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LENDING SOLUTIONS: What’s Actually Behind Your Flagging Earnings Conundrum? – The Answer Might Surprise You

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BY LORRIE WOHLFEIL

Why should loan growth be a top priority for your credit union? Because when it comes to outperforming your peers, everything else hinges on such growth. “Credit Union Business’s” lending expert uses cases studies to illustrate the keys to growing both yield and ROA. Some of these strategies may not be what you think.

At Lending Solutions Consulting Inc. (LSCI), credit unions almost universally contact us for help with how to boost their return on assets.This has become the measure of performance for credit unions and is a tool to see whether you are outperforming or under performing against your peers.Much like receiving a passing grade in school, achieving a positive ROA is not an entitlement but it has become a mandatory requirement.If you can outperform peers and achieve an ROA over one percent, you have made the Dean’s List.Again, much as achieving the Dean’s List in school is acquired through hours of studying, understanding why some credit unions can achieve strong earnings and others struggle requires the same analytical approach.

To begin our discussion, we believe there are distinct characteristics credit unions that continually outperform their peers and achieve a high ROA have in common:

  1. Loan-to-share ratios above 90 percent.
  2. Net loan yields of 7.5 percent – Net yield is described as gross yield less charge-offs.
  3. Unsecured loans that comprise 15 percent to 20 percent of the total loan portfolio.
  4. Mortgage loans that comprise 40 percent or less of a total loan portfolio – A target should be on acquiring a greater segment of the non-conforming loan business.
  5. A 13 percent to 15 percent spread in their rate matrix.
  6. Between 15 percent and 20 percent “D” & “E” paper –This has to be largely acquired through “smart” car loans where the payments are reasonable for the salaries backing them, forced payments are in place and evidence of stable jobs exists.
  7. Delinquencies and charge-offs higher than peers – This is not a misprint.
  8. Double-digit loan growth.

Bullet points number #1 and #8 both pertain to total loans and loan growth goals.It is the core belief of our organization – and what LSCI was founded on – that “everything follows loans.”The following charts taken from a credit union’s financial performance reports will point out to you the significance of making loan growth a top priority.As a credit union’s loan-to-share ratio declines, so does its ROA.For XYZ Credit Union, since 2011 total loans outstanding has dropped by $4,000,000 with a reduction in loan to share of 35 percent.In that same time period, ROA has also declined by approximately 50 percent.

LS1

Credit unions will continue to get squeezed if they keep their money in investments instead of loaning it out.The following chart illustrates how critical it is to increase loans outstanding. You can see that this credit union made $560,000 more in loan income with almost $12.6 million less invested in loans.ls2

Bullet point #7 on the successful credit union characteristic list often surprises credit unions and can go so faras to make them nervous.Going back countless years, credit unions have been “preached to” that the good word states to keep losses at bay.In fact, it’s not hard to do this.If you loan your money out to only the highest-qualified members at your credit union with the added security of collateral, you will, in fact, have very low delinquency and ultimately losses.The problem becomes that your spread between your loans and investments isn’t enough to cover expenses, and as a result your yield will struggle.This tendency will be discussed in further detail later.ls3

The above chart reflects the following for XYZ Credit Union.

  • Delinquency has decreased by 42 percent since 2013; however, earnings have decreased by 34 percent.While we don’t endorse higher losses, most credit unions that make the most money have a higher tolerance for loss.This is because they understand that their overall earnings, driven by a lucrative yield, will be higher due to a higher tolerance for risk.This concept will be discussed in further detail below.ls4
  • We applaud ourselves for lowering losses; however, look at the relationship between appetite for risk and yield. (Look at the differences on the previous charts between both credit unions.)
  • Credit Union #2’s delinquency is 176 percent higher. (Note: Both credit unions have reduced their delinquencies.)
  • Credit union #2 has earnings that are 500 percent higher.
  • Which credit union do you want to be?
  • What does the relationship between earnings and yield show?

Bullet points #2, #3 and #4 pertain to loan yield and portfolio mix.While a decline has happened industry wide, due largely to the economy, credit unions have to stop hiding behind this excuse.The prime rate has been flat, and industry trends suggest auto rates are increasing. The declining trend should be closely analyzed and reversed.It is my belief that the majority of credit unions’ declining loan yields are due to portfolio mix, appetite for risk and pricing and not exclusively uncontrollable outside factors.In the previous chart,you will see that the credit union making the Dean’s List has a yield that is almost one percent higher than its peer.There is no question that loan yield can measure your earnings success and what your appetite for risk is.ls5

Averaging December 2014 and June 2015 total loans outstanding and utilizing XYZ yield peak from 2011, the credit union would be on track to earn approximately $22,370,000 in loan income.What would an additional $5,000,000 do for this credit union’s bottom line or yours?ls6

The above table reflects the following:

  • The negative relationship between real estate and loan yield. (You could substitute real estate for A+/A auto loans and the negative impact would be the same.)
  • The negative relationship between a declining loan yield and ROA.
  • Referencing the “credit union #2” most desired data above versus the “credit union #1” least desired data,credit union #2 averaged 11 percent growth in unsecured loans over the past four years while credit union #1 averaged negative three percent growth.The correlation between yields and product mix/growth is illustrated and also supports that “all loans are indeed not created equal.”ls7

The above chart reflects that the majority of ABC CU’s growth is occurring in its lowest-yielding product.

Bullet point #6 references appetite for risk.Credit unions deny far too many loans.When your lenders are looking at a loan, they should focus on two key elements with FICO scores:

  1. What would the score be if it was based on repayment with the credit union exclusively?
  2. What would the score be if you were measuring performance on “like loans”(i.e., purchasing an auto and analyzing past auto performance)?

When your lenders do this, they will start being able to approve far more loans than they are now and, more critically, more loans with sought-after lucrative yields.Many credit unions, from their Boards of Directors down to their employees, fear having 15 percent to 20 percent of their portfolios in “D” and “E” paper.They fear becoming known as a “sub-prime shop.”I will argue the following:

  • Bad things happen to good people.
  • People pay their credit unions oftentimes when they pay no one else.
  • Your sub-prime rates are far lower than what you will be throwing your member to when you deny them.
  • You have “A” and “B” members whowill file bankruptcy against you.
  • Some of your “D” and “E” past bankrupts represent far less risk than your indebted low “A” members that are trending down.
  • The trend of the score is far more important than where it is today.
  • Your staff, if trained properly, should be in the business of helping members re-establish their scores.

Lorrie Wohlfeil began her career at LSCI in August of 1995. As a business analyst, Lorrie is primarily in charge of the Portfolio Analysis program, an external audit dedicated to helping credit unions make stronger loan decisions and seek sales opportunities. Lorrie also works hand in hand with our onsite consultants and has attended numerous Rex Johnson University of Lending and specialty schools. Before starting the Portfolio Analysis program, Lorrie designed the highly successful training program in place at Lending Solutions, Inc. (LSI) and personally trained many of the loan underwriters at LSI. Lorrie also spent four years as an onsite consultant for LSI. During that time, she not only educated credit unions on lending but also trained their staff to make superior lending decisions. Lorrie graduated from the University of Kansas with a degree in Business Communications.

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