 1997 June 2008

Real Estate Loans to Total Loans 35.0% 53.3%

Net Long-Term Assets to Assets 20.2% 32.1%

Regular Shares + Share Drafts to Total Shares +Borrowings

49.4% 36.5%

Certificates + Money Markets to Total Shares +Borrowings

38.4% 49.3%

Borrowings to Total Shares & Borrowings 0.4% 4.3%Fee Income to Net Income 57.7% 163.2%

3Credit unions with assets less than $250 million can also demonstrate elevated risk levels

discussed in this Letter. Examiners should apply the guidance provided to all credit unionsexhibiting high risk characteristics, not only those with assets greater than $250 million.


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Credit unions with a balance sheet exhibiting the growing concentration in real estate

loans funded by more volatile shares requires a high level of oversight and moreadvanced risk modeling systems. Examiners must closely scrutinize the risk systems

and models employed by credit unions exhibiting these characteristics.

Earnings

The credit union industrys income structure is being impacted by changes in thebalance sheet composition, the interest rate environment, and economic conditions.

An increase in the operating expense ratio and compression of the net interest

margin has occurred since 2005. As Chart 2 illustrates, the industry balance sheet

would be unprofitable without fee income as the historical core share and loan

products no longer provide sufficient spread to cover operating expenses. Creditunions not able to find additional efficiencies in operations found other ways to boost

income, such as increasing loans or offering other fee-generating products or

services. This trend pointsto a significant change in

credit union operations, one

that is untested in thecurrent economic

environment.

Lower levels of earnings can

be acceptable depending on

the level of net worth,4

quality of assets and

liabilities/shares, and thelevel of control exerted over

the earnings structure. An

overly simplistic focus ongrowth to increase earnings

in the current environment isvery likely to involvestrategies that necessitate excessive risk-taking and could drive unsafe and unsound

behavior.

Examiners must evaluate credit union earnings relative to the financial and

operational risk exposure, strategic plans, and net worth needs based on current andpotential risks. Lower levels of earnings should continue to be viewed positively if

they result from a sound and well-executed strategy to balance risk exposure or to

position the credit union to achieve long-term growth, financial stability, andmember service objectives. Any unsafe and unsound concentration risks affecting

earnings must be addressed with the management of the credit union and

adequately reflected in the CAMEL and risk ratings.

4 Thus, credit unions need not engage in reactive or extraordinary measures simply becauseearnings levels decline as a result of broader economic conditions when net worth levels meet orexceed their needs. In fact, such measures likely involve significant risks, either in terms ofaccepting greater risks to generate higher returns, and/or in terms of short-sighted trade-offs(e.g., increasing fees, selling less profitable business lines, engaging in high risk lending)affecting the longer-term strategic positioning of the credit union. NCUA Letter to Federal CreditUnions 06-FCU-04, August 2006


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Reliance on Third-Party Providers

The methods credit unions use to obtain the assets and liabilities/shares changed

dramatically in recent years while the use of third-parties to facilitate lending

services increased significantly. These third-parties could be credit union serviceorganizations (CUSOs), mortgage brokerage firms, other financial institutions, or

other third-parties. Loan participations and outright purchasing of real estate loansoriginated by other parties has also increased. Third-party risk is addressed in

Supervisory Letter No. 07-01, October 2007 - Evaluating Third Party Relationships.

Letter 07-01 provides a good reference for examiners to use when evaluating a

credit unions due diligence process.

Assessment of Risk Management Systems forMortgage Portfolios

Since 2002, real estate values have cycled from historical increases to historical

declines in certain geographic areas. As real estate valuations were dramatically

increasing, mortgage loan originators expanded beyond the traditional mortgage

products. Although the credit union industry does not report large amounts of non-

traditional mortgage lending,5 there is some exposure to this lending type. These

loans amount to $7.2 billion, or 3.7 percent of all first mortgages, which indicates a

low level of industry-wide risk. In addition to new types of mortgages, many

mortgage originators demonstrated willingness to lower credit underwritingstandards, including:

Low-doc or no-doc loans;

Relying on stated income without verification;

Determining capacity to repay solely on the initial payment for interest only

hybrid adjustable rate mortgages (ARMs) or payment option ARMs;

Risk layering6

through simultaneous second mortgages; and,

High loan-to-value ratios for first or second lien loans.

The vast majority of credit unions followed traditional mortgage underwriting

practices consistent with the characteristics of their field of membership. However,

due to the prevalence of high risk underwriting practices in the mortgage industry

over the past several years, any credit union with real estate loans on their books islikely to have increased risk exposure. For instance, if the credit union holds a

second mortgage behind a senior lien underwritten using the practices mentioned,

these loans are at a higher risk of default.

5NCUA Call Report data for non-traditional mortgages is limited to Interest Only or Optional

Payment first mortgage loans.6

Risk-layering refers to loans that combine multiple nontraditional features, such as interest onlyloans, with reduced documentation and/or a simultaneous second-lien loan. Management shoulddemonstrate that mitigating factors support the underwriting decision and the borrowers capacityto repay. Mitigating factors could include higher credit scores, lower loan-to-value and debt-to-income ratios, significant liquid assets, mortgage insurance, or other credit enhancements. Whilehigher pricing is often used to address elevated risk levels, it does not replace the need for soundunderwriting.


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While the weakened mortgage market is causing increased delinquency and loan

losses across nearly all types of lending, real estate loan categories demonstrate thegreatest increase. Other real estate loans (those not in a first lien position) show a

higher degree of credit risk as evidenced by the significant increase in delinquency

and losses during 2007 and through the first six months of 2008.

Table 2

Range for

1997-2006 2007

June 2008

(annualized)

First Mortgage Delinquency 0.26% - 0.49% 0.64% 0.78%

Other Real Estate Delinquency 0.24% - 0.41% 0.73% 0.78%

Non-Real Estate Delinquency 1.01% - 1.30% 1.21% 1.19%

First Mortgage Charge-off 0.01% - 0.02% 0.02% 0.07%

Other Real Estate Charge-off 0.04% - 0.06% 0.19% 0.53%

Non-Real Estate Charge-off 0.67% - 1.00% 0.93% 1.25%

In some areas of the country, property values have declined in excess of 20

percent,7 which puts even well underwritten, conventional mortgages at some risk.

An article titled Hybrid ARMs: Addressing the Risks, Managing the Fallout, included

in the summer 2008 edition of FDICs Supervisory Insight, begins with the followingstatement:

Recent turmoil in U.S. residential mortgage markets has shattered the

long-held belief that home mortgage lending is inherently a low-risk

activity.

This observation is important when evaluating the risks faced by every credit union

granting or holding real estate loans. The dramatic changes in the credit marketsand in real estate valuations affect nearly all credit unions, even the vast majority

that adhered to conventional real estate lending practices and products. What was

once the safest loan a credit union could grant now carries with it thepotential forincreased credit risk, even when prudent underwriting standards are followed.

Evaluating Mortgage Portfolios

When a credit union has a large mortgage portfolio or a portfolio with high-riskcharacteristics, examiners need to ensure risk managementpractices arecommensurate with the risk assumed and management clearly identifies and

measures the risk taken. Examiners should determine whether risk managementprocesses include:

Setting individual and aggregate loan limits based on net worth and the

overall risk profile within the balance sheet;

Updating credit risk scores periodically on all borrowers;

Monitoring home values by geographic area;

7Based on reports produced by the Office of Federal Enterprise Oversight and the National

Association of Realtors.


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market factors indicate a potential decline in home values, or when theborrowers payment performance deteriorates and a greater reliance is placed

on the collateral;

Ensuring that appraisals obtained reflect realistic values based on currentmarket conditions and comply with regulatory and industry requirements,

especially if related to a loan underwritten by a third-party where theyselected the appraiser;

Monitoring transactional volume and activity on home equity lines of credit

(HELOCs); and

Analyzing whether increasing loan-to-value (LTV) ratios necessitate reducing,

suspending, or discontinuing existing credit lines8 (e.g., HELOCs).

Management should be producing periodic reports for the portfolio management

process, including:

Origination and portfolio trends by product, loan structure, originator channel,credit score, LTV, debt-to-income ratio (DTI), lien position, documentation

type, property type, appraiser, appraised value, and appraisal date;

Delinquency and loss distribution trends by product and originator channel

with some accompanying analysis of significant underwriting characteristics,

such as credit score, LTV, DTI;

Vintage tracking9 (i.e., static pool analysis);

The performance of third-party (brokers and correspondents) originated

loans; and

Market trends by geographic area and property type to identify areas of

rapidly appreciating or depreciating housing values.

High Loan-to-Value Loans

In some cases, examiners will find the existence of high loan-to-value (HLTV) loans,

especially in the markets with declining home values and in product lines designed to

serve low-income members. When HLTV loans are present, management should

monitor such loans closely. In reviewing HLTV loan portfolios, examiners should

review:

The existence and reasonableness of the board policy limit on HLTV loans tonet worth;

The repayment terms and structure of the senior liens as the risk of the

senior liens impact the subordinate liens;

The tracking of all LTVs in excess of 80 percent, including factors such as theexistence of mortgage insurance;

8Letter 05-CU-07, Managing Risks Associated with Home Equity Lending, outlines the

circumstances when credit lines can be reduced or discontinued under Regulation Z.9

Risk Alert 05-Risk-01, Specialized Lending Activities Third-Party Indirect Lending andParticipations, and the accompanying supplemental guidance whitepaper on static pool analysisdiscusses how such analysis can be used to track the performance of most loan pools. Thisguidance can be applied to all non-traditional products or other loan products, not just indirectlending.


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Inclusion of unfunded commitments such as available unused lines of credit in

LTV computations; and

The reporting of the aggregation of HLTV loans to the board of directors at

least monthly.

Mortgage Loan Workouts

During an economic downturn, credit unions are more likely to offer mortgage loanworkout programs to their members. Examiners must closely evaluate these

programs to ensure management exercises the proper level of due diligence in

developing and monitoring these inherently higher risk programs. When the credit

union originated and holds the distressed loan, management should be encouraged

to take appropriate actions to rework the loan as necessary to reduce the credit

unions loss exposure.10 At the same time, examiners must ensure the program

does not cause unintended consequences such as masking delinquency or delaying

the timely recognition of loan losses.

When reviewing loan workout programs, examiners must ensure the credit union

adheres to the following minimal controls:

Strict aggregate program limits in terms of total loans and net worth;

A requirement for the borrower to meet traditional underwriting standards interms of the credit score, employment stability, etc;

If HLTVs are accepted, a documented assessment showing the current

property value and anticipated value over the next 12-24 months (consider

using nationally recognized real estate valuation sources), as well asthe LTV at the end of that period;11 and

Monthly reporting to their board of directors on the loans originated under theprogram, including the risk profile of theportfolio related to current LTV,delinquency, losses, and credit quality.

If the credit union offers a loan workout program to members with distressed

mortgages held by another institution,12 the level of oversight and control should be

equally diligent and based on time-tested sound lending practices. In addition to thecontrols above, there should also be a requirement for the member to obtain

concessions from the originating lender so the credit union is not fully absorbing the

risk of the distressed mortgage and accompanying collateral.

10Letter to Credit Unions number 07-CU-06 Working with Residential Mortgage Borrowers.

11This control is intended to guide credit unions making HLTV loans both to consider the current

property value and to exercise caution in light of potential future declines in the property value,not to make lending decisions based on forecasted higher property values.12

These would be mortgages in which the credit union does not have a direct interest. In thoseinstances where a credit union attempts to help their member out of a problem loan with anotherinstitution they should apply traditionally proven and sound underwriting guidelines.


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Risk Focused Supervision and Monitoring

There are several pillars to the RFE program including examinations, supervision,and district management, each of which contributes to the programs overall

effectiveness. Given the current ability of credit unions to rapidly change the

composition of their balance sheet and risk profile, coupled with their growing

complexity, a responsive and results-oriented supervision program is essential.

Identifying a potential problem early provides credit union management and NCUA

with the best chance of resolution without requiring assistance from the NCUSIF.

One of the key parts of the supervision program is off-site monitoring. However, thereview of numbers by themselves often does not provide the depth of an issue.

When signs of increased risk are present through off-site monitoring, the review may

lead to a phone contact or an on-site contact to gain an understanding of thechanges and risks.

District Management

Off-site review of the quarterly call report, financial trends, regional risk systems,and national risk reports are essential pieces of district management and the RFE

process. These reviews provide insight into the impact from changes to the balance

sheet structure related to a new product or service, or provide the first indication ofa material change in strategic direction. The review of data must be coupled with

consistent communication between the credit union and examiner for effective

district management.

During on-site or off-site contacts, examiners should become aware of any new

products or services, changes in strategic direction for each credit union in the

assigned district, and changes in key management positions. This knowledge allows

the examiner to put the financial trends in perspective and adequately evaluate the

credit unions risk profile.

Where feasible, it is a good practice to address shortfalls in the planning or riskmanagement of a new product/service or a change in strategic direction before

implementation. Examiners typically become aware of these situations through the

review of board minutes or other credit union documents, quarterly call reports, orthrough conversations with management and the officials of the credit union.13

Among other things, plans should address prudent limitations to manage the risk to

net worth, the projected costs and income, interest rate risk impact (if applicable),long-term strategic goals, and on-going monitoring.

Off-Site Contacts

Off-site supervision and timely identification of risk trends is a critical component ofthe overall supervision process. Ensuring growth trends are in line with strategic

planning and risk management strategies is essential in determining whether there is

undue potential risk to the credit union. Periodically reassessing existing asset orliability concentrations based on changes in internal and external factors is also a

valuable supervision step.

13These reviews and/or conversations could be through off-site or on-site supervision.


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Examiners should consider the following questions when conducting off-site reviews

of quarterly data, reports, and other information provided by credit unions:

Do call reports, financial performance reports, historical warnings reports,

or risk reports reflect any unusual trends, possible data errors, or

anomalies warranting further review?

Is the growth in any asset or liability category unusual or inconsistent withthe credit unions strategic plan or established risk thresholds?

Is the growth rate excessive, when all factors are considered (e.g.

compared to the credit unions own historical trends, geographic, or

industry trends)?

Is the volume or concentration of any loan product or asset category

excessive when measured against net worth, particularly in light of

existing economic conditions?

How is the credit union funding loan growth? Is it through current

liquidity, borrowed funds, brokered deposits, or some other source or

combination of sources? Does the funding source(s) create other risk

considerations? Is loan growth from the credit unions use of a third-party? Does this

represent a new vendor relationship or a change in relationship not

previously reviewed?

Are the earnings, liquidity, and net worth levels consistent with the creditunions current plans and strategies?

Can management adequately explain their growth strategies? Do they

have a solid understanding of the potential risks, and are adequate plans,systems, and controls in place to manage those risks?

Has there been a substantial change in senior management? What is the

background of the new management staff and is their tolerance for risk

consistent with historical information?

Examiners should contact credit unions in a timely manner when there is asubstantial change in the balance sheet composition or trends. This is particularly

critical when the product or service may have unique risk characteristics or when

there is concern that a concentration is developing that could create an undue level

of risk not considered by management. This may necessitate an on-site contact to

address the questions or concerns.

On-Site Contacts

Examiners may determine an on-site visit is necessary to review the trends and to

ensure management has a full understanding of the risks associated with theirstrategy. It is important to remain vigilant when assessing managements strategicvision and risk management processes, especially when there appears to be a shift in

strategic direction.

Open and clear communication with senior credit union management is a key

element of a successful on-site contact and effective supervision. Senior

management should be forthcoming with answers and support for areas of potential

risk and provide examiners unrestricted access to documentation and staff members


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to facilitate the contact and understanding of the credit unions practices. A lack of

candor or limiting access to records or staff are red flags examiners should notaccept. Examiners should discuss problems involving lack of cooperation with their

supervisor, communicate with the credit union officials to obtain required cooperation

and/or records, and document the issues in the administrative record.

When performing on-site assessments and monitoring the risks outlined in thisLetter, whether through routine examinations or interim on-site supervision contacts,

examiners should constantly evaluate managements capabilities including whether:

Short-term decisions and strategies are based on a sound business model,that all risks have been fully considered, and potential short-term gains

are not being pursued to the detriment of long-term risk exposure;

Risks being taken are commensurate with the expertise of credit unionstaff and with the level of available net worth;

Potential risk to the institution is within board established risk parameters;

Processes and procedures are appropriate in light of the risks taken; and

Third-party vendors have been thoroughly reviewed prior to entering intosuch relationships and adequate controls over the product/servicingprocess are maintained.

Problem Resolution

When a contact discloses elevated levels of risk without prudent risk management

practices, examiners must take appropriate supervisory action.

It is important to remember there does not have to be an imminent risk of loss to be

a safety and soundness concern. While there is no finite list of concerns, examplesinclude: (1) A credit union growing a program rapidly without prudent risk

management practices in place; (2) A credit union with a significant mismatch in the

asset/liability structure and lacking proper interest rate risk management; or (3) Acredit union failing to perform initial and on-going due diligence when using a third-

party.

Examiners must evaluate the situation based on their own experience, assess the

individual credit unions management of risk, and determine whether corrective

action is required. When elevated risk is present and management of the risk is not

sufficient, examiners must consider a credit unions ability to continue offering a

program and the potential impact to net worth using a worst-case scenario.

Supervisory actions may include requiring the cessation or moderation of growth in a

program until proper risk management practices are in place. As always, examiners

should consult with their supervisor prior to initiating such action .

Conclusion

Diligence in NCUAs examination and supervision efforts is of paramount importance

to help ensure the continued success of the industry and maintain public confidence

in the credit union system. Flexibility in the examination and supervision approach isneeded to match the changing credit union business model, as well as deal with the

challenges presented by the current real estate market.


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NCUA has issued numerous letters to the credit union industry regarding the

associated risks given various economic, interest rate, or credit cycles. The coremessage and guidance in these letters represent sound risk management practices

and are applicable today, including:

Applying prudent policies, realistic limitations, and business strategies for allasset, liability and share categories;

Considering carefully the risk to net worth and the level of earnings requiredto sustain strategies under various economic and interest rate environments;

Employing proper diversification strategies in order to avoid excessive

concentrations in or reliance on any asset, liability or share category;

Evaluating and clearly understanding the risks involved before implementing

new strategies, introducing member products, or materially increasing any

loan or asset holding;

Performing initial and on-going due diligence when using a third-party to

provide services, loan underwriting, or purchase/manage assets or liabilities;

and

Measuring, monitoring, and controlling the risks from all strategies andmaking operational adjustments as necessary.


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Resources

1. NCUA Letters to Credit Unions No. 57, June 1981 Diversification in theInvestment Portfolio

2. NCUA Letters to Credit Unions No 60, October 1981 - Deregulation of Share,

Share Draft, and Share Certificate Accounts

3. NCUA Letters to Credit Unions No. 124, June 1991 - Real Estate Secured Credit

by Credit Union Members

4. NCUA Letters to Credit Unions No. 130, February 1992 - Changes in Interest

Rates During Examinations

5. NCUA Letters to Credit Unions No. 146, August 1993 - Yields on Assets

6. NCUA Letters to Credit Unions No. 154, April 1994 - Credit Unions' Lending

Policies

7. NCUA Letters to Credit Unions No. 174, August 1995 - Risk-Based Loans

8. NCUA Letters to Credit Unions No. 99-CU-05, June 1999 Risk-Based Lending

9. NCUA Letters to Credit Unions No. 99-CU-12, August 1999 - Real Estate Lending

and Balance Sheet Risk Management

10.NCUA Letters to Credit Unions No. 00-CU-13, December 2000 - Liquidity and

Balance Sheet Risk Management

11.NCUA Letters to Credit Unions No. 01-CU-08, July 2001 - Liability Management Highly Rate-Sensitive & Volatile Funding Sources

12.NCUA Letters to Credit Unions No. 03-CU-11, July 2003 - Non-Maturity Sharesand Balance Sheet Risk

13.NCUA Letters to Credit Unions No. 03-CU-15, September 2003 - Real EstateConcentrations and Interest Rate Risk Management for Credit Unions with Large

Positions in Fixed-Rate Mortgage Portfolios

14.NCUA Letters to Credit Unions No. 04-CU-13, September 2004 - Specialized

Lending Activities

15.NCUA Letters to Credit Unions No. 05-CU-07, May 2005 - Risks Associated with

Home Equity Lending

16.NCUA Risk Alert No. 05-RISK-01, June 2005 - Specialized Lending Activities

Third-Party Subprime Indirect Lending and Participations

17.NCUA Letters to Credit Unions No. 05-CU-15, October 2005 - Increasing Risks in

Mortgage Lending


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18.NCUA Letters to Federal Credit Unions No. 06-FCU-04, August 2006 - Evaluation

of Earnings

19.NCUA Letters to Credit Unions No. 06-CU-16, October 2006 - Interagency

Guidance on Nontraditional Mortgage Product Risk

20.NCUA Letters to Credit Unions No. 07-CU-06, April 2007 - Working withResidential Mortgage Borrowers

21.NCUA Letters to Credit Unions No. 07-CU-09, July 2007 - Subprime MortgageLending

22.NCUA Letters to Credit Unions No. 07-CU-13, December 2007 - SupervisoryLetter-Evaluation Third Party Relationships

23.NCUA Letters to Credit Unions No. 08-CU-05, March 2008 - Statement onReporting Loss Mitigation Efforts of Securitized Subprime Residential Mortgages

24.NCUA Letters to Credit Unions No. 08-CU-09, April 2008 - Evaluating Third Party

Relationships Questionnaire

25.NCUA Letters to Credit Unions No. 08-CU-14, June 2008 - Consumer Information

for Hybrid Adjustable Rate Mortgage Products

26.FDIC Supervisory Insights Summer 2008, Volume 5, Issue 1

http://www.fdic.gov/regulations/examinations/supervisory/insights/sisum08/inde

x.html

portfolio risk analysis

Documents