#  NCUA LETTER TO CREDIT UNIONS

**NATIONAL CREDIT UNION ADMINISTRATION**

**1775 Duke Street, Alexandria, VA 22314**

  ----------------------------------- -----------------------------------
  **DATE: September 2004**            **LETTER NO.: 04-CU-13**

  ----------------------------------- -----------------------------------

**TO: Federally Insured Credit Unions**

**SUBJ: Specialized Lending Activities**

**ENCL: [AIRES Questionnaires](../04-CU-13-Encl-1.xls):**

(1) **Sub-Prime Lending Controls**

(2) **Indirect Lending Controls**

(3) **Outsourced Lending Relationships**

Dear Board of Directors:

The March 31, 2004 financial trends show that while the total volume of
loans is increasing, shares are increasing at a faster rate causing the
loan to share ratio to decline. As credit unions search for more lending
opportunities, they may choose alternative lending arrangements.

As credit unions increasingly turn to alternative lending arrangements
to meet their strategic objectives, safety and soundness concerns
increase along with risks. As a result, NCUA has reviewed and updated
the guidance provided to examiners to ensure it adequately explores
pertinent issues and concerns.

This letter focuses on three higher risk lending activities -- sub-prime
lending, indirect lending, and outsourced lending relationships. Each of
these lending activities can make good strategic business sense for
credit unions when done with proper care. However, engaging in any of
these lending activities exposes a credit union to a range of risks
including credit, interest rate, liquidity, transaction, compliance,
strategic, and reputation. It takes proper planning, experienced staff,
and adequate controls and monitoring to make these profitable and
productive activities for serving members.

**[Sub-prime Lending]{.underline}**. Sub-prime lending is the practice
of extending credit to borrowers who have weak credit histories (e.g.,
delinquent payments, charge-offs, judgments, bankruptcies), or reduced
payment capacity (e.g., high debt ratios or low credit scores). A
sub-prime portfolio will likely display significantly higher delinquency
and/or loss rates than prime portfolios. Typically, higher interest
rates and fees are charged to sub-prime borrowers to compensate for the
higher risk. Sub-prime portfolios generally require more intense and
specialized collection efforts increasing a credit union's expenses in
this area.

The term "sub-prime" is often misused to refer to certain "predatory" or
"abusive" lending practices since a greater proportion of these
practices occurs against sub-prime borrowers. Sub-prime lending that is
appropriately underwritten, priced, and administered can serve to
increase access to credit for borrowers with special credit needs and is
not predatory by design. NCUA views as unsafe and unsound loans to
borrowers who do not demonstrate the capacity to repay the loan as
structured and where reliance for repayment is placed on the collateral
pledged.

While sub-prime lending involves higher levels of risk and skill,
properly managed, it can be a sound book of business. Sound underwriting
practices, effective control and monitoring systems, and sufficient
capital levels are key components to a well-managed program.

**[Indirect Lending]{.underline}**. Indirect lending is an arrangement
where a credit union contracts with a merchant to originate loans at the
point of sale (e.g., an auto dealer). Generally, indirect lending is
associated with auto loans. An indirect lending program can lead to
rapid growth, changing the structure and risk profile of a credit
union's balance sheet quickly. In addition to credit risk, on-going
evaluation of both a credit union's liquidity and interest rate risk is
essential.

A credit union should periodically review its approved dealers to ensure
they meet certain standards including reputation, experience, and
financial condition. Periodic review of approved dealers will ensure the
dealer is not using excessive sales pressure on the borrower to increase
its sales volume which could result in lower credit quality for the
loans presented to the credit union. On-going review and monitoring of
individual dealer loan statistics ensures the dealer's compliance with
credit union credit criteria.

Written contracts should be in place addressing, at a minimum, dealer
compensation, credit criteria, documentation standards, and dealer
reserves. A dealer reserve account is controlled by the credit union and
provides for charging back non-performing loans to the dealer under
certain conditions.

Increased loan volume is a tangible benefit of indirect lending.
Indirect lending can also provide a source of new members. However, a
credit union needs to properly plan for and understand the risks of the
program.

**[Outsourced Lending Relationships]{.underline}**. Outsourced lending
relationships can provide a credit union with greater flexibility in
offering loans to members. Typically, a credit union will contract with
a third party to originate or service loans. NCUA Letter to Credit
Unions No. 01-CU-20 addresses "Due Diligence Over Third Party Service
Providers" and provides useful guidance for credit unions dealing with
outsourced lending relationships. The letter highlights planning,
background checks, legal review, financial review, return on investment,
and controls such as policies and procedures, staff oversight, and
reporting.

Outsourcing functions can be a profitable venture; however, a credit
union must ensure proper controls and monitoring are in place.

**[Summary]{.underline}**. When a credit union engages in any higher
risk activity, it should be compatible with a credit union's risk
tolerance, administrative capabilities, and strategic goals. The
projected and realized impact on a credit union's financial performance
should be analyzed regularly. Reasonable program limits should be
established as well as on-going program monitoring and analysis.

Examiners will assess whether a credit union involved in specialized
higher-risk lending activities has adequately planned for, and is
monitoring and controlling those activities. Management will be
adversely rated for failure to manage and control such programs.

To increase awareness and understanding of NCUA's approach to
specialized lending programs, we are enclosing the revised examiner
questionnaires used to evaluate programs. We encourage you to review
these, compare them to your existing and/or planned activities, and then
be in a position to effectively respond to and address questions that
may arise.

Should you have any questions, please do not hesitate to contact your
district examiner, regional office, or state supervisory authority.

Sincerely,

/S/

JoAnn M. Johnson

Chairman

[Enclosures](../04-CU-13-Encl-1.xls)