Q&A with Emily Hollis

Emily Hollis
January 26, 2010 | COMMENTS

Question: Our credit union is performing fairly well in this environment, but examiners seem to have a different mindset. The focus seems to be to reduce risk to a point where we can't make money. Am I missing something?

Unfortunately, government intervention tends to heighten when a crisis occurs, oftentimes to a point where it is assumed that all will take the direction of the fallen. For our industry, the answer seems so simple, education. One of my favorite quotes is from Warren Buffet: “Risk is not knowing what you are doing.”

I have seen this issue arise again and again for months, and have witnessed many examples of exemplary management and yet lost opportunities. First, income lost due to not knowing the difference between real risk and managing risk; and second, management being forced to sit back and appease the examiner are two common circumstances I have recently encountered. Regardless of the situation education takes time and is work.

The events that have unraveled recently in this nation were unfathomable a few years back. Many smart guys (and gals) were simply wrong. Losses in our industry were unavoidable for the risks taken. However, it is important to note that the extent of the losses could have been mitigated.

You can't broad-brush risk. It would border on neglect for any credit union to overlook all means of serving members, earning incremental income, and enhancing capital just because failures have occurred. Failures occurred due to bad decisions on CMOs, non-conforming mortgage-backed securities, derivatives, commercial loans, and even indirect loans. However, to avoid them completely can also be detrimental. In other words, totally avoiding risk does not guarantee survival . It would be difficult for any institution to maintain profitability without some degree of risk. Risk should not be avoided but managed and through that process education of the staff, board members and most importantly, the regulators is paramount.

WesCorp had losses because they bought a considerable amount of non-conforming, mortgage-backed securities which supported senior structures and therefore had the possibility of losing 100 percent of the principal. Private label securities should never be purchased unless all that are responsible are fully competent and comfortable with their structure. That being said, some can be good investments

Case in point: We have a client that wanted to allocate 40 percent of its investment portfolio to non-conforming, mortgage-backed securities. Only super senior/senior structures were purchased. When these securities were compared to a yield of similar duration on 100 percent Agency mortgage-backed securities, an incremental 165 basis points (bps) was earned. Anticipated lifetime credit losses to the tune of $300,000 (a ctual credit losses are not projected for another two years but due to accounting requirements, OTTI must currently be taken) decreased the yield by 7 bps to a net incremental spread of 158 bps. The net effect was incremental income of over $5 million per year. In other words, OTTI charges were only a fraction of the lifetime incremental earnings. The strategy was extremely successful largely due to the fact that management was educated, the examiner was educated, and the board was educated.

One other example was a credit union earning 180 bps ROA on a large consumer loan portfolio. Their investment portfolio had a yield of less than one percent and had been used purely for liquidity. They have very little in prime auto loans. Their credit department is highly educated and so well managed in the non- prime market that they are thriving. Although defaults have increased, their margins continue to remain healthy. They know their market and therefore know how to price their loans accordingly.

Our industry is a great one and we need to ensure its survival and continued success. Tying the hands of management is not the answer. Adapting to the new environment and education are the keys to success.

Emily Hollis is a CFA and president of ALM First Financial Advisors in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com.