Author: Chip Filson

Whether the event is a first date, a rookie’s initial at bat, or a novice composer’s first ballad, the promise of an initial appearance is often projected into future success.

Kyle Hauptman’s first NCUA board meeting, one week after being sworn in, was a two-day marathon. How could he possibly process the hundreds of pages of budgets and board action memorandum and make a meaningful contribution?

I believe his premiere was positive for several reasons.

Not Following a Script

Public NCUA board meetings are supposed to enlighten because they are the only authorized occasion that individual members may debate issues with each other. Internal preparation for the board meetings is handled among policy advisors and staff shuffling among the three directors to seek a consensus or positions on agenda items.

Unfortunately, board meetings are rarely enlightened discussions of the core issues. Rather, the board members read prepared statements, staff presenters are provided questions in advance, and answers readily supplied . The meetings are stage-managed public relations exercises. No views are changed or positions further illuminated. The recent virtual meetings, audio only format, has made this approach even more pronounced.

Hauptman’s remarks however sounded as if he was not reading a script. And in so doing, he made some interesting observations.

The first was to call NCUA’s insurance role a “monopoly,” an accurate term, but one I do not recall being uttered by another board member. A monopoly is not a positive characterization in a free market economy. With that description, he cautioned that such authority must be used carefully.

He also noted that all NCUA funding comes from credit union members. The government, he asserted, should not be holding money that the members can use to meet their needs. The fact that all agency expenses are paid by the industry is known, but rarely acknowledged by agency leaders.

Newcomers to NCUA’s board often begin with fresh insights and comments. They have yet to be caught up by the bureaucratic vortex of expertise and self-interest which can overwhelm outsiders’ initial perceptions. But that centrifugal pull may be tempered by his first major decision, the choice of his Senior Advisor.

A Credit Union Veteran Goes to DC

Sarah Canepa Bang, Hauptman’s first personnel decision, may not be in the same role as Jimmy Stewart of Mr. Smith Goes to Washington fame. But she brings a lifetime of credit union experience with several cooperative and credit union organizations in multiple states. She knows where bodies have been buried. And where saints have trod. She has achieved hard earned success and experienced economic setback.

For decades a CEO or senior manager, as well as serving in numerous volunteer roles, Sarah brings a thorough appreciation of how NCUA’s actions affect members, not just institutions. She is approachable and listens, aware she does not have all the answers.

Most importantly in an industry in which relationships are vital for collaborative advantage, she can bring to Hauptman views and connections that will give him information to set informed priorities and make member-focused decisions.

Discernment and earned life experiences are combined in these two capable NCUA newcomers. That is a promising union for a country and industry navigating unprecedented events.

As credit unions enter a New Year, a $3.0 billion dollar question hangs over the cooperative system. Will the AME surpluses be returned in full, or will NCUA devise a way to hold back funds as it did when closing the TCCUSF in 2017?

The September 30, 2020, update on the five corporate AME’s shows a total of $3.035 billion in surplus. This would return the membership capital, a portion of paid in capital, and even a liquidating dividend for the credit union members of four of the five corporates. Only WesCorp members will receive nothing as that estate still reports a loss.

There are two kinds of payouts. The thousands of credit unions with membership capital in the former Members United, Southwest, and Constitution corporates should receive $572 million, $712 million and $36 million, respectively, according to the September data.

The balance remaining in the US Central estate after allocating $620 million to the four other AMEs is $1.065 billion. This should go to the eleven active corporates that will share according to their pro rata ownership of membership and paid in capital at US Central. These percentages are listed below in the column headed % USC MSC.

(Source: NCUA)

NCUA documented these obligations with receiver’s certificates sent to all credit unions upon liquidation. The agency reported an initial payment of $171.4 million to over 900 Southwest Corporate shareholders in July.

Will Credit Unions Receive Their Money?

The distribution process seems simple enough. All NGN’s holders are paid off and the trusts wound up. The legacy assets are released, sold and the cash distributed. Except that is not NCUA’s traditional instinct.

When NCUA recommended closing the TCCUSF earlier than the 2021 final NGN maturity, credit unions were in favor, expecting a portion of their $5.0 billion in premiums to be returned years early. Instead NCUA “merged” the $3.1 billion into the NCUSIF, not returning the cash to credit unions.

Congress in establishing the TCCUSF in 2009 explicitly rejected this use of the funds: “These provisions are intended to ensure that the activities of the Fund are restricted to resolving problems in the corporate credit union system, and not used for other purposes, such as for dealing with natural person credit union problems.”

To merge and retain the funds, NCUA repudiated all previous analysis by raising the NOL above 1.3%, a distortion still practiced today. And it immediately expensed $650 million in the year’s final quarter to add to NCUSIF’s loss reserves—without explanation.

When NCUA closed the TCCUSF, it promised future “dividends” which were actually refunds of premiums paid. Credit unions received a $735 million “dividend” in 2018, and a second $160.1 in 2019. However, NCUA still held onto at least $1.3 billion more in surplus by keeping the NOL at 1.38 versus the 1.3 cap in place for 35 years.

In closing the TCCUSF early, NCUA has returned only 29% ($895 million) of the TCCUSF surplus to credit unions. The Agency retained or spent the other 71%.

Government Craves Funds

The innate bureaucratic reluctance to return credit union money is supported by some NCUA board members who openly advocate for more NCUSIF funding. Board member Harper covets the FDIC’s flexibility, the freedom to assess and risk rate premiums, and its ability to set the NOL at whatever level the FDIC determines is necessary.

Harper’s statements show a misunderstanding of the NCUSIF’s unique financial model. Credit unions’ cooperative undertaking is to always maintain 1% of insured shares as a perpetual underwriting commitment. In return for this open-ended funding, credit unions, fearful that government would just spend these ever-flowing deposits, asked for and received statutory and operational guardrails on the fund’s management. These are the constraints that Harper now wants to undo.

The FDIC’s premium model Harper frequently references has required government bailouts on at least three occasions. NCUSIF, never. That’s why the NCUA 1984 restructuring was called “A Better Way.”

As former NCUA Chairman Ed Callahan prophesized in NCUA’s 1984 Annual Report, “Don’t set it up and forget about it. It’s unique. It’s a better way. But just as important, it’s yours to monitor—because if you don’t it’ll go just like everything else government touches. When government gets more money, it wants to spend more. Our goal is to spend less. You have to hold us to that promise.” (How to Keep Your Insurance Fund Strong and Cost Effective, pg 18, NCUA 1984 Annual Report)

Action Required

Start by asking the NCUA board to publish a plan for winding up the AMEs and distributing the cash. The audits will soon be done. There are no reasons to withhold any details of the remaining assets and their value.

Every credit union will benefit from this clarity and knowing there is a commitment to return the funds. The Corporate system will also gain additional capital to expand their services.

Already there are discrepancies between the latest AME numbers and the membership capital totals NCUA published. It is vital to NCUA’s credibility to produce its plan with full details. Another regulator described the importance of such action as follows:

“The essence of an effective deposit insurance system is the trust of the banking public in the operations of the deposit insurer. The only way to build trust is to make those operations transparent so that your stakeholders have the information and the means to hold you accountable. It is all about being accessible, understandable, and responsive to both regulated entities and those we seek to protect vis-à-vis deposit insurance.

“If you do not trust the system in which you live, you do not feel a part of it. It is not your government.” –Jelena McWilliams, Chair FDIC

When NCUA closed the TCCUSF in 2017 (ahead of the 2021 NGN final maturities) credit union’s expectation was an early return of their special premiums. But the Agency disavowed that hope by keeping all the money. Let’s ensure the money goes to where it belongs this time, all $3.0 billion plus.

The total assets of the NCUSIF are approaching $20 billion, all of which are invested in U.S. Treasury securities. Yet there appears to be no active oversight of fund management. NCUA has passed a rule, examiner’s guidance and numerous letters to ensure credit unions implement an interest rate risk (IRR) policy. This required practice does not seem to be followed within NCUA.

In the September 2020 NCUSIF statements, the CFO reported the following new fixed rate, fixed term investments during the month:

2 Year at .12%
3 Year at .15%
4 year at .20%
5 Year at .27%
6 Year at .36%
7 Year at . 45%

These yields are at historic lows. There is only one direction rates can go. The only question is when. While the Fed has indicated it will keep this level until the recovery and inflation are well underway, there is no way to know how soon this will be.

Are these prudent investments given these unusual economic circumstances? Does NCUA have an IRR policy for this $20 billion of credit union funds?

The Revenue Implications

Almost all the NCUSIF’s income is from its investments. The revenue from this fixed 7-year ladder is easy to calculate at current rates.

For each $100 million, 10 basis points in yield will generate annual income of $100,000.

For example, in the above investments, the additional annual income by going from a 2- to 3-year fixed term is $30,000 per $100 million.

Extending from a 2- to 7-year term, results in a .33% or $330,000 pickup for the added five years of fixed rate risk.

NCUSIF’s total investment income was $306 million in 2019. Revenue is $211 million for the first nine months of 2020. So, the incremental revenue gain going further out the curve in the current rate environment is inconsequential. Investing $1 billion dollars fixed for 7 years for a .38% gain in yield versus staying short term adds only $3.8 million more in annual revenue.

Shock Testing the Strategy

NCUA requires all credit unions to perform IRR shock tests of their investments to determine the impact on revenue and net economic value (NEV) of the portfolio in various rate scenarios.

The table below shows three different scenarios for a parallel and immediate increase across the entire yield curve for the fund’s September investments.

Term	Rate	Base Price	Up100 Price	Up100 % Price Change	Up200 Price	Up200 % Price Change	Up300 Price	Up300 % Price Change
4 Years	0.20%	100	96.033	-3.97%	92.069	-7.93%	88.108	-11.89%
5 Years	0.27%	100	95.029	-4.97%	90.06	-9.94%	85.093	-14.91%
6 Years	0.36%	100	94.024	-5.98%	88.051	-11.95%	82.081	-17.92%
7 Years	0.45%	100	93.019	-6.98%	86.041	-13.96%	79.066	-20.93%

A 300-basis point shock test (final column) is the minimum required by examiners. In this shock of the four longest maturities, the decline in principal value is from 12 to 21%. That means investments could not be converted to cash without taking a significant capital loss or a significant “haircut” if used as collateral for borrowing.

This outcome is a critical in evaluating whether the marginal revenue gain out the curve is worth the risk to principal when rates change.

Rates will certainly go up. No one knows the timing, how fast, or how far. The second judgment therefore, considers the probability of increased revenue from higher future rates which would exceed the short-term gain in income by extending out the curve now.

When the Fed begins its move, it will most likely change the current 0-.25 bps overnight rate to a range of .25-.50 basis points. This is the pattern of rate adjustments, both up and down, over the past decade. Therefore, this first change by itself will result in overnight rates in excess of the current seven-year fixed rate return.

Sitting on a $585 Million Gain in Value

The most immediate need for a coherent IRR strategy, is that the NCUSIF’s existing investments now have a market value that exceeds book, by almost $600 million.

Do nothing till maturity and the gain goes away. Sell part of the gains now and the fund records more than enough revenue to meet its projected expenses in 2021.

By shortening the average life with a partial rebalancing, the fund will then be positioned to follow rates up.

Who Oversees NCUSIF IRR Strategy?

Analyzing the risks to principal and income from September’s investment decisions suggests a reassessment of current investment practice is much needed.

Who is responsible for this analysis? Who monitors the relevance and execution of the IRR policy, if there is one?

If this were a credit union, we know for certain what the answers would be. Management drafts and carries out policy. The Board approves policy and monitors performance.

In the case of the NCUSIF, these two critical functions are clouded in bureaucratic fog. The agency is explicit in assigning IRR responsibility for a credit union. Should policy be any less explicit for the NCUSIF? Should this activity be part of the monthly report to the Board?

Where is the OIG?

A quick review of OIG activity would suggest that once again, the OIG is asleep at the switch when it comes to monitoring NCUA’s internal conduct. Here is a report of its audit in 2011 of NCUA’s external review of IRR in examinations.

“In 2011 NCUA’s Inspector General released a report on a “self-initiated” audit to determine (1) whether the National Credit Union Administration’s (NCUA) interest rate risk (IRR) policy and procedures help to effectively reduce IRR; and (2) what action NCUA has taken or plans to take to identify and address credit unions with IRR concerns. To accomplish our objective, we interviewed NCUA headquarters and regional management and staff. We also obtained and reviewed NCUA guidance, policies, procedures, and other available information regarding interest rate risk. In addition, we judgmentally selected five credit unions, one from each of NCUA’s five regions, and analyzed the corresponding examination and supervision reports and related documents. We determined that NCUA has taken steps to identify and address credit unions with interest rate risk concerns.” [emphasis added]

However, the OIG is silent on this topic in NCUA’s internal IRR. NCUA’s “policy and procedures” for its own responsibility, if they exist. certainly call for a similar audit.

Below are the Agency’s requirements for effective credit union IRR practice. They provide a detailed framework for NCUA’s own investment management.

Excerpts from NCUA’s IRR Requirements for Credit Unions from the rule, FAQs and guidance in letters. All excerpts are verbatim.

Why is the Interest Rate Risk (IRR) rule written as a requirement for insurance?

Interest rate risk is a core risk which confronts FICUs; similar risks exist with regards to lending and investments for which regulatory requirements for insurance already exist. As a requirement for insurance the rule applies to all FICUs. The rule combines the many elements of asset liability management into a comprehensive framework for managing core risk.

IRR Policy

Who is responsible for the adequacy of the policy?

The Board of Directors is responsible for a credit union’s IRR policy.

What should the policy include?

A written policy should:

• Identify parties responsible for review of the credit union’s IRR exposure.
• Direct appropriate actions to ensure that management identifies, measures, monitors, and controls IRR exposure.
• State the frequency with which monitoring and measurement will be reported to the board.
• Set risk limits for IRR exposure based on selected measurement. (for example, GAP, NII or NEV)
• Choose tests such as interest rate shocks, that the credit union will perform using the selected measures.
• Provide for periodic review of material changes in IRR exposure and compliance with board approved policy and risk limits.
• Provide for assessment of the IRR impact of any new business activities prior to implementation.
• Provide for an annual review of policy to ensure it is commensurate with size, complexity and risk profile of the credit union.
• When appropriate, establish monitoring limits for individual portfolios, activities, and lines of business.

Oversight and Management

How should management implement the Board policy?

Management should:

• Develop and maintain adequate IRR measurement systems.
• Evaluate and understand IRR exposures;
• Establish an appropriate system of internal controls (risk taker should be separate from those measuring, i.e. does the modeler also pick the investments?);
• Allocate sufficient resources for an effective IRR program (should include competent staff with technical knowledge of the IRR program);
• Identify procedures and assumptions involved in the IRR measurement system (i.e. the credit union’s IRR model inputs);
• Establish clear lines of authority for managing IRR; and
• Provide a sufficient set of reports to comply with Board approved policies.

When should I consider my IRR management program as being effective?

Your program will be considered effective when it has a well-defined policy and it identifies, measures, monitors and controls interest rate risk, and you use these to guide decision making. Your program should be able to adjust as products are added or increased, interest rates shift, balance sheet changes and capital positions change.

Assumptions For IRR Policy

Projected interest rate assumptions are a critical part of measuring IRR and may be generated from internal analysis and/or external information-provider sources. Internal interest rate forecasts, which may be derived from implied forward yield curves, economic analysis, or historical regressions, should be documented to support the assumptions used in the analysis. Key rate assumptions that should be considered include assumptions for relevant market rates, repricing rates, replacement interest rates, and discount rates.

Stress Testing

Stress testing, which includes both scenario and sensitivity analysis, is an integral part of IRR management. Scenario analysis simulates possible outcomes given an event or series of events, while sensitivity analysis estimates the impact of change in one or only a few of a simulation model’s significant assumptions.

With IRR stress testing, the modeled scenarios involve changing interest rates by defined amounts and potentially severe magnitudes. At a minimum, standard stress tests typically include instantaneous, parallel, and sustained shocks in the yield curve of +/- 300 basis points. [emphasis added]

Parallel and static interest rate shocks in the yield curve of only +/- 300 basis points may not be sufficient to adequately assess IRR. In addition to the standard IRR policy limits, a credit union must determine the number of potential interest rate movements, including meaningful stress situations for which it will measure and analyze its IRR. In developing these appropriate rate scenarios, management should consider a variety of factors, such as the shape and level of the current and historical term structure of interest rates.

Operational Considerations

The use of stress testing is an essential discipline within the IRR management process. By generating a variety of stress test results, a credit union gains critical insight into the specific factors that have a material impact on the risk measurement results. Risk management decisions are better supported when the decision makers have a range of information available to guide risk mitigation actions.