Category: NCUA

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D. Michael Riley’s Observations on “Creative Destruction”

In response to last week’s post on the impact of mergers on the future of the cooperative system, this former NCUA senior executive sent the following comment.

Mike Riley, December 1984

“Creative destruction” is uncomfortable to see in print. But it existed before Adam Smith, Malthus, Marx. Keynes, Schumpeter, and others began to try to explain the economic drivers and motivations that shape our world.

Cultural changes seem to be the main driver today. The personal seems to have switched to the impersonal, i.e. give me what I want on my terms with not  much regard to others. Fast and low cost are the motivators. (disclaimer: I love Amazon.)

We have to deal with what we have.  I am concerned about sound credit unions merging.  When I was a new examiner, I had 30 -40 credit unions who were below $100,000 and none of the rest I had were over a million. And no, I did not start in 1934.

This was in the seventies. They were basically in small towns or in rural areas where there was a factory of some sort. As I visited them (most were happy to see me, albeit a regulator, to hear about the outside world), it was obvious that the Board and Committees were involved in the credit union. Their members and the Treasurer were most involved of all. They were making loans on washers, dryers, refrigerators. Most of their members had no real access to credit except at an exorbitant rate. No savings accounts available to the members.

The credit unions really cared about their members. I remember one credit union was trying to decide on whether to make used car loans. They wanted some advice from me.  About 8 months later I came back and before I could start the exam they wanted me to go out and look at this used car and meet the borrower.

They were so proud of this accomplishment. (As a good regulator, I did check to see if the loan was to a Board member or family member.)  It seemed to be a good loan. Not to get maudlin, but this shaped my views of what credit unions are. And fortunately, the larger credit unions were much the same.

After I moved on, I tried to keep track of these credit unions. Around 1990 I put together a list of where these credit union were. I couldn’t find a few; but a little other 20 had liquidated because the factory closed down or the key people left or retired. Another 30 or so had merged either voluntarily or involuntarily. About 6 were still alive and functioning. To be fair, at the same time the American economy was undergoing a major transformation and jobs and manufacturing were moving overseas.

Ongoing Mergers

This ongoing march continues. The merger of two sound credit unions without some legitimate reason doesn’t seem to be member oriented. I still think of the members of those small credit unions who received services such as buying a washer that no one else would do.

Bigger is not better if the member does not benefit.  How many of these mergers produce lower loan rates , higher dividends, or distinctly better products at a lower price? Carried to the extreme we will be left with 20 credit unions that are no different than large banks.

NCUA’s Role

Schumpeter opined “If someone wants to commit suicide, it is a good thing if a doctor is present.”

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A Former Fed Regulator On Reasons for SVB Failure

A segment from the March 14, Marketplace daily report on NPR follows.  The interviewer is host Kai Ryssdal and the guest commentator is  Daniel Tarullo who teaches at Harvard Law School.

Between 2009 and 2017, Tarullo was on the Federal Reserve Board of Governors; specifically, he served as oversight governor for the supervision and regulation committee.

Silicon Valley Bank (SVB) analysts are looking for situations where there are balance sheet or business model parallels that could lead to more bank failures. Tarullo asserts that management will always be first in line when  blame is assessed.

However that is not the full story.  He believes the proximate cause is closer to home–a regulator with a light touch.

I believe  his last comment highlighted below describes NCUA’s approach to supervision.  How else do you explain a credit union CEO and Chair giving themselves a $10 million fund under their sole control or $1.0 million dollar credit union CEO bonus upon merger, among other abuses?

Interview Excerpts:

Ryssdal: All right, so look, that’s why we got you on the phone. You ran, among other things you did at the Fed, the committee on supervision and regulation. And I am not the first person to ask, nor will I be the first person to ask, where were the regulators? Why did this come out of the blue?

Tarullo: That’s a huge question, isn’t it? There are two places to look: One is to supervision and the other is to regulation. Now, of course, we’re stipulating that there’s a management failure, but I think everybody would agree with that. So in terms of the government, the debate publicly has been, “Gee, were the 2018-2019 changes in the [Dodd-Frank] law and Fed regulations respectively to blame?” And, as I think you know, I was opposed to both the [rollback of the] law and the changes in the regulations.

But I don’t think there’s that direct of a connection between those specific changes and Silicon Valley. And so what that tells us is the failure was in the oversight by supervisors — people who were supposed to be watching whether things like the proportion of uninsured deposits was creating some unusual risks for that particular bank.

Ryssdal: That’s not terribly reassuring, I gotta tell you.

Tarullo: No, it’s not. And I think that the review that the Fed has launched — and it’s significant that it’s headed by the vice chair for supervision, Michael Barr, who is, you know, relatively new — I think the significance of having him run that rather than staff is precisely because they want to find out where the supervisory failures lay. Were they with the specific team that had responsibility for Silicon Valley? Or were the failures more widespread in the sense that Washington was providing kind of a light touch supervisory direction to them?

Ryssdal: What do you think?

Tarullo: I suspect that it’s a combination of the two. But given the signals that the Fed was sending, you know, in the last several years, I believe that part of it is just the “don’t be too tight in your supervision, you need to find legal problems before you tell the banks to change what they were doing.”

 

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Respecting Cooperative Owners: The One Thing Essential

This past week’s financial runs show how fragile consumer confidence can be.

A critical distinction in credit union design is democratic ownership-one member one vote.

One of the challenges however is that it is easy to treat owners only as customers.  The fact is that many “owners” today are ordinary consumers attracted by a competitive rate or other marketing message.  In some cases, the customer is just an indirect loan borrower who had minimal voice in the selection of where the loan was made.

There is a difference between customers and owners in a financial institution.

Customers do not vote for directors at the annual meeting;

Customers do not vote on merger proposals for their institution;

Customers do not have a residual interest in the reserves of their firm.

Ownership is traditionally honored in other communications such as members’  founding stories or recognizing those who have played special roles in the credit union or cooperative system.

The One Thing Essential

Transparency is one critical leadership characteristic that acknowledges the owner’s role.

Without full, continuous and open communications, the default is to treat owners as customers.  That unfortunately is the attitude of many in positions of leadership today.

Most importantly lack of transparency on specific credit union commitments means the owners have little or no basis for their responsibility of electing directors.

A Regulatory Shortcoming

An example is from last week’s subordinated debt rule approved by NCUA.  Every party to the transaction is provided full information:  Senior management/boards, the brokers, the consultant, NCUA, and most importantly the individuals and entities (including other credit unions) that buy the debt.

Debt issuance of $100 and $200 million have been completed in the past 12 months. The only persons not provided the details of these events are the owners.  It is their loyalty that is the basis for issuing these borrowings that can now extend as far as 30 years.

Without transparency, there is no possibility of accountability.  The owners are removed from any role in governance.  NCUA presumes its in loco parentis role if something doesn’t go according to plan-a distinct prospect with terms of 10, 20 and now 30 years.

Senior Management and Board Compensation

Only state-chartered credit unions are required to file IRS form 990 which discloses senior management and board compensation, political donations and other activities such as grants for all non profits.

These disclosures are essential for owners to know the incentives and circumstances board and management have agreed to in leading the credit union.

Compensation consultants today are plentiful  with four part plans and multiple ways to structure payments now or later.  There are increasing references to a “change of control” clause which would trigger executive payouts no matter other merger bonus and benefits negotiated by the CEO.

Without compensation transparency there can be no accountability.  State charters have disclosed this for decades.  The same logic applies to federal charters.  This information is an important step in owner oversight, even consumer protection.

The Place and Time to Start Showing Trust in Owners

In the months ahead, most credit unions will hold their annual meetings-in person and virtual.  In preparation the annual audit will be available, a Chairman’s report prepared and other required business conducted including election of directors.

Some meetings will include updates on projects such as a new building or branch expansion, a report by a foundation or community activity.  Others will include an educational presentation, an outside speaker and even a meal.

The annual meeting is a primary opportunity for leadership to engage with owners in open and full conversations.

It is especially important in light of recent examples about the resilience of regional and smaller banks.   Confidence in an institution is based on trust.   Trust is not created in a day or by a special press release about a firm’s financial standing.  It is a relationship founded on open communication as both customers and owners over years.

Nothing could be more important this year than showing coop owners that the CEO and board  deserve their trust by being fully transparent with facts and open to the members’ questions and points of view.

That is how free markets are supposed to function in a competitive economy. That is how democracy is supposed to work.

 

 

 

 

 

 

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When Actions Speak Louder Than Words

Last Friday I received the following email from a credit union’s CFO:

“My CEO and I were discussing the new offering from the Feds, the Bank Term Funding Program (BFTP).  We have outstanding borrowings due over the next few months.  Liquidity is still tight.  I am considering utilizing this program as the current rate offered is almost 65BPs less than the FHLB 1-year term.

“I sat in on an “Ask the Feds” session on Wednesday to learn more about the program.  I’m curious as to your thoughts on utilizing this source of funding for Credit Unions.  Do you know of any CUs that have received any funding?

“Also, I’d love to hear what you think as far as there not being any negative stigma attached to institutions that do receive funding from this source.  Borrowing from the FRB is usually viewed negatively as it is seen as the “lender of last resort.”  During the webinar, the speakers assured everyone this would not be the case with this program.”

The follow query was posted by a credit union member on LinkedIn early last week:

I am thinking of transferring all my money. To my 2 credit unions !!!  Why is it more secure??

Latest Actions Taken

The following are reports  by the Fed and the FHLB system to respond to the financial firms’ liquidity needs. From a Reuters report on the FHLB system on March 13, 2023:

U.S. Federal Home Loan Banks beefed up their lending war chests on Monday to provide more liquidity to banks amid continued higher-than-usual demand for funds as the fallout from the collapses of Silicon Valley Bank and Signature Bank reverberates through medium- and smaller-size financial institutions.

The FHL Bank system raised $88.73 billion by selling short-term notes with maturities from three months to one year on Monday afternoon, according to Informa Global Markets, a provider of syndicated bond data. The offering was raised from an initial $64 billion due to high demand.

Bloomberg on the Fed’s lending ;program as of March 16, 2023: 

Banks borrowed heavily over the last week from two Fed backstop facilities. Data published by the central bank showed $152.85 billion in borrowing from the discount window—the traditional liquidity backstop for banks—in the week ended March 15. It was a record high and a staggering increase from the $4.58 billion borrowed the previous week. The prior all-time high? It was $111 billion during the 2008 financial crisis. 

“Talking Points”

From press releases by CUNA’s CEO Jim Nussle: “Credit union deposits are safe, secure and insured.”  A March 17, CUNA  headline: “Credit unions are a safe harbor.”

Chairman Harper ‘s words at NCUA’s Thursday. March 16,  monthly board meeting:

“Consumers can remain confident that their hard-earned deposits at federally insured credit unions are safe, just as they always have been, and that the NCUA will continue to act expeditiously, when needed, to preserve the stability of the credit union system.”

Vice Chair Hauptman offered no liquidity initiatives. Rather he lists actions NCUA has taken he believes relevant to the current situation.  (emphasis added)

“Even though there’s no analogy to the Silicon Valley Bank and credit union system, previous boards and this board have been urging credit unions to ensure they have appropriate sources of emergency liquidity.

“At the same time, we have urged Congress to strengthen the Central Liquidity Facility, the CLF, by allowing corporates to act as agents for subsets of members. When interest rates started rising, we published guidance on NCUA’s NEV, Net Economic Value methodology – that guidance clarified that credit union management must have an appropriate plan for managing interest rate risk.

“I’ll also note, a little while back, we encouraged the use of interest rate derivatives for exactly situations like this. The events of this past week underscore exactly why we were so concerned about interest rate risk. And this board is very aware that it is fairly unprecedented the rate-hiking cycle we’ve been in. We know it’s not easy to manage, but that is what credit union management is paid to do.”

“I’m grateful for the hard work by credit unions and NCUA to ensure confidence and a safe and sound system. I know springtime is often annual membership meeting season for a lot of credit unions. No doubt, some members will have questions. I hope you credit unions out there will use this opportunity to educate members not only on your credit union, but the credit union difference.” (end excerpt)

His message is clearly a preemptive defense of the regulator’s accountability.  “NCUA did all we could.  If there is a problem in a credit union, it is not on us.”

Credit unions might wish the NCUA board in is quarterly updates had been more diligent in monitoring the NCUSIF’s interest rate risk.  Or that the CLF had been made “shovel ready” versus asking for more resources and authority when existing ones had not been used since 2009. For that’s what the NCUA Board is paid to do.

When Action Counts

The two federal “agencies” that credit unions are using (after the corporates) are the FHLB and the Federal Reserve.

The CLF is missing in action , and silent, even though it has the same “protracted lending authority” as does the Federal Reserve.

This is not a credit issue. In each bank failure to date no one has pointed to an absence of capital compliance. There have been other regulatory shortcomings mentioned, but not capital. As one observer noted: The main takeaway is capital is not king; it’s a court jester.  Confidence is king.  Runs start from lack of confidence, and no amount of capital is enough.

The foundation for system stability is action not words. Confidence comes from seeing those with responsibility being proactive versus  reactive; public versus silent; and fact-based versus rhetorical reaffirmations.

CLF Missing In Action

Credit unions and their members are addressing similar concerns about their ability to access funds.

What’s going on at the CLF?  Where is the initiative shown by both the FHLB system and Fed with actions now to meet liquidity needs? Is the CLF capable of providing same, or even next day, liquidity?

This is the moment to show that the CLF can be relevant, responsive and a vital factor in coop resilience.  If the NCUA and credit unions fail to join together in this moment, this week, then why have a CLF at all?

 PS:  If a credit union can share their experience borrowing from the FED and provide answers to the CFO’s questions above, please post in the comment section.  Thank you.

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An Irish Weekend and Remembrance

As Bucky Sebastian reminded me many times about this past weekend, “Everyone’s Irish.” St. Patricks Day comes in the middle of Lent because an Irishman could not go for forty days without a drink.

At least that’s one theory.

So I got out my best Irish hat and tried out his thesis with a dark lager and two helpings of shepherd’s pie. There was even a vegan option.  Here’s the outcome.

Ed Callahan Remembered

Which reminds us of the great Irishman who believed in his deepest being, the potential for credit unions. This is Jim Blaine’s, March 17, 2016 portrait of Ed.

“Always suspected that the problem with Ed Callahan was that as a youth he was beaten too often by Nuns in parochial school or, perhaps, not beaten enough. Well, whatever, either way the Nuns left their mark – an indomitable spirit!

Ed Callahan was Irish – brash, pugnacious, loud, hard drinking, fun loving – alive! But why be redundant? I said he was Irish!

For over a quarter of a century, we all watched and observed as Ed Callahan created shock waves in the credit union world. No one was neutral about Ed Callahan. His friends were fiercely loyal, his enemies equally committed. Ed inspired many and angered quite a few. Ed had style; he had presence. With Ed, you weren’t allowed to make contact without becoming involved, excited, immersed, engaged.

At Marquette, Ed must have played football in the same way he played life – without a helmet. You had no doubt that Ed Callahan always played for keeps. He had no intentions of losing, that was not one of the options. Ed was very straight-forward; your choices were always clear. The mission was defined; and, there was only one direct path to the goal. That path was either with you, around you, over you, under you, or through you; you could step aside or get on board. It was your choice; but your choice never changed the mission, nor the path, nor the goal.

Some said that Ed was a visionary…

… they were wrong. Ed Callahan was a revolutionary. Visionaries talk about change, revolutionaries take you there. Ed led from the front – a leader of conviction, rather than convenience; principles above posture – courageous. Revolutionaries, by definition, create problems; overturn apple carts; rebuke the status quo. That happened at NCUA. Appointed by President Reagan, Ed arrived at NCUA in the midst of turmoil. Ed defined the mission; he reformed and remolded the Agency. He taught a regulatory agency how to stop working to prevent the last crisis. He explained that a coach never executes a play and that on Monday morning it’s never hard to see what went wrong – but it is rarely relevant. Teacher, coach, lessons in life; hopefully well learned, hopefully still remembered.

But let me celebrate the essence of the man – that indomitable spirit – one last time, for those who never had the opportunity; for those who still have doubts; for those who never fully understood. One of Ed’s harshest critics, noted with much wryness, that even in death Ed “couldn’t get it right”. Why, I asked? “Because Callahan died on March 18th instead of on the 17th, his beloved St. Patrick’s Day.” You know this type of critic – cynical, smug, self-assured without much basis, not really worth the effort, but…

Just for the record, I would simply like to point out one final time that – first and foremost – Ed Callahan was a fully-fledged, fully-flagrant Irishman – body and soul! And, no self-respecting Irishman would ever celebrate the end of St. Patrick’s Day until the last bell at the pub had rung. That would have meant that Ed Callahan’s “last call” would have come sometime after 4:00 am – on the morning of the 18th. Style, presence, courage – true to the last! A shamrock of joyful vigor and purpose!  

And one last thought… in the final analysis you can say many things about a great man’s life… some men are admired, some are respected, some are envied, some are feared… and countless other adjectives and accolades. But, in the final analysis, the most important thing you can say about a great man is… he will be missed. ” 

And, Ed Callahan will be missed…  

 
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THE Credit Union Lesson from SVB and Regulation

In a news conference following the failed Bay of Pigs invasion of Cuba, President Kennedy remarked:  “Victory has a thousand fathers, but defeat is an orphan. “

The SVB’s failure proves this adage untrue.  The press and numerous pundits have already assigned multiple parentage: the CEO and management, the Fed’s rapid rate increases, regulatory and examination shortcomings, the external auditor’s clean opinion, the Silicon Valley customers $40 billion twitter run, Trump’s deregulation in 2018 and the Biden administration DEI policy objectives.

When everyone and everything is to blame, then no one is accountable.  Just another “black swan” event. With more investigations/hearings to come, each new revelation will just add to the piles of condemnations.  No lessons taken away.  More regulations of course, for this is the default response whenever the barn door is left open.

A Spotlight on One Factor

From all these commentaries, I want to highlight one aspect that contributed to overlooking this risky situation. This factor has just become a part of the credit union regulatory eco-system.

In responding to my analysis earlier this week, Doug Fecher, the retired CEO of Wright-Patt Credit Union in Ohio, commented:

This situation makes me wonder if NCUA’s new “RBC” standards would have flagged the risks to SVB’s balance sheet. From what I can tell, much (most) of SVB’s investments were in “risk-free” treasury bonds and high quality agency securities, which in NCUA’s RBC formula would have earned some of the lowest risk multipliers.

To me it is another example of the folly of RBC-style risk management regimes … and why NCUA was wrongheaded in its pursuit of RBC.

This point of view is not limited to Doug’s observation.

During his time as Vice Chair of the FDIC, Thomas Hoenig challenged the agency’s reliance on risk-based capital requirements.  He questioned both the theory and practice, pointing to the lending distortions which contributed to banking losses during the Great Recession.

He wrote about the SVB failure in this commentary:

The regulator apparently relied on the bank’s risk-weighted capital standard for judging SVB’s balance sheet strength. Under the risk weighted system government and government guaranteed securities are not counted as part of the balance sheet for calculating capital to “risk-weighted” assets.

This allowed the bank to report a ratio of around 16%, giving the appearance of strongly capitalized bank. However, this calculation failed to account for interest rate risk in its securities portfolio or the risk of having a highly concentrated balance sheet. It misled the public, and apparently the regulators.

In contrast, if the regulator had focused on SVB’s ratio of equity capital-to-total assets, including government securities, the ratio falls to near 8 percent; and if they had calculated the ratio as tangible capital-to-assets (removing intangibles and certain unbooked loses from capital) the ratio would have fallen to near 5%.

What this would have disclosed to the world is that the bank’s assets could not lose 16% of their value before insolvency but only 5%, a stark contrast.

Had the regulator not relied on the misleading risk-weighted capital measure, it might have take actions sooner. A simple capital-to-asset ratio, tells the regulator and public in simple, realistic terms how much a money a bank can lose before becoming insolvent. The regulatory authorities need to stop pretending that their complex and confusing capital models work; they don’t.

RBC and Credit Unions: A First Birthday

RBC became the surrogate capital ratio for all credit unions with assets greater than $500 million one year ago on January 1, 2022.

Before this in a September of 2021 analysis, Why Risk Based Capital is Far Too Risky. Hoenig is quoted:

“A risk-based system  inflates the role of regulators and denigrates the role of bank managers. 

We may have inadvertently created a system that discourages the very loan growth we seek, and instead turned our financial system into one that rewards itself more than it supports economic activity.”

RBC and Asset Bubbles

Shortly after the critique of regulatory incentives induced by risk weighted assets, in Asset Bubbles and Credit Unions (JANUARY 10, 2022) the consequences from potential Fed tightening were noted:

When funding looks inexpensive and asset values stable or rising, what could go wrong?

The short answer is that the Fed’s inflation response will disrupt all asset valuations and their expected returns.

The distorted results  caused by RBC was presented in Credit Unions & Risk Based Capital (RBC): A Preliminary Analysis in February of this year.  Among the findings:

The 304 credit unions who adopted RBC, manage $822.7 billion in assets.  But the risk weighted assets total only $479 billion.  That 58% ratio is the NCUA’s discounting of total assets total by assigning relative risk weights. and,

One credit union with assets between five and ten billion dollars, reports standard net worth of 12.5% and an RBC ratio of 48.3%.  

This February analysis using June 2022 data of RBC credit unions showed that:

250 of these 308 credit unions reported unrealized declines in the market value of investments that exceeded 25% of net worth.   Four credit unions reported a decline greater than 50% of capital.  This was before the five additional Federal Reserve’s  rate increases through the end of the year. 

RBC’s primary focus is credit risk, the loss of value from principal losses from loans or other assets.  Balance sheet duration mismatch is not captured as are other common management errors:  concentration in either product or market focus, limited or no diversification of product or market, or  just simple operational mismanagement.

These common challenges become amplified by insufficiently considered non-organic growth forays such as third party loan purchases or originations. Whole bank acquisitions are an example of such risks often accompanied (disguised?} by growing amounts of the balance sheet’s intangible asset, goodwill.

The RBC proxy indicator for safety and soundness creates a distorted impression of real institutional risks.   Managers learn to game the system so that boards, members, and regulators fail to understand the institution’s total financial situation.

And when along comes a change in underlying assumptions, like the Fed’s rate increases, the previously unrecognized vulnerabilities quickly appear.

RBC creates for some institutions a theoretical capital ratio that is nothing more than a “regulatory  house of cards.”  SVB will not be the last example.

As Doug Fecher recommended in his 2016 comment letter on the proposed rule, “RBC should be a tool, not a rule.”

To his credit,  Kennedy learned from the Bay of Pigs misjudgments when the Cuban missile crisis occurred in 1962.

 

 

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Subordinated Debt: The Fastest Growing Balance Sheet Account in Credit Unions

In 2022 subordinated debt issued by credit unions grew to $3.381 billion, a 257% increase from December 2021.

The number of credit unions using this form of temporary capital grew from 105 to 150. They represent about 7.3% of total system assets.

While still a very small percentage (1.4%) of the system’s total year end capital, its use is highly concentrated in a few credit unions.

NCUA is presenting a final rule on subordinated debt at this Thursday’s board meeting.  A point of interest will be how much detail is given the board and public about how credit unions used the funds, the various sources, and the reliance on this debt to meet capital compliance ratios.

These details are especially relevant today when bank failures wiped out not only all stockholder equity and retained earnings, but also all bond debt.

Rented Capital or Buy Now, Return Later

By rule subdebt is an unusual financial instrument.

Subdebt is reported as a liability, that is a borrowing, on the credit union’s books.  But because of the structure of the debt, NCUA considers it to be capital when calculating net worth for RBC-CCULR and low-income credit unions.

Subdebt can be sold to other credit unions as well as outside investors. Purchasers perceive it to be an investment, but technically it is a loan to the credit union which makes it as an eligible “investment”  for credit unions to hold.

In the event of credit union failure, the subdebt is at risk if all the credit union’s capital is depleted.

A Financial Growth Hormone

Unlike traditional retained earnings capital, subdebt is not free, with the interest rate varying depending on the structure and the credit union’s financial situation.

Because its inclusion in computing capital ratios is time-limited, the most common justification given by credit unions for raising the debt is to accelerate balance sheet growth.  Book the capital upfront, then leverage it for additional ROA to have increased earnings to repay the “borrowed” capital down the road.

This financial leverage requires raising more funds matched with earning assets to achieve a spread, or net interest margin, to make the process earning accretive. Buying whole banks is one obvious tactic to accomplish both balance sheet growth goals at once.

The process refocuses credit union financial priorities from creating member value to enhancing institutional financial performance through leverage.

Most Use Is by a Few Large Credit Unions

Community development credit unions are major issuers of subdebt.   The two charters under the Self-Help brand have together raised over $700 million.  Hope FCU in Mississippi and Latino in North Carolina have issued over $100 million each.

Bank purchases have been an important part of other credit union’s use of debt:  VyStar, GreenState, and George’s Own for example.

In other situations where the amounts are more modest, the intended use is less clear.  Is it just a form of “capital insurance” to meet the increased capital ratios of RBC/CCULR?   Is it to “test the waters” to see how the process works? Issuing subdebt is not a simple effort as for example, opening a FHLB account.

The Most Important Missing Rule Requirement

Subdebt has been bought by banks, insurance companies, investors and even other credit unions.

Sometimes the events are announced publicly either by the broker facilitating the transaction or the credit union.   The purpose is rarely specified other than to seek new opportunities for. . .  and then fill in the blank with a generality.

It is the members who pay the cost of the debt. The interest on the debt is an operating expense that comes before dividends.  If the only use is capital insurance or assurance, then the members should be informed as to the terms, cost and role of this approach to meeting regulations.   It is a management and board responsibility to be transparent and accountable to their owners.

If the goal is more ambitious, to capture new growth possibilities, the disclosure is even more critical.   Financial leverage, especially non-organic growth, increases risk.

In both instances the commitments undertaken can extend as far as ten years.  That term reinforces the need for full disclosure so members are aware of the commitments being made on their behalf.

The most important requirement that should be part of the revised subdebt rule is for full transparency for each transaction.  The purchasers of the debt are given all the details of the borrowing as their funds are at risk should the credit union fail.

Shouldn’t the member-owners also be informed of the commitments and terms made using their long-standing loyalty which, in reality, is underwriting the transaction’s terms?

It’s an opportunity for credit union members to be treated as actual owners, not just customers.

 

 

 

 

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What Can Be Done about the Drought of New Credit Union Charters?

There are financial deserts in towns and cities across America; there is also an absence of new credit union charters.

Since December of 2016, the number of federally insured credit unions has fallen from 5,785 to 4.780, at yearend 2022.  This is a decline of over 165 charters per year.  In this same six years, 14 new charters were granted.

Expanding FOM’s to “underserved areas” or opening an out of area credit union branch, is not the same solution as a locally inspired and managed charter.

Obtaining a new charter has never been more difficult for interested groups. Through its insurance approval, NCUA has final say on all new applications whether for a federal or state charter.

Today, credit union startups are as rare as __________ (you fill in the blank).

At this week’s GAC convention an NCUA board member announced the agency’s latest new chartering enhancement: the provisional charter phase.  This approach does not address the fundamental charter barriers.

Could an example from the movement’s history suggest a solution?

The Chartering Record of the First Federal Regulator

Looking at the record of Claude Orchard  demonstrates what is possible for an individual government leader.   He was the first federal administrator/regulator managing a new bureau within the Farm Credit Administration to create a federal credit union system.  He was recruited for this startup role by Roy Bergengren, who along with Edward Filene, founded the credit union movement.

The story of how and why he was chosen is told here.   Bergengren nominated Orchard because he had “the proper credit union spirit.” This had been demonstrated by his efforts to charter over 70 de novo state credit unions for his employer Amour.

Orchard accepted this government role in the middle of the depression using borrowed FCA staff.  The state chartered system was the only model of how to create a federal option.  That experience and belief in the mission is what  Orchard brought to this new role.

Unlike the banking and S&L industry there was no insurance fund for credit union shares/savings.   The coop model was based on self-help, self-financing and self-governance.  Self-starters provided the human and social (trust) capital; no minimum financial capital was needed.  Credit unions tapped into the quintessential American entrepreneurial spirit to help others.

Orchard’s critical tenure as the first federal regulator is described  in a special NCUA 50th Anniversary Report published in 1984:

“He emphasized organizing as much as supervision. ‘I think in general we tried in the beginning to avoid paperwork because it seemed to me like that was a waster of effort.  After all what we were out for was to get some charters and get some organizational work done.’

When Mr. Orchard stepped down in in 1953, federal credit unions numbered over 6,500.   During his 19 year he espoused a passionate belief in the ideals of creditunionism.  ‘It seems to me that we have here a tool. If it can be made to really be responsive and to really be, in the end, under the control of the members, it can teach people in this country something about democracy which could be taught in no other way.‘

Deane Gannon, his successor at the Bureau of Federal Credit Unions said to Mr. Orchard on the 30th anniversary of the Federal Credit Union Act, ‘If it hadn’t been for you none of us would be here to celebrate anything.‘”

That last observation echoes today.   How many charters will be left to celebrate the 100th anniversary of the FCU Act in 2034?

Alternatives  Are  Springing Up

For the credit union movement to remain relevant it will require modern day Claude Orchards. These are leaders who believe in creditunionism.  And possess the passion to encourage new entrants to join the movement.

Regulatory process or policy improvements may help.  But the real shortfall is leadership committed to expanding credit union options.

To address the continuing financial inequities throughout American communities, alternative solutions are being created.  Many of these startups are outside the purview of banking regulators.

These community focused lenders are listed in  Inclusiv’s 2022 CDFI Program Aware Book.  The firm introduces its role with these words:

Access to affordable financial products and services is a staple of economically sound communities. Yet at least one quarter of American households do not have bank accounts or rely on costly payday lenders and check-cashing outlets.

In recent years, the lack of access to capital investments for small businesses and other critical community development projects has also led to increased need for alternative and reliable sources of financing.

Mission-driven organizations called Community Development Financial Institutions–or CDFIs–fill these gaps by offering affordable financial products and services that meet the unique needs of economically underserved communities.

Through awards and trainings, the Community Development Financial Institutions Program (CDFI Program) invests in and builds the capacity of CDFIs, empowering them to grow, achieve organizational sustainability, and contribute to the revitalization of their communities.

Of the total $199.4 million awarded to 435 organizations, only 176 or 40% were to credit unions.  The rest of the field included 213 local loan funds, 43  banks and 3 venture capital firms.

Without credit union charters, alternative organizations will be created to serve individuals and their communities.   These lenders may not put credit unions out of business, but will  attract the entrepreneurs that would have  added critical momentum to the cooperative system.

Credit unions can qualify for CDFI status and grants.   But Inclusiv has a much broader vision for implementing Claude Orchard’s  playbook.

In their listing of 2022 total awards and grants, every amount of over $1.0 million went to an organization that was not a credit union.  A few were banks, but most were de novo local community lenders or venture capital firms.

Without credit union options, civic motivated entrepreneurs will seek other solutions, and slowly replace credit union’s role.

Today it is Inclusiv carrying out Orchard’s vision.

Should NCUA delegate its chartering function to those who have “the proper spirit” to secure credit unions’ future?

It will also result in “teaching people in this country something about democracy which could be taught in no other way.”

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Two Positive Updates & a Disheartening Decision

Callahan’s Trend Watch industry analysis on February 15 was a very informative event. It was timely and comprehensive.

Here is the industry summary slide:

The numbers I believe most important in the presentation are the 3.4% share growth, the 20% on balance sheet loan growth and the ROA of .89.

The full 66 slide deck with the opening economic assessment and credit union case study can be found here.

The Theme of Tighter Liquidity

A theme woven throughout the five-part financial analysis was tighter liquidity and the increased competition for savings.   Slides documented the rising loan-to-share ratio, the drawdown of investments and cash, the increase of FHLB borrowings, and the continuing high level of loan originations, but lower secondary market sales.

These are all valid points.   However liquidity constraints are rarely fatal.  It most often just means slower than normal balance sheet growth. That is the intent of the Federal Reserve’s policy of raising  rates.

Credit Unions’ Advantage

I think the most important response to this tightening liquidity is slide no. 24 which shows the share composition of the industry.  Core deposits of regular shares and share drafts are 58.3% of funding.  When money market savings are added the total is 80%.

This local, consumer-based funding strategy is credit unions’ most important strategic advantage versus larger institutions.  Those firms rely on wholesale funds, large commercial or municipal deposits and regularly  move between funding options to maintain net interest margins.  These firms are at the mercy of market rates because they lack local franchises.

In contrast, most credit unions have average core deposit lives from ALM modeling of over ten years. The rates paid on these relationship based deposits rise more slowly and shield institutions from the extreme impacts of rapid rate increases.   In fact the industry’s net interest margin rose in the final quarter to 2.86% (slide 56) and is now higher than the average operating expense ratio.

Rates are likely to continue to rise.  There will be competition at the margin for large balances especially as money market mutual funds are now paying 4.5% or more.  If credit unions take care of their core members, they will take care of the credit union.

The February NCUA Board Meeting

The NCUA Board had three topics:  NCUSIF update, a proposed FOM rule change, and a new rule for reporting certain cyber incidents to NCUA within 72 hours of the event.  The NCUSIF’s status affects every credit union so I will focus on that briefing.

We learned the fund set a new goal of holding at least $4.0 billion in overnights which it is projected to reach by summer.  Currently that treasury account pays 4.6%.  With several more Fed increases on the way the earnings on this $4.0 billion amount alone (20% of total investments) would potentially cover almost all of the fund’s 2023 operating expenses.

Hopefully this change presages a different  approach to  managing NCUSIF.  Managing  investments using weighted average maturity (WAM, currently 3.25 years) to meet all revenue needs, versus a static ladder approach, means results are not dependent on the vagaries of the market.

At the moment the NCUSIF portfolio shows a decline from book value of $1.7 billion.  This will reduce future earnings versus current market rates until the fund’s investments mature, a process that could take over three years at current rate levels.

Other information that came out in the board’s dialogue with staff:

  • Nine of the past thirteen liquidations are due to fraud. Fraud is a factor in about 75% of failures;
  • More corporate AME recoveries are on the way. Credit unions have been individually notified. The total will be near $220 million;
  • If the NOL 1% deposit true up were aligned with the insured deposit total, yearend NOL would be about .003 of lower at 1.297% versus the reported 1.3%. Share declines in the second half of the year will result in net refunds of the 1% deposits of $63 million from the total held as of June;
  • Staff will present an analysis next month of how to better align the NOL ratio with actual events;
  • The E&I director presented multiple reasons for NCUSIF’s not relying on borrowings during a crisis, but instead keeping its funds liquid;
  • The E&I director also commented that the increase in CAMELS codes 3, 4, 5 was only partly due to liquidity; rather the downgrades reflected credit and broader risk management shortfalls;
  • NCUSIF’s 2022 $208 million in operating expenses were $18 million below authorized amounts;
  • The funds allowance account ($185 million) equals 1.1 basis points of insured shares. The actual insured loss for the past five years has been less the .4 of a basis point.

Both the Callahans Trend Watch industry report and NCUA’s  insured fund update with the latest CAMELS distributions suggest a very stable, sound and well performing cooperative system.

A Disappointing NCUA Response

Against this positive news, is a February 15  release from the Dakota Credit Union Association.   It stated NCUA had denied claims of 28 North Dakota credit unions for their $13.8 million of US Central recoveries from their corporate’s  PIC and MCA capital accounts.

These credit unions were the owners of Midwest  Corporate which placed these member funds in the US Central’s equity accounts, a legal requirement for membership.   The NCUA claimed that the owners of Midwest Corporate had no rightful claim, even though a claim certificate for these assets was provided by NCUA.

Nothing in this certificate says that the claim is no longer valid if a corporate voluntarily liquidates.

Under the corporate stabilization program corporate owners were forced to choose between recapitalizing after writing off millions in capital losses in 2009, merge with another corporate, or voluntarily liquidate.

Both the Iowa  and Dakota corporates chose to voluntarily liquidate versus facing the prospect of further corporate capital calls.

The NCUA oversaw the liquidation of both Corporates in 2011. The NCUA’s liquidating agent knew  that claim certificates were issued, that there was no wording that voluntary liquidation would negate future recoveries for the corporates’ owners and that NCUA’s legal obligation is to return recoveries to the credit union’s owners, whether in voluntary or involuntary liquidation.

The claim receipt specifically states: “No further action is required on your part to file or activate a liquidation claim.”  Yet that is just the opposite of what NCUA is now saying the credit unions must do.

For example NCUA continues to pay recoveries to the owners of the four corporates who were conserved and involuntarily liquidated by the agency.

According to Dakota League President Olson, NCUA has failed even to inform the league  in what accounts these funds are now held.  Are they being distributed to all other US Central owners? To the NCUSIF? Or held in escrow?

“This is a clear case of obstruction through bureaucratic hurdles and complicated language where the process is the punishment, and does not provide justice,” stated Olson.

These funds  ultimately belong to the member-owners of these credit unions  The NCUSIF is in good shape.  This is not a legal issue.  It is common sense.

NCUA controlled all the options for every corporate through through its stabilization plan. It took total responsibility for returning funds-no further action required. No one will critique returning members’ money.  But failure to do so undermines trust in the Board ‘s judgment, its leadership of staff, and its fiduciary responsibility for credit union member funds.

The NCUA board should do the “right thing” for these credit unions and their members.

 

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Quick Takes on NCUA’s Four KPMG December 2022 Audits

On February 13, 2023 NCUA posted the December yearend audits of its four managed funds.

Publishing this audited information plus the interim monthly financial updates is an important resource for credit unions to monitor the Agency’s financial performance.

Today’s NCUA board meeting will include a public discussion of the NCUSIF, the largest and most critical report because it relies on the credit unions’  1% capital deposit as its funding base.

General Audit Observations

Three of the four funds are presented following GAAP accounting standards.  These three financial statements and footnotes are easy to follow.   However the NCUSIF is presented using Federal GAAP accounting.  There are fundamental differences in presentation and transparency between these two approaches.  I’ll address these below.

Total NCUA expenses in its three main funds (NCUSIF, Operating and CLF) total $ 332.1 million, an increase of $14.5 million (4.6%) from 2021.   The NCUSIF paid 63% of this expense total.   It should be noted that all NCUA’s revenue is from credit unions and interest on their funds held by the agency.

The smallest of the four, the community Development Revolving Loan Fund does not have allocated expenses and has minimal activity-only $1.5 million in “technical assistance grants.”

The NCUSIF’s Audit

The Board meeting is only discussing the NCUSIF today. It is the most consequential for credit unions in terms of credit union impact and support.

The NCUSIF had a  stable year.  Total expenses rose to $208 million or 4.5%.   Net cash losses were just over $10 million.  However $33 million additional expense was added to the reserve account raising its total by $ 23 million to $185 million.  That reserve balance  equates to 1.1 basis points of insured shares, a  ratio greater than the most recent five years net cash loss rate.

Several very important issues are not directly addressed in the audit.  But hopefully will be raised by Board members.

The first is the Federal GAAP presentation that uses completely misleading terms for a non-appropriated government entity.  Fed GAAP has no accounting concept of retained earnings, but rather presents “cumulative result of operations.”   This number includes any changes in the market value of the fund’s major asset-treasury securities as of the audit date.

Other accounting categories such as intragovernmental assets, exchange revenue, public liabilities, net position and order of presentation are completely foreign concepts for standard GAAP financial statements.  They obscure  understanding of financial performance.  Even NCUA staff converts the information to a standard GAAP format for the board.

The accounting term “cumulative results of operations”  which replaces “retained earnings” shows a decline  from $4.8 billion to $3.2 billion due to the $1.6 billion difference in market and book value of the NCUSIF’s investments.  Also the fund’s total capital which includes  the 1% deposit shows a fall from $20.6 billion to $20.2 billion.

This is how the balance sheet is reported even though the NCUSIF had a positive bottom line of $185 million using standard GAAP accounting.  Any reporter or other user of this statement would be left with a very negative impression of the Fund’s balance sheet financial position from this presentation.

Also Federal GAAP considers all AME and NCUSIF managed estates as “fiduciary” and therefore not part of the NCUSIF’s balance sheet.   As a result only the net amount of the corporate and natural person combined AME numbers is shown in footnotes.  Expenses are netted against income.  Tracking the reasons for increases and decreases in “net liabilities” is impossible as only totals are provided.

This off-balance sheet accounting means the corporate AME’s and NPCU estates are not part of the monthly NCUSIF updates.  Their  revenue and expenses are not reported.  And the amounts under management are large, in the hundreds of millions for the Corporate estates, that are still owed credit unions.

This is a situation ripe for error and mismanagement.  Timely and full disclosure of these off-balance sheet funds are material to understanding the fund’s actual performance.

The All Important NOL

The most important yearend result is the NOL calculation.  A footnote reports the “NCUA’s calculation” as 1.3% or below the board’s 1.33% cap.

This is a ratio composed of the June 2022, 1% capitalization balance, an audited retained earnings (note the switch to GAAP) at December 2022, and an unaudited insured shares total as of February 10, 2023.  Two different accounting dates are used in the numerator (June 30 and December 31) and an unaudited total in the denominator.   The result is a misleading NOL ratio.

Share growth in 2023 was just 3.4% with credit unions reported lower total insured shares at December 31 than at June 30.  However the larger June 1% deposit number is used in the denominator even though net deposit refunds will be sent from this total.   In essence the actual NOL is slightly overstated.

Moreover, It is easy to estimate what credit unions’ 1% deposit net liability is. Just take 1% of the denominator’s total for insured shares.   That is how private GAAP would present the ratio—and how the NCUA did the calculation until 2001.   As a consequence this  ratio misstates actual NOL and potentially, dividends due to credit unions.

The NCUSIF’s Investment Management

 

The fund’s most important asset is its $21 million of treasury investments.  The yearend audit shows a larger overnight cash position than in 2021.  However the fund’s weighted average life of 3.3 years has been largely unchanged during the past 12 months of Fed tightening.

The portfolio’s decline in market value is almost $1.7 billion at yearend.  This is important because the decline equates to over 10 basis points of the fund’s 30 basis point in retained earnings.  This  amount, on top of the 1% deposit, must remain at or above 1.2% or an equity restoration plan is required.

What is the fund’s interest risk management monitoring process?  Why would the NCUSIF keep investing long term in a rising rate environment?  Especially when there is an inverted yield curve?

As of Wednesday’s Feb 15’s market close, the one year treasury yield was 4.96% and the seven year was 1% lower at 3.94%.   This inverted yield curve has existed for almost six months.  All of the fundamentals suggest a shorter WAM for the NCUSIF’s portfolio.

The consequence of a 3.3 year weighted average maturity (WAM) is that NCUSIF investments will underperform market rates until the yield curve stabilizes at a new normal.   If today’s environment were representative of the future, it would take the fund over three years to recover its market losses.   During this adjustment, the NCUSIF revenue is shortchanged from current market returns.  Credit unions will suffer the shortfall either in lost dividends or, in a worst case scenario, a fee to maintain the NOL.

So today’s meeting is an important opportunity to see what the board and staff take away from this year’s NCUSIF performance.   The numbers are in, now what do they mean?  How can the fund’s presentation and management be more transparent to its credit union owners?   In short, how can performance be improved?

The Central Liquidity Facility

 

The CLF had a most interesting year financially as it reported $546 million in capital stock redemptions by agent corporates, partially offset by a $132 million increase in regular member shares.  Total capital declined by a net amount of $400 million due to these  stock paybacks and new purchases.

As has been the case since 2010, the CLF made no loans.  It paid out 97.3% of its $20.7 million net income in quarterly stock dividends totaling $3.69 per $50 share over the entire year.   That  equates to  a 7.4% annual dividend yield.

The CLF’s borrowing authority reverted to 12 times its capital and surplus with the expiration of the CARES Act temporary increase.   As a result, and also due to the decline in total capital , the CLF’s maximum borrowing amount fell from $35.7 in 2021 to $17.5 at yearend 2022.

All the CLF’s revenue is from interest on investments, which are kept at Treasury., even though CLF has broader statutory investment authority than the NCUSIF.   Income jumped from $4.5 to $22 million. Most of this increase was passed through as a dividend.

A point of inquiry would be why the liquidity facility had 7.6% of its investments in the 5-10 year maturity bucket.  Or why it keeps almost 40% in the 1-5 year range.   It would seem prudent that the CLF should place  investments no longer than the limit the NCUA places on corporates, or two years.

Operating Holds Fund Balance Exceeding Annual Expenses

 

The Operating Fund had expenses of $122.8 after all internal transfers, a $5.3 million (4.7%) increase over 2021.

The Fund retained an equity surplus of $133 million or 108% of 2022’s  total operating expenditures.  Interest on this fund balance did grow from nil to $2.4 million  as market rates rose.

Even though NCUA said it would reduce the credit union funds held by assessing a lower 2022 operating fee, the ending balance is still over three times the agency levels of earlier years.  It is far in excess of any cash flow coverage necessary  until the new year’s operating fees are received.

Transparency Only Matters if Credit Unions Pay Attention

One of the most important checks and balances credit unions requested in 1984 which NCUA committed to,  was an annual external CPA (not GAO) audit of the NCUSIF in return for the open ended 1% deposit funding base.

In addition, monthly financial updates would help monitor the fund’s expenses, reserves and overall management.

However, if the reports are not used by credit unions and only the press releases are followed, then the reporting and transparency model will not work.

For credit unions used to monthly financial analysis, this responsibility should be a “walk in the park.”   Take it.