Tag: Feature

Economic Uncertainties and Scenario Risk Management

Prior to the Coronavirus expectations were for a gradual economic slowdown in 2020, but most economists were not expecting a full-blown recession. The abruptness and severity of the economic impact of the Coronavirus have been unprecedented, to say the least. First-quarter estimates of economic contraction are around a seasonally adjusted 5% annualized rate. Some second-quarter estimates range around a massive 20% contraction. Estimates of the unemployment peak in the near-term range widely from 15% to as high as 30%. However, a lot of uncertainties come in the months and quarters following the first half of 2020. Will the recovery be a “V”, “U”, or “L” shape is often the question asked? Some economists are expecting anywhere from an 8% to 12% annualized GDP growth rate bounce back in the second half of 2020 and some degree of bounce back is certainly likely. The very large uncertainty lies in how much that bounce back will be and how constant it will be in terms of the economy returning to positive growth on a sustained basis. For example, the unemployment rate will certainly come down substantially from its Coronavirus peak, but it is difficult to forecast to what level it will return. The days of sub 4.0% unemployment are gone and for the medium-term, the unemployment rate could settle in the high single digits. Unfortunately, many jobs and businesses will not be able to return and the pace that larger company job losses come back may be questionable for some industries. New jobs and areas of growth will certainly emerge, but it will take time. In considering the economic outlook, the credit union may want to contemplate several scenarios such as a quick bounce back in the second half of 2020, a more gradual and drawn out improvement after some initial bounce back, and a worst-case scenario where improvements happen slowly over a longer time period. Unfortunately, given the high degree of uncertainty at the current time, it may be prudent to plan for the latter two. From a risk management perspective, this means that credit unions should look hard at credit, liquidity, net interest income, and capital stress scenarios and plan accordingly.

Forecasting credit performance going forward will be challenging to say the least. As unemployment rates rise to unprecedented highs in the near term, recent legislation allows credit unions to enact forbearance programs for those members affected economically by the Coronavirus. Also, the legislation does not require a troubled debt restructuring (TDR) status for these loan modifications. Given the immediate and lasting economic uncertainties along with government policy reactions, determining actual future losses will be challenging for credit unions. Credit models generally are challenged with the uncertainties of government policy reactions. One possibility would be to consider different economic distress scenarios and be aware and prepared for the most severe that has a material probability of occurring.

During the last financial crisis and recession, credit unions generally experienced member share growth and even an acceleration of share growth at certain times. However, can we be certain this will be the case again? Various liquidity drivers impacting the balance sheet should be considered. For example, as opposed to share growth continuing unabated, what if members have a greater reliance on using savings to pay expenses. In addition, lower interest rates generally mean faster real estate prepayment rates, however, this will be offset by loan forbearance programs and the possibility of some members needing short term loans. As this is a vastly different crisis that may have a longer, more drawn-out lasting impact, the credit union should be on a heightened liquidity risk assessment and management alert.

From 2016 through 2018 the Federal Reserve gradually increased the federal funds rate and the U.S. Treasury yield curve also increased. Credit Unions began to see net interest income increase as balance sheets grew and margins expanded. However, during those later years, the U.S. Treasury yield curve began to flatten and even invert at times. During the second half of 2019, the Federal Reserve decreased the federal funds rate 75 basis points and many credit unions began to see net interest margin pressures emerge in the fourth quarter of 2019. With the onset of the Coronavirus crisis, the federal funds rate was swiftly taken to zero and the U.S. Treasury yield curve was well below 1.00% out to a 10-year term at the end of the first quarter. Net interest income will continue to be under pressure again due to a lower interest rate environment and possibly lower or even negative loan growth for some credit unions. Base case expectations for net interest income pressures should be assessed, but also the possibility of further pressures such as a lower level of loan growth or even negative loan growth stress scenarios.

Risk management is a function of credit union management and the need for risk management is heightened with such a high level of uncertainties and potential for adverse outcomes. Base case and stress scenarios allow the credit union the ability to assess the impact on capital and plan accordingly. Through all of this, keep in mind that it’s times like these where the credit union can show members their value by supporting them through financial challenges. Times like these can present the credit union with the opportunity to step up support for members with actions such as loan forbearance and small-dollar lending programs. Risk management is a function of credit union management and needs to be heightened during these times, but it is ultimately done to provide the best service to members and particularly in their time of need.

Oct 01 2019

CECL – What We’ve Learned that Will Benefit Your Credit Union

This past summer, the Financial Accounting Standards Board (FASB) delayed the implementation of CECL for credit unions moving it to January 2023. Although this will provide credit unions some relief in implementing CECL, many credit unions continue to cite compliance with CECL as one of their top concerns. Some groups are campaigning to have CECL abolished for credit unions and point to the fact that credit unions, in general, did not cause the issues that led to the creation of CECL. Besides, a majority of credit unions typically have appropriately funded allowance accounts.

As strong credit union advocates, we certainly support such endeavors and are in complete agreement with the reasoning. However, in our continued efforts to help credit unions, we’ve taken a different approach. Rather than spend energy and resources trying to make CECL go away, we’ve focused on how to make CECL compliance comfortable, easy, affordable, and attainable.

At Mark H. Smith, Inc., we believe the right approach and methodologies for CECL do not need to be a daunting task and a tremendous resources drain. Instead of hoping for a seemingly difficult challenge to go away, we’ve chosen to address it head-on for credit unions. In this article, we discuss some of the areas of concern and provide you with some considerations.

Data Requirement

One area of concern around CECL has been the historical data requirement—particularly the questions of what data do I need and how far back. Some (in-sourced and out-sourced) solutions stipulate five to seven years of historical loss experience data. This sounds reasonable on the surface, but will that be sufficient to help you forecast expected loss for the estimated remaining life of the loan portfolio? Another approach suggests the credit union needs to look at its own historical credit loss experience through a full economic and credit cycle. Unfortunately, for the recent cycle, that would mean over ten years of data and most likely closer to 15 years.

Another consideration is what if the next several years of credit performance conditions don’t look like the last several years? Put another way, what-if economic growth contracts, unemployment increases, and credit loss conditions change from the past several years? One answer could be that an adjustment would be necessary, but what is that adjustment, and how does it relate to your credit union’s loan loss experience and expectations? Is the adjustment predictive of your credit union’s specific loss experience or does it rely on other factors that may not be related to your credit union? The right amount of data elements and the amount of history needed for an excellent CECL solution continues to be a question for many credit unions.

Data Assessment

How to prepare for CECL and what data is needed are essential questions in performing your CECL assessment, and we completely understand that it can sound rather daunting, particularly for credit unions with staff and resource limitations. After all, you have a credit union to run and members to serve as opposed to spending your time gathering and assessing years of historical data. At Mark H. Smith, Inc., we have learned that it doesn’t need to be a significant resource drain for the credit union at all. The answers lie in choosing a methodology and solution that works for your credit union. Options are available that may not require you to spend your time gathering and assessing years of data. Don’t look at in-house or outsourced solutions and think they all have the same data gathering and assessment requirements. Ask yourself if you want to do all of the data gathering, cleansing, analysis, and reporting,or do you want the methodology and/or solution to do the work for you? All solutions are not created equal, and there is the right solution for your credit union. For example, consider the possibility that you can meet the historical look-back time frame and data element considerations discussed above without having to expend a lot of your resources. Your own credit union’s historical loss experience data may be readily available with the right methodology. We have seen in-house as well as out-sourced solutions with methodologies that are very resource-draining while others are a piece of cake. We encourage credit unions to look for in-house and outsourced solutions that complement business goals and objectives, fulfill the CECL requirements, and enable staff more time to serve members.

Forecasted Loss Experience

Following the above data assessments, we have found some credit unions with a few loan types that do not have enough historical loan loss experience (due to the number of loans or lack of enough history) to mathematically and reliably use as a component for forecasting loss experience. Also, keep in mind there is an optimal level of segmenting loan types. More segmenting does not necessarily mean better or more compliant results. Too much segmentation can result in a higher degree of error or unreliability as segmented sizes become too small.

We strongly suggest that a credit union’s first and primary CECL analysis and assessment should begin with using their own loss experience, but we have found that for smaller loan portfolios, it is also imperative to have peer loss experience resources for comparison. The peer information is not only insightful to the credit union but in some instances, it is crucial to provide support for the CECL results. Loan types with a small number of loans can be problematic, but new loan types, new lending goals, change in underwriting practices, and other loan developments should be considered. Peer historical loss information comes into the equation to supplement and in some cases, support or confirm the results of the analysis using the credit union’s own historical loss data. In the hundreds of CECL reports that we have run for credit unions, we have learned that peer and industry comparison loss experiences by loan type are a crucial part of their CECL analysis. In determining the right solution for your credit union, the availability of peer and industry loss experience, along with having more than one methodology available for comparison should be essential components.

Wishful thinking can at times be a strong force to make the positive happen, and we are all about working to make the positive happen for credit unions. However, wishful thinking to make a FASB requirement go away is probably not the best strategy. That doesn’t mean addressing CECL has to be an insurmountable endeavor as many fear-mongers would have you believe. With the right approach to finding the right solution and methodology, CECL can be comfortably addressed without being a resource drain. If you would like to know more about how Mark H. Smith, Inc. can help your credit union comfortably, easily, and affordably address CECL, please feel free to contact us.

Jul 12 2019

What Goes Up Must Come Down

There has been talk and speculation that the Fed may unwind some of the rate increases they have made over the last two years. One of the biggest factors contributing to interest rate risk is the possibility that in a rising rate environment, funding costs will increase quicker and higher than interest income, causing net interest margins to decrease and earnings to be negatively impacted. Regulators have emphasized potential exposures in a rising rate environment and have constantly warned that credit unions will face income challenges when rates increase. The fear is that when interest rates increase, the credit unions’ ability to remain profitable and viable will be at risk.

Most of the interest rate risk modeling we have done, for the instantaneous and parallel 3% uprate shock, forecasts improvement in net interest margins during a three-year timeframe. Occasionally, there is a decrease (interest rate risk) in the net interest margin in the first year. Once the credit union has increased dividend rates necessary to retain funding, net interest margins typically improve and outpace the flat rate net interest income forecasts. Some regulators may express that positive results in an uprate scenario cannot be realistic. When a large percentage of the credit union’s funding is in regular shares and share drafts, the ability to control interest rate risk and improve net interest margin is highly likely. Regular shares and share drafts have much lower rate sensitivities than other deposits and can be managed to control funding costs while the assets reprice.

Based on Federal Reserve data, federal fund rates bottomed out at .07% in 2014 and remained low for the next two years. From 2017 to now, rates have steadily increased anywhere from 11 to 25 basis points each quarter. As of May 31st, 2019, the rate was 2.39% and was three basis points from the highest point in over ten years. From December 2016 to now the steady rate increases total 185 basis points. Many of us have been lulled along as rates have increased because the overall impact to net interest margins and earnings have been subtle, but good. This increase is almost two-thirds of the customary 300 bps rate shock. While the rate increase has been gradual, not instantaneous or parallel and the yield curve has flattened, the increase should not be considered trivial. For two and one-half years rates have increased steadily, but there has been very little movement in deposit rates and cost of funds.

FRB_H15 2019 03

After the financial crisis, there was a significant inflow of deposits into federally insured financial institutions as individuals looked for safe places to hold their money. Most of the deposits that came in seem to have stayed in the system. Some deposits may have left the security of a bank or credit union for more lucrative pastures, but total deposits at credit unions continued to increase. Loan growth has been good over the last few years, and some financial institutions experienced liquidity pressures and raised their deposit rates or ran CD specials to entice new deposits to fund more loan growth. Credit unions that did not need to buy deposits were able to keep dividends very close to the historical lows and retain deposits, and net interest margins improved when asset yields increased. The following chart shows how little cost of funds have changed since quarter 4 of 2016. It is worth noticing in the 4^th quarter of each year that cost of funds increased and then settled lower in the first quarter of the year. This increase can be tied to special dividends given at year end to share profits and give back to members. The act of giving back to the members demonstrates a big difference between credit unions and banks.

Total Credit Union

Weighted Average Cost of Funds

The chart demonstrates that cost of funds increased, but it was minimal and gradual. Therefore, net interest margins improved. One of the biggest factors for the improvement in net interest margins is primarily due to the ability to control funding costs. When net interest margins improve as interest rates increase, interest rate risk is relatively non-existent.

Net Interest Income & Fed Funds Summer 2019

Now with the possibility that market rates may decline, managers and boards should prepare for the likelihood that the improvements in net interest margins that have been enjoyed the last few years may be coming to an end. As interest rates tumbled in 2008 and 2009, many credit union boards were slow to reduce dividend rates and earnings were impacted. If rates do decline, even though the funding increases have been minimal, credit unions should consider reversing any dividend increases as soon as possible. If asset yields unwind and deposit rates are reduced, with limited ability to reduce deposit rates, net interest margins will compress. For many years, the down rate shock scenarios of the interest rate risk analysis were dismissed as improbable. Now that the possibility is growing that interest rates may decrease, it is important to review and discuss the down rate scenarios. Strategies and the potential impact to the net interest margin should be discussed with your board and ALCO.

Jun 20 2018

The Changing Tides of Non-Interest Income

Average fee and other operating income were both increasing leading up to the financial crisis. However, since the financial crisis, fee income has been steadily decreasing and other operating income has been increasing. The increase in other operating income has just about offset the decrease in fee income. This trend becomes more pronounced as the asset size of credit unions increases (see graphs below). What do these changes in income mean going forward?

Average Annualized Fee and Other Operating Income (% of Avg Assets in Basis Points)
All Credit Unions

MHSI Interactive Peer Analysis

Average Annualized Fee and Other Operating Income (% of Avg Assets in Basis Points)
Credit Unions > $500 Million in Assets

MHSI Interactive Peer Analysis

Fee income is described in the NCUA 5300 Call Report Instructions as “Fees charged for services (i.e., overdraft fees, ATM fees, credit card fees, etc.).” Fee income must be directly from the credit union members—while other operating income is from third-parties. Common other operating income items are income derived from selling real estate loans on the secondary market and interchange income.

As net interest margins have been squeezed the past 10 years, many credit unions have relied on fee and other operating income to keep their ROA positive. But rather than put that strain on their members, credit union managers have been looking to revenue sources other than their members directly.

Lowering fee income can be a great benefit to members. It does, however, come with a risk to the financial stability of the credit union. Currently, credit unions have been able to offset the fee income with other operating income. While continually seeking other sources of income to ultimately benefit members is prudent and proper management of the credit union, reliance on any particular source can be problematic. For instance, a lot of credit unions have increased selling real estate loans on the secondary market. If the market for real estate loans changes, then there can be consequences not only to the loan portfolio, but also to other operating income. If fee income has been allowed to drop due to the increase in other operating income, then this downturn in income could spell trouble.

Fee income can have a negative stigma, but for many members the services that go along with the fees far outweigh the costs. For example, offering the underserved better service and pricing for payday loan type services can be a win for everybody, but particularly the member in need of this service. Finding the right balance in fee income can be tricky and takes much more individual thought and approach. For almost all credit unions, fee income is an essential pillar to financial viability and in turn the ability to provide the services that all members need. The consequences of a continually decreasing fee income should be defined and measured along with follow-up on possible adjustments to undesired trends.

Just as credit unions should monitor concentration risk and diversify loan and investment portfolios, monitoring and diversifying fee and other operating income is also essential—especially if it is being relied upon for a positive ROA. It is important to look at the sources of fee and other operating income and identify potential concentration risks. This process can also help identify areas of new income potential or a need to review fee structure. Credit union management should be aware of the risks that come with lowering fee income and look for a diversified fee and other operating income structure that will support the credit union’s financial stability.

Mar 20 2018

Member Regular Share Vs. CD Migration Analysis

In June of 2006 the federal funds target rate was at 5.25%. From 2007 to the end of 2008 the rate was decreased to a range of 0.00% to 0.25% where it remained until December of 2015. Since that time, the target began to slowly increase to a range of 1.25% to 1.50% at the end of December 2017. During the decrease and subsequent increase, credit unions continued to see member deposit growth. This was counter to what some had expected given that rates paid on member deposits also dropped close to zero percent. However, taking a look at the historical member deposit mix and rates may offer a view of what they may do as rates rise.

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Member Regular Share Vs. CD Migration AnalysisRead More »

Sep 29 2017

CECL and Comprehensive Loan Analytics Survey Results

Mark H. Smith, Inc. recently conducted a survey on CECL and Comprehensive Loan Analytics. This was a follow-up survey to the CECL survey we conducted earlier in the year (see previous CECL survey results here). This survey was designed to assess Mark H. Smith, Inc. credit union client needs not only from a CECL perspective, but also to explore their needs for more comprehensive and in-depth loan analytics. Here are the results of our survey:

Level of Current Loan Analytics and Future Plans
Based on the survey, most credit unions currently performed some level of loan analytics, but the majority believed it to be a minimal amount. However, most were looking to expand their loan analytics function. This was the case for credit unions of all asset sizes. A large majority would be interested in an affordable loan analytics service.

Biggest Concerns with CECL and Loan Analytics
The biggest concerns with CECL and loan analytics were in finding the knowledge/expertise, time/cost, and data collection methods. The good news is that you no longer need to have a big budget to afford comprehensive and in-depth loan analytics. Technology improvements have made it so more credit unions have access to extensive credit risk and performance loan analytics without the high cost or in-house sophistication.

CECL and Loan Analytic Solutions
We understand these concerns and are listening! At Mark H. Smith, Inc., we will be offering a CECL-only solution and a comprehensive loan and deposit analytics solution.

CECL and Comprehensive Loan Analytics Survey Results

Survey Questions and Graphs
Below are the questions that were asked in the survey and a graphical representation of the response to each of them.

As always, we are dedicated to providing our credit union clients with high-quality services and extensive client support at an affordable price. Our goal is to add value to your credit union.Your success is our success.

Feb 17 2017

Revisiting Interest Rate Risk: It is Still a Factor!

For almost a decade, short term interest rates have been manipulated and driven down to historically low levels by the Federal Reserve. Even today, short term rates remain near lows. For some financial managers in the credit union sector, that’s all they have known. Many credit union CFO’s and financial managers have never personally experienced high rates or rising rates in their professional capacity. They have only heard about them and read about them in history books. But we all know that, at least for some of us, it takes personal experience to internalize and feel the impact of an event.

From a regulatory standpoint, it appears that regulators continue to be concerned about the potential for interest rate risk (IRR). The topic remains on NCUA’s list of regulatory priorities for 2017. Additionally, the agency has gone to great efforts to revamp its regulatory approach to IRR as announced in a Letter to Credit Unions 16-CU-08. We suggest that all credit unions review the revised IRR supervisory procedures covered in the letter.

It is important to remember that in a historical context, credit unions have performed well when rates have moved up quickly. In the 2004-06 run up, the target rate for Fed Funds moved 425 basis points in about two years. Credit unions performed well during this period. In fact, in this real-world event, which represented a true ramped shock, credit unions as a group increased net interest income slightly.

The key to the industry performance was non-maturity shares. System-wide regular shares and checking rates paid by credit unions increased only 50 to 150 basis points. In many cases credit unions chose not to pay any interest on checking accounts. Credit union money market rates did increase at a greater rate, but in most cases lagged the market. In previous rates-up shock scenarios in the 1990s and even in the granddaddy of all rates-up scenarios in the early 1980s, credit union non-maturity shares have performed well and allowed credit unions to operate successfully and withstand, to a considerable extent, the negative impact of rising rates.

An additional factor in credit unions’ success in the last rates-up scenario was the impact of the credit unions’ investment portfolios. For many of you, your investment portfolio represents a significant portion of your assets. For the most part, issues held by credit unions mature in five years or less, allowing financial managers to reprice their investment portfolio on an expedited basis and control or manage margin compression.

Let’s look at the current state of affairs from two perspectives: That of the regulators, and then, that of operating your own credit unions.

The NCUA continues to regard IRR as a major risk factor. A large portion of regular shares and share draft accounts have been a key component to improved credit union performance when rates have risen quickly. While there is a strong understanding of how rates and deposits behaved in past rates up cycles, federal regulators and credit union managers have concerns as to the performance of non-maturity shares in future rising rate periods. With those questions in mind, combined with the possibility of several rate increases during 2017, NCUA will continue, and credit union management should continue, to put a strong emphasis on IRR.

Effective January 1, 2017, NCUA adopted a standardized measurement of interest rate risk in the form of the Net Economic Value Supervisory Test. One purpose of this test is to establish a uniform and transparent estimate of market risk for examination purposes. Another is to guide exam staff as to the scale and scope of their review so it fits the credit union’s level of risk. Finally, it should improve the agencies efficiency and effectiveness.

The Net Economic Value Supervisory Test measures interest rate risk exposure relative to capital under a prescribed interest rate shock scenario using standard non-maturity share valuations. NCUA is clear these valuation assumptions are for exam purposes and should not be construed as recommended assumptions for ongoing interest rate risk management. During my career in the credit union industry for almost 40 years, I have observed that when NCUA puts out a number, some credit unions, especially those on the smaller side, are tempted to adopt that number and manage to it. While the NEV Supervisory test provides valuable information, and should improve the exam process, we caution against using the standard non-maturity share valuations exclusively as they have the potential to overestimate IRR and hinder earnings.

For our ALMPro clients, we included the NEV Supervisory Test in the report along with several additional scenarios for comparison purposes to help management strategize and plan if non-maturity deposit behaviors turn out to be different than history has demonstrated. In addition, we recommend periodically performing sensitivity testing of key assumptions within the interest rate risk model allowing the credit union to see the likely impact of various scenarios on its financial performance. For those credit unions not analyzing alternative scenarios and conducting sensitivity testing, we suggest they begin.

Multiple scenarios, including those put forth by NCUA, certainly provide valuable information when it comes to measuring, monitoring, and managing interest rate risk. We also counsel not adopting risk guidelines based on the NCUA supervisory test. Risk guidelines should be based on the unique financial profile and characteristics of each individual credit union.

From an operational perspective, we at Mark H. Smith Inc. see IRR for most small and midsized credit unions as low to moderate. Such risk appears to be manageable based on outcomes from previous rates-up cycles and current IRR modeling, combined with additional sensitivity testing. Credit unions should continue to monitor and estimate IRR and, in those instances where IRR appears to be greater than desired, take proactive measures to lower the estimated risk.

The Federal Reserve Open Market Committee is expected to raise the Fed Funds target range by 25 basis points two to three times in 2017. We believe that for a majority of small and midsize credit unions, such a rise would be very manageable. It may present the opportunity to put some added basis points into the net interest margin and allow many credit unions to begin operating more profitably.

We wish you success in all of your endeavors in 2017. If you have questions or would like to further discuss some of the points in this article, feel free to give us a call.

Dec 08 2016

Utah First FCU Success In The Face Of Intense Competition

Utah First Federal Credit Union continues to succeed and outperform the majority of its peers. Based in Salt Lake City, Utah, Utah First is not lacking for competition. It’s true that at $304 million, the credit union has resources that many small credit unions don’t. However, it is overshadowed in size, measured in assets and branches, by 11 larger credit unions in the Salt Lake City metro area where it operates. These include mega credit unions America First FCU at $8 billion and Mountain America FCU at $6 billion, with branches it seems on every corner. It also competes against all of the major banks for its business lending success— more on that later. Utah First has eight branches including its main office in downtown Salt Lake City. Darin Moody is the 32-year veteran leading the credit union. As CEO for the past 24 years, he is ably assisted by David Hill, CFO, and a staff of very experienced credit union professionals.

The credit union’s unique way of doing business has led to very strong financial results, summarized as follows: In its most recent call report, the credit union reported ROA of 1.5%, as compared to its peer group at .53%. Other benchmarks include loans to shares at 92% versus peers at 71% and yield on average loans at 5.5% versus 4.9% for peers. It has consistently performed in the top percentile of net income for many decades. Long-term success has allowed the credit union to grow from its humble beginnings to over $300 million in assets and a net worth ratio at 10.8%.

Humble Beginnings

When we talk about humble beginnings, very few credit unions can top Utah First’s heritage. The credit union was founded in 1935 in the midst of The Great Depression. A group of German immigrants living in Salt Lake City were not having success finding the loans they needed to bring their families to America. They banded together to form the Utah German America FCU, under the then recently created Federal Credit Union Act. The original credit union booked 23 shares outstanding totaling $115. Subsequently, the name evolved to reflect the current nature of the credit union’s membership.

A Credit Union—Just a Little Different Than Most

When interviewing Darin and Dave, I was able to capture some of the concepts which make the credit union different. One clear strategy is to take profitable business that its competitor credit unions and banks often reject. The credit union’s goal is to be among the best lenders in the Salt Lake Valley. However, their methods for qualifying loan applicants differ a bit from traditional lenders. If you were to drive Interstate 15, which runs the length of the Salt Lake Valley, you would see billboards for many lenders advertising very low loan rates. Utah First won’t be among them. Its policy is to charge a reasonable rate which is acceptable to the member but not always the lowest rate on the street. Given their success in originating and retaining business, this approach has proven workable for Utah First.

Management professes that they will loan to anyone that can demonstrate a strong likelihood of repayment. The term “colorful credit history” was used to describe some borrowers. That doesn’t mean the credit union will loan to just anyone with a poor credit score. In addition to showing adequate resources to repay, applicants must demonstrate and explain credit failures and relate how they will overcome them. Risk-based lending is used by many credit unions, but Utah First appears to have taken it up a level.

An Example of Smart Lending

One example is the credit union’s short-term real estate purchase money program which was instigated at the height of The Great Recession in the previous decade. Credit union management felt that many homeowners, having had their credit tarnished by a short sale or deed in lieu of foreclosure, were actually good risks being rejected by major lenders. The credit union chose to waive the standard three-year post-foreclosure waiting period requirement for selected applicants. Utah First lent millions of dollars to this distressed group of borrowers on a short five-year balloon mortgage loan. The rates were not the lowest but were very reasonable in light of the circumstance. At least the borrowers must have thought so, as they participated in droves. This allowed borrowing members to replace their lost homes at favorable prices and then refinance several years later when their credit was restored. These members who were grateful to be able to replace their homes turned out to be loyal repeat borrowers. This was demonstrated as Utah First captured a large portion of the refinance business at the end of the five-year term. In this segment of its business, the credit union reported zero loan losses. It is typical of how the credit union does business a bit differently.

Heart and Soul

Of all those real estate secured loans, $60 million are classified as member business loans under NCUA criteria. Actually, this number is a little misleading. Because of the limitations on member business loans, the credit union has sold non-recourse participations on many of its loans. Loan demand for member business loans is steady and, at times, intense. Each member business loan is secured with a first mortgage and carries an average loan-to-value ratio at around 60%. Problem loans are rare. In its long history of business lending, the credit union has never had a loan classified at TDR (troubled debt restructure). Additionally, the credit union utilizes an audit firm with strong business lending expertise to review portions of its business loan portfolio periodically. Management reports that its regulator appears to have some confidence in the credit union loan practices. It appears the large real estate secured loan portfolio has not been a regulatory issue for the credit union in recent years.

As of its September 2016 Call Report, the credit union had borrowed $17 million in the internet CD market to fund its lending. The credit union’s investment portfolio comprises approximately 10% of the credit union’s assets and effectively functions as a liquidity fund for the credit union. The credit union also has lines of credit with the Federal Home Loan Bank and the Federal Reserve. Liquidity Risk does not appear to be problematic.

As mentioned previously, the credit union’s business methodology is not new. It has been doing this for decades. It has a cadre of experienced executives who are adept at identifying good borrowers and rejecting those who appear questionable.

Interest Rate Risk and Liquidity Risk

Real estate secured loans comprise almost half of the credit union’s assets. All of the mortgage based lending carries some credit union optionality in the rate and while repayment terms may extend out quite a ways, the credit union is able to lay off most of the rate risk. The credit union runs an in-house model operated by CFO Dave Hill. Dave models the credit union’s rate risk and liquidity risk at least monthly with more intensive modeling done on a quarterly basis. Dave is very experienced and knowledgeable and brings a high level of modeling expertise to the table. He runs multiple scenarios to stress the credit union’s exposure to the aforementioned risks. The IRR scenarios are very conservative, even forecasting non-maturity shares at or near par value and with very short decay speeds. Over the years, CEO Moody reports that regulators have become comfortable with their risk profile.

Not a How-To

This is not a how-to profile. Such an effort would be way beyond the scope of this newsletter article; but it does demonstrate that a midsized credit union with limited resources can prosper in the presence of intense competition from much larger and more visible competitors. Hopefully we have given you some ideas that may be helpful in improving profitability and service to your members. Your comments are always appreciated at Mark@markhsmith.com .

Sep 19 2016

Being A Little Different Pays Off

Box Elder County FCU is a $106 million credit union located in a rural and historically agricultural county in northwestern Utah. In recent years the credit union has performed well above average when measured by some of the most commonly used credit union metrics. ROA for the calendar year 2015 was 1.75% compared to peer of .54%. Over the last three calendar years ROA has averaged 1.77%. For the same three-year look-back period the net worth (capital) ratio increased from 21.3% to 21.9% and total assets increased from $86.6 million to $105.7 million. In this article we will examine both the financial and human nature of the credit union’s operations and discover why it excelled when many of its counterparts struggled.

First let’s take a quick look at the credit union and its members. Box Elder County Credit Union has its roots in the employees of the Intermountain Indian School dating back almost 60 years. The school, which was a U.S. Government facility, was closed in 1984. Prior to the school closure, the credit union’s Board of Directors successfully petitioned NCUA for a community charter to include the residents of Box Elder County. The County continues to be the credit union’s primary field of membership.

Box Elder County, Utah, has a population of approximately fifty-three thousand. It is located in the far northwestern part of the state. The credit union is based in Brigham City, the county seat, which has a population of about twenty thousand. The economic history of the county is founded on agriculture and it continues to be a significant part of the county’s economy. However, there has been progress in the private sector over the years. Competition-wise, Box Elder faces two, $2 billion+ credit unions that operate branches in Brigham City and another $100 million credit union based about a mile away. Additionally, several regional and national banks operate branches in the immediate area.

Returning to the analysis of the credit union, it doesn’t take long when perusing the NCUA FPR for Box Elder, to see where the credit union differentiates itself from its peers in the level of non-interest income that the credit union earns.

The credit union’s non-interest revenue provides income significantly greater than its peers. One might guess the members are pounded with outrageous fees. In reviewing the credit union fee schedule it is clear that this is not the case. Punitive fees, meant to discourage unacceptable behaviors such as NSF, are similar to the other credit unions in the area and are well below those charged by the local banking branches.

OK so let’s look at the generation of non-interest revenue. The bottom line for the success of the credit union in achieving an above-peer non-interest income lies in the success of selling insurance products and vehicle warranties to its members and the resulting commission income. This migration to a sales culture did not come easy. In fact it took many years. Loan officers often have difficulty transitioning to a sales environment. The principal products sold by loan officers are:

Loan insurance; this is a package that combines credit life, disability, and income protection to the member.
Gap insurance; covers the gap in coverage between the replacement cost for a vehicle and the amount the member collision coverage provides. The gap can be significant for newer cars and trucks.
Vehicle Warranties; cover the cost for major mechanical repairs. Loan officers are expected to sell these policies and warranties. They are incentivized to do so. Sales incentives can make up a significant part of their compensation.

Approximately one-third of the loans written include at least one of the above offerings. The credit union is working towards a sales success rate of 40%.

Some experts question the value to the borrower with regard to these add-on products. Box Elder’s response is thoughtful. First, the coverage is optional and the loan decision is not driven by the sales success. Second, the cost to the member is significantly less than if the borrower were to purchase similar coverage from a dealer or third party. Lastly, the credit union sees these add-ons as especially suitable for paycheck-to-paycheck borrowers.

Members can choose to manage their personal finances as they will. But we all know that many borrowers live paycheck-to-paycheck with few or no resources to fall back on. Even the loss of one paycheck would be very detrimental. Insurance coverages and warranties make a lot of sense for these borrowers.

Lastly we know that incentivizing loan officers to make and add to loans raises a conflict for the officer. If a loan officer stands to benefit personally in the lending process, their judgement is subject to question. In order to maintain the integrity of the lending process the credit union utilizes a separate underwriting function to back up the loan officers. A loan officer who originates a loan and sells additional services for commission will require another loan officer to underwrite and approve the loan.

In recent weeks the issues of sales cultures and incentives to staff members to sell has come under scrutiny due to the actions of one giant bank. Hundreds or perhaps thousands of the bank’s employees have been terminated due to apparent irregularities at the bank. Well, first of all, most credit unions do not present the opportunity for such gross misconduct because of their small size and their orientation to member service. But it is a risk that needs to be addressed. In the next issue of CU ALM Report we will treat the topic of internal controls that will identify unlawful and undesirable conduct in those few instances where it happens in the credit union system.

Jul 27 2016

Lemonade From Lemons

For the last five years, smallish Family Focus Federal Credit Union (Family Focus) in Omaha, Nebraska, has defied the odds. While most credit unions at its asset size, $31 million, have struggled, and many have given up entirely by merging with larger credit unions, Family Focus has thrived. For the five years ended December 2015, ROA averaged 1.4%. The high was 2.04% and the low was 1.13%. For the year ended December 2015, net interest margin was 5.26%. By any yardstick, attaining this level of success borders on phenomenal. In this article, we will endeavor to uncover and explain the key factors for the success of this credit union.

Family Focus is primarily a single SEG credit union serving employees and family members of the Metropolitan Utilities District (MUD) in Omaha, Nebraska. Its field of membership is small, with a count of 850 employees in the SEG group but also serving family members. Although this field of membership is well paid, it is maturing and does not present the opportunities for loan demand that it once did. In fact, for many similar credit unions, this is the recipe for stagnation and ultimate failure—not because members don’t pay back their loans, but because members mature out of the lending categories into savers and the credit union is unable to transition and acquire new borrowing members. Family Focus has overcome this obstacle with a dedicated marketing culture and commitment to members. It offers traditional credit union products and has avoided indirect lending. In fact, the credit union does not have a single indirect loan on its books. It does deploy a risk-based lending strategy in which loan rates are based on credit worthiness. For the year ended December 2015, loans-to-total assets were 79.5%, leaving a liquidity fund, some very short-term liquid investments, and the new building to round out the assets. The liability side is traditional shares and certificates. Net worth is above peer group.

This credit union clearly is doing some things right. Let’s identify some of them and then focus on the ones that seems to be most impactful. The credit union operates very efficiently. It is in every sense a full-service credit union with a free-standing new, albeit small, building and a menu of member services that are as robust as those offered by larger credit unions. Operating hours are what you would expect. In the past ten years, the credit union has doubled its asset size without increasing the number of employees. In other words, every employee is managing twice the assets that he/she was doing ten years ago. The credit union is staffed with employees who truly understand what credit unions are all about. As I interviewed employees and directors, the word “love” kept popping out spontaneously. The management of the credit union, starting with the Board of Directors, has truly cultivated an environment where members are looked at and cared for as family. On the other hand, each employee and volunteer that I interviewed understands unequivocally that the credit union is a business and absolutely needs to be managed in a businesslike way in order to prosper over the long-run. The credit union excels at walking the fine line between looking out for its members and managing the credit union in a businesslike way where it can earn net worth and capitalize future growth. Over the last five years, the net worth ratio has increased from 10.8% to 13.7%.

As I interviewed the volunteers and key management employees, the most apparent difference between Family Focus and 3,000+ similar credit unions in the U.S. is the credit union’s commitment to a sales/marketing culture. Management, including the Board of Directors, recognized a decade ago that business as usual would not produce success. When her predecessor resigned to manage another credit union, Amy Brodersen was promoted to the CEO position of the struggling small credit union. At the time, Amy had been employed with the credit union 16 years, starting as a member service rep in a three-person office. Amy says she loved the credit union from the start. The members were great and the credit union’s business philosophy fit her personal outlook. Her previous experience had been in a savings and loan where the only goal was profitability. She had found a home at the credit union.

Amy tells us that it took her about two years to determine what needed to be done for the credit union to prosper. Even in 2006, the aging field of membership was shifting its emphasis from borrowing to savings. The decision was made that the credit union would convert itself into a sales/marketing and member service institution and ultimately was reorganized along those lines. An outside consultant was engaged to assist in the conversion. The transition was complicated and painful for some employees. Mistakes occurred and it was a two-steps-forward-and-one-back-process.
The credit union staff is now organized into two distinct divisions which are referred to as Day 1 and Day 2. Day 1 serves members when they have an initial need or a new need recurs. If a prospective member walks in the door, they will be served by the Day 1 staff. A current member who has a new need, a new loan for example, or who wants to open a new share relationship or certificate, will also be served by the Day 1 staff. The second segment is referred to as Day 2. These staff members serve the recurring and more traditional needs of the credit union’s members.

The sales/marketing culture resides with every member of the staff. However, the primary responsibility for new business lies with the Day 1 group. That includes new loans, new members, and new depositary relationships. Loans and deposits are both important to the credit union. It is effectively totally loaned out and always looking for new deposits.
The leader of the Day 1 effort, in other words, the marketing effort, is Kari Rager, Chief Solutions Officer. Kari is a long-time credit union employee who predates the conversion to a sales culture. However, she recognized the need to change and enthusiastically endorsed the new sales culture. Her chief responsibility is to oversee the marketing function. She is strategic minded and results focused. She shares the deep commitment to the credit union and its members. Commitment is a common thread discovered in almost every interview with the volunteers and staff. Kari is totally committed to the marketing environment. Her responsibilities include driving business growth and new products. Her primary focus is on ensuring the credit union’s sales culture functions effectively. Her enthusiasm is contagious.

Dave Lorimor is the Member Solutions Consultant. He describes his job as 90% sales. Dave never worked at a credit union before Family Focus, but had extensive sales experience at car dealerships and call centers. Prior to coming to Family Focus he had never belonged to a credit union. His college degree is in secondary education. Dave’s comment was, “Sales is sales; product knowledge is important, but never sells anything.” Every request for a new loan or share relationship goes through Dave. He is the member’s advocate. He also describes sales as a contact sport—the more contact, the more success. He visits the small branch located on the MUD headquarters on paydays, promotes a barbeque with members, and participates in the MUD employee events. He is a unique individual in the credit union environment.

Most credit union loan officers did not start out in sales. In fact, most credit union loan officers are what they are because they don’t want to be in sales. In sales, things are often stressful. Successful salespersons are extremely well-paid. This is the point at which many attempts for credit unions to remake themselves as sales or marketing organizations fall apart. Many sales professionals do not have the temperament to work at a credit union. Finding an effective salesperson willing to work for less pay but a more comfortable environment could be tricky. For Dave Lorimor, it was a tradeoff. He traded a 70- to 80-hour a week, high-stress, well-paid sales position for a job that allows more regular hours, but less pay. He does receive a salary, but the majority of his compensation is based on sales success. Sales success is defined as new loans and deposits.
Dave’s counterpart is Carol Nary, Member Solutions Analyst. Carol is an experienced loan underwriter and performs that function independently. This is where the control function for sound lending comes in. Dave, the salesman, finds the loan applicant and completes the loan application. Then Carol underwrites and approves the loan. The marketing function has no approval function. A third clerical staff person also supports Dave and Carol in originating loans. Yes, it’s true there are conflicts. Dave effectively is the member advocate. Every loan application is a great one in Dave’s mind. Carol represents the credit union and looks after its interests. Basically, they work it out.

What the credit union refers to as the Day 2 staff are the employees who serve the credit union’s members on a day-to-day basis—what many of us would call member service reps and tellers. While their function is more traditional, each employee of the credit union understands and is trained extensively in the marketing function. The Day 2 staff can augment their regular salary with marketing incentives by providing leads to the Day 1 group. Each knows that their livelihood and continued employment depend on the success the credit union achieves in attracting new loans and deposits.

So, who’s responsible for the success the credit union has achieved in recent years? Is it the CEO, Amy? Her marketing staff? Or maybe this vision originated with the Board of Directors. Each of the above deflect credit to the others. Amy credits the Board of Directors and the staff. The staff credits Amy and each other. The Board credits Amy and the staff. Amy emphasizes the board’s involvement and support. In the end it appears to be truly a team effort with each team member understanding and effectively carrying out their respective roles.

An intense sales culture such as Family Focus is challenging to achieve. It takes time and total commitment by the board, management, and team members. It may not be for every credit union. But for Family Focus it has meant the difference between achieving success or being an also-ran.

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