Kennedy School of Government CR16-02-1674.

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Phenix Federal Credit Union:

Budgeting and Performance Evaluation

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I. Introduction

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In December 1998, the Board of the Atlanta, Georgia-based Phenix Federal Credit Union
(Phenix) was conducting its quarterly review of interest rates and finalizing its annual budget for
1999. As in other credit unions, the Board, rather than management, was responsible for setting
loan and deposit rates as well as fee policies. Carita Womack, Chair of the Board, reviewed the
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detailed budget plan prepared by the CEO, Carl Massey. She and the other members of the Board
were particularly concerned about a contraction in loans over the last two years and about
increases in operating costs. The Board was now meeting to approve the annual budget and was
considering changing rates and fees in order to improve the financial performance of this $29
million financial institution.

The Board was seeking to balance two constituencies: long-time and new members. Its
long-time members were government employees, who were mostly older. These members favored
high deposit rates and appreciated the personalized service offered by branch personnel. Newer
members were younger. They were more likely to borrow; thus, they favored low loan rates. They
also preferred the convenience of ATMs and Web banking to the teller services provided at the
branches.

This case was written by Professors Elizabeth Keating, Assistant Professor of Public Policy, John F. Kennedy School of
Government, Harvard University, and Donald P. Cram as a basis for class discussion rather than to illustrate effective
or ineffective handling of an administrative situation. The writing of this case was supported by an Massachusetts
Institute of Technology Sloan course development grant. This case is to be accompanied by an Excel spreadsheet,
1674_0.xls, that contains Phenix’s financial statements. (1002)

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Phenix’s History

Phenix Federal Credit Union was established in 1948 to serve government employees, as
well as their immediate families, who worked in regional offices of various federal agencies. In the
1980s, the federal credit union regulator, National Credit Union Administration (NCUA),
permitted federally chartered credit unions to expand by accepting additional selected employee
groups (SEGs). Each SEG was composed of employees of the same firm. Over time, Phenix came to
serve selected groups of federal employees in Atlanta and Birmingham, Alabama, as well as
employees of about 100 small businesses in the Atlanta area.

In late 1996, Phenix took over a smaller credit union, Employees Savings and Credit

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Association (ESCA). ESCA was a $4.2 million state-chartered credit union, the company sponsor of

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which was in the process of being acquired. Phenix benefited from the merger by acquiring a
branch office in a growing suburb and by achieving some economies of scale. The neighborhood
surrounding the former ESCA branch was thriving, with many new businesses, and both former
Phenix and former ESCA members were actively using the branch. The Board viewed the
employees working at the new businesses as potentially attractive new SEGs. In addition, the
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market value of the branch (which was now owned by Phenix) increased markedly over the next
several years.

Having just celebrated its 50th anniversary, the Phenix staff and Board were optimistic
about the institution’s future. The Atlanta-based credit union now served over 12,000 members
through four branch offices and four ATM cash-dispensing machines. It employed a staff of 23
full-time and 2 part-time employees. In early 1998, it hired a new marketing manager, who
developed a business plan to expand the credit union’s membership and loan base.

Phenix’s Philosophy: “Not-for-Profit, Not for Charity, But for Service”

Phenix’s philosophy was modeled on the credit union industry motto, “not-for-profit, not
for charity, but for service.” The U.S. credit union movement started in New England in 1909,
based upon a philosophy of self-help and cooperation. The primary goal of the movement was “to
make more available to people of small means credit for provident purposes.”1 Prior to the creation
of credit unions, it was difficult to obtain consumer credit. Credit unions served members by
specializing in short-term personal loans, such as car loans. Over time, credit unions, including
Phenix, increasingly offered first and second mortgages. Eventually, commercial banks and thrifts
began to offer consumer loans, until commercial banks, thrifts, and credit unions offered similar
loan and deposit products.

1
Federal Credit Union Act (1934) as amended on March 31, 1982.

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

While the products were similar, the pricing and service orientation of Phenix and its
fellow credit unions differed from that of commercial banks. Credit unions prided themselves on
their reputation for treating their “members” (depositors and borrowers) with respect and
providing personal service. Since credit unions were cooperative organizations, the members were
actually the owners. Credit unions paid their members a financial return through lower rates on
loans and higher “dividends on shares” (comparable to interest on deposits). Most credit unions
charged relatively modest service fees in comparison to banks. Finally, credit unions were
governed by people elected exclusively from the membership. Their stewardship role was
highlighted by the Board’s non-delegable tasks, which included approving new members, hiring
and compensating the CEO, and determining rates on loans and dividends on shares (deposits).

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The Credit Union Industry: Field of Membership

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The ability of a credit union to grow was constrained by its “field of membership.” The
goal of federally chartered credit unions, like Phenix, was to serve individuals with a “common
bond,” such as occupation, association, or residential affiliation. The predominant premise of
credit unions was occupational, with members working for a common employer, such as a
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company or government agency. For example, to have had a deposit or borrowing relationship
with Phenix, a person must have been employed by a federal government agency or a firm that
was one of Phenix’s SEGs. The Phenix core members consisted of government employees working
in Atlanta-based regional offices of several federal agencies.

One benefit for Phenix of the SEGs admitted in the 1980s and the ESCA merger was an
influx of younger members with borrowing needs. Although credit unions were prohibited from
adding new SEGs in the 1995-6 period pending the outcome of a Supreme Court case, Congress
soon after enacted legislation permitting federal credit unions to add SEGs comprised of 3,000 or
fewer members. Accordingly, in the late 1990’s Phenix was again preparing to market its services
to prospective SEGs in the Atlanta vicinity.

II. Phenix’s Financial Situation

In the early 1990s, Phenix suffered some financial difficulties arising from poor
bookkeeping practices, slow loan processing, and substantial loan defaults. In order to restore
profitability and rebuild the capital base, the Board canceled dividends on shares (equivalent to
not paying interest on checking and savings accounts) for several months in late 1991. The
dividend cut resulted in a number of long-time members closing their accounts. Total assets
declined almost 5%, from $22.9 million at year-end 1991 to $21.8 million as of June 30, 1992. A new
President/CEO, Carl Massey, recruited during 1992, turned around the operations with the active
involvement of the Board. The ratio of delinquent loans to total loans fell from over 3% at year-end

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

1991 to 1.20% by mid-year 1992. Loan applications, which once took two weeks to process, were
given same-day review.

In the mid-1990s, Phenix operated profitably and grew substantially. However, in 1996,
the credit union began exhibiting new problems. Phenix discovered that its 1996 merger partner,
ESCA, had understated its problem loans. As a result, the number of delinquent loans climbed in
late 1996, and substantial charge-offs were incurred in 1996, 1997, and 1998. Table 1 depicts the
health of Phenix’s loan portfolio.

Table 1. Phenix Loan Portfolio Quality, 1993-1998

12/93 12/94 12/95 12/96 12/97 6/98
Total Number of Loans in Bankruptcy 10 16 13 31 22 21

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Total Number of Loans 2,951 4,069 4,231 4,621 4,548 3,617

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As % of Total Loans Made 0.34% 0.39% 0.31% 0.67% 0.48% 0.58%
Total Amount of Loans in Bankruptcy (in
thousands) $ 72 60 13 137 112 101
Total Amount of Loans (in thousands) $15,442 17,445 18,304 20,325 20,103 20,023
As % of Total Loans 0.47% 0.34% 0.07% 0.67% 0.56% 0.50%
Delinquent Loans/TL 0.83% 0.60% 0.79% 1.66% 1.22% 1.64%
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Net Charge-offs/ TL 0.23% 0.39% 0.19% 0.94% 0.80% 1.18%*

* Annualized

In addition to the loan quality concerns, Phenix was forced to relocate unexpectedly. The
project entailed moving the main branch from the lobby of one government building into a central
corridor of the new “Federal Center,” a major United States government office complex in Atlanta.
The administrative offices were also relocated to another nearby location in late 1997. Moving had
not been anticipated, and it substantially increased 1997 and 1998 operating expenses. As was the
case with the old main branch, the new location was provided rent-free by the U.S. government;
however, Phenix now paid market rent on its administrative offices.

The new main branch location put Phenix in more direct competition with the $221 million
state-chartered Associated & Federal Employees Credit Union, which operated a branch on the
same corridor. Traditionally, credit unions have avoided competition among themselves by having
non-overlapping fields of memberships. The State of Georgia, however, had granted a license to
Associated and Federal Employees with a field of membership that overlapped with 25% of
Phenix’s membership.

Phenix’s Budgeting Process

Phenix engaged in an extensive and formal budgeting process. This commenced each
September with a Board planning session. During this session, the Board and CEO discussed
trends in the credit union industry, reviewed financial projections for the current year, and set

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

corporate goals for the coming year. The CEO then took the financial targets and developed a
conservative budget with monthly income statements and balance sheets. In December, the budget
was presented to the Board for discussion and approval.

At the September 1998 meeting, the Board and CEO set financial targets for the next five
years. The planning process also produced the following non-financial goals: to complete Y2K
compliance, to evaluate the feasibility of a new branch office in downtown Atlanta, to install two
new ATMs, to provide more home banking services via the Internet, to consider offering shared
branching services at one branch, to expand the membership base, to provide members with more
marketing and educational services, and to develop a technology plan.

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Setting Target Financial Ratios

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Table 2 compares the financial targets set for the current budget to those of the previous
year and actual performance, if available.
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Table 2. Financial Ratio Targets

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Actual Jan.-Sep. Budget Budget

Financial Targets 1997 1998 1998 1999-2003
Key Goals:
Total Operating Expenses Less Loan
Loss Provision/ Total Assets* 6.54% 6.89% 6.00% 6.25%
Capital/Total Assets # ** 12.40% 13.05% 12.00% 12.00%
Annual Asset Growth 1.03% 1.98% 7-8.00% 5.00%
Delinquent Loans/TL # 1.22% 1.28%* 1.00% 1.00%
Charge-offs/Total Loans# 0.79% 0.77%* 0.75% 0.75%
Other Budget Objectives:
Return on Average Assets # 0.59% 0.11% 1.50% 0.65%
Total Loans/Total Shares 86.3% 86.2% 89% 85%
Total Shares/Total Assets 85.4% 85.5% 86.5% 85.5%
*Annualized
**Capital is defined as the loan loss allowance, regular reserves, and undivided earnings
# a key ratio used to determine a credit union’s CAMEL rating

Several financial ratios in Table 2 were selected to coincide with regulatory requirements.
Credit unions were rated according to Capitalization, Asset quality, Management, Earnings, and
Liquidity (CAMEL) ratings developed by the federal credit union regulator. Four of the target
financial ratios (capital/assets, delinquent loans/total loans, charge-offs/total loans, and return on
average assets) were relied upon to determine the C, A, and E components of the CAMEL rating.
Table 3 provides the cut-off points of key ratios for credit unions with $10 million to $50 million, as
announced by the NCUA in 1994. While the single overall CAMEL ratings were not publicly
disclosed, NCUA examiners were known for setting these as a conservative function of component
ratings.

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Table 3. CAMEL Ratings for Credit Unions with $10-50 million in assets
CAMEL 1-2 CAMEL 2-3 CAMEL 3-4 CAMEL 4-5
C- Capital/Assets* 8.00% 6.00% 3.00% 1.00%
A – Delinquent Loans/Total Loans 1.25% 2.50% 3.50% 5.50%
A –Net Charge-offs/Average Loans 0.25% 0.75% 1.50% 2.00%
E –Return on Average Assets 1.00% 0.80% 0.35% 0.20%
*Capital includes the loan loss allowance, regular reserves, and undivided earnings.

One key CAMEL ratio, return on average assets (ROAA), was not used as a target goal by
Phenix in its 1998 budget. Unlike publicly traded firms, credit unions did not focus on profitability,
but rather sought to deliver member benefits, such as low loan rates, high dividend rates, low fees,
and high quality service. ROAA for credit unions was computed after dividends on shares were
calculated. These dividends could be considered partially deposit interest and partially a return on

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members’ investment. As credit unions could build their equity only through retained earnings,

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ROAA could be viewed as a capital rather than an earnings measure; i.e., at what pace the credit
union was building its equity. By building equity and distributing fewer benefits, a credit union
could invest more in providing customer service and offer greater benefits to members in the
future. Since Phenix’s equity base was strong, the importance of ROAA was being downplayed.
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At Phenix, supplemental target ratios were added based on CEO Massey’s experience in
managing credit unions. Massey found that the net operating expense ratio was closely related to
whether a credit union operated profitably. Specifically, a credit union with a 6% operating ratio or
lower generally operated profitably. He also observed the importance of maintaining a high
loan/share ratio, as it indicated whether the credit union was serving its borrowers and showed
that shares were invested in loans, rather than lower-yield investments. The asset growth ratio
helped focus management’s attention on the need to market services to existing members as well
as expand the membership base.

Developing the Projected Income Statement and Balance Sheet

The CEO created the projected monthly balance sheet by relying on the financial targets to
determine total assets, total loans, delinquent loans, and shares. He first computed total assets.
Shares were computed based on the share/asset ratio, while loans were determined by applying
the projected loan/share ratio. Investments were viewed as a liquidity buffer, dropping if loans
expand relative to total assets and expanding if loan growth is slower. The loan loss allowance was
generally held as a constant fraction of total loans. Depreciation was set at historical amounts. A
number of other factors, such as cash, were determined by common-sizing the balance sheet; i.e.,
taking the ratio of the account to total assets and applying that ratio to the projected year-end total
assets. Dividends were declared quarterly and payable in the following quarter. Accounts payable
was set based on the need to keep the accounting equation in balance. Net income for the year was
reflected by an increase in undivided earnings on the balance sheet.

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Once the balance sheet was prepared, then the CEO developed the projected income
statement. The interest and investment income were computed using the lower of a five-month
average yield or the current month’s yield multiplied by month-end loan and investment balances,
respectively. Dividends on shares (comparable to interest on deposits) were computed by taking
the higher of current month’s yield or the five-month average multiplied by the month-end total
shares.

The compensation numbers were developed based on a detailed schedule that included all
job positions (including vacancies) and current salaries. The forecasted numbers were based upon
a cost of living increase for all employees and additional raises based on performance. In addition,
employee benefits were 18% of total compensation. Finally, a performance bonus of about 3% of

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net income was budgeted. Many operating expense items were computed by determining the ratio

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of the actual current year operating expense/total assets and then applying that ratio to projected
total assets (after correcting for any unusual expenses). The loan loss provision was determined by
the increase in the loan loss allowance over the year plus the targeted amount of charge-offs.

The 1999 Budget Situation

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To prepare the 1999 budget, the CEO collected recent actual financial performance data as
well as the 1998 budget information in Appendix A. He stated assumptions for use in the
proposed 1999 budget in Appendix B.

An analysis of the Phenix revenue and cost structure revealed that most of its operating
costs were relatively fixed. From an activity-based costing perspective, the supply exceeded the
usage of resources. The office move created unexpected one-time office operating and occupancy
expenses in 1997. Massey expected 1999 occupancy expenses to remain unchanged from 1998,
since the new administrative offices increased the ongoing office operating and occupancy
expenses. He expected compensation to increase by a cost-of-living increase of 1.3% plus $26,000
for the hiring of one new full-time and one new part-time employee. To cut costs, he considered
cutting travel and conference expenses substantially.

In addition to operating expenses, a key budget area was the pricing of deposits, loans,
and fees. The current yields were as follows:

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Table 4. Current Yield Data

5 Month Average Current Month
Loans 10.34% 10.30%
Investments 5.48% 5.99%
Late Charges/Total Loans .0142% .0154%
Other Fee Income/Total Assets 2.02% 2.29%
Dividends/Average Assets 2.95%*
*9 month average for 1998

Massey then submitted a proposed 1999 annual budget (Appendix C) to the Board for
approval.

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III. Products and Services

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Deposit Services: As with all credit unions, dividends on shares (i.e., deposit interest) at
Phenix were subject to available earnings. Deposits were federally insured up to $100,000 by the
National Credit Union Share Insurance Fund operated by the NCUA. In order to join the credit
union, Phenix required that members open a regular share account for at least five dollars. The
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minimum initial deposit for a money market account was $1,000. Recent share balances and
dividend rates are listed in Table 5, with comparable data for a larger local credit union,
Associated and Federal Employees, presented in Table 6.

Table 5. Phenix Share Balances and Dividend Rates

6/30/97 12/31/97 6/30/98 6/30/97 12/31/97 6/30/98
Account Type APR APR APR $ Balance $ Balance $ Balance
Share Drafts* (Checking) 0% 0% 0% $ 3,144,055 $ 3,088,082 $ 3,280,634
Reg. Shares** (Savings) 3.00% 3.00% 3.00% 10,710,713 10,001,137 11,091,201
IRA Accounts 3.25% 3.25% 3.25% 623,564 1,717,446 1,565,042
Money Market Shares 3.25% 3.25% 3.75% 1,171,455 1,085,385 1,412,375
Share CD- 3-9 Mth 5.96% 5.94% 5.77% 1,177,472 2,059,864 1,827,851
Share CD- 12-36 Mth NA NA NA 6,000,870 4,566,501 4,372,522
Share CD- 36-60 Mth NA 6.05% 6.05% 742,947 780,519 1,029,085
Total $ 23,571,076 $ 23,298,934 $ 24,578,710
* on average monthly balance of $500 and over
** on average monthly balance of $100 and over

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Table 6. Associated and Federal Employees Share Balances and Dividend Rates
6/30/97 12/31/97 6/30/98 6/30/97 12/31/97 6/30/98
Account Type APR APR APR $ Balance $ Balance $ Balance
Share Drafts* (Checking) 3.25% 3.25% 3.25% $ 62,944,503 $ 77,752,363 $ 83,406,140
Reg. Shares** (Savings) 3.50% 3.50% 3.25% 113,773,844 140,610,495 149,233,788
IRA Accounts 3.50% 3.50% 3.50% 39,551,841 43,524,509 43,163,136
Money Market Shares NA NA NA NA NA NA
All Other Shares NA NA 3.25% 44,590,219 52,118,256 52,894,779
Share CD- 3-9 Mth 5.78% 5.65% 5.77% 47,045,549 62,960,478 64,288,667
Share CD- 12-36 Mth NA NA NA 13,270,437 15,582,656 17,397,191
Share CD- 36-60 Mth NA NA NA 8,630,286 9,741,596 10,593,260
Total $ 329,806,679 $ 402,290,353 $ 420,976,961

Dividends on regular shares, share drafts, and IRAs were set quarterly by the board.

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Phenix maintained dividends on share draft and regular shares at 0% and 3%, respectively, for

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many years. The money market and CD rates were adjusted more frequently to respond to
changing market conditions. The Board generally sought to keep these rates at 25 basis points
above the rates offered by banks in the Atlanta area. In late 1997 and 1998, members shifted their
deposits away from the interest-free share draft accounts and low-paying regular shares into
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money market and CDs with maturities over three years. The rates for other banking institutions
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are shown in Table 7.

Table 7. Comparative Dividend Rates at 6/30/98
Account Type Phenix Associated Nationsbank SunTrust Wachovia Atlanta Avg.
Share Drafts* (Checking) 0% 3.25% 0.75% 0.75% 0.75% 2.22%
Money Market Shares 3.75% NA 2.40% 2.00% 2.00% 3.10%
Share CD- 3-9 Mth NA 5.77% 4.60-4.90% 4.17-4.85% 3.90-4.85% 4.59-5.39%
Share CD- 12-36 Mth 6.05% NA 4.95-5.15% 4.95% 5.00-5.10% 5.60%
Share CD- 36-60 Mth NA NA 5.35% 5.05% 5.25% 5.77%

Loan Services

While shares were relatively stable, Phenix had greater difficulty maintaining and
expanding its loan portfolio. As a result, Phenix concentrated its new marketing efforts on loan,
rather than deposit, growth. The Board’s loan policy was to have rates at or just below the market.
Phenix members actively shopped for good rates when making a car purchase and in selecting
credit cards. Phenix established a call center at its administrative offices to streamline loan
approval procedures so that members could get approvals in about an hour. The current loan mix
is displayed in Table 8, with Associated and Federal Employees’ loan information presented in
Table 9. A comparison to loan rates offered by five local commercial banks is given in Table 10.

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Table 8. Phenix Loan Balances and Loan Mix

6/30/97 12/31/97 6/30/98 6/30/97 12/31/97 6/30/98
Loan Type APR APR APR $ Balance $ Balance $ Balance
Unsecured Credit 12.75% 12.75% 12.75% $ 4,052,084 $ 4,091,431 $ 5,777,922
Card
Unsecured-Signature 13.75% 13.75% 18.00% 2,802,068 2,978,961 1,145,340
New Vehicle 8.25% 8.25% 8.25% 7,506,448 7,502,614 7,507,246
Used Vehicle 7.90% 7.90% 7.90% 2,556,458 2,704,496 3,412,667
First Mortgage 8.00% 7.75% 8.13% 100,229 99,003 97,529
Home Equity 8.25% 8.25% 9.50% 2,153,281 1,847,527 1,592,511
Other Member 12.75% 11.00% 8.50% 658,056 878,931 490,189
Loans
Total Loans $19,828,624 $20,102,963 $20,023,404

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Table 9. Associated and Federal Employees Loan Balances and Loan Mix
6/30/97 12/31/97 6/30/98 6/30/97 12/31/97 6/30/98
Loan Type APR APR APR $ Balance $ Balance $ Balance
Unsecured Credit Card 12.00% 12.00% 12.00% $ 21,567,626 $ 30,223,589 28,274,788
Unsecured-Signature 18.00% 18.00% 18.00% 3,368,445 6,835,480 5,050,759
New Vehicle 7.90% 7.90% 7.90% 53,276,573 50,971,698 48,751,525
Used Vehicle 7.25% 7.25% 7.90% 45,524,376 77,313,161 83,157,759
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First Mortgage 8.00% 7.38% 7.00% 10,146,650 13,296,967 13,827,333

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Home Equity 8.50% 8.50% 8.50% 44,709,986 54,234,033 57,080,919

Other Member Loans 5.50% 5.50% 5.25% 6,756,465 8,319,628 6,580,158
Total Loans $185,350,121 $241,194,556 $242,723,241

Table 10. Comparative Loan Rates at 6/30/98

Loan Type Phenix Associated Nationsbank SunTrust Wachovia Atlanta Avg.
Unsecured Credit Card 12.75% 12.00% NA NA 14.98% 14.81%
Auto 8.25% 7.90% 8.90% 8.90% 8.90% 8.81%
Home Equity 9.50% 8.50% 10.50% 9.50% 10.50% 9.80%

Unsecured loans and auto loans were generally fixed-term at either a fixed or variable rate.
The Phenix Board set a variable-rate consumer loan (VRCL) index, which was used to change the
rate on outstanding variable-rate loans. The loan rate schedule indicated the initial three-month
interest rate offered on variable-rate loans. Approximately 25% of the home equity loans were
“open-ended”; i.e., repayable at any time with variable interest rates; and the remainder were
close-ended and fixed-rate.

Historically, Phenix offered one fixed and one variable loan rate per product, rather than
applying risk-based pricing. The one-rate policy was common in the credit union industry. Some
credit unions were reluctant to shift to risk-based lending, believing that it infringed on the
egalitarian and cooperative credit union principles by which the borrowers were treated equally.
More recently, some marginal borrowers were offered credit, but at a higher rate, in order to
compensate Phenix for the additional risk. For most long-term loans, Phenix charged an additional
0.5% if the loan was not repaid using payroll deductions.

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

At Phenix, a potential borrower filed a loan application with one of three loan officers. The
loan officer collected a credit bureau report and additional data and made a loan decision.
Applications that were rejected or marginal were then reviewed by the staff loan review committee
(composed of all three loan officers). Rejected applicants could appeal the loan decision to a
volunteer loan review committee composed of credit union members and then appeal further to
the CEO and eventually to the Board of Directors, which was composed of volunteer credit union
members. Complaints by existing borrowers were filed with the member loan review committee
and were investigated.

In making their lending decisions, credit unions had to comply with several banking and
consumer protection laws, such as the Home Mortgage Act and the Truth in Lending Act. As

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credit unions were required to serve their members, they were exempt from the Community

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Reinvestment Act. The consumer lending laws explicitly prohibited lending institutions from
using age, race, gender, religion, national origin, marital status, and receipt of public assistance as
factors in granting loans or credit. In most cases, individuals who were denied credit had to be
provided with an explanation for the credit denial.
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Phenix used an informal set of credit standards rather than a formal, computer-based
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scoring system. The CEO had previous experience in an institution that relied on credit scores
generated from data in credit bureau reports. As credit bureau reports often included incorrect
data, the credit scores could be unreliable. Since the scoring criteria were not explicit, the lending
officers often had no way to determine why a seemingly good risk received an unfavorable score
or a poor risk was associated with a favorable score. The CEO believed that such a “black box”
scoring system did not serve members well and left Phenix vulnerable to lawsuits for violating
consumer lending laws. The Phenix credit standards were designed to examine a wider range of
factors than were included in many credit scoring systems, including a member’s personal history,
reasons behind previous borrowing problems, etc. In contrast, advocates of credit scoring systems
suggested that their credit standards were more objective and facilitated a faster turnaround time
for credit applicants.

The largest source of consumer loan losses at Phenix arose from borrowers filing for
personal bankruptcy. A major concern among consumer lenders nationwide was the increased
frequency of personal bankruptcy in the current period of low unemployment. Traditionally,
individuals declared bankruptcy only if no other options appeared available. As a result, the
frequency varied with unemployment and inversely with economic growth. The other major
factors contributing to bankruptcy were divorce and family medical problems. In the 1990’s,
excessive credit card debts and gambling were becoming more common reasons for bankruptcy. In
addition, the stigma of bankruptcy had been reduced, and many people filed for bankruptcy
sooner than in the past.

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Phenix experienced an increase in bankruptcies during 1997 and 1998, with an associated
negative impact on delinquent loans and charge-offs, as seen in Table 1. Despite making many
secured loans, Phenix was affected by Georgia’s bankruptcy laws, which generally permitted
borrowers to keep their homes and automobiles. Phenix, like many credit unions, had traditionally
been willing to work with borrowers who declared bankruptcy but reaffirmed their debt to Phenix.
Although legally discharged from the debt, these borrowers could become eligible for new loans
from Phenix if the old debt was fully repaid.

This self-help philosophy was credited with helping to reduce loan losses. First, Phenix,
like many credit unions, offered education on budgeting and financial planning to its members.
Phenix monitored loan repayments, contacting borrowers if they fell behind in their payments and

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often charging penalty interest on late payments. Once a loan became one or two months

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delinquent, Phenix worked more actively with the borrower, often using an employee or an
outside agent to collect payments. Credit union members were encouraged to discuss any loan
repayment problems with loan officers early on and to negotiate workable payment terms. Weekly
payments or per paycheck terms were frequently possible. Phenix, like other credit unions, offered
credit counseling services to its borrowers. Eventually, Phenix might have repossessed any
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collateral or foreclosed on a house. When loans became delinquent or charged off, the CEO and
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Board reviewed the loans to identify factors contributing to these problems.

Fees for Services

The non-profit philosophy led most credit unions to offer virtually fee-free banking
services. Generally credit unions did not require minimum balances or charge check-processing
fees. They also did not charge for most teller services. They did, however, charge penalty fees for
bounced checks and late loan payments in order to discourage members from abusing their
banking privileges. Many credit unions, including Phenix, billed their members a fee for using
ATMs operated by other financial institutions. The 1998 fee schedule at Phenix was:

Table 11. Fee Schedule in 1998

Fee Type Cost Fee Type Cost
Excess Withdrawals from Savings or
Monthly Service Charge—personal $ 0.00 Money Market $ 3.00-$ 7.00
Monthly Service Charge –business $15.00 Withdrawals from foreign ATM machines $ 0.75
Bounced Checks (member) $25.00 ATM Card Replacement $ 5.00
Bounced Checks (3rd Party) $15.00 Certified or Official Check $ 0.75
Money Order $ 2.00 Stop Payment Orders $15.00

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Compensation and Incentive Systems

Phenix had 24 full-time positions, of which 6 were vacant in 1998. Employee turnover
averaged about 3-4 employees a year, with most employees leaving to assume more prestigious
positions at other credit unions or for personal reasons. Many of the job openings were filled
internally through promotions. PFCU had a reputation for re-hiring former employees who left in
good standing.

The PFCU compensation plan was similar to that of many credit unions. The Board of
Directors set the compensation of the CEO, and the CEO set the compensation of the remaining
employees in accordance with Board policy. Traditionally, the employees were paid a salary and

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are eligible for a bonus. Salaries were generally increased based on a cost-of-living index as well as

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merit raises. The salary scale was relatively flat, with the CEO making no more that 5 times the
newest teller. Bonuses were paid based on the financial performance of the entire credit union in
the prior year. The most recent bonus pool was set at about 3% of net income before bonuses, with
each employee receiving an identical dollar amount in bonus. The employees also benefited from
being members of the credit union.
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New Marketing Initiatives

The Phenix Board and management recognized that the long-term health of the credit
union relied upon increasing the membership base and developing a higher quality, yet expanding
loan portfolio. Membership and new loan performance data from 1996-1998 are provided in Table
12. Phenix recruited a new marketing manager in early 1998; this individual developed a
marketing and promotional plan to be implemented in 1999.

Table 12. Marketing Data

12/31/96 6/30/97 12/31/97 6/30/98
Current Members 11,619 12,010 12,204 12,621
Potential Members 29,048 29,048 29,048 29,048
# New Loans Granted- YTD 730 294 547 254
$ New Loans Granted – YTD 9,077,613 2,911,390 5,960,534 3,354,510

Phenix also invested in new banking technologies. In 1997, Phenix opened a call center
staffed by three member service representatives and an automated response center. Most members
commented that the call center was an improvement over the existing telephone system, although
some older members were disappointed that they couldn’t call their longtime bank contact directly
for information. The younger members quickly moved to using the automated response center for
many transactions. Phenix also offered a Website (www.phenixfederalcu.org), which members
could access to examine rates or apply for loans. The response was less than expected. In addition,
numerous credit unions offered services jointly with other credit unions to achieve economies of

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

scale and reduce pressure to merge. Phenix offered its members use of other firms’ ATM machines
for cash withdrawals for a fee as well as access to a network of “shared branches” across the
country.

Phenix was at this point considering additional technological investments that could
improve its service delivery. As a midsize credit union, Phenix wanted to be on the leading edge
with service delivery but could not afford to invest in risky or untested technology. Phenix was
considering investing in one or two automated kiosks, which would be located in the Atlanta area.
Unlike ATMs, which could only dispense cash in the state of Georgia, kiosks could accept deposits,
take transfers between accounts, and could be designed to accept loan application information.
Secondly, Phenix investigated creating a shared branch office that would provide service to

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members of several credit unions. The proposed office would have been located in a building close

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to its administrative office/call center and two blocks away from its main branch. Finally, Phenix
was exploring the possibility of expanding its Internet services to allow members to do their
banking from their home or office.

Questions
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1. (a) Compute the 1997 and 1998 budget variances for both the income statement
and balance sheet using Sheet1 of the phenix.xls spreadsheet. What were the key
differences in the balance sheet accounts? What were the significant static budget
variances in the income statement?
(b) Compute volume and rate variances for interest on loans and other loan-driven
income statement items using Sheet2 of the phenix.xls spreadsheet. To what extent
were the significant loan-related static budget variances in the income statement
attributable to volume versus rate variances?
(c) Compute volume and rate variances for dividends on shares and other share-
driven income statement items using Sheet2 of the phenix.xls spreadsheet as a
model. Assume in this analysis that fee income, late charges, and other operating
expenses have as their key cost driver shares, rather than loans. Were the
significant share-related static budget variances in the income statement
attributable to volume versus rate variances?
2. a) Examine the proposed 1999 annual budget for Phenix in the appendices. Were
the key financial ratios set in September 1998 for the 1999 fiscal year readily
achievable? What other budget assumptions, if any, would you have
recommended be changed?
b) What suggestions would you have had for improving PFCU’s budgeting
process and numerical calculations, given that Phenix management assumed
the institution was growing and that it wanted to maintain a conservative
budget?

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

3. (a) Examine the loan and deposit rates and fees. What loan and deposit rates and
fees should the Board have accepted in order to boost profitability in the next
year?
(b) Consider, in turn, raising and lowering loan, deposit, and fee rates. What were
the most likely short- versus long-term consequences on volume, mix, credit
quality, and profitability? Suggestion: Consider any opportunity costs as well
as effects on quality.
4. Consider Phenix’s costing system and the information available to the CEO and
Board to make pricing and product mix decisions. What additional internal
costing information would you like to have had? What additional external
information (e.g., competitor data) would you like to have had?

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5. Credit unions were cooperatives, rather than publicly traded firms. What would

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you consider to have been the economic objective function of Phenix? What were
the economic constraints?
6. (a) Compensation contracts were often viewed as an incentive tool used to better
align the interests of shareholders and managers. Was the PFCU employee
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compensation plan an effective incentive mechanism in achieving the 1999

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budget?
(b) Given Phenix’s earnings outlook, future bonuses were expected to be modest at
best. What alternative incentive systems (other than bonuses) could the Board
have considered for the CEO, employees, and members?
7. Phenix’s actual loan quality was worse than the budgeted quality and might have
worsened, given the growing bankruptcy rate nationwide. What were the
strengths and weaknesses of its loan approval and monitoring systems, such as its
credit standards, its multiple-stage appeals process, and its collection practices?

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Appendix A. Phenix Financial Statements 1996-1998

Actual Actual Budget Actual Budget

BALANCE SHEET 12/31/96 12/31/97 12/31/97 06/30/98 12/31/98
Total Loans $ 20,325 $ 20,103 $ 21,293 $ 20,023 $ 21,861
Allowance for Loan Losses (132) (168) (124) (167) (183)
Cash and Cash Equivalents 395 740 699 504 751
Total Investments 5,311 5,610 4,558 7,307 5,857
Land and Building 310 304 304 301 298
Other Fixed Assets 591 524 446 494 563
Other Real Estate Owned (Foreclosed) 0 0 0 0 0
Other Assets 213 178 484 234 191

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TOTAL ASSETS $ 27,014 $ 27,291 $ 27,659 $ 28,695 $ 29,338

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Accrued Dividends Payable on Shares 131 129 213 131 208
Accounts Payable 369 480 (19) 631 (408)
TOTAL LIABILITIES 500 609 194 762 (200)
Total Shares and Deposits 23,250 23,299 23,927 24,579 25,719
Regular Reserves 1,092 1,026 1,064 1,021 1,064
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Undivided Earnings 2,171 2,357 2,474 2,334 2,755

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TOTAL LIABILITIES AND EQUITY $ 27,014 $ 27,291 $ 27,659 $ 28,696 $ 29,338

INCOME STATEMENT 12 Mths 12 Mths 12 Mths 6 Mths 12 Mths
Interest on Loans 2,082 2,107 2,187 1,005 2,176
Income from Investments 233 307 244 174 320
Fee Income 434 461 482 241 521
Late Charges on Loans 32 40 21 18 41
TOTAL GROSS INCOME 2,781 2,916 2,934 1,437 3,058
Employee Compensation and Benefits 707 768 831 383 783
Travel and Conference Expenses 24 40 50 38 43
Office Occupancy Expense 20 92* 27 31 29
Office Operations Expense 382 484* 413 265 484
Educational & Promotional Expenses 39 43 41 21 46
Loan Servicing Expense 25 26 26 6 28
Professional and Other Services 236 257 248 165 276
Loan Loss Provision 49 205 143 119 176
Operating Fees 6 6 8 3 6
Other Miscellaneous Operating 47 68 34 22 73
TOTAL OPERATING EXPENSES 1,534 1,990 1,820 1,052 1,944
INCOME FROM OPERATIONS 1,246 925 1,114 385 1,114
Gain on Disposal of Fixed Assets 7 0 0 0 0
Dividends on Shares** (769) (806) (843) (413) (833)
NET INCOME *** 485 120 271 (28) 281
* Increase due to an unexpected move of Phenix’s main office.
** Shares are comparable to deposits; dividends are comparable to interest on deposits.
*** As a cooperative organization, Phenix is exempt from state and federal income taxes.

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Appendix B. Proposed Phenix 1999 Annual Budget Assumptions

The key assumptions in this budget were:

Balance Sheet:
• Total asset growth of 5%
• Achieving share/asset and loan/share ratios of 85.5% and 85% precisely
• $6 K depreciation on land and buildings, as in 1998
• 5% growth in Other Fixed Assets, Cash, and Other Assets
• Total Investments are set to be Total Assets less Total Loans, and all Other Assets
• Regular Reserves are unchanged

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• Undivided Earnings =undivided earnings from 1998 + 1999 net income

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• Accrued Dividends = 25% of dividends on shares; i.e., 3 months of dividends
• Accounts Payable = Total Liabilities and Equity -- all other liability and equity accounts

Income Statement:
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• Gross income items = lowest IR in Table 4 * average loan or investment balance

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• Dividends on Shares = lowest IR in Table 4 * average share balance

• Other Income = used higher rate in Table 4 as fee rates are raised
• Compensation increased by cost of living of 1.3% + $26,000 for new employees
• Office Operating Expense unchanged from 1998
• Office Occupancy Expense retains the same ratio to Total Assets as in the 1998 budget
• Loan Loss Provision = increase in Loan Loss Allowance + charge-offs, with charge-offs =
0.75% of average loans
• Other Operating Expenses retain the same ratio to Total Assets as in 1998 actuals

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 Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

Appendix C: Proposed Phenix 1999 Annual Budget

Actual Budget Budget Budget

BALANCE SHEET 12/31/97 12/31/97 12/31/98 12/31/99
Total Loans $ 20,103 $ 21,293 $ 21,861 $21,399
Allowance for Loan Losses (168) (124) (183) (187)
Cash and Cash Equivalents 740 699 751 653
Total Investments 5,610 4,558 5,857 6,725
Land and Building 304 304 298 292
Other Fixed Assets 524 446 563 334
Other Real Estate Owned (Foreclosed) 0 0 0 0
Other Assets 178 484 191 228

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TOTAL ASSETS $ 27,291 $ 27,659 $ 29,338 $29,445

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Accrued Dividends Payable on Shares 129 213 208 213
Accounts Payable 480 (19) (408) 283
TOTAL LIABILITIES 609 194 (200) 496
Total Shares and Deposits 23,299 23,927 25,719 25,175
Regular Reserves 1,026 1,064 1,064 954
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Undivided Earnings 2,357 2,474 2,755 2,582

TOTAL LIABILITIES AND EQUITY $ 27,291 $ 27,659 $29,338 $ 29,445

Actual Budget Budget Budget

INCOME STATEMENT 12/31/97 12/31/97 12/31/98 12/31/99
Interest on Loans 2,107 2,187 2,176 2,147
Income from Investments 307 244 320 339
Fee Income 461 482 521 660
Late Charges on Loans 40 21 41 36
TOTAL GROSS INCOME 2,916 2,934 3,058 3,182
Employee Compensation and Benefits 768 831 783 805
Travel and Conference Expenses 40 50 43 43
Office Occupancy Expense 92 27 29 67
Office Operations Expense 484 413 484 495
Educational and Promotional Expenses 43 41 46 55
Loan Servicing Expense 26 26 28 53
Professional and Other Services 257 248 276 317
Loan Loss Provision 205 143 176 189
Operating Fees 6 8 6 9
Other Miscellaneous Operating 68 34 73 24
TOTAL OPERATING EXPENSES 1,990 1,820 1,944 2,056
INCOME FROM OPERATIONS 925 1,114 1,114 1,126
Gain on Disposal of Fixed Assets 0 0 0 0
Dividends on Shares (806) (843) (833) (838)
NET INCOME 120 271 281 288

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Note: The following image is of an interactive, Excel file supplement.

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Phenix Federal Credit Union _________________________________________________ CR16-02-1674.0

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