Category: Lessons from For-Profits

The fastest growing mutual fund family over the past decade has been the Vanguard funds. Their products feature no load, low cost index funds. The underlying philosophy is that investors cannot beat the market. Paying fees to investment managers that claim superior returns not only locks in higher costs, but also the claim to beat market averages is rarely achieved.

But there is one other critical advantage that allows Vanguard to offer this approach to investing contrary to the market positioning of virtually all other major mutual fund advisors. The funds are owned by their investors.

As described in a recent LA Times article: “the investment group is swelling at a dramatic pace, thanks to one crucial advantage over its rivals: It is owned by its own funds, allowing it to use profits after covering costs and business investments to lower its fees, rather than reward outside shareholders with dividends and buybacks.

In other words, the more it grows, the cheaper its funds can become, in turn generating more growth — a virtuous cycle that has helped Vanguard more than triple in size since 2011. It is particularly dominant in the U.S., where last year it took in more money than its two biggest rivals, BlackRock and Fidelity, combined, according to Morningstar.

Vanguard today accounts for over a quarter of the entire U.S. mutual-fund market — a market share almost as big as Fidelity, BlackRock and Capital Group put together — and it is one of the biggest shareholders in virtually every major listed U.S. company.”

A Harbinger for Credit Unions?

NCUA Chairman Ed Callahan (1981-1985) frequently described credit unions as America’s best kept secret or a “sleeping giant.”

Vanguard is a powerful example for cooperative design where the user-owners are the sole focus of management’s priorities. Could Vanguard’s success become an example for credit union’s future contribution to the American economy?

The most common rationale for credit union growth is to achieve new scale. Larger size is meant to bring more efficiency, productivity and market clout. And hopefully member value.

In a situation where everything or everyone else stays constant, growing larger might produce this outcome. But even in the most hospitable circumstances, the law of diminishing returns sets in.

Learning From Another Industry Serving Consumers

In a recent plane flight I sat next to a mining engineer from Houston, Texas. We talked about the largest and deepest mines in the world including a mile-deep open pit copper mine run by Kennecott in Utah.

Productivity is measured by the ounces of ore (1-3 oz) per ton of rock extracted. The constant challenge for geological engineers is to try to find veins so mining is still economically feasible. But, sooner or later, ore recovery is not worth the additional cost.

Our discussion then turned to Houston’s recent floods in part exacerbated by the city’s paving over much of its surface area by concrete. As an example he mentioned that Houston had the widest highway system anywhere in the world.

I returned home and found this was no Texas exaggeration. The Katy Freeway covers 26 lanes of freeways, toll lanes, frontage and emergency roads. At Beltway 8 it is in fact the largest according to the Houston Chronicle.

The Result of Becoming the Biggest Highway

So did this investment from 2008 help traffic flow faster? At first, for a short time, it did. But now, traffic engineers call it a Monument to Futility.

For as capacity is increased, so does “induced demand.” In fact, the same journey now takes longer on this highway mammoth than before the expansion.

My flight companion told me one result of this new congestion is that companies the highway has meant to serve are now moving to less crowded areas of the Houston metroplex. Not just the head office, but also tens of thousands of employees jobs are relocating for more open spaces.

The moral is that scale changes things, some unanticipated or even unintended. Consumers’ loyalty to is rarely based on size or scale-“the biggest”. Rather satisfaction comes from service and personal responsiveness.

Many factors cause each credit union to be the size it is today. Understanding that legacy may be more valuable than yearning for bigger scale wherein existing comparative and competitive advantages are significantly lessened in exchange for unproven future benefits.

In a February 2019 article in The Review of Financial Studies a research report by professors at the Columbia Business School was published.

The professors’ objective was to ask why US homeowners were slow to consider refinancing options even when it could provide significant savings.

The study was based on one financial institution’s offer to 550,000 eligible borrowers under the Home Affordable Refinance Program (HARP).

What were the behavioral factors that caused the homeowners not to take the refinancing offers? All current borrowers were sent pre-approved applications; there were no fees. Yet 51% passed on the opportunity which would provide an average savings of $9,000.

The Primary Reason for Not Acting

“Survey data indicate that among all the behavioral factors examined, only suspicion of banks’ motives is consistently related to the probability of accepting a refinancing offer,” concluded the authors.

The study also looked at the impact of incentives including use of Fannie Mae and Freddie Mac to increase credibility, a $500 cashback if the process took more than 30 days, and a gift card for an immediate acceptance.

The result: “We report the results of three field experiments showing that enticing offers made by banks fail to increase participation and may even deepen suspicion.”

The paper’s bottom line: “Our findings highlight the important role of trust in financial decisions.”

Can Trust be Marketed?

Most credit union teams know trust matters. It is common sense. The challenge is how to communicate this fundamental characteristic of cooperative design. Is it by emulating the marketing strategies of the banking industry? Or honoring the loyalty and relationships that build a cooperative?

I am uncertain on the issue of credit unions’ whole bank purchases. Are they an aberration, an opportunity, or events for just a moment in time, even though the practice dates back to 2012? While consequential for some individual credit unions, the 30 or so total purchases are not yet a significant factor in the industry’s $1.6 trillion assets. And it is mostly a side show in comparison with the 200-250 voluntary mergers occurring per year.

Largest Bank Purchase Announced

In early December, the largest bank purchase to date was announced. Suncoast Schools CU will buy Apollo Bank to extend the credit union’s reach into the greater Miami market.

No financial terms were announced. Apollo Bank reported $747 million in assets and $74 million in bank capital as of September 30, 2019. Its $545 million loans are primarily in real estate and commercial, not consumer credit. It has five Miami area offices.

Suncoast sees the acquisition as a way to jump into the 6 million greater Miami market area, expand its consumer loan portfolio, and enhance its commercial lending capability.

The Financial Impact on Suncoast

Even though both boards have approved the purchase, the value of the transaction was not released. Therefore, it is not possible to analyze the transaction’s risk, if any, to the credit union. From call reports, we learn that Apollo Bank has been profitable. The stock is not publicly traded so we cannot use a market valuation to compare with the purchase price.

In traditional bank sales, a price in excess of book for a steadily performing firm is commonplace. Because this cannot be a stock transaction, Suncoast will pay the total negotiated value in cash to shareholders. Its board’s approval suggests they anticipate no major change in Suncoast’s financial or risk profile that might delay the purchase.

How a Bank-Credit Union Purchase Works

Should Apollo Bank’s negotiated share price be approximately 125% of book value, this purchase would cost Suncoast $100 million. To simplify myriads of accounting details, assume the bank’s assets and liabilities are valued near book. This would result in Suncoast recording a net equity acquired in merger of approximately $77 million and a goodwill entry for the amount in excess of the net book figure, or approximately $25 million.

The bank’s shareholders receive cash. They can do whatever they choose with their $100 million. They can deposit it in the credit union, buy stock in another company, pay off loans or spend it. The purchase agreement will ordinarily contain other conditions such as terms for retained employees with possible performance goals, representations, non-compete agreements, and other understandings. Purchase documents for shareholders can run into hundreds of pages. Teams of outside accountants, consultants and advisors are normally engaged by each party to complete the transaction.

Comparing Bank Purchases with Credit Union Mergers

If Apollo Bank were instead Apollo Credit Union whose board and CEO had agreed to the merger, the credit union’s member-owners would not be treated the same as its bank shareholders. In fact, no merger of two sound credit unions has never resulted in a meaningful payout of the accumulated reserves created by generations of member loyalty.

A hypothetical Apollo Credit Union merger, under current practice, would transfer all its accumulated equity to Suncoast. The total wealth transfer is double the equity amount under current credit union merger practices. Suncoast books the excess of assets over liabilities as “equity acquired in a merger,” similar to the bank transaction. But then, as no cash is paid from equity to member-owners, the credit union recognizes the amount of equity transferred over and above the net assets, as “negative good will”. This is income for the credit union to use however it chooses to spend its revenue.

Needless to say, there would never be a bank purchase under these terms. A bank CEO and board that would even suggest doing so, using a rationale of expanded services and capabilities available from the much larger credit union ($10 billion Suncoast), would be subject to potential legal liability by shareholders for failing to represent their best interests. Shareholders would undoubtedly turn such an offer down, and start looking for another CEO and board.

The Critical Issue from Credit Unions Buying Banks

In a credit union bank purchase, the owners are given much greater respect, due diligence information, and ultimately money, than the member-owners receive in a credit union merger. The underlying economics of the situations are virtually identical. Moreover, the 30 bank purchases demonstrate the financial strength of credit unions to indeed pay owners their full equity interest ,and possibly more, and yet still have a mutually agreeable and sound transaction approved by regulators.

Should the boards and CEOs of well-run credit unions considering mergers be more assertive representing their member-owners’ interests? The bank transactions show that it is not only financially feasible, but also a fiduciary responsibility.

NCUA’s Role

When Chairman Hood was asked about bank purchases in Congress recently, he responded that these were voluntary market transactions, but that NCUA would be looking into them. He did not explain what that meant. However, the critical issue these transactions raise is whether member-owners in the economically equivalent situation of a bank purchase, are being given proper consideration in mergers.

Clearly these “voluntary, market-based” bank purchase transactions would never happen if the terms were similar to current credit union mergers. So why are NCUA and state regulators routinely approving the same economic events that transfer member-owners double equity value with no compensation? These may be “voluntary” but are hardly market-based transactions.

Merger Terms Now Available

Moreover, credit union mergers are not documented in any way similar to bank purchases as to why the transactions are in the members’ best interests. When reviewing the information now publicly available on all mergers, the descriptions of member benefits are rarely more than assertions of a brighter future or marketing “happy talk.” The most explicit details are the increased compensation CEOs and senior managers will receive from the transaction. Even when there is a token “special dividend” to encourage members to vote for the merger, the amount is minuscule compared to the double equity being transferred to the surviving credit union.

Reviewing the published letters boards of directors sent to members encouraging their approval of merger proposals, it is clear that the most immediate benefits go to the CEO and managers giving up their leadership responsibilities to another credit union. In a number of cases the members who are supposedly gaining something, could have joined the surviving credit union anyway, if it indeed offered a better value.

What Is Being Lost in Mergers

In most mergers routinely approved by NCUA, there are no safety and soundness issues. So, what is the regulator’s responsibility? Should it not be to ensure that the members who are being urged to give up control of their credit union are indeed treated equitably? For the members and their communities are losing not just their collective resources, but also any meaningful say over the direction, priorities, leadership and institutional role in their home markets. The credit union system loses another leadership cadre. Employees find future leadership opportunities diminished.

All credit unions start small. Some emerge to become large and some even evolve into national leaders. With every cooperative charter cancelled, a potential source for breakout growth and entrepreneurial innovation is extinguished. The community or market being served loses a critical component of its financial and economic ecosystem. Choices become fewer. For in some instances, the merger intentionally removes a cooperative competitor that the surviving credit union could not otherwise successfully dislodge.

Rethinking Current Credit Union Merger Process and Practice

If Chairman Hood believes market-based transactions are good, shouldn’t credit union merger practices be more substantive with real market disciplines? Why should a cooperative’s wealth be transferred in negotiations where members are now excluded from the process in any meaningful way? There has never been a merger turned down in a member vote. This is not democratic control, rather it suggests that incumbents take advantage of their position oblivious to the legacy they inherited as well as their responsibility to future generations.

As cooperatives, credit unions are a blend of financial and market concepts. Credit unions buy banks; however current merger practice is little more than legally sanctioned theft of the member-owners’ collective contribution to their credit union’s success.

As cooperative architects, both regulators and credit unions who believe in this member-owned, one person, one vote model, must address this merger inequity. For it is incentivizing behaviors that undermine the hopes of cooperative owners and contradict the public promises that gave credit unions a unique standing in America’s financial system.

The purchase of banks is showing that credit union member-owners are not receiving comparable consideration and respect for similar economic transactions.

Credit unions should take the lead to reform a system that is becoming corrupt in appearance, if not in practice. If they do not, then external forces in Congress, the media, consumer advocates or even private lawsuits are likely to challenge the entire cooperative system’s structure and oversight. And then all 100 million plus members may lose.