In 2010 NCUA’s regulatory activity reigned unchecked. Even though the economy was on the mend its penchant for shutting down credit unions was unabated.  It would ultimately lead to the liquidation of five corporate credit unions in September—the most catastrophic decision in credit union history.

On August 3^rd, 2010, six years after founding, Kappa Alpha Psi FCU ($750K, Dallas, Tx) fell under NCUA’s knee having been served a surprise order of liquidation and charter revocation.

In the regulatory environment, one might assume this was just another small credit union falling prey to economic circumstances.  But then something happened that no other credit union had dared in this situation. The credit union appealed NCUA’s action, filing a complaint contesting the order on both factual and constitutional grounds.

KAPFCU requested  a temporary restraining order against NCUA:  “Petitioner fears that before a show cause hearing can be held, the Respondent will complete what has already been threatened, and that is to hastily liquidate assets, expend money, enter or break contracts and disrupt the ongoing operations of the credit union.”

In response, a federal judge in DC granted a temporary injunction and scheduled a hearing on the issue in the time provided for an appeal.

Who  is Kappa Alpha Psi (source: KAP web page)

“The Kappa Alpha Psi®  college Fraternity, was born in an environment saturated in racism.  Indiana became the 19^th state of the Union in 1816 and it founded Indiana University in Bloomington four years later. The state of Indiana became a stronghold for the Ku Klux Klan.

In the school years of 1910-11, a small group of Black students attended the University. Most  working their way through school. Realizing that they had no part in the social life of the university they decided that a Greek-letter fraternity would do much to fill the missing link in their college existence. . .

It became the first incorporated Black Fraternity in the United States, granted a charter by the Indiana Secretary of State on May 15, 1911.

Kappa Alpha Psi® is the 1^st historically black Greek Letter intercollegiate Fraternity incorporated as a national body.  The Fraternity has over 125,000 members with 700 undergraduate and alumni chapters in nearly every state of the United States, and international chapters in Nigeria, South Africa, the West Indies, the United Kingdom, Germany, Korea and Japan.

One of the Objectives of the Fraternity is: “To promote the spiritual, social, intellectual and moral welfare of members.”  Reliance would be placed upon high Christian ideals and the purpose of ACHIEVEMENT.

The Fraternity seeks to raise the sights of Black youths and stimulate them to accomplishments higher than might otherwise be realized or even imagined.

Local chapters participate in community outreach activities to feed the homeless, provide scholarships to young people matriculating to college, serve as mentors to young men, participate in blood drives and serve as hosts of seminars for public health awareness to name a few.”

The Credit Union’s Brief History

Kappa Alpha Psi FCU, chartered in 2004, was in its sixth full year of operation when NCUA struck.  It was classified as a “new” credit union, that is, in operation for less than 10 years and its total assets did not exceed $10 million.

NCUA Regulations provide that ‘new credit unions’ must be ‘adequately capitalized’ or (6%) Net Worth Ratio within 10 years.

NCUA based its liquidation order on the credit union’s net worth ratio, asserting that because the financial institution was minimally capitalized at the end of first quarter 2010 with no reasonable prospect for becoming capitalized, prompt corrective action was warranted.

The credit union notes its first quarter net worth ratio was 1.95%; by the June 30, 2010 second quarter however, the credit union was moderately capitalized with a net worth ratio of 3.67%– a 600% increase since its December 31, 2009 rating.

These numbers, for reasons never explained, were not reflected on the credit union’s second quarter 2010 Call Report posted by NCUA. Who altered Kappa Alpha Psi FCU’s second quarter Call Report to make it appear insolvent? What was the basis for the change? Why was the credit union not contacted?

Read Part II for the outcome tomorrow:

Why Kappa Alpha Psi FCU’s Stance Matters Today

Part I showed how the changeover of NCUA board chairs has perpetuated a leadership vacuum at the agency frustrating effective policy development and positive relations with the industry. Following is a recent example of this challenge.

A classic case of ineffective pubic policy  is NCUA’s management of the corporate credit union crisis. It also demonstrates the embedded cultural mindset from the agency’s actions in this event.

This regulatory hangover continues whenever any corporate topic arises. Since 2009, NCUA’s attitude in supervising the corporate system could be described as, “If you don’t have a seat at the table, then you must be on the menu.”

The absence of market expertise at the NCUA board and staff level has created policy decisions by rote. Lacking different perspectives and professional insights, the existing culture plods on. When governmental backgrounds are the dominant experience senior officials bring to their roles, the disconnect with credit unions competing in the open market can become great.

Policy On Autopilot

One example of this bureaucratic legacy is from the NCUA board’s January 2021 meeting. It approved by a 3-0 vote a final rule 704 permitting corporate credit unions to invest in the subordinated debt of natural person credit unions. However, this “loan” must be deducted 100% when computing a corporate’s net worth ratio.

The following is the logic for this rule from the board memorandum:

NCUA claims open-ended authority: The FCU’s “broad mandate,” “plenary grant of regulatory authority,” and “an express grant of authority” can be exercised as “the Board deems appropriate.” The words are presented as unrestricted power to do whatever the board wishes. An unchecked authority.

“Under the FCU Act, the NCUA is the chartering and supervisory authority for Federal credit unions (FCUs) and the federal supervisory authority for federally insured credit unions (FICUs). The FCU Act grants the NCUA a broad mandate to issue regulations governing both FCUs and FICUs. Section 120 of the FCU Act is a general grant of regulatory authority and authorizes the Board to prescribe regulations for the administration of the FCU Act. Section 209 of the FCU Act is a plenary grant of regulatory authority to the NCUA to issue regulations necessary or appropriate to carry out its role as share insurer for all FICUs. The FCU Act also includes an express grant of authority for the Board to subject federally chartered central, or corporate, credit unions to such rules, regulations, and orders as the Board deems appropriate.”

It’s a loan: “Treating the purchase of such subordinated debt instruments as lending ensures consistent treatment between natural person credit unions and corporate credit unions.”

It must be fully deductible from the capital ratio: “The Board believes that fully deducting such instruments from Tier 1 capital ensures any potential losses do not affect the capital position of the investing corporate credit union. This measured approach strikes the right balance between providing corporate credit unions the flexibility to purchase natural person credit union subordinated debt instruments and avoiding undue systemic risk to the credit union system.”

The Result: A Nonsensical Rule

This “updated” rule restores an activity, previously allowed but then revoked, to make a loan. But only if it is 100% deducted in calculating the required net worth ratio.

Loans are a credit union’s primary purpose. Few “loans” would ever be made on the condition that the institution must “write it off“ when calculating capital compliance.

In effect, NCUA confesses a lack of confidence in its own supervisory decisions. For NCUA must first approve all the subordinated debt issuance by natural person credit unions. The rule’s logic is that this approval and oversight are so suspect that the only prudent behavior is to write it off if a corporate purchases this loan debt. This is not mere risk rating; it is 100% reduction from capital when calculating net worth.

The write off is not proper accounting under GAAP. It is an imposition of regulatory accounting practice or RAP. There is no limit to RAP interpretations; see authority claimed above.

No facts were offered to support this claimed risk. Has any issuance of subordinated debt ever been written down or subject to a loss? What is the evidence to document this risk? Moreover, how important is this debt option for credit unions? If it is an important, why discourage its use this way?

If NCUA is so concerned about investments or loans used as capital by the recipient, then why aren’t credit unions required to write down their home loan bank equity requirements?

Or closer to home, why aren’t the corporates required to write off their CLF capital investments. Are they not at risk?

The ultimate rationale is that this is the way we have done it before. The result is that past errors of policy, guidance, interpretations compound far into the future. The mind set continues.

“In addition, the February 2020 proposed rule included a requirement for a corporate credit union to fully deduct the amount of the subordinated debt instrument from its Tier 1 capital to ensure consistent treatment between investments in the capital of other corporate credit unions and natural person credit unions. Under the current regulation, corporate credit unions are currently required to deduct from Tier 1 capital any investments in perpetual contributed capital and nonperpetual capital accounts that are maintained at other corporate credit unions.”

This rule is not based on any assessment of actual risks, Moreover it perpetuates “confirmation bias” errors that have been extraordinarily costly to the corporate and credit union system.

Which Leadership Model Will New Chair Harper Follow?

He inherits a decade-long policy of top-down mandates. Former board member McWatters described the situation this way in a 2015 speech to Pennsylvania League’s Annual Meeting:

“NCUA should not treat members of the credit union community as Victorian era children—speak when you’re spoken to and otherwise mind your manners and go off with your nanny—but should, instead, renounce its imperious ‘my-way-or–the-highway’ approach and actively solicit input from the community on NCUA’s budget and the budgetary process.

“With the strong visceral response within the agency against budget hearings, it seems that some expect masses of credit union community members to charge the NCUA ramparts with pitchforks and flaming torches to free themselves from regulatory serfdom. I, conversely, welcome all comments and criticism from the community.

“I champion the right of the regulated to speak to the regulator on the record regarding the expenditure of their limited resources. . . It’s simply a matter of respect and professionalism evidenced through the lens of transparency and full accountability.”

‘Step Down from the Ivory Tower’

McWatters also cautioned against the view that board nomination validates knowledge:

“Regulatory wisdom is not metaphysically bestowed upon an NCUA board member once the gavel falls on his or her Senate confirmation. NCUA should not, accordingly, pretend that it’s a modern-day Oracle of Delphi where all insight of the credit union community begins once you enter the doors at 1775 Duke Street in Alexandria, Virginia.”

https://www.cutoday.info/Fresh-Today/McWatters-Says-NCUA-Treats-CUs-as-Victorian-Era-Children-Comments-Draw-Rebuke-From-Chairman

Duty vs Loyalty

The Chair’s approach to board leadership also affects how agency staff perceive their jobs. Is staff supposed to provide their professional judgment, or are they just expected to fall in line with the Chair’s approach?

This staff dilemma was described by former Chairman Rick Metsger: “As I told Mark Treichel, the then executive director of the agency when I became chairman when he offered his loyalty, I said I didn’t want his loyalty, but I did expect his loyalty to the mission of the agency and that he would offer unvarnished opinions and options to help me make the best decisions possible.”

https://www.cutoday.info/THE-tude/Political-Storm-Karma-Makes-Landfall-at-NCUA

Harper’s Challenge: Reset or More of the Same?

Todd Harper was chief policy advisor to Chairman Matz. Her top-down leadership approach to policy is what prompted the above comments by board members and staff who worked with her.

Will Harper follow her leadership and policy example? Or will he embrace the widespread belief that there needs to be a reset in Agency and credit union relations?

Since 2017 there have been four NCUA Chairmen designated by the President. Two republicans and two democrats.

The Board’s primary responsibility is the “management” of the agency as stated in the Federal Credit Union Act. The chair sets the agenda and is the primary spokesperson for the Agency.

Any organization that undergoes four changes of the titular leader in the same number of years would face unusual difficulties in both policy and operational effectiveness.

In the past decade, no one has accused NCUA of being well governed. Less than optimal outcomes can be endured in normal times. When crisis occurs, ineffective decisions can be destructive. A prime example is the ruinous handling of the corporate legacy asset resolution plans in 2008-2010.

These prior mistakes compound; the legacy perpetuates in subsequent decisions. The errors become hard-to-shed precedents especially when there is an organizational aversion to back-testing past events.

An Example of Effective Leadership

In October 1981 when Ed Callahan became NCUA chair, the economy had double digit unemployment and inflation. Credit unions had only one concern: survival. Only in 1977 had NCUA become an independent agency governed by a three-person board. The CLF was still in formation. The NCUSIF was out of cash and using 208 guarantees to assist troubled credit unions to work through problems.

Chairman Callahan’s approach was twofold: implement deregulation so that credit unions, not the government, could make the essential business decisions to serve members and effectively compete in the changing market; and secondly, build a regulatory infrastructure and supervision capable of overseeing the deregulated industry.

But his approach was not top-down but bottom-up policy implementation. To succeed, he initiated a multi-faceted open dialogue with credit unions. The first effort was a 24-minute video produced by the Illinois Credit Union League entitled: “Deregulation–What Does It Really Mean?” The video featured a panel discussion of three credit union CEOs, CUNA’s Vice President for Governmental Affairs, and Bucky and Ed from NCUA.

A comment in the video by Chairman Callahan illustrates his approach to policy leadership:

“Do you want government off your backs?

“Even though I think credit unions want deregulation, I am more committed to the fact that we have to respond to their needs. If they don’t want deregulation, we will see that it doesn’t happen.

“Write us a letter so that we can respond to your needs. I will read each one personally.”

Three months later, April 1982, the NCUA board approved the complete deregulation of all savings accounts with full credit union support. It took the other depository institutions until June 1987 to shed their regulatory deposit limits.

The key to success was having participants with experience in the room, even some who had made mistakes, but who were willing to learn from their involvement. Secondly, persons who would come at issues from a variety of viewpoints and backgrounds–not a single framework–but with multiple perspectives.

A Mutual Process

This engagement with the industry resulting in share deregulation was just the beginning. The insights of credit union leaders were crucial in all areas of policy development.

Before developing a new NCUSIF financial structure, the agency received input from all segments of the industry to prepare a Report to Congress, required by the Garn-St. Germain Depository Institutions Act of 1982. In April 1983 this seven-chapter, 100-page credit union share insurance analysis was submitted. It ended with a list of over 60 names of industry contributors, many of whom were quoted in the study.

The recommendations in that joint study became the basis for the 1% deposit NCUSIF restructure, A Better Way, passed by Congress in 1984. The dramatic change occurred because of the support of the entire system.

In a similar manner, the Central Liquidity Facility was completely opened to all credit unions in an innovative partnership with US Central, the corporate network and the CLF. This liquidity safety net is an example of a public-private partnership based on the unique principles of cooperative design. NCUA ended this valuable partnership when it liquidated US Central.

From 1982 forward, credit unions recorded annual, sound double-digit growth. This mutual approach built a regulatory infrastructure responsive to the moment. The credit union system prospered for the next 25 years.

Bureaucracy is built on the adherence to traditional practice when making decisions. This “mind set” or “culture,” may suffice in normal times. But when changes to meet credit union needs is necessary, then the approach “we’ve always done it this way” will not suffice.

When the 2008/09 financial crisis happened, the agency took a different approach. The legacy of which continues.

Part II will show how this hangover of poor regulatory decisions can infect subsequent rules for decades.

“The relationship between credit unions and the regulatory agency is one founded on mutual self-respect, and on the realization that both sides share equally in the responsibility for the survival and future development of credit unions.

It seemed as though we would never escape the attitude that the regulator knows best (but) a dramatic change has taken place in the last few years. We now have a federal regulatory agency which openly concedes that credit union people know more about running credit unions than the agency does.

The nature of the federal bureaucracy, being what it is, there will be a great amount of inertia to cause it to revert to a less creative and less cooperative approach to regulation credit unions. I would not like to see that happen.”

– Frank Wielga, CEO Pennsylvania State Employees Credit Union, NCUA 1984 Annual Report, pg. 14.

On January 4^th the NCUA board published a request for information (RFI) seeking “input on how best to streamline and improve agency communication with its stakeholders.”

This formal 8-page process listed dozens of existing communications, loads of data and website activity as examples of current efforts.

Below is my “comment” using a 1982 Agency photograph.

It shows NCUA Chairman Ed Callahan holding an open press conference following the monthly board meeting. In the picture are representatives from CUNA, credit union newsletter writers, and NCUA personnel including the Public Affairs Officer. This was standard agency practice for all board meetings in DC and on the road. Senior staff would attend as necessary. Responding to credit union and press interest was more than an obligation as a public servant; it was also an opportunity to listen and learn how the agency was viewed.

When is the last time an NCUA board member held an open press conference? Or did a Q&A following a speech?

Real communication occurs when a person engages in a “dialogue” with their audience. It demonstrates the presenter’s ability, confidence and mastery of their subject.

Communication, Like Leadership, Starts at the Top

Authentic communication is not a public relations strategy. It is leaders willing to expose their ideas in public discourse.

To improve the agency’s presentations, the place to start is at the top. Forget the typed out scripted board exchanges, the deluge of press releases, the flood of email updates.

Schedule monthly, or more frequent, zoom or in person conferences welcoming all comers, especially the press. Bona-fide conversations are the heart of real communications.

The best way to learn what is on a person’s, or industry’s mind, is to listen. In real time. With live people on Zoom or in-person.

Will the new NCUA Chairman lead by example? Or with press releases?

Following is an American Banker article from 1984 reporting on NCUA and credit union’s progress.  The story is built around an interview with Chairman Callahan and the policy of deregulation.

Alpha: The Government Giveth

Esau Jenkins – pre of Citizens’ Committee of Charleston County announces Credit union approved!

From The Pittsburg Courier, October 8, 1966, page 16.

Omega-The Government Taketh Away

C O Federal Credit Union Conserved

ALEXANDRIA, Va. (Jan. 5, 2021) – The National Credit Union Administration today placed C O Federal Credit Union in Charleston, South Carolina, into conservatorship.

C O Federal Credit Union serves members of The Citizen Committee of Charleston County, South Carolina, who live in Charleston County and members of the International Longshoreman’s Association — Local #1422 in Charleston.

C O Federal Credit Union is a federally insured, federally chartered credit union with 785 members and assets of $4,488,256 and over 10% net worth according to the credit union’s most recent Call Report

Member services will continue uninterrupted at the credit union’s main office at 117 Spring St., Suite C, Charleston, South Carolina.

Long Live the Government!

The Greek letters alpha and omega

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.

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.