PPP Forgiveness and Other COVID-19 Concerns Creating a Perfect Storm?

loan check being handed over by a business executive
Jim Devine Photo

3 minutes

Hopefully, the relatively strong capital position credit unions have will help.

The U.S. Small Business Administration has indicated that financial institutions (including credit unions) under $10 billion in assets have stepped up and collectively have around $60 billion (about a third) of the second-round Paycheck Protection Program funds under their management.

To best serve the interest of their small-business members and themselves, credit unions that took on these loans must work to ensure that these debts are forgiven and not rolled over into low-yielding two-year loans that may need to be refinanced to be repaid. 

Without a doubt, careful recordkeeping will be critical to justify forgiveness. There will be lots of borrowers reaching out for help, and providing clarification will be a very challenging component of the servicing responsibilities for these loans. (Some companies are offering assistance with this process, such as—but certainly not limited to—Jack Henry, Abrigo and Capiform.)

In addition to processing the forgiveness and rollover loan components of PPP, credit unions also need to be developing their game plans for the likely significant rise in the levels of nonperformance in their consumer and business loan portfolios. Add these concerns to declining net interest margins caused by the unprecedented low interest rate environment and the decline in transaction-based fee income coming from the pandemic-driven slowdown in the economy, and we have a perfect storm scenario.

The good news, if there is any, is that the credit union industry, in general, is in a relatively strong capital position going into these unchartered waters. The bad news is that anything close to 8% capital is considered strong. To put this in perspective, that means that a “well-capitalized” credit union would have $0.92 in liabilities for every $0.08 in equity.

If you do the math, that means that the resulting debt/equity leverage ratio would be $11.50/$1, and the vast majority of the debt is from deposit/share accounts that are technically due to be repaid on demand. If the owners of a small business with a balance sheet reflecting an $11.50/$1 debt-to-equity ratio seeking a loan with all the debt due on demand walked into a financial institution, they would be quickly denied and walked back to the front door.

It does not take a lot of disruption to put a financial institution that is leveraged in this manner into a challenging position. Given this reality, the current economic environment is scary.

Credit unions are going to see their combined loan portfolios go from the less than 1% non-performance experienced over the last several years to double-digit levels. They will have to be very adept at choosing sensible workout strategies and will likely see their allowance for loan and lease losses go up dramatically. Borrowers will be asking for forbearance and forgiveness on existing loans and CUs will have to engage in these negotiations with a real sense of the borrower’s business model and related cash flow/debt service coverage capacities in order to pick sensible options for loan restructuring.

Credit union balance sheet management skills will really be put to the test. Every CU should be doing a proactive assessment of existing loan portfolios in anticipation of these challenges. No one wants to panic and end up jumping from the proverbial frying pan into the fire.

Jim Devine is CEO of Hipereon Inc., Kirkland, Washington, and a faculty member for CUES School of Business Lending™.

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