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Credit problems began to plague Linda during a 10-month stretch of unemployment last year. She fell behind on her mortgage, credit card bills, and other payments, and found herself in deep debt. But she didn’t cause creditors any losses, and she’s getting her finances back in order now that she’s working again.
Now consider Jim’s situation. Jim defaulted on his mortgage after his home’s value plummeted far below the amount he owed his lender. He decided it made no financial sense to continue making mortgage payments so he walked away from the mortgage. He never hit a stretch of unemployment or income loss, and he kept all his other credit accounts current. Jim could afford to pay his mortgage, but simply chose not to because the numbers weren’t in his favor.
Jump ahead three or four years, when Linda and Jim come to your credit union for vehicle loans. Let’s say they now have roughly the same credit scores. Which one is creditworthy? Which one should get a loan? Jim? Linda? Both? Neither?
That’s the dilemma credit unions will face in coming years, suggests Bill Vogeney, senior vice president/chief lending officer at $2.8 billion asset Ent Federal Credit Union, Colorado Springs, Colo., and secretary/treasurer of the CUNA Lending Council. Consumers like Linda and Jim belong to a group Vogeney calls “the newly credit impaired.”
“These folks have never had credit problems in the past, but they’re having them now because of the economy,” he explains. “They probably never dreamed they’d have credit problems. And they’ll need credit again at some point in the future.”
The newly credit impaired comprise “an emerging group that hasn’t been fully defined,” Vogeney says. “I think we’ll have at least another two years of fairly high foreclosures, and we could be looking at five or six years before unemployment returns to the 6% range.”
Credit unions will wrestle with the issue of how—and whether—to meet the borrowing needs of today’s newly credit-impaired members for at least a decade, Vogeney says.
Who are they?
The newly credit impaired have unique stories about how they got that way. Some lost their jobs or had their incomes severely reduced. Maybe they found work in another city and left behind a house that never sold. Unable to afford two houses, they saw foreclosure on the old house as the only way out.
Or perhaps they bought a house that was beyond their means in the first place. Some mortgage broker juggled the numbers and got them into more house than they could afford, and now they’re facing foreclosure.
They all took different routes but arrived at the same place: credit impaired.
So how many U.S. consumers fall into this category? It’s difficult to say. One indicator is the number of people whose credit scores have tumbled.
“Approximately two million consumers, out of the entire consumer population of around 215 million, dropped from a higher credit score band into the lowest score band” from second quarter 2008 to second quarter 2009, says Michele Bodda, vice president of product management and development for the credit services division of Experian.
Credit unions haven’t been immune to this decline in consumer credit quality. Their average loan delinquency rate increased from 1.44% as of January 2009 to 1.92% as of January 2010.
And credit unions’ overall first-mortgage delinquency rate has almost doubled—from 1% as of September 2008 to 1.93% as of September 2009, according to the Credit Union National Association’s (CUNA) economics and statistics department.
Jim in the earlier example represents a subgroup among the credit impaired. He didn’t lose his job or have his salary reduced.
He could afford his mortgage payments. He merely decided it was to his financial advantage to stop paying and walk away.
The term “strategic defaulter” has emerged to describe people like Jim.
When a home’s value falls below 75% of the amount owed on the mortgage, homeowners start to think seriously about walking away even if they can afford to pay, according to research from First American CoreLogic, as reported in a recent issue of The New York Times.
An estimated 4.5 million homeowners had reached this critical threshold by the third quarter of 2009. The number is expected to peak at 5.1 million by mid-2010. These homeowners make up a large pool of potential strategic defaulters.
Jeff Stone, executive vice president and chief credit officer at $1.4 billion asset North Island Credit Union in San Diego, has witnessed this trend. He recalls a member who went into foreclosure last summer on a mortgage obtained from another lender. Because the member had kept all other credit obligations current, Stone surmises it was a strategic default.
By early 2010, the member’s credit score had climbed back over 700. “It makes no sense to me that people can walk away from a mortgage, go through foreclosure, and have their credit score over 700 again after only seven months,” says Stone.
“I’ve come to the conclusion—and I haven’t seen anything yet to change my mind—that credit scores tell how people act only in good times,” Stone observes. “That’s why we don’t look at the scores as closely as what’s actually in the credit report.”
Going forward, the newly credit impaired will need financial counseling, Vogeney says. Like many credit unions, Ent Federal has geared up its counseling to debt-troubled members by making more referrals to an outside agency and by expanding its own financial counseling program.
When the newly credit impaired come looking for loans, Vogeney sees Ent Federal making what he calls “story loans.”
“It’s going to require, at a minimum, a more thorough loan interview,” he explains. “We’ll have to discover members’ stories. Were they simply caught in the economic fire storm, or were they more responsible for their own problems?”
It becomes a matter of reading the applicant as much as the application. “You’re basically assessing the person’s sincerity level,” says Dale Frankhouse, director of business services and mortgage lending at $382 million asset Sun Federal Credit Union in Maumee, Ohio. “It’s not just the credit score and the income figure. What’s the person’s attitude? Is there a sense of responsibility for past obligations?”
As Frankhouse sees it, story loans play to credit unions’ strengths. “We’re experts at listening to members’ stories,” he says. “That’s one attribute that sets us apart from other financial institutions.”
Comparing the member’s story against the credit report can be revealing. “You can see when they got in credit trouble,” Frankhouse explains, “and whether it coincides with when they lost their job or had their hours reduced.
“Be careful if you see four or five different periods of credit problems over the past few years, and those dates don’t jibe with their story,” he continues. “You’ll quickly see anything that doesn’t fit.”
While it’s important to get all the facts, in-depth loan interviews can be highly personal and require extra tact on the interviewer’s part.
“We have members who are proud of their credit histories and excellent payment records,” Frankhouse says. “And now it’s different for them, and they’re probably embarrassed. We have to approach them in a nonjudgmental, compassionate way.”
Getting the member’s story is one step. Another is diving into the credit report.
While the credit score won’t tell the whole story, Vogeney notes, the manual review of the credit report presents a wealth of information.
“It takes experienced loan underwriters to see beyond the credit score—to look at the credit report and to come up with a story of their own,” Vogeney says. “Then they have to determine whether it matches the member’s story.”
Software can help analyze credit report data and assist in loan decisions. But credit unions still tend to rely on manual reviews of credit reports, and that’s entirely appropriate, observes Bodda.
“Credit unions are in a unique position to spend the time to assess the member’s creditworthiness and to understand the member’s situation,” she says. “They can build relationships with members based on mutual trust.”
Manually reviewing a credit report can give credit unions insight into a member’s creditworthiness on a product-by-product basis.
“If I’m looking at a mortgage application, I might look at the credit report differently than I would if that person were applying for an auto loan or a credit card,” Bodda explains.
Automated tools to help mine credit-report data “might gain traction over the next year or two as credit unions gain intelligence from the heightened manual reviews they’re doing and look for ways to streamline that process,” says Bodda.
Back to basics
Serving the future needs of credit-impaired members will entail “old-line underwriting,” says Stone. “There needs to be a return to common sense. That means traditional underwriting and not cutting corners.”
Scrutinizing the credit report, listening to a member’s story about past credit problems, verifying a member’s current financial situation, and assessing a member’s attitudes are all ingredients of old-line underwriting.
Vogeney says it boils down to asking three questions:
1. Does the member have the ability to repay?
2. Does the member have the intent to repay?
3. Does the member have a history of repaying loans?”
As the final step, close the loan the right way, he advises. Earlier in his lending career, Vogeney learned that “a loan closed correctly is half collected,” he says.
“Make sure borrowers understand you’re giving them a second chance, and they should make good use of it because you don’t give third chances,” Vogeney advises.
While lending to the newly credit impaired will present challenges in the years ahead, “it’s going to be an area that’s ripe for the taking,” Vogeney predicts.
He foresees fierce competition over the next decade for the super-prime borrower. Lenders will scramble to extend credit to them, but shy away from lending to consumers “whose credit is on the fringe,” he says.
Stone envisions a slightly different scenario. An abundance of lenders could emerge, not having the best motives, “who will target people who ditched all their credit obligations during this recession,” he says.
Such lenders and consumers will, unfortunately, forget the lessons learned during the past couple of years, Stone adds.
However the scenario plays out, credit unions should stand ready to meet the borrowing needs of the newly credit impaired, Frankhouse says, and determine to the best of their ability who deserves that second chance.
“You can’t make every loan,” he says. “You have to figure out which of those members are willing and able to repay. You need to have that conversation.”