Credit unions looking to expand their lending base have shown a tendency to accept greater risks in their lending and investment practices. the American Institute of Certified Public Accountants warns, including a leaning toward derivatives.

Like many other financial institutions, credit unions have gotten increasingly involved with derivatives, mostly mortgage-backed derivatives--complex nontraditional financial instruments that may involve a substantial risk of loss. For example, some credit unions have been experiencing large losses on interest-only and principal-only mortgage-backed derivative strips because of record mortgage refinancings of the past 18 months.

"Users and issuers of such instruments must have the expertise necessary to understand and manage the related risks," cautions the AICPA.

"Accounting for derivatives is complex" it said. "Given the instant innovation and complexity of derivatives, accounting literature does not explicitly cover some derivatives." However, the Financial Accounting Standards Board is working to expand standards in this area.

For some, that comes too late. Today Credit Union, a Sysott, N.Y.-based institution, experienced a loss of more than $1 million as a result of prepayments that evaporated its interest-only investments, forcing it to merge with nearby Nassau County CU.

Credit unions became limited in their derivative investment options after a three-part collateralized mortgage obligation suitability test was passed last year. Interest-only and principal-only strips can now only be used as hedges.

The continued slowdown in lending nationwide, coupled with increased competition from nonfinancial institution players, such as car finance companies and corporate credit card issuers, has prompted many credit unions to extend lending into other territories as well.

Regulatory concerns about credit concentrations, especially in real estate. have led some credit unions to search for new credit markets. Some credit unions, for example, have hooked up with car dealers to boost their share of the auto loan market.

"Some credit unions have attempted to increase yields by increasing the risk they are willing to accept, for example, adopting more lenient lending policies that may include business lending, investing in new and complex financial instruments and the funding of longer-term assets with shorter-term liabilities," noted the institute.

"The various risks associated with these actions may be significant, and auditors should be alert to changes in loan and investment policies and to the effect of those changes on audit risk." suggests the AICPA.

"The subjectivity of determining loan loss allowances, continued economic uncertainty and intense regulatory scrutiny, reinforces the need for careful planning and execution of audit procedures in this era."

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