When analyzing the profitability of your loan portfolio, particularly if it includes indirect auto loans, how well do you examine the loans you carry?
Conducting a multi-dimensional data analysis that looks at loan performance, risk concentration and other collateral characteristics is good ... but is it enough? For example, does it show the impact to the bottom line when a loan purchased at a premium pays off within a year?
It makes sense for your credit union to analyze historical and projected cash flows, but in reality, most analyses do not ... and that can be a costly omission for your credit union.
Cash-flow analysis is straight-forward: all cash amounts coming in and all cash amounts going out that are associated with a loan are lined up from loan origination to termination. Net yield, or net present value, is then calculated on that cash flow stream. The result is an accurate and explainable profitability estimate. The cash flow stream for active loans incorporates a loan's actual history and projects its future payments according to prepayment, default and recovery assumptions.
The key elements of a cash-flow analysis include:
* Measuring the internal rate of return or net present value on a stream of cash flows.
* Performing the analysis at the loan level and employing loan-level assumptions.
* Incorporating all cash amounts that are associated with the loan, such as upfront fees, charge-backs, servicing costs, delinquencies, voluntary prepayments, actual losses, projected losses, cost of funds, and other items that may be specific to certain loans.
* Generating reports across multiple dimensions.
* Ensuring source data is complete with no loans included or excluded selectively, as may occur when a loan system is purged.
* Managing data gathering costs.
Armed with information culled through the analysis, your credit union can set pricing structures for individual loan criteria, identify less-profitable dealers, and determine any overpriced premiums paid for underperforming loans.
Consider the following example of two auto dealers. This recent indirect loan analysis was performed using the cash-flow modeling methodology described above: Despite very different gross margins, projected net yield of the two portfolios is approximately equal, due mostly to higher projected losses for Dealer B. The following points are noteworthy:
* Yield compensation for lower credit quality is evident.
* As the analysis is repeated in the future, it will become clear how actual losses compare with projected losses and, thus, whether the compensation in yield is sufficient.
* Upfront fees are a significantly greater cost for Dealer A than for Dealer B, which raises the following questions: Is there something about Dealer A's loans that cause them to pay off more quickly? Are charge-back agreements sufficient? Are the fees themselves paid to Dealer A at appropriate levels?
Many credit unions see the benefits of cash flow analysis. Moreover, the NCUA suggested this method in its 2006 guidance white paper, "Static Pool Analysis: Evaluation of Loan Data and Projections of Performance," and again in a 2008 supervisory letter that stated, "Such analysis can be used to track the performance of most loan pools."
Whether you choose to conduct the loan-profitability analysis in house or with an outside vendor, it's important to commit the resources needed to ensure an accurate and quality review. This includes having access to the right software, staff expertise and sufficient man hours to thoroughly complete the analysis.
In view of today's low-interest-rate environment-and its effect on your credit union's profitability-analyzing your indirect-loan portfolio should include more than multi-dimensional data analysis accompanied by colorful charts. Adding cash-flow projections can greatly strengthen the value of your program analysis and highlight its true relationship to your bottom line.
Kevin Kirksey is the valuation and risk analytics manager at ALM Financial Advisors. He can be reached at 800-752-4628 or www.almfirst.com.