Static Pool or Credit Migration—That Is the Question04.16.2018
CECL is coming, CECL is coming! Yes, and folks are well underway with their CECL committees seeking the best methods to prepare for the new changes. Lots of discussions on discounted cash flows, on static pool and its close brother vintage analysis. Funding that ALLL account is going to be key! We have a one-time shot at making a capital adjustment as well. In all of the discussions which can seem overwhelming and confusing to many, their stands a clear and simple path to properly funding, while not over or underfunding, your ALLL account and in the process offering great value to you and your members. It’s called credit migration (CM). We aren’t seeing much about CM as a CECL response tool, which offers some key benefits to credit unions such as:
- Lending deeper to more credit union members
- Lend more efficiently by helping members improve their credit standing
- Lend more profitably by expanding your loan portfolio
One expert, Dr. Randy Thompson of TCT Risk Solutions, tells us about how CM works and offers four CU scenarios that I think most CU managers can relate to.
Static Pool Analysis vs. Credit Migration
As 2020 approaches credit unions are preparing to change from the Incurred loss model to the required Current Expected Credit Loss (CECL) model. The primary difference of the two models is calculating a loss ratio for loans based on expected losses over the life of loans instead of using actual losses from a previous period. Two of the main methodologies suggested by FASB are static pool analysis and credit migration. Each of these methods follows distinct paths to calculate a loss ratio for loans within disparate pools. Understanding the differences between these methods can help credit union leaders make informed decisions as to which method will be serve their needs. So, let’s examine the key components of each method.
A static pool is as group of loans that were originated during a time period in which all internal and external risk factors were basically the same. Once the pool has been established, no loans are removed from the pool and no loans are added to the pool; the pool remains static. For example, a static pool could include all direct loans originated in the year 2012. Another pool may be all loans originated in the “D” credit tier during the first quarter of 2014. So, any time either internal or external factors change, a new pool must be initiated.
Credit migration, on the other hand, is a dynamic process that examines the movement of credit scores within each loan pool. Because of the dynamic nature of the credit migration, all loans are grouped by pools and monitored over time. The existing structure of the loan portfolio is maintained and applied.
Credit Migration Member Scenarios
To better understand the workings of credit migration, consider these brief descriptions of four typical credit union members.
- CU member 1: Ruth is a member who avoids risk and maintains a consistent lifestyle. No major changes in her behavior or financials practices. Her credit score has not changed in the past five years and will not likely change in the next five years.
- CU member 2: Henry is a long-time member who has had a high credit score for years. He has had several loans including a Visa card with a significant credit limit. Recently he lost his job, and his ability to repay loans has declined resulting in a drop of credit score from A to D.
- CU member 3: Liz is a relative credit newbie who recently finished school and entered the workforce. She did not have a credit score when she approached the credit union for a loan because she had not borrowed money while in school. 18 months later she has established an A+ credit score.
- CU member 4: John is a relatively new member who had a bad turn of events a couple of years ago. Lost his job, experienced a divorce and lost his home. His credit score cratered to an E at that time. He retrained and obtained a new job. He came to you for a car loan which you approved at the appropriate rate. He has been rebuilding his credit and now has an A credit score.
These four individuals represent all the members with loans at your credit union. Some maintain consistent credit status, others have credit status that is declining. Still others are improving their credit and achieving higher credit scores.
What Credit Migration Does
Credit migration identifies and tracks the movement of each of these members over time. As a member improves his/her credit score, the Current Expected Credit Loss for that loan decreases. If a member’s credit score is declining the Current Expected Credit Loss for that loan increases. Credit migration, then, calculates a net credit change that shows the impact of the improved scores netted against the declining scores.
For example, if a credit union had $1,000,000 in balances where the credit status that declined from A to D the resulting required increase in ALLL placement could be roughly $40,000. If the same credit union had another $1,000,000 in balances where credit status improved from E to C the resulting decrease in ALLL placement could be roughly $35,000. This means the net effect would be a required increase of ALLL of $5,000.
Static pool does not identify the improving scores. In fact, it suggests that the credit union membership consists of only Ruth and Henry. This is the reason why static pool analyses have indicated that the ALLL requirement under CECL will increased dramatically for credit unions.
Credit migration offers at least two distinctive advantages to credit unions.
- First, since CECL requires a lookout over the life of loans, the static pool analysis could result in a significant number of distinct pools created each time either internal or external factors changed. This could make the data collection and management requirements overwhelming. Credit migration uses the total of loans included in the current portfolio. Simple data management.
- Second, the net credit change effect in credit migration protects the credit union from significant and unnecessary increases in ALLL requirements. Improving credit scores result in a lower the ALLL requirement on those loans. This net protects the credit union and makes sense of the ALLL estimate.
Dr. Randy Thompson, founder of TCT Risk, and co-contributor of this article, is engaged in a pilot study with Equifax on the effects of lending deeper and allowing credit unions to become more profitable with credit migration. If you think you would like to participate in this study, please contact firstname.lastname@example.org or call 406-315-2809.