Credit unions have the challenging, but interesting, job of deciding how best to deploy capital. While they are precluded from many investments for regulatory reasons, they have many options to choose from: securities (generally risk-free, such as Treasurys and US Agency debentures), direct loan originations, indirect loan originations, loan purchases (participations and eligible obligations) and third-party originations.
The rationale behind selecting securities as an investment is usually either opting for the safety of a risk-free investment or not having enough opportunities in the alternatives. In essence, risk-free securities are a place to park cash that will generally not yield as much as the other options but provides a safe place to earn a yield greater than zero. In this article, we will focus on the alternatives.
The first step in putting the alternatives on a more equal footing is establishing a standard definition for yield. At LoanStreet, we prefer defining yield using the semi-annual bond-equivalent convention. This approach has two main advantages: first, it is the convention used for Treasury and Agency debenture quotation, allowing for easy comparison; and second, it is the standard used in most securitizations which, even if a credit union is not permitted to purchase certain securitizations (such as auto securitizations), can still serve as a point of reference for a particular loan product. The approach’s primary disadvantage is that the yield differs from the interest rate on a monthly-pay loan at par, which can be counterintuitive for some loan professionals. However, the conversion between monthly yield (MY) and semi-annual bond-equivalent (SA BEQ) is straightforward:
SA BEQ = ((1+MY/12)^6 – 1) * 2
In this equation, both yields are quoted in decimal format, i.e., .06 for 6%.
The next step is projecting the cash flows on each alternative, starting with the total purchase cost at the initiation of the transaction, followed by the periodic distributions of principal, interest and any other fees or expected payments (late fees, etc.). These projections should (a) account for losses, allowing the comparison of loans and pools with different credit quality, (b) for loans serviced in-house, should account for the cost of servicing, and (c) should also reflect the expected date that the cash will be received. This date will usually be the contractual payment date, but in the case of a participation (or serviced by a third-party), it is delayed from the contractual payment date of the underlying loans to allow the third-party servicer to make distributions only once a month (see our paper “Is Your Yield Getting Delayed – Understanding The Impact Of Delay Days”).
It’s important to note that the total purchase cost mentioned above should reflect ALL costs associated with an alternative. In the case of a Treasury or similar, these costs will not be material, as there will be little, if any, time spent performing due diligence on the US government. However, for most other investment options, there will be costs associated with the origination or purchase. In some cases, such as direct auto loans, the costs may only consist of the expenses of the underwriting and closing process (including the personnel). In other cases, however, such as indirect auto loans, the costs include those previously mentioned for direct loans, the dealer reserve expenses, and potentially additional labor expenses (i.e., dealer reps). The costs associated with purchasing a participation will, to a degree, be relative to the size of the participation (as opposed to the dollar amount being purchased), given the due diligence required tends to reflect the number of loans being reviewed.
Once all the cash flows and their associated dates are calculated and prepared, it becomes a matter to calculate an IRR on them, for instance, using the XIRR function in Excel, (although the results from this function must be converted into SA BEQ).
For example, consider the situation where a credit union has $6mm available for investment and is weighing whether to originate direct auto loans, indirect auto loans or purchase a portion of a $30mm loan participation. For purposes of this example, let’s further assume that all of the loans are identical in terms of credit, size and all other characteristics other than the source, and have the following characteristics:
For simplicity, we will make several assumptions, including (i) all loans are originated on the 15th of the month with payments received in a timely fashion; (ii) for the participation, loans are purchased at par at origination, (so no accrued interest), with the participation payments received on the 1st of the month, i.e., a 15-day delay; and (iii) all loans are similar in credit (so we are ignoring losses since they would impact the yields equally).
Once cash flows are generated, aligned with the correct dates, and yields are calculated, the results look like this:
Note: LoanStreet offering sheets include the impact of servicing and the delay, but not the impact of the expenses.
All alternatives experience some reduction in after-expense yield below the stated coupon as a result of expenses and servicing fees and costs, and, in the case of the participation, delay days (the SA BEQ yield equivalent of the stated coupon is 7.10%, with the difference shown as the “drag”). However, the most significant impact on after-cost yield is a result of the dealer reserves, as these are often relatively large costs. In this example, we use 1%, but many credit unions pay more.
Of course, the real world is rarely as simple and straightforward as this example — credit attributes will differ, loans will have a variety of terms, interest rates, origination and payment dates, and participations may be offered at prices other than par (and usually at yields higher than those of organically originated loans) along the added complexity of managing prepayment risks. Also, there can be additional fees and income that are received in all three of the examples, which would increase the example yield, though in generally equal amounts.
While credit unions looking to deploy capital must balance qualitative considerations (such as serving a credit union’s members, expanding the membership, maintaining dealer relationships, and managing or maintaining personnel), balance sheet managers can make more confident, quantitative decisions when they compare their assets and prospective investments on an equal basis. By using this apples-to-apples approach that includes costs, credit unions can quantify the yield cost or benefit of their originations relative to a participation, enabling them to determine which route to take.
This article was authored by Eric Marcus, Managing Director and Head of Trading at LoanStreet.
1The semi-annual part of the convention reflects the frequency with which Treasury notes and bonds pay interest.
