Static Pool Analysis:

Evaluation of Loan Data and Projections of Performance

March 2006

**Introduction**

This whitepaper provides examiners with a discussion on measuring and
predicting the effect of vehicle loan performance on loan portfolio
yield using a process developed by the NCUA (NCUA Static Pool Analysis
Tool). Examiners may use this tool to review a credit union's static
pool analysis for an indirect vehicle loan portfolio. Credit union staff
can use static pool analysis to make informed decisions about whether to
increase funding, continue at current levels, or curtail acquisitions of
loans based on results of actual yields or an expected yield analysis.
**This whitepaper is not intended to disregard other alternative
approaches nor is it intended to be the only tool used by a credit union
to validate strategic decisions regarding lending programs.**

**Background**

In June 2005, NCUA issued Risk Alert 05-RISK-01 (the Risk Alert),
Subject: Specialized Lending Activities -- Third-Party Subprime Indirect
Lending and Participations, available on the website at
<http://www.ncua.gov/letters/RiskAlert/2005/05-RISK-01.pdf>, to address
increasing concern over the effectiveness of controls in place at credit
unions to manage such programs. The Risk Alert highlights issues
relating to a credit union's ability to not only control the activities
of a third-party as it relates to underwriting and servicing loans, but
also to adequately track overall performance of the loans in the
program. Static pool analysis can be used to evaluate just about any
type of loan pool performance, regardless of the underlying
characteristics of the loans in the pool. The Risk Alert cited this type
of analysis as the most effective method of evaluating the performance
of a pool of auto loans.

Since the Risk Alert was issued, many credit unions engaged in
third-party subprime indirect lending have taken steps to perform static
pool analysis. Therefore, the NCUA developed this paper to assist
examiner staff in understanding static pool analysis and to better
prepare you for evaluating static pool analysis conducted by or on
behalf of credit unions.

**Discussion**

[Is the yield on a pool of loans the same as the loan rate?]{.underline}

A pool of loans with 18 percent loan rates doesn't necessarily return 18
percent. Several factors may reduce the yield below the average loan
rate. Borrowers may fail to make timely or full payments. Borrowers in
default make no interest payments. Or a lender may restructure loan
terms, reducing the loan rate, to facilitate workout of troubled debt.

Proceeds from the sale of a repossessed car, including any insurance
recovery, may be less than the principal amount due. Borrowers may file
bankruptcy petitions. The bankruptcy court may reduce the loan principal
amount and/or loan rate.

Finally, when a credit union pays fees to acquire loans, the yield will
be less than the average loan rate because the credit union must recover
the premium from the interest paid.

[What affects the yield?]{.underline}

"Prepayments" may severely affect the overall yield of the portfolio.
Prepayments include all early reductions of loan principal. Examples of
prepayments include: early loan payoffs; insurance payoffs; and defaults
due to bankruptcy and delinquencies.

To the extent there is less than total recovery of principal (including
through repossession and resale, and any insurance) loss severity
becomes an important characteristic of portfolio return.

[What analysis should examiners expect credit unions to perform before
investing in a pool of loans?]{.underline}

Before investing in a pool of loans, credit unions should analyze static
loan pool data provided by the vendor, or perform appropriate
alternative due diligence, to validate the underwriting criteria. It is
appropriate to analyze how a fixed group of loans have performed, in
order to reliably predict expected future performance. Once an initial
assessment has been performed, credit unions should perform ongoing
static pool analysis to monitor the performance of the loans in the
pool.

Once the credit union has acquired loans, the credit union should use
the actual cash flows and a range of expected cash flows to calculate a
range of expected yields. For matured pools[^1], compute the
[actual]{.underline} yield to maturity by computing the internal rate of
return[^2] on all cash flows. For pools that have not yet matured,
compute an [expected]{.underline} yield by making assumptions about
future performance and computing the internal rate of return on all
historical cash flows and expected future cash flows. Vary the
assumptions to understand the sensitivity of the expected yield to
changes in assumptions.

A static pool is comprised of loans originated with the same
underwriting criteria during the same month, quarter, or year. Ideally,
all loans originated in the same time period are included in the
performance data.

A static pool covering loans originated in one calendar year is
sometimes called a "vintage origination year" or "vintage data." Vintage
data is less "static" than shorter time periods, since new loans are
continually added to the portfolio over the course of that year's
vintage.[^3]

[Why should examiners expect to see credit unions perform static pool
analysis?]{.underline}

As outlined in the Risk Alert, the most effective method of evaluating
the probable performance of a vendor's underwriting criteria is through
an analysis of static loan pool data. Historically, new loans tend to
perform better than older "seasoned" loans in a portfolio. Therefore,
static loan pool analysis of a fully formed pool[^4] is not distorted by
new loans entering the pool.

Static pool analysis can provide key measures affecting overall
portfolio yield. NCUA's Yield Model requires the following three key
inputs:

-   Constant Prepayment Rate (CPR);

-   Default Proportion; and

-   Loss Severity.

*Constant Prepayment Rate*

We define prepayments as unscheduled reductions in principal outstanding
in the pool of loans. We use CPR as the measure of the prepayment rate
at which a loan is expected to prepay, expressed as an annual percentage
of the remaining loan balance.

*Default Proportion*

The default proportion represents the part of prepayments that result
from defaults. We include defaults in our definition of prepayments.

It is sufficient to compute the default proportion as the ratio of the
dollar amount of defaults for a time period divided by the total
prepayments for that time period.

*Loss Severity*

Where the payment of principal and interest is not fully guaranteed,
part of the defaults will result in a loss. After a default, loss of
principal results from uncollectible principal, such as a deficiency
following repossession, as well as bankruptcy reductions of principal.

It is sufficient to compute the loss severity as the simple ratio of the
dollar loss for a time period divided by the dollar amount of defaults
for that time period. In other words, loss severity is that portion of
the default amount not recovered.

[Why isn't monthly return on average assets sufficient?]{.underline}

Static pool analysis keeps the focus on the expected return to maturity.
The month-to-month performance of a small pool of loans may vary
dramatically, with some months with a low or negative return on average
assets, and other months with a high return. These monthly fluctuations
do not provide the long-term perspective available through static pool
analysis.

In addition, monthly return on average assets will not highlight the
return on separate pools of loans. When new loans continue to be added
to a balance sheet, the initial performance of the new loans can mask
the performance of the older loans.

[What data is needed for static pool analysis?]{.underline}

Static pool analysis is based on the actual cash flows of a pool of
loans. All cash outflows and cash inflows associated with the pool of
loans should be recorded. Recording cash flows in the month of
occurrence generally should provide sufficient accuracy for evaluating
loan performance.

*Examples of Cash Outflows:*

Amount of loans

Origination fees to third parties (including any insurance premium)

Servicing fees

Repossession/reconditioning/remarketing expenses

Other costs paid to administer a program[^5]

*Examples of Cash Inflows:*

Regularly scheduled loan payments (interest and scheduled principal
repayments)

Prepayments of principal (e.g., as a result of cash payoff, trade-in, or
refinancing)

Proceeds of repossession sales

Insurance recoveries (e.g., skip insurance, lien holder's credit
insurance)

Rebates received

**Static pool data also includes reductions of principal because of
default write-offs or bankruptcy reductions, which do not entail cash
flow.** This loss data is used in preparing prepayment rates, default
proportions, and loss severities.

Static pool data should include at least 24 months of history, at a
minimum.[^6] However, some view even 36 months of data as insufficient,
since the amount of pool experience necessary for a meaningful
evaluation of trends varies by asset type.[^7] SEC rules for
asset-backed securities require disclosure of information, to the extent
material, for a minimum of five years.[^8]

Delinquency data, another non-cash item, can be useful in trend spotting
and forecasting future defaults. Thus, it is helpful if static pool data
also includes delinquency data.

[How is static pool data reported?]{.underline}

Static pool data is generally displayed in columns and rows. Each row
represents one static pool (for example, one month of loan
originations). Each column represents one month of performance. Data can
be presented in dollars in one table, and percentages in another.
Monthly (that is, periodic or non-cumulative) and cumulative performance
statistics can be presented in tables.

[What static pool data is tracked by most institutional
investors?]{.underline}

Useful static pool data includes delinquencies, defaults, gross losses,
net losses, and actual prepayment amounts and rates. Examples of static
pool data for asset-backed securities, disclosed under SEC Regulation
AB, are available by searching the web for static pool data.

Most investors in asset-backed securities track cumulative credit loss
rates throughout the duration of the pool of loans. This is a key factor
in monitoring credit exposure of the asset-backed security versus the
available credit enhancements (i.e., the loss mitigators such as
insurance).

Lenders may benefit from graphing cumulative credit loss experience over
time. This is often referred to as a "credit loss curve." Credit loss
data can be stratified and analyzed by almost any characteristic.
Lenders can use static pool data to identify opportunities for
improvement in underwriting. For example, by tracking delinquencies and
losses by car dealer, credit unions can identify weak originators.

[Should examiners expect to see credit unions work cooperatively to
prepare an analysis?]{.underline}

When considering purchase of loans from a common originator, credit
unions should consider combining their efforts in performing static pool
analysis. Credit unions should be able to demonstrate a reasonable basis
to rely upon static pool data from another credit union or vendor in
evaluating their own loans.

[Should examiners expect credit unions to use all available
data?]{.underline}

Static pool analysis should include all of an originator's data that is
available, reasonably reliable, and relevant. Caution is warranted if
analysis is based on incomplete or select data unless the originator can
demonstrate the excluded data is not relevant to the loans under
consideration.

[How do credit unions make assumptions about future
performance?]{.underline}

Credit unions should use historical performance as part of the basis to
project future payments and recoveries. Historical performance includes
the actual payments, delinquencies, defaults, and recoveries. We
recognize there will be judgment involved in making assumptions about
future performance. Credit unions should document and disclose
assumptions they make.

[How can credit unions estimate historic prepayment rates?]{.underline}

When credit unions do not have actual prepayment data, management can
estimate historical prepayment speeds using the NCUA Prepayment Model,
embedded below. The spreadsheet computes an estimate of prepayments by
approximating the scheduled principal payment each month.

When making CPR calculations using the NCUA Prepayment Model, credit
unions should start with a fully formed static pool. If loans are still
being added to the pool, the spreadsheet will compute a negative CPR.
Negative CPRs don't make sense for most vehicle loan pools, since the
balance on an individual loan that is performing should be declining
each month. However, examiners may see a negative CPR in the first month
of a fully formed pool, as a result of scheduled delays in first
payments on loans.

The NCUA Prepayment Model computes estimates of historic average CPRs
for different time periods, such as one month, three months, six months,
and twelve months. If credit unions observe patterns in prepayment rates
over different time periods as loans age, they can use this information
in projecting future performance. The NCUA Yield Model, discussed below,
can accept different CPRs for each month.

When using the NCUA Yield Model, the yield on a pool of loans purchased
at a premium over a period that is longer than one month will not be
accurate if negative CPRs are used to simulate multi-month periods. This
is because the model will use the purchase premium only for loans
acquired initially. The negative CPR will compute an addition to the
principal balance after the initial acquisition, but the model will not
include a purchase premium on the additional loans. Credit unions must
modify the model to input premium paid on loans acquired after the
initial input.

[Example Computation of Prepayment]{.underline}

The embedded NCUA Prepayment Model, in an Excel™ workbook, below
provides an example computation of CPR based on the outstanding balance
at the beginning of each month. Simplifying assumptions are noted on the
first sheet, along with a summary. For illustrative purposes, the sample
workbook contains fictional data.

![](media/image1.wmf)

[What factors should examiners expect credit unions to consider when
projecting performance?]{.underline}

Macroeconomic variables can affect future performance. Credit unions
should consider the economic environment during the static pool period.
When forecasting future performance, management should consider whether
the economic environment is likely to change. For example, rising
unemployment may be positively correlated with rising delinquencies and
defaults. Thus, credit unions should use a range of assumptions about
future performance to compute a range of estimated returns.

Another approach to assessing sensitivity is to set an absolute level of
change in one or more assumptions. For example, one way to vary the
inputs for portfolio statistics is to increase CPR (both up and down) by
a factor of 50 percent.

Alternatively, management may be interested in how high CPR (or other
variables) must increase before the Bond Equivalent Yield (BEY)[^9] will
fall below a desired minimum return.

[What is the NCUA Yield Model?]{.underline}

The NCUA Yield Model is an Excel™ spreadsheet that contains multiple
Tabs that are designed to follow a logical pattern of completing a
Static Pool Analysis. See Tab 1 in the NCUA Yield Model for a graphical
overview of the NCUA Yield Model.

Before using the NCUA Yield Model, individuals should have a clear
understanding of a few terms and how they are used in the model:

-   Weighted-Average Coupon (WAC) is the arithmetic mean
    (dollar-weighted) of the coupon rate of the underlying loans in a
    pool. See Tab 2 in the NCUA Yield Model for a sample calculation of
    WAC for a pool of loans.

-   Weighted Average Maturity (WAM) applies the same concept of
    "weighting" to the maturity of a loan pool based on the maturity of
    the individual loans in the pool. See Tab 3 in the NCUA Yield Model
    for a sample calculation of WAM for a pool of loans.

-   Single Monthly Mortality (SMM) is a measure of the prepayment rate
    of a loan pool. Important Note: The NCUA Yield Model uses the term
    "prepayment" to describe any unexpected reductions of principal in
    the loan pool. This includes defaults or early payoffs. As the name
    implies, the pool is "dying-off" faster than scheduled. In order to
    calculate a SMM for a given historical period, there must be
    associated prepayment for that period -- no prepayment, no SMM. See
    the NCUA Prepayment Model for a sample calculation of SMM for a pool
    of loans.

-   Constant Prepayment Rate (CPR) is essentially an annualized
    representation of the SMM. CPR is used to measure the prepayment
    rate at which a loan is expected to repay (ahead of schedule),
    expressed as an annual percentage of the remaining loan balance. See
    the NCUA Prepayment Model for a sample calculation of a CPR for a
    pool of loans.

-   Default Proportion represents the part of prepayments resulting from
    defaults. So as prepayments are received, the portion associated
    with defaults should be tracked and maintained. Default proportion
    is computed as the dollars in defaults for a period of time divided
    by the total prepayments for that same time period.

-   Loss Severity is the ultimate loss of a defaulted loan after any
    funds from the sale of collateral or insurance proceeds are applied
    to the loan balance. Loss of principal can result from any
    uncollected principal or bankruptcy reductions of principal. Loss
    severity is computed by dividing the dollar loss for a time period
    by the dollar amount of defaults for that same time period.

-   Bond Equivalent Yield is a measure of the return over the life of a
    pool of loans. This method of measuring yield is used in the NCUA
    Yield Model. It allows the yield of different "investments" with
    different payment frequencies to be compared equally on a
    semi-annual basis.

[What assumptions are in the NCUA Yield Model?]{.underline}

The NCUA Yield Model gives examiners a simple tool to review and test
credit union assumptions and yield calculations. Examiners should be
aware of some simplifying assumptions in the model that impacts its
accuracy. These assumptions can be modified by any user of the model,
since the workbook is not password protected.

*Assumption Regarding Weighted Average Coupon (WAC)*

Once the initial weighted average coupon is calculated, the NCUA
modeling process assumes the WAC remains constant throughout the life of
the pool. Ideally, the actual interest cash flows from the historical
period will be used to compute yield. If historical cash flows are not
available, the NCUA Yield Model estimates the interest cash flows using
the input WAC. If the coupon rates on the loans in the pool vary, the
model's estimated interest may not be very accurate, since prepayments
will cause the actual WAC to change. When the coupons vary
substantially, credit unions should be encouraged to use actual interest
cash flows in computing yield. On the other hand, if the coupon rates
for the loans in the pool are relatively close together, then using the
initial WAC is acceptable.

The NCUA Yield Model uses the WAC to estimate scheduled principal
reductions.

*Assumption Regarding Weighted Average Maturity (WAM)*

Once the initial weighted average maturity is calculated and input for a
given pool of loans, the NCUA Yield Model assumes that the WAM declines
by one month each month. For example, if the original WAM is 66 months,
after one month the model will assume the remaining WAM is 65 months.
Ideally, the actual remaining WAM will be used to compute estimated
future cash flows. When the remaining WAM varies from the original WAM
significantly, the model will not produce accurate estimates of future
cash flows. On the other hand, if the maturity dates for the loans in
the pool are relatively close together, then using the actual remaining
WAM is not necessary.

The NCUA Yield Model also uses the WAM to estimate scheduled principal
reductions.

*Assumption Regarding Estimated Scheduled Principal Reduction*

The NCUA Prepayment Model and the NCUA Yield Model assume that the
scheduled principal payment for each loan in the pool is based on the
WAM of the entire pool, and not the actual maturity of each individual
loan in the pool. For example, if there are two loans in a pool, one
with a five year maturity and one with a six year maturity, and the WAM
is 5.5 years, the NCUA Yield Model will compute scheduled principal so
the loans payoff in 5.5 years.

It is not appropriate to use the scheduled principal for all loans to
override the estimated scheduled principal amounts. When projecting
future principal payments, the NCUA Yield Model uses the prepayment
rates to reduce the principal outstanding. The contractual scheduled
principal amounts will not reflect the projected prepayments.

*Assumption Regarding Estimated Interest Cash Flows*

The NCUA Yield Model assumes all the interest is paid if the principal
is outstanding until the date of default. This assumption will overstate
the yield. For the historical period, it is better to use the actual
historical interest cash flows to calculate yield.

Use of accounting interest accruals to estimate interest cash flows will
also tend to overstate the yield. Accounting accruals that recognize
interest in earlier periods and reverse the interest when the loan is
deemed in default will cause this overstated yield.

[How do credit unions compute the yield on a matured pool of
loans?]{.underline}

Here are the steps in performing simple static pool analysis on a pool
of matured loans using the NCUA Yield Model:[^10]

1.  Gather a sample of loans issued in the past (a month, quarter or
    year), along with reliable data about the source, timing and amounts
    of actual cash flows. It is easiest to perform this analysis on
    loans originated in a single month.

2.  Compute historic prepayment speeds. If the actual prepayment data is
    not available, use the NCUA Prepayment Model to estimate historical
    CPR. The static pool data needed for this step is the ending
    principal balance of the loans each month, the weighted average
    coupon, and the weighted average maturity.

3.  Determine default proportion based on static pool data. The default
    proportion is the loan balance in default as a percentage of the
    loan prepayments.

4.  Determine loss severity based on static pool data. The loss severity
    is the principal balance not recovered as a percentage of the loan
    balance in default.

5.  Input each of these performance statistics into the NCUA Yield
    Model, along with other characteristics (servicing fee, other costs)
    to compute the bond-equivalent yield (BEY).

6.  Vary the inputs for the performance statistics to determine how
    sensitive the BEY is to changes in the variables.

[How do credit unions compute the expected yield on a pool of active
loans?]{.underline}

Here are the steps in performing simple static pool analysis on a pool
of loans that have not matured (same as above, with ***[extra
steps]{.underline}*** *noted*), using the NCUA Yield Model:

1.  Gather a sample of loans issued in the past (a month, quarter or
    year), along with reliable data about the source, timing and amounts
    of actual cash flows. It is easiest to perform this analysis on
    loans originated in a single month.

2.  Compute historic prepayment speeds. If the actual prepayment data is
    not available, use the NCUA Prepayment Model to estimate historical
    CPR. The static pool data needed for this step is the ending
    principal balance of the loans each month, the weighted average
    coupon, and the weighted average maturity.

3.  Determine default proportion based on static pool performance. The
    default proportion is the loan balance in default as a percentage of
    the loan prepayments. ***[Extra step]{.underline}***: *Since not all
    loans have matured, determine a consistent way to categorize loans
    as "default" (that is, defaulted already or likely to default). For
    example, all defaulted loans and all loans over 90 days past due
    could be added.*

4.  Determine loss severity based on static pool performance. The loss
    severity is the principal balance not recovered as a percentage of
    the loan balance in default. ***[Extra step]{.underline}***: *Since
    all loans in the default category have not been fully processed
    (repossessed, resold, and any insurance recovery received),
    determine a consistent way to estimate the percentage of loans in
    default that will not be recovered. For example, apply the loss
    severity from a matured portfolio to the loans in process of
    collection.*

5.  ***[Extra step:]{.underline}*** *Use each of these performance
    statistics, along with performance statistics from matured loan
    portfolios, to project expected CPR, default proportion, and loss
    severity to maturity.*

6.  Input each of these performance statistics *(**[extra
    step]{.underline}***: *as well as* *the projected statistics)* into
    the NCUA Yield Model, along with other characteristics (servicing
    fee, other costs) to compute the bond equivalent yield (BEY).[^11]

7.  Vary the inputs for the performance statistics to determine how
    sensitive the BEY is to changes in the variables.

[What is the exact yield to maturity on a pool of loans?]{.underline}

Because there is uncertainty about future cash flows before all loans in
a pool have matured, an exact yield cannot be calculated. A range of
expected returns by varying the inputs should be calculated. The NCUA
Yield Model allows both actual cash flows and projections of future
payments and recoveries to calculate BEY.

The exact portfolio yield for a pool of matured loans is calculated as
the internal rate of return, using all the actual cash flows. The NCUA
Yield Model simplifies the process, using a number of assumptions likely
to overstate the actual BEY. For example, the model assumes all loans
with principal outstanding make timely payment of principal and
interest. This means each borrower is modeled to make all principal and
interest payments up to the time of default. Since defaults may not be
recognized for a period of a couple months, the model overstates the
interest income and, therefore, overstates the expected yield.

[NCUA Yield Model]{.underline}

Embedded below is a version of the NCUA Yield Model that permits time
varying inputs for prepayments, default proportion, and loss severity.

![](media/image2.wmf)

**Conclusion**

Static pool analysis is a useful tool to enable credit union managers to
make informed decisions regarding lending programs based on actual and
expected performance of the loans. The process discussed in this paper
is one method for examiners to review such an analysis. Examiners are
not expected to complete this model for credit unions, but can use it to
vary assumptions as deemed necessary to validate assumptions made by
credit unions.

This tool is not intended to replace management's due diligence, but is
meant to augment existing practices. Use of this model by a credit union
does not in and of itself constitute successful due diligence of static
pool analysis referenced in the Risk Alert. Examiner staff with
questions about this paper or using the model should contact their
regional office.

[^1]: A "matured pool" means a pool of loans with all loans having
    reached maturity, and all cash flows associated with the particular
    pool are known.

[^2]: The internal rate of return (IRR) is the interest rate received
    for an investment consisting of payments and income that occur at
    regular periods.

[^3]: See, Securities and Exchange Commission (SEC) Release No. 33-8518,
    "Asset-Backed Securities" (Dec. 2, 2004) \[70 FR 1506, at 1540 (Jan.
    7, 2005)\].

[^4]: When a static pool is "fully formed," no additional loans are
    added to the pool.

[^5]: Other costs may include any expenses incurred to administer the
    loan program (e.g., data processing costs, consulting fees, or
    additional staff).

[^6]: NCUA Risk Alert No. 05-RISK-01 (June 2005), at 4.

[^7]: SEC Asset-Backed Securities, at 1540, referencing comments of the
    American Securitization Forum, of the Bond Market Association, and
    the Metropolitan Life Insurance Company.

[^8]: See SEC Regulation AB, 17 CFR 229.1105(a)(3)(i).

[^9]: A measure of the return over the life of an investment or loan,
    assuming the return is computed using a semi-annual interest formula
    and an actual day year. We use bond-equivalent yield to make
    comparisons between different investments using a consistent measure
    of return.

[^10]: Of course, if credit unions have the data available, they should
    compute the actual yield on a pool of matured loans by calculating
    the internal rate of return on all of the actual cash flows.

[^11]: The NCUA Yield Model computes both the monthly yield and the BEY.
    BEY, based on semi-annual compounding, can be directly compared to
    bond-equivalent yields on investments.