By Alison Herrick, Partner, Wipfli
Repossessions and foreclosure rates have both risen over the past year. This increase generates new risks for credit unions, especially those that have made issuing auto and home loans a core part of their business model.
As this trend seems likely to continue, credit union leaders should make now their moment to prepare. An uptick in repossessions and foreclosures affects your accounting, member service and risk management, so you’ll need to take certain actions to shore up your team and your processes in those areas.
Keep reading to learn more.
Higher Repossessions and Foreclosure Rates Create Risks for Credit Unions
Consumer debt recently hit a record high of almost $19 trillion. As a result, more Americans are having trouble paying their bills, which is starting to be reflected in repossession and foreclosure rates.
Foreclosures are higher than at any point in the last six years. Repossession of vehicles has increased to levels last seen during the Great Recession, due to increased new and used car prices as well as elevated interest rates.
This debt environment creates new risks for credit unions, which typically rely on home and vehicle loans as a core part of their businesses. Your credit union may face both risks in your loan portfolio and process-related challenges, such as incorrectly accounting for foreclosures or repossessions in your books and underestimating credit loss reserves.
There also may be operational and compliance risks if collection, repossession, foreclosure, and loss mitigation processes are not consistently executed.
Key risks include:
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Portfolio risks: Higher default rates affect the loans you’ve directly issued to your members. But you also need to consider your participations and indirect loans. If your credit union has joined other institutions in a shared loan pool, you’ve essentially issued loans to borrowers you don’t have a direct relationship with, which means you are more reliant on the lead lender’s collection and reporting procedures. In an indirect lending situation, the credit union’s relationship with the borrower is typically limited, which results in less borrower loyalty in fulfilling their obligations.
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Liquidity dangers: For credit unions, which may lack the deep financial reserves of large national institutions, a significant drop in repayment rates for core loan products could represent a genuine liquidity risk.
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Team inexperience: Is your team prepared to navigate an influx of new foreclosures? If you don’t have experience navigating this area, you may run into compliance or even process challenges – like failing to offer at-risk borrowers a workout that could help them avoid a foreclosure in the first place.
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Accounting and financial reporting risk: GAAP accounting errors around vehicle repossessions are common. For example, you are supposed to immediately write down the value of a vehicle your credit union repossesses. However, many credit unions wait until after the vehicle has been sold to record the write-down through the reserves, creating a GAAP departure and potential delay in recognizing losses.
How Should Credit Unions Adapt to the Repo and Foreclosure Uptick?
In today’s repossession and foreclosure environment, your credit union should focus on managing risks, maintaining compliance and strengthening processes. Keep a close eye on red flags, brush up on your accounting and review your options for what to do if you notice an increase in defaults.
Key action steps include:
1. Double-check your accounting processes
Accounting mistakes today can cause significant headaches down the road. Make sure your accounting team knows how to properly account for repossessions and foreclosures and avoid common errors like the timing of a write-down.
Under GAAP, accounting for either a repossession or a foreclosure should be based on fair value minus costs to sell. Make sure you’re taking the approach, and lean on advisory support if you need further guidance.
Your controls should be designed to ensure timely write-downs to fair value less estimated costs to sell, appropriate approval and documentation of valuation inputs, accurate recording of gains or losses on disposition and completeness of supporting schedules used in financial reporting.
2. Actively engage with borrowers
Use the data you have on your borrowers to watch for both individual warning signs and broader trends. Notice an increase in credit card debt, for example? This could be an indicator that more of your members are using credit cards to pay living expenses, heralding a wave of defaults to come.
If you see that an individual borrower is at higher risk of default, be proactive. Reach out to the borrower to discuss a workout or a refinance to help them stay in repayment. This won’t always work, but it can reduce your default rates.
3. Keep an eye on your participations
Do your due diligence and carefully evaluate your risks around participations. Unless you’re the lead lender, you may not have access to all relevant documents and reports around the state of the loans in the pool, so make sure you get that information. You also need to understand what sort of options you have if the loans start to go bad.
4. Educate your borrowers on last-ditch options
Last-ditch options like a voluntary repossession or a deed in lieu are far from ideal. However, these may hurt a borrower’s credit less than a regular default would, while also simplifying matters for your team. Make sure your at-risk borrowers are aware of these options and their benefits in a situation where a default is no longer avoidable.
5. Check your compliance
Each state has its own rules that govern repossessions, foreclosures and collections. Review the rules for every state you operate in to make sure you’re in compliance, as regulators may give this area more attention as the volume of defaults goes up. Also make sure your team has the resources to stay on top of regulatory requirements and changes.
6. Decide how to handle collections
Consider if you would rather handle collections internally or outsource to a collections agency. Either option can work, but you should evaluate what makes the most sense for your credit union in light of the current environment.
7. Reserve appropriately
As delinquencies, repossessions and foreclosures increase, credit unions should evaluate whether credit losses are being reserved for on a timely basis. This includes ensuring the allowance methodology appropriately reflects current portfolio performance, emerging loss trends and relevant qualitative factors, such as changes in economic conditions, collateral values, borrower behavior, underwriting practices and collection experience.
Waiting until a loss is realized or collateral is sold can delay recognition of credit deterioration and may result in reserves that do not fully reflect the risk in your portfolio.
8. Seek advisory support
Guidance from an accounting and advisory firm can help you adapt to today’s consumer debt climate. Look to an advisor to help you in areas like risk management, loan review, accounting processes, internal controls and regulatory compliance.
Connect with Wipfli to learn more.
