Editor's note: Read part two of this article, about deposits.
Clients are asking us how low they can go with loan rates in an effort to “stimulate” demand. Their concern about earnings levels is growing, and their worry about interest rate risk remains high. Where are the earnings going to come from? How can we determine the right rate and if it covers the risk? Here are key elements for properly pricing loans.
First, it’s time to face facts. For many, still-performing loans made back in 2008 and 2009 are starting to pay off. Replacement rates on new loans are well below the old rates, causing concern over future income levels. Loan demand remains soft, and we are seeing a continued movement of earning assets from loans to investments, where yields are meager at best.
When making loan pricing decisions, many credit unions fall into the yield-comparison trap. With cash and investment yields earning near 0 percent, the decision to make a car loan at 3 percent is rationalized by the thought that we are at least earning more income than by leaving funds in the investment portfolio. However, that logic fails to consider critical factors.
First, are we being paid for the risk we are taking with the member? We can all relate to the credit risk costs that have plagued many financial institutions in the last few years. Second, such concerns as funding costs, origination expenses, servicing costs and loan fees must be properly considered. Failure to do so means unforeseen risks.
Here’s a true story to explain. During a recent client call, the discussion turned to the large volume of cash and investments, slow loan demand, and pay-downs of existing loans. Share costs are at the bottom of market on most accounts. Projections reveal net interest margin is expected to drop nearly 25 percent below 2012 levels in 2013, or a decline in net income of 70 percent. Why? Low loan demand and replacement rates that are significantly lower than historical loan yields.
During the meeting with this client’s asset/liability committee, a few possible solutions were presented. The chief lending officer pushed to retain in portfolio fixed-rate mortgages that are currently being sold. The obvious concerns were voiced over this idea. Long-term, fixed-rate loans at the bottom of the market! No way!! Haven’t you heard of interest rate and concentration risk? So, if not mortgages, what? Also considered was the option of lowering car loan rates to 2 percent or 3 percent, increasing indirect dealer fees, and making more participations, each of which carries its own unique risks.
This conversation is happening in financial institutions across the country. Where can your credit union find answers? Read on.
Costs of Loss
Key data are required to appropriately price loans. First, begin with the idea that in all cases, we are pricing and managing risks. Whether it’s credit or interest rate risk, no increase in earnings comes without risk. So, to better underwrite risk, we need to be armed with data on major risk items that impact pricing. The first area to attack is credit loss costs associated with each loan and risk tier.
To begin, let’s consider a 72-month car loan originated by the credit union directly with the member. When setting the rates, how do we consider the real costs incurred when making a loan vs. simple comparison to competitive market rates? We usually don’t.
Real costs consist of credit loss costs, incremental operating expenses associated with the loans, and possibly the cost of capital if we are trying to grow assets and, in turn, keep our capital ratios from dropping. Let’s begin with the costs of credit.
A component of every loan rate is an amount we charge for the potential loss. In pricing loans going forward, we should consider actual loss experience. When credit unions model loan pricing, credit risk costs are considered in the loan profitability calculation.
In our example, the credit union has calculated loss experience on 72-month car loans as a 0.76 percent historical cost. This is the cost of actual loss on previous 72-month car loans with no allowance made for such factors as credit grade or loan-to-value ratio.
This simple example of loss experience is a good starting point for most credit unions. Credit unions have been practicing risk-based pricing for years. When charging a differential rate by credit class, we should develop and use loss experience data at that same level. We are finding many credit unions developing loss data to better match pricing detail. For instance, the loss experience data may be broken down by loan type, credit score/grade, LTV tier, or a combined approach.
Tracking loss data by these categories over time helps credit unions arrive at historical loss rates. If you have not begun to track data at this level, but are continuing the pricing of LTV and credit, it’s time you begin to gather this data to ensure you have accurate data for future pricing.