Spectre of bad lending continues to haunt credit unions

Despite their "open for business" claims, credit unions are in fact struggling to make new loans, writes Bill Hobbs

The legacy of boom time lending, when few questions were asked of peoples ability to repay and bad lending practices prevailed, is haunting credit unions as much as banks. When inevitably implemented, a consumer debt forgiveness programme will impact most severely on credit unions, given their lending strategies, policy and practices.

Despite their trade bodies “open for business” publicity and claims of increasing lending, credit unions are in fact struggling to make new loans. So much so, that their financial stability is threatened unless they find a way to make more loans quickly and safely. The news is not good; 10% of credit union loans are in arrears of more than ten weeks, new lending has collapsed and balance sheets have shrunk by an overall average of 5%.

Audited accounts of a sample of thirty leading credit unions representing €2.7bn, one fifth of the movements’ total assets and €1.4bn of the €6.2bn consumer loan book, show a dramatic decline in new loan issues. On average they lent 27% less in 2009 over 2008 with some of the largest dropping by over 45%. One major community credit union reported a drop of 67% with a leading employer based credit union reporting a 59% decline. All bar one credit union reported significant reductions in loan repayments, indicative of increasing loan defaults. Tellingly while new loan issues dropped by over a quarter, the overall loan book declined by only 4%, evidencing that the credit unions are engaging in wholesale loan modification, mainly rescheduling bad loans over longer time periods.

The hollowing out of the loan book where bad loans are rescheduled means two things. The first is bad debt provisions increase and secondly credit risk is amplified as longer term loans are inherently riskier. More so where the have been made due to problems with borrowers breaching their original loan contracts.

Ever since 2000, the underperformance of credit union lending and poor credit risk practices has threatened to undermine their financial stability. By 2005, despite boom time economic conditions when people were far better off, credit unions reported loan arrears over three times the level that would have been expected. Bad debts were not being written off and provisions were being manipulated to maintain high dividend pay out rates to savers. Last year credit unions reported that almost 10% of their loans were in arrears of more than ten weeks – a critical loan default risk threshold for unsecured short term consumer loans. At least €620m is exposed to significant losses. However as credit unions use a method for calculating loan arrears which underestimates in some cases arrears by as much as 45%, the true position will not be known until arrears are more accurately reported on this year. It is highly likely the 10% figure is a significant underestimate- the true figure may climb to 15%, by the end of this year, where upwards of €1bn may be at risk.

The Irish credit union business model which relies on rewarding savers with dividends derived from profits made from making loans is foundering as new lending dramatically declines.

The problem for Irish credit unions is this; in any one year they have to re-lend 50% of their loan book to stand still. Lend less and their loan book shrinks. Entirely reliant on loan interest and investment income, any decline in lending will severely impact on income and ability to finance operating expenses, pay a dividend and provide for reserves. Unlike their peers elsewhere, as Irish credit unions have not developed other sources of income, they are overly exposed to lending risks. This risk is amplified by their low ratio of lending to total assets where less than 50% of money is out on loans. So much so that interest on loans barely covers operating costs.

In any one year credit unions issue about 900,000 loans totalling €3.1bn. About half of these range between €5000 and €25,000 range. Total loans in this category are just over €3bn. As only 20% of loans are backed by savings as collateral, fully €5bn is unsecured short to medium term consumer lending much of which has a sub-prime pathology – where people used credit unions loans as secondary or last resort sources of personal finance. Many borrowers, including first time house buyers, who used credit unions loans to fund their down payments, are experiencing significant problems.

Tellingly all but one of the thirty credit unions analysed showed a dramatic decline in loan issues. But this did not translate into a drop in overall loans. This is clear evidence of the amount of loan modifications, mainly loan rescheduling, as bad loans are stretched out over longer terms. Analogous to pouring more sand on a land mine – loan modifications may hide the problem but it doesn’t make it any less explosive. Buying time in the vain hope that borrowers will make good unsecured loan repayments flies in the face of an unpalatable certainty - billions in unsecured consumer loans will have to be written off by Irish banks and credit unions.

International experience indicates that troubled unsecured consumer lending results in debt write offs of upwards of 75% with median experience of 50%. There are no indications that loan loss experience in Ireland will be any better.

Credit unions remain a significant source of consumer loans and could increase new loans by at least 50%. The problem is not one of lack of flexibility to lend as claimed by their trade bodies but of competence to do so safely. As with all problems, resolution begins with admitting to the problem itself.

Faced with significant challenges, they must lend more in ratio to their assets, to improve financial stability. They have to reverse the dramatic decline in new loans. And they must do this safely within tough economic conditions. They will also have to slash operating costs which are far too high to sustain their business and find ways to increase fee income if they are to remunerate savers, fund loan losses and repair capital reserves.


A version of this article appeared in the Irish Examiner, Business Section, Monday 22nd March 2010