Does the economy have you considering tightening your lending criteria? Loosening them? Beware when taking either action.
As promised last month, I’ll mix in a little bit of storytelling to my articles for a while. I’ll be celebrating 40 years in lending in September and 35 years at the executive level in credit unions in November. I love storytelling, as people tend to remember stories a lot better than a lot of boring facts and figures.
The last three years really have been a challenge for credit unions and lenders, haven’t they? I’ve been joking (sadly, not a joke) that COVID-19 shortened my career by four years; that’s the difference between my planned retirement year pre-pandemic and when I plan to retire now.
And all joking aside, we’ve had a series of whipsaw events with rates and liquidity that have made maintaining a consistent lending strategy, including credit quality, just about impossible. On top of this, there seems to be a greater gap in income and economic well-being among consumers, literal “haves” and “have-nots.” As a result, your credit may be faced with some difficult decisions for which I offer some observations from my nearly 40 years in lending.
The Easiest Thing to Do as a Lending Leader Right Now Is ….
The easiest thing to do as a leader in lending right now is to tighten your lending criteria. And for many credit unions, that’s perhaps your biggest initiative now.
When I came to the credit union movement almost 35 years ago, I took over a severely distressed $120 million loan portfolio. It may have been the worst loan portfolio among the top 100 credit unions in the country. It needed immediate changes, including massive ones in underwriting. The credit union also had to address issues with forced-place insurance (also known as collateral protection insurance) on auto loans that had created severe loss levels on a big portion of the portfolio. The loan review process, which included volunteers and a board member or two, shared specific loan losses with the loan officers; if they made a loan that went bad, they saw it and had to learn from it.
After several years, the loan quality problems were fixed, but I then had a new challenge: I had to start growing the portfolio again. In talking with the lenders, I realized we scared the heck out of them over the previous several years. They were afraid to make a loan. They had tightened up their criteria and they weren’t going to budge now.
Tightening your criteria is the easiest thing to do as a lending leader. Want an effective way to do it? Scare your people. The unintended consequence of this approach? You’ve paralyzed your staff. Moving the Brooklyn Bridge might seem easy compared to loosening up your criteria when you need to.
What did I learn from this experience? Almost immediately, I decided that short of a crisis with loan losses, the last thing I wanted to do was share specific loan loss information with my underwriters or loan officers. My advice to you? Be very conscious of constant changes, especially dramatic changes, to lending policy.
As I’ve written before, the more you open your lending spigot in good times, the more you’ll have to close it when the economy turns. I want to maximize opportunities to make lending, credit quality, and overall performance as sustainable as possible. Constant changes to your credit policy, anything more than tweaks, can cause a lot of staff confusion and hesitancy.
The Toughest Thing to Do as Lending Leader Right Now Is …
The toughest thing to do as a lending leader is to loosen your credit policy—or perhaps I should say, successfully loosen your credit policy for more than 18 to 24 months. As I previously stated, I found it tough to get my lenders to open up and get closer to an optimized credit policy in the past. Yet there’s so much more to it than fixing the mental trauma caused by seeing too many loan losses. Yes, you can stop doing those kinds of loan reviews if that’s been an issue in your shop, but there’s so much more to this challenge.
Challenge 1: Higher loan volume is the credit union equivalent of crack cocaine. It’s hard to kick. It’s intoxicating. The CEO is happy. The staff loves being busy, not to mention they love the incentives. Auto dealers are dancing on their desks; let the good times roll. When everyone’s happy, they all forget recessions are a real thing and will happen again. In the past, I’ve written about inertia and lending; this is another example. A body in motion (your lending department) will tend to remain in motion unless acted upon by an outside force. Unfortunately, those outside forces are not pleasant (examiners, recessions, boards, collectors traumatized by a flood of delinquency, etc.)
I saw this, live and in living color, in the latter half of the 1990s. When I was at my previous credit union, another credit union in the state was really making things happen. For about three years, they were growing their loan portfolio by 25% to 30% a year, when my credit union was growing at a measly 10% to 12%.
Believe me, I took a lot of heat over the fact we weren’t growing that quickly. So much so, I clearly remember a Friday afternoon meeting with the CEO and the COO about it. It wasn’t our first conversation about it. I was convinced the other credit union wasn’t doing things the right way, and I had resisted doing anything drastic about matching growth numbers like those.
I remember the meeting well because that morning I was walking around the credit union looking for boxes; I was convinced my refusal to do what I thought were crazy things to get 25% growth was finally going to get me fired. As it turned out, it wasn’t me that got fired. The CEO and CLO at the other credit union lost their jobs about 12 to 15 months later, a sad event as I considered both to be friends. Their growth was intoxicating, and it was tough to kick.
Challenge 2, closely related to Challenge One: You need to set a goal, and potentially intermediate goals, and know when you’ve reached them. When everyone’s happy, they let their guard down. What was your goal for taking on additional risk? Have you surpassed that goal? It’s somewhat akin to running a marathon, crossing the tape and continuing to run at an even faster pace! A sane, rational runner is going to stop running, get rested up and reflect on why in the heck they ran a marathon in the first place! In lending, you need to figure out when you crossed the predetermined finish line and evaluate your results and other metrics before you realize you ran yourself off a cliff.
Challenge 3: You can’t just pull your goal for additional risk out of thin air. What kind of analysis did you do? Did you have focused, smaller goals on specific products and credit tiers? Did you forecast what that would do to loan yields, overall growth and loan losses? Going further, what other metrics did you consider that you could use to further evaluate results and ensure your position is well-calibrated and you’re not ready to run off that cliff? I’m thinking of things like approval ratios, average loan size, FICO score distribution on new loans, the change in score distribution for the portfolio over time, etc.
Challenge 4: It will often take you and your portfolio 24 months to realize you made a mistake with your credit policy. I theorized this early in my career and have proven it since then with better data. At least when it comes to consumer loans, the source of most loan losses, the average life of your portfolio is probably 24 to 30 months. In essence, after 24 to 30 months, half of your portfolio is made up of loans made during that time. I am a big fan of the parable of the boiled frog; those 24 to 30 months provide a lot of opportunity to be that boiled frog—unaware of your changing environment until it’s too late. If you don’t closely monitor your static pool loss data and you’ve made a mistake with your credit policy, you’re the next serving of frog legs.
If you can’t easily evaluate your static pool data, you may want to consider this idea: Mistakes in your credit policy will result in more and earlier defaults. Going back to my early credit union days, I didn’t have a FICO score to work with—it didn’t exist. There were no measurable factors like that to easily see the risk of loans. That said, I did see changes in credit policy down the line manifest in the time to default—the time between the origination and default. In 1989-1990, the average car loan at my prior credit union defaulted in 12 months. Once we fixed most of the lending problems and re-assessed, the time to default had grown to 24 months. That said, if you have static pool data, it will allow you to essentially cut in half the time it takes you to properly assess the outcomes of changes in your credit policy.
Challenge 5: Credit unions tend to be laggards. We tend to lag the market when it comes to rates; we tend to be slow to lower rates and raise rates, both on loans and deposits. We tend to be slow in responding to changes in credit policy as well. Admittedly, here at Ent, I was too slow to loosen the reins on credit policy in 2012 and 2013 coming out of the Great Recession that technically ended by early 2010 but felt like it was still a thing until 2013 or 2014. The result was we missed out on some additional loan growth (and earnings) that we didn’t start to enjoy until 2014.
If you mistime your loosening due to economic cycles and wait too long to expand your credit risk, your run of growth may bump up against the next recession. The solution is a certain amount of fearlessness. The quicker you can benefit from an improving economy, the better your results in taking on more risk will be.
The End Game?
I often speak of sustainability when it comes to lending strategy and credit quality. The last three or four years have proven to me that “sustainability” is a very relative term; successful lenders have to make adjustments to respond to the economy and competition. The key is making small adjustments and timing those adjustments as well as possible.
Arguably, the best thing we can do for our credit unions and our members is to be consistent in service. If a member got approved for a loan at a good rate two years ago and their circumstances haven’t changed, they expect to be approved today for a loan at a great rate. If you’re constantly creating more financial and lending ups and downs for your credit union through your lending practices, any interpretation of consistent service is impossible.
Bill Vogeney is chief revenue officer and self-professed lending geek at $9.8 billion Ent Credit Union, Colorado Springs, Colorado. He’d like to remind you that when he started in lending 40 years ago, there were no child labor laws.