Lesson from Harvey: The importance of stress testing your loan portfolio

In the aftermath of Hurricane Harvey, we can all agree that the most important objectives are aiding the victims and rebuilding what was lost by those affected. However, from a credit union perspective, it also reminds us how an unforeseen event can affect the strategy and viability of their institution. Events like Harvey are precisely the reason why it is important for credit unions to understand the significance of stress testing their portfolio.

If a month ago, you polled Houston area credit union leaders about potential risks to their loan portfolio, and subsequently their capital, it would be interesting to see how many of them would have cited a catastrophic weather event. Although we almost instinctively associate a portfolio shock with economic events – events similar to the lead-up to the 2008 housing bubble, for example – it is hard to imagine any one event having a bigger impact on a credit union’s membership and collateral values than what Harvey will likely have on Houston and the surrounding communities. The underlying lesson is that credit quality and collateral markets can change quickly, and not always in the exact way we envision, or plan for.

Harvey has undoubtedly been an impetus for economic shock in the Houston area, checking each of the following boxes that affect the stability of lending portfolios:  

• Home Values – widespread flooding has rendered 70% of Harris County under at least 1.5 feet of water, many of which were not covered by flood insurance. This means thousands of flooded homes, and a grim short term effect on the Houston housing market.
• Automobile Values – there are reports that likely 500,000 vehicles have been destroyed by Harvey. Even if the individual, or the lender, can find and retrieve the collateral, it is likely going to be worth nothing.
• Small Businesses – despite optimistic tones from municipal leaders, small businesses, the engine of most local economies, have an uphill climb to navigate rebuilding, finding employees, and continuing operations.
• Member Livelihoods – it is difficult to think about getting back to work when there is 18 inches of water in your living room, or your car has been flooded, or your place of employment is shut-down. Even with the expected influx of insurance money, it is likely that Harvey has interrupted the income source for many credit union members.

For a credit union in southeast Texas that didn’t deliberately plan for and proactively shape their strategy to withstand a stress scenario, the recovery might be the hardest thing their institution has ever faced.

The question facing the rest of us is stark: what is going to be your “Harvey”? There will inevitably be an event that stresses your credit union, and it will be important that you are positioned to weather the storm. Here are some tips on how you can create an infrastructure that will facilitate a useful stress testing model:

• Understand your collateral – most credit unions record an original LTV on their auto and mortgage loans, but do you re-measure LTV periodically? By obtaining fresh collateral values, and comparing them to current balances, you can better understand your current position of exposure, and get a real-time view of your risk of loss.
• Understand your credit quality – when underwriting, credit unions typically look at the member’s FICO score to determine eligibility and interest rate. The tricky thing about FICO scores is that they change. Rescoring your loan portfolio after origination provides you a fresh data point on your member and allows you to calculate score migration.
• Understand your market – to better understand the environment you are operating in consider pulling data germane to your geographic market related to housing and unemployment trends.

After establishing sound baselines in these areas, you are ready to apply stress assumptions of how much collateral values and credit quality could change based on the conditions confronting your individual credit union.

At the very least, credit unions should stress their portfolio considering the risk of a general economic decline. However, an effective stress testing program should also include a deeper dive into risks relevant to your portfolio mix, and lending environment.

For instance, you may have loan pools that carry heavy regulatory risk, such as student loans. Or you may have member business loans at risk for a total industry collapse – see the taxi medallion industry. And, of course, you may be geographically positioned on the coast, watching the tropics, and are at risk of a near-total loss related to a weather event.

By thinking outside-the-box about your risk gamut, you can execute stress tests tailored to specific scenarios that will better inform you on the following:

• Risk Adjusted Capital Position –starting with recorded net worth, you can simulate a collateral scenario that estimates value at risk and interest rate risk to determine if the credit union’s current capital position can withstand that particular shock scenario.
• Allowance for Loan Losses – when you simulate a drop in collateral quality, you can project how that will affect your losses, and determine if the credit union is properly reserved. If you find that your ALLL account isn’t adequately funded, you can analyze if you have the capital available to increase the reserve.
• Concentration Limits – if you observe that stressing a particular loan pool significantly increases losses to the credit union, you can determine if your current concentration limits should be revised.

It’s true, getting serious about stress testing your portfolio will not stop your “Harvey” event from happening, but it will allow the credit union to:

• Gain a better understanding of its static situation,
• Think critically about the risks confronting it,
• Forecast projections of how a stress event would affect the institution,
• Shape strategy to confronting those risks and mitigate the impact,
• Not have to wait until a stress event occurs to react

Planning for the next “worst case scenario” is more than just thinking about the next change in the economic cycle. Rather, it’s taking a proactive approach to understanding catastrophic risk, and arming your credit union with the right amount of data to inform a well thought out stress testing program, and support a lending strategy that will sustain you when you are faced with your own “Harvey”.