Why do credit unions see superior loss experience in residential real estate loans?

In most financial industry discussions, credit unions receive little attention. It is not hard to see why. In a ranking of financial institutions based on asset size, the largest credit union, Navy Federal, comes in at number 38 and is less than half the size of the 24th-largest bank, Keycorp.¹ Altogether, based on asset size, credit unions represent just 6% of the U.S. financial market. But our studies reveal that credit unions consistently distinguish themselves in an important way: They are superior in real estate loss experience to date.

Loss experience is a measurement of total losses with respect to a portfolio of loans. Total losses include all expenses associated with the sale of a home that a bank has acquired after foreclosing on a delinquent borrower. The delinquency status of these homes is also known as real estate owned (REO). In addition to the costs of maintaining and selling the REO home, banks may suffer additional loss when the sale price of the home is exceeded by the loan's current balance. Note that banks make a profit when the loan's current balance plus expenses associated with the home sale is exceeded by the sale price of the home.

Figure 1 shows a comparison of real estate delinquency rates, a leading indicator of losses, between banks and credit unions. These delinquency rates are determined as the total number of delinquent loans at the end of the calendar year divided by the total number of outstanding loans at year-end.

The delinquency rate of credit union loans is dwarfed by that of bank loans. In order to protect themselves from the potential losses associated with borrowers defaulting on their loans, both credit unions and banks generally require mortgage insurance from most home buyers who obtain a loan for more than 80% of the value of the home. Mortgage insurance benefits lenders by providing protection against losses associated with borrower default and also allows home buyers to purchase a home with as little as 3% down. These losses include the unpaid principal balance plus accumulated interest due under the loan and miscellaneous balances due less the net proceed of the sale of the home.

When assessing the loss potential of mortgage insurers, loan characteristics such as FICO score, loan-to-value ratio, loan amortization, and occupancy type are analyzed. Based on these underwriting characteristics, credit unions have historically underwritten loans with a more favorable profile than banks have. Not only have credit unions underwritten higher-quality loans, but they have also experienced more favorable loss experience compared to that of banks on loans with similar underwriting characteristics.²

As an example, when doing a comparison of the state of Florida premium rates for United Guaranty Residential Insurance Company's (UGRIC) credit union loans versus its bank loans, the average premium rate is significantly lower than its non-credit union average premium rate. The comparison holds when looking at premium rates from comparable risk characteristics.

Do superior customer relations reduce risk?

Credit unions by their very nature are focused on their customers and their communities. Established as nonprofit, cooperative financial institutions, credit unions are owned and run by their members, who are linked by a common factor, typically geography or employment. Members pool their funds to make loans to one another and the profits are used to reduce interest rates on loans and increase rates on deposit vehicles. Many credit unions are run by a volunteer board, elected by members.

In general, credit unions have been less apt to securitize loans and more likely to hold them in portfolio. As a result, there is an incentive for greater underwriting scrutiny, given that most loans are held in portfolio. Risk retention has historically been and continues to be an important feature in underwriting practices for credit unions. The industry participants and regulators have recognized the value of risk retention as evidenced by the risk retention requirements found in the Dodd-Frank Act.

While credit unions are relatively small individually, their presence is widespread. According to the National Credit Union Association 2009 statistical report, there are more than 7,554 federally insured credit unions in the United States, with 89.9 million members and loans of more than $300 billion in real estate loans outstanding.

It may be precisely because credit unions are community-based that they are able to achieve superior loss performance. Credit union officers typically live and work in their communities, giving them ample opportunity to understand their markets and local economies. They also seem to have a strong sense of their customers' needs. For more than two decades, the customer satisfaction survey conducted by the American Bankers Association and Gallup consistently ranked credit unions higher than banks. It is possible that being better informed about customer needs and the local market helps credit unions enhance their underwriting performance even as they engender customer loyalty, which in turn helps reduce loan delinquency. It may also be that because credit unions are cooperative-based, the members demand higher standards of lending to ensure that their own interests in the credit union are met.

In addition, there may be an inherent increase in the responsibility level of the borrower that is due to the credit unions' philosophy in running a business. This philosophy is revealed in the seven principles stated on the Credit Union National Association website:

1. Voluntary membership
2. Democratic member control
3. Members' economic participation
4. Autonomy and independence
5. Education, training, and information
6. Cooperation among cooperatives
7. Concern for community

However these factors are considered for individual credit unions, the forecasting implications for the industry are clear: Credit unions demonstrate a clear and consistent advantage in real estate loan loss experience. Both credit unions and banks have adopted stricter underwriting policies because of the stresses of the current environment. It remains to be seen whether the historical superiority of credit unions will hold up in the current environment. Early indications suggest it may persist, but the jury is still out.

1 Based on data from http://www.creditunions.com and http://www.ffiec.gov/nicpubweb/nicweb/Top50form.aspx.

2 Based on a letter to Congress dated January 19, 2010, from Daniel A. Mica, president and CEO of the Credit Union National Association.