By Michael DeFors
MCUL Regulatory Affairs Director
Credit unions, along with other financial depositories, are operating in a new financial world. With changes in the economy and new realities in meeting current member service expectations, most credit unions are responding by developing new products and services to enhance the bottom line and better serve their members. These changes often represent new and untested risks for individual credit unions that must learn to address them over time.
State and federal regulators have also had to adjust to these changes. As official guardians of the nation’s financial institutions, additional expectations are placed on them to understand the risks associated with new products and services offered by the institutions they oversee. Due to dramatic drops in land values, the mortgage loan area in particular represents a special challenge during the current financial turmoil.
With the arrival of Michael Fryzel, the new NCUA chairman, the NCUA board has taken a look at the credit union business model and how it has changed over the years. NCUA has issued new guidance that alerts federally-insured credit unions as to how the regulator will evaluate not only this newer business model, but also new risk management practices individual credit unions have employed. This article will provide a summary of these guidelines and are equally applicable to state-chartered credit unions as well.
In NCUA Letter to Federal Credit Unions (No. 08-CU-20), released in August 2008, NCUA describes how balance sheets have changed over the past decade; the lessons learned from the imprudent use of third parties; and the impact of declining real estate values on credit union mortgage loan portfolios. Through this letter and the supervisory letter it contains, credit unions have been given the same guidance NCUA provided to its field staff in evaluating the emerging risks and assessing the steps taken by the credit union to limit exposure. The letter also stresses timely and open communication between the credit union and the regulator.
Evolution of the Credit Union Business Model
A picture of the current state of credit unions across the country reveals that the NCUSIF has a concentration risk of federally-insured credit unions holding nearly 80 percent of the credit union industry’s outstanding real estate loans. The number of these credit unions amounts to over 7 percent of the nearly 8,000 federally-insured credit unions, and all of these are in excess of $250 million in assets.
Based on that snapshot, one can conclude that the structure of the credit union balance sheet and income statement have materially changed over the past 10 years. Assets have shifted from traditional consumer loans to real estate loans, with the latter comprising over 53 percent of total loans. This concentration of assets represents less diversity, and thus greater risk to the credit union and the NCUSIF resulting in more regulatory concern and scrutiny.
Other financial information in the letter reveals that there has been a significant shift from the traditional, stable source of funding to funding that is much more sensitive to market rate movement. While not necessarily representing an unsafe situation, this change demands greater monitoring of trends and daily awareness of overall economic fluctuations. This funding shift has impacted those credit unions that have a higher concentration of real estate loans using more volatile sources of funds. As a result, regulators will be evaluating a credit union’s oversight process and the modeling systems they employ.
The balance sheet composition has also changed, as the interest rate environment and economic conditions have similarly impacted the credit union income structure. A compression of the net interest margin with an increase in the operating expense ratio has occurred steadily since 2005. Credit unions that are hard pressed for income have moved to enhance revenues by increasing their lending activity and expanding their fee-based products and services, both of which represent a significant change in typical credit union operations. According to the letter, both approaches are untested over various economic cycles. A credit union’s desire to grow by an increase in earnings, given the current financial turmoil, would likely mean employing strategies that necessitate excessive risk taking and result in unsafe and unsound practices. Business lending for high-rise development projects in Florida is clear evidence of that. As for fee-based products, it should be noted that nationwide, this approach has also grown dramatically such that the balance sheet has become unprofitable without the use of fee-based services. Are the regulators aware and concerned? You bet.
The letter notes that lower levels of earnings can be acceptable depending on a credit union’s level of net worth, its quality of assets and liabilities/shares, and the level of control that is exerted over the earnings structure. Examiners will be looking at the entire financial picture and won’t necessarily view negatively lower earnings if resulting from an otherwise sound and well-executed strategy to balance risk exposure, to position the credit union to achieve long-term growth, financial stability and member service objectives. Examiners observing unsafe and unsound practices will address this issue with management and adequately reflect it in the CAMEL and risk ratings.
The use of third parties has also increased dramatically as credit unions realized important efficiencies in outsourcing various credit union operations and products to CUSOs, mortgage brokerage firms, other financial institutions, or other third parties. While use of third parties is acceptable and not discouraged, regulators will examine how use of a third party fits into the credit union’s strategic plan, its internal risk assessment process, staffing resources, due diligence of the third party, legal review of the arrangement and ongoing monitoring, and risk mitigation and control efforts. Another letter to credit unions was issued by NCUA in 2008 that outlines what is expected in any third-party relationship.
Finally, of special note in the letter and due largely to the current economic conditions, examiners will be taking particular interest in a credit union’s mortgage lending operation and its practices and procedures for underwriting and risk management. While credit unions did not participate widely in the use of riskier, non-traditional loan products, related exposure still exists since many credit unions hold second liens on homes where the underlying loan was non-traditional and therefore presents a higher risk of default. With a weakened mortgage market, delinquencies have increased along with loan losses across nearly all types of real estate lending categories.