Credit union executives struggle to determine the proper amountthat needs to be set aside in their Allowances for Loan and LeaseLosses.

The Office of the Comptroller of the Currency has issued aseries of Policy Statements intended to guide financialinstitutions in the calculation of the Reserve for Loan Lossesconsistent with GAAP. The most recent Policy Statement, publishedin 2006, identifies credit unions and the NCUA as subject to itsprovisions.

In this policy statement, two specific directives are includedthat address calculation of the reserve for individually identifiedloans. They state:

• “For purposes of this policy statement, the term “estimatedcredit losses” means an estimate of the current amount of loansthat is probable the institution will be unable to collect givenfacts and circumstances of the evaluation date.”
• “Under FAS 114, an individual loan is impaired when, based oncurrent information and events, it is probable that a creditor willbe unable to collect all amounts due according to contractual termsof the loan agreement. It is implicit in these conditions that itmust be probable that one or more future events will occurconfirming the fact of loss. Thus, under GAAP, the purpose of theALLL is not to absorb all the risk in the loan portfolio, but tocover probable credit losses that have already been incurred.”

Thompson Consulting and Training recently initiated alongitudinal study to quantify the probability of actual loss forloans that become 60 or more days delinquent. Loan data from clientcredit unions is gathered monthly. The study so far has covered atime period of several years. The study is ongoing. As withany ongoing study, findings may vary over time. But, here is whathas been observed to date:

• In a normal environment, with consistent collection activity,between 25% and 35% of unsecured loan balances that become 60 ormore days delinquent are eventually charged off
• 80% to 90% of total delinquencies and charge-offs areattributable to loans that have impaired FICO scores (dropped 2 ormore grades)
• Less than 10% of total delinquencies and charge-offs areattributable to loans with an unchanged FICO score
• The most effective way to manage charge-offs is to identify andcontrol loans associated with declining FICO scores
• The largest segment of delinquent loans comes from loans thatwere originally “B” or “C” grades and subsequently dropped to “D”or “E”
• The most valid indicator of impending delinquency and loan lossfor any loan is a declining FICO score

From this study and other research, TCT concludes that anempirical, statistically validated credit migration model whichincludes a reporting system that identifies loans(individually and categorically) that are experiencing decliningFICO scores will significantly contribute to:

• Correct placements to ALLL
• Controlling delinquencies and charge-offs more effectively thanrelying on other reporting systems or subjective methods
• The most up-to-date and effective lending policies andprocedures including Concentration Risk policies
• Insight into lending problems that lie ahead and correctiveactions needed

DennisChild is a retired credit union CEO in Logan, Utah,who has been associated with TCT in Boise, Idaho,for 25 years.