Things were going so well in 2019 and January 2020, until the COVID-19 virus pandemic. Many credit unions are asking about how to estimate their allowance for loan losses (ALL) amidst the economic crisis caused by the virus. It may be a while before most credit unions see delinquency rates rise, and loan charge-offs begin to manifest themselves. In fact, at the urging of NCUA, many credit unions are relaxing their collection efforts by allowing members to skip payments and are offering loan concessions. Further, the federal government has issued new requirements prohibiting foreclosures for 60 days. Many credit unions are asking the question, “how do I estimate the 2020 ALL” amidst all of the uncertainty about the US economy and its potential impact on loan losses?

Qualitative and Environmental Factors

Most credit unions use a 1–2 year net historical loss ratio for estimating loan losses. In a period of rising loan losses, this method can tend to underestimate potential loan losses, since actual loan charge-offs will not begin to show up in the loan loss averages for several months or quarters. Current accounting standards allow the use of qualitative and environmental estimates (Q&E) to supplement the estimate of loan losses. In other words, a judgmental estimate of additional or reduced expected loan losses is not yet reflected in the loan loss ratios. While historical loss experience provides a reasonable starting point for the credit union’s analysis, historical losses, or even recent trends in losses, do not by themselves form a sufficient basis to determine the appropriate level for the ALL. Management should also consider those qualitative or environmental factors that are likely to cause estimated credit losses associated with the institution’s existing portfolio to differ from historical loss experience, including but not limited to:

• Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses.

• Changes in international, national, regional, and local economic and business conditions and developments affect the collectability of the portfolio, including the condition of various market segments.

• Changes in the nature and volume of the portfolio and in the terms of loans.

• Changes in the experience, ability, and depth of lending management and other relevant staff.

• Changes in the volume and severity of past-due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans.

• Changes in the quality of the institution’s loan review system.

• Changes in the value of underlying collateral for collateral-dependent loans.

• The existence and effect of any concentrations of credit and changes in the level of such concentrations.

• The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the institution’s existing portfolio.

• Regulatory, legal, or technological environment to which the entity has exposure.

• Changes and expected changes in the general market condition of either the geographical area or the industry to which the credit union has exposure.

COVID-19 Economic Impact

While it may be too early to tell, the COVID-19 impact on the US economy could have the following impact that credit unions will want to consider when developing their Q&E factors:

1. Consider local unemployment statistics for your credit union member base. For example, if most of your members are federal government employees and are not laid off, your loan losses might be less than a credit union in a region where several large employers have laid off or furloughed most of their employees.

2. Consider new and used auto sales as an early indicator of auto loan losses.

3. Consider using the 2008-09 industry averages for a commercial loan portfolio collateralized by real estate as a possible estimate of an expected 2020 trend. This may be a viable alternative until more current data is available.

4. What percentage of loans are paid by direct debit? These loans might be less likely to default than loans to members who mail in their loan payments.

5. New home sales and trends in home values may be a good indicator of a decline in residential home loan collateral.

Close monitoring of your credit union’s loan portfolio performance will be critical as we move through 2020. This is especially important for commercial loan portfolios.

Should I change the lookback period?

Many credit unions are asking, “should I change the lookback period for loan loss averages?” We think that using the Q&E analysis described above is a better approach than changing the lookback period. The lookback period should be fairly short i.e., 1–2 years, and one that best reflects the average loan losses. The current economic crisis is very unusual and could be short-term. Further, the impact could vary between geographical areas of the US. Therefore, using the Q&E is a better approach for estimating losses than changing the lookback period, in our view.

NCUA Regulatory Relief

NCUA has issued relief in a number of areas related to the COVID-19 pandemic. As it relates to loans, loan modifications that are made because of the COVID-19 crisis will not have to be treated as trouble debt restructuring (TDRs), according to NCUA. FASB has yet to rule on the subject.

More Information

See the link below for a complete review of relief: https://www.ncua.gov/newsroom/press-release/2020/ncua-board-approves-regulatory-relief-measures-response-covid-19