The Credit Union-Regulator Relationship

“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.”

(NCUA 1984 Annual Report, Page 14)

588,000 Members About to Lose Their Credit Union

On June 12 I described NCUA’s May 17, 2019 conservatorship of Municipal Credit Union in New York City. The critical point was who will be the conservator? What will be the plan? Will NCUA’s chosen leader knock the place down or build it up? We now have an answer.

In less than two months on the job, the conservator recorded a June 30, second quarter loss of $125 million. This results in a reduction of net worth from 7.60% (well-capitalized) at March 30 to 3.41% (under-capitalized) at June 30.

Municipal’s 2-Year Report

The conservatorship was initiated by New York regulators in June 2018 by removing the full board and appointing an administrator, who was then let go earlier this year. New York then appointed NCUA conservator.

In late June several “unnamed sources” placed a leak in a CUToday story saying the credit union had a large underfunded defined benefit plan in an amount of over $100 million. NCUA declined to comment on the story, continuing a pattern of silent neglect throughout the entire conservatorship.

But the loss was a lot more than a benefit funding issue for a credit union which had reported a $3 million net income in the 2019 first quarter. The conservator’s total expenses in the quarter of $168.6 million were more than three times the first quarter total of $49 million. Of this increase, $130 was added to personal expenses, $19.1 quarterly increase in office operations, $8.9 million spent on professional services and $9.3 million in loan loss provision. This loss provision increased the coverage ratio from 147% to 177% even though there was no increase of delinquency at .76% of loans.

Who is Acting in the Members’ Best Interest?

The clear answer is nobody. For any so called expert to come in and wipe out half of a credit union’s net worth in less than 45 days on the job shows an inability to look at options, identify alternatives and develop a plan to sustain operations. An underfunded pension obligation is not a new situation for both public or private organizations. Defined benefits are paid out in decades to come and funding plans similarly are long term. Multiple options are available to manage underfunding which is why actuarial assessments are a normal part of a plan’s annual review. The only time cash in full is required is if the plan is to be terminated immediately which can result in every plan member being 100% vested in full whatever the plan’s actuarial cash requirements might be.

The lack of any explanation, public discussion or consideration of alternatives plus the abruptness of the action, suggests kick-the-barn-down strategy to justify a merger of this $3.0 billion credit union chartered in 1916. For cashing out the plan, if that is the reason for the expense, would leave any subsequent leader with no options and with having to develop a new retirement benefit for employees.

Silence and quiet leaks to the press are not patterns of accountability. NCUA board members may make speeches about all sorts of future risks and opportunities but fail to speak to the immediate needs of 588,000 members who have seen a complete breakdown of regulatory responsibility and accountability.

Every year NCUA and the state have examined the credit union. The credit union must have a CPA annual audit which would include an actuarial assessment of the benefit plan. And yet no action was taken until the CEO was found to have embezzled money. Compounding the failure to address the defined benefit funding (if it was an exam issue) is choosing a conservator with no ability to develop a plan for sustainability. Conservatorship becomes nothing more than preparation for a fire sale.

The members have no voice, they have been denied any role in their CU’s future. The credit union has a 22 branch network and a sound and diverse $2.0 billion loan portfolio and over $660 million in cash. Shares are up 6% and loans over 8% from June 2018, during a full year of conservatorship. And the reward for their loyalty and patronage is to be tossed aside as the regulators attempt to cover with silence their repeated failures to address issues that were clearly disclosed previously.

The Cooperative Advantage

Two factors provide credit unions a major advantage when problems occur. The first is the member relationship, loyalty and trust. The second, derived from the first, is patience when resolving problems.

There is no public pressure on stock price to divest of problems and move to new markets. With the right leadership in place credit unions have survived the most severe crises.

In the June 12 article of NCUA’s actions, a line from Hamilton states, “you have no control, who lives, who dies, who tells your story?” There are only two sources for help—can the members mobilize to assert their rightful role? Will credit unions demand accountability from a regulator whose absence from the fray is a stunning dereliction of duty?

A Modest Proposal for Secondary Capital

NCUA’s June delay in implementing a new risk based capital (RBC) rule was in part explained by the need to examine whether a secondary capital option should be part of the new capital model.

Cooperative design and history suggest there is an immediate and straightforward additional capital option. This solution can be implemented regardless of the outcome of the RBC discussions.

The 1934 Federal Credit Union Act mandated that the par value “shall be $5 per share,” an amount in the law based on twenty five years of state-chartered credit union practice.

Credit unions had no share insurance funds, state or federal, until the 1970s.  Prior to that all member shares were at risk, that is equity for the institution.   An ongoing consequence of this financial structure, even in the era of deregulation, is that credit union shares are second in payment priority in event of liquidation to all other liabilities. This means that third party lenders to credit unions, such as the FHLB system or banks, know that equity is more than a credit union’s retained earnings. In the event of failure, the insurance fund must pay lenders’ outstanding loans ahead of shares.

The $5 Par Share Value Today

The historical par value of  $5 was often purchased on an installment plan, for example,  25 cents a week. This par value, now a variable amount, was the foundation for all funding and was at risk should the credit union not succeed.  Virtually all FCUs and state charters still active today, were financed with this membership shares-at-risk model. This shared fate meant that the cooperative model was indeed based on common values and purpose.

The value of the $5 initial member share purchase requirement today depends on which index one uses to analyze changes in economic value.   There are at least seven choices from the consumer price index to various efforts that track the cost of labor, to nominal GDP per capita. The range of results from these various indexes shows that the value of the $5 share in 1934 would range from $62.70 (CPI) to $373 (GDP per capita) in 2019.

Reengaging Members in the Cooperative Model

The option to ask members to purchase one at risk (uninsured) capital share with specified minimum par value would provide additional equity but more importantly signify once again the uniqueness of the cooperative model. It would be available only to members, limited in individual amounts, and subject to terms and conditions set by the boards.

There is no need to invent multiple plans for secondary capital sold to third parties creating a potential conflict with member’s returns. Instead the original design that successfully launched tens of thousands of charters could become today’s solution for capital flexibility when that is in the members’ best interest.

NCUA Board has a Unique Opportunity to Eliminate the Flawed Risk Based Capital Proposal

This Thursday (June 20) the NCUA Board has only one topic on the agenda: the Risk Based Capital Rule (RBNW). Rodney Hood will be the 4th Chairman to address the issue.

He and fellow board member McWatters will have the chance to set a whole new direction for regulatory policy if they choose to do the obvious and cancel outright this deeply flawed rule-making effort.

Not only would such an action align with the administration’s policy priorities, it would also end a regulatory approach that is problematic. All other financial regulators have moved away from the belief that future risk can be both predicted and modeled so accurately so as to require specific and relative levels of capital more than sufficient for any future crisis.

The Proposal’s Flawed Foundation

In the post 2008/2009 financial crisis, FDIC and bank regulators reduced reliance on risk-based approaches in favor of a simple leverage capital ratio. Tomas Hoenig, the former Vice Chairman of the FDIC, championed this clearly understood and easily calculated capital ratio. At the same time, he repeatedly documented the flawed premises and historical errors of modeling future risk relativities among myriad categories of bank assets.

However, NCUA under Chairman Matz introduced this flawed approach that was so lacking in factual foundation that the initial draft had to be withdrawn; but then it was reintroduced a second time.

This revised proposal drew significant dissent from new board member McWatters who was in the minority 2:1 board vote to approve the regulation.

“Based upon my thirty plus years of experience as an attorney who has worked in many intricate issues of statutory and regulatory interpretation, I am of the view that NCUA does not possess the legal authority under the NCUA to adopt a two-tier RBNW regulatory standard.

NCUA staff did not undertake a formal estimate of the recurring compliance costs of the proposed regulations… Regrettably this additional burden falls on a financial services sector that is not too-big-to-fail and was in manner responsible for the recent financial crisis.”

Kicking the Can Down the Road

The objections and complications of the rule were so great that NCUA delayed the final implementation until 2019 to allow time for the agency to expand its call report and internal software to be able to monitor the new rule.

When there were two board members only, Metzger and McWatters, they agreed to postpone implementation another year, til 2020. Congress has even proposed a law to delay this proposal further, a traditional political tactic when a flawed policy cannot be ended outright.

In the meantime, credit unions reported continually rising levels of capital, ending at over 11% collective net worth as of March 31.  This is 400 basis points over the well-capitalized regulatory requirement of 7%.

Taking a Cue from Bob Dylan

In 1966 the folk singer Bob Dylan faced a circumstance which he memorialized in the song 4th Time Around.  It starts with these words:

When she said, “Don’t waste your words, they’re just lies.” I cried she was deaf.

This is the 4th NCUA Board to consider imposing a detailed capital model when the credit union system was the only one to navigate the last crisis relatively intact under no risk-based rule. The RBNW rule is not only flawed but potentially dangerous to the future of credit unions. It rates certain categories of assets as risk free versus other assets.

This approach could induce credit unions to make decisions that could end up pushing all credit unions into the same risk profiles. As FDIC Vice Chairman Hoenig pointed out, the lowest rated risk categories before the Great Recession were sovereign debt and real estate collateralized securities. Both asset classes were at the center of the declines in asset values in the 2008-2009 crisis.

As the woman in Dylan’s song pleads, “Don’t get cute.” The circumstances and history of this wrong-headed regulatory effort suggest that it is time for the board not to get cute once again. Rather it should reject this approach to determining credit union capital adequacy. Or will the Board be deaf to the lessons provided by the last sixty years of this misguided effort?

Cooperatives and Avoiding the “Blame Game”

After the Bay of Pigs fiasco in which a CIA backed Cuban exile group landed in Cuba to overthrow Castro and were defeated within days, President Kennedy took full responsibility with the observation “Victory has a thousand fathers, but defeat is an orphan.”

Unfortunately that is not true in real life. Whenever a problem shows up, especially one that results in real loss and tragedy, there are plenty of persons willing to point out those responsible for the defeat. It is called the “blame game.” Its purpose is to shift responsibility away from those responsible for resolving problems to those who caused the “defeat.”

The whole taxi medallion crisis, centered in New York City, is a case in point.

The New York Times ran a series of three articles two weeks ago showing the harm caused to almost 1,000 individual medallions owners by the dramatic declines in value since 2014. This three-part series was just converted to a video broadcast in a 30-minute Hulu special in The Weekly.

The fingers of blame are pointed everywhere: at the taxi-limousine commission, the New York city council, the medallion brokers, the multiple bank and credit union lenders, the regulators. And of course the external-event-defense: Uber and Lyft’s ride sharing economic disruption. NCUA in its public statements has blamed the credit unions, boards, disruption and even admitted its oversight of “concentration risk” was not as diligent as it should have been. But no matter, NCUA just took over $1.0 billion in cash and paid off the shareholders, gave the loan medallion portfolios to external servicers, and washed its hands of the problem.

And that is the real problem. Credit unions were formed to walk toward members and their difficulties especially in times of trouble. Instead of encouraging and helping the medallion borrowers at the time of greatest need, NCUA cut and ran. Most of the taxi medallion credit unions had fully reserved for the potential losses as values fell to cash only sales of around $200,000. In one case a merged credit union had not only written down the values, but still had loss reserves of over 50% for the amounts still on the books. But the examiners prohibited the credit union from rewriting loans or making other accommodations that were in everyone’s best interest. As one CEO said, the examiner’s goal was to put the credit union out of business.

The billion dollar cash outlay for the liquidations of LOMTO and Melrose locks in losses at the time of lowest value. And therefore the greatest loss. No upside potential is possible. In the NY Times Hulu video story, an advocate for the medallion owners states that the income from a taxi license would support a loan of $400,000; but that value can only be realized if someone is using it to generate income. Meanwhile hedge funds are paying cash at foreclosures because lenders and regulators have shut off any financing possibilities for medallion user-owners.

An economic valuation cycle is thus turned into multiple personal crises for credit union borrowers because the institutions set up to serve them, denied help when the members were most in need.

Disasters happen. Some are caused by internal failures, some by external events over which an institution may have no control. This is why there is a regulatory system. And why as part of this “system” credit unions have an “insurance pool” funded by 1% of every shareholders savings. This is the critical source of financing when necessary to transition from problem to solution. But resolutions get aborted when the fund is used to expense away current difficulties. That is not why cooperatives were created. That is not why the NCUSIF was funded with members’ savings.

The inability of NCUA leaders to acknowledge their responsibility for resolving problems, not liquidate them, only leads to the next set of problems. In this case it is the destitution of over 700 medallion owners who have declared bankruptcy and for many others burdened with debt they cannot see a way out of. The expensing of member funds to make problems go away ultimately leads to greater and greater problems down the road. The self-help and self-financing capability of the cooperative model is compromised any time a problem just becomes a liquidation event. Mergers just transfer the responsibility to somewhere else in the system. The crucial resilience and patience that cooperative design allows is fatally neglected for instant resolutions.

The problem of relations with Cuba that JFK thought he was resolving is still unfinished business today. When NCUA plays the blame game versus acknowledging the responsibility to transform problems into turnaround stories, there will never be any victories for which to claim success. Only an ever mounting, open ended expenditure of member funds to sweep mistakes under the rug. This corruption of the system’s cooperative model could in the end destroy it.

The Hamilton Question and New York’s Municipal Credit Union’s Conservatorship by NCUA

The last song in the runaway hit musical Hamilton ends with a question:

Let me tell you what I wish I’d known
When I was young and dreamed of glory
You have no control
Who lives, who dies, who tells your story?

On May 17, 2019 NCUA was appointed conservator of the $3.03 billion state-charted Municipal Credit Union. The March 2019 call report data shows 588,000 members, a net worth ratio of 7.6%, delinquency of .77%, and an allowance account funded at 150% of total delinquencies. No taxi medallion loans.

The New York regulator had previously removed MCU’s supervisory committee in May 2018 and the full board in June 2018. It designated an “on premises administrator”, Mark Ricca, to oversee the general management. Mark had no credit union background.

When appointing NCUA conservator, the state also removed its chosen administrator. NCUA provided no information about who will be running the credit union and under what guidance since there appears to be no immediate financial safety and soundness issues, but a leadership transition event.

The impetus for state action was the arrest in May 2018 of the former CEO Kam Wong. He pleaded guilty in November 2018 and in June 2019 was sentenced to five years in prison and ordered to forfeit $9.9 million to pay restitution to the credit union for the amount he had defrauded. The misuse of credit union funds extended from 2013 through 2018. The credit union has received a bond settlement for loss as well.

What’s next for the members?

On January 10th the Brookings Institution hosted a conference entitled Ten Years Later: Lessons from the 2008-09 Financial Crisis. One speaker was Lawrence Summers who was Treasury Secretary from 2009-2011, a PhD economist and former president of Harvard University,

During the Q&A he was asked why the government did not take over the direction of the troubled banks and insurance companies instead of TARP funding, much like the conservatorships of Freddie and Fannie. His answer was succinct: “it is my experience that government intervention in banks is a major destroyer of asset value.” He further commented who wants to run or do business with a conserved government-directed institution?

NCUA’s track record as a conservator is extremely mixed but on balance proves out Summer’s conclusion. NCUA’s conservatorship of the two largest corporates and then takeover of three more in a mass liquidation process destroyed solvent institutions that according to NCUA’s own numbers today have estate surpluses of over $5.6 billion, of which $3.1 has been transferred into the NCUSIF.

By setting itself up to run a credit union as a conservator, NCUA has a conflict of interest. Does it act in the members’ best interests or does it act in its own self-interest? As in all conservatorships, the members have no voice. The board is gone, and often the person appointed to lead has little or no background in the credit union, and is little more than a hired gun until some external resolution can be reached. Restoring the credit union to self-sufficiency rarely occurs, because in so doing it contradicts the logic that government takeover was necessary in the first place. Moreover as in this case, the NCUA and the state had examined the credit union annually from 2013 to 2018 while the misappropriations occurred, and apparently found no wrong doing. So the tendency is to shift the responsibility for the situation to the bad actor and the lack of board oversight, not the possible shortcomings in the exam process.

The Key to Success

Conservatorship or even replacing a CEO while leaving the board in place to ensure members’ interests are represented, can be done successfully. During the financial crisis several noteworthy turnarounds were engineered by John Tippets at North Island Credit Union and Bill Connors and Andy Hunter at Silver State Credit Union in Nevada.

The key success factor is finding and supporting the right turnaround leader. The challenge is simple: Any jackass can kick down a barn, but it takes a carpenter to build one.

Will NCUA appoint a jackass or a carpenter? Someone to play caretaker until the agency elects a merger partner to resolve a leadership transition? Certainly there will be vultures a plenty looking to take the “problem” off NCUA’s hands.

Or will the NCUA find someone with the experience, political skills and leadership to restore the credit union to its pivotal role in the New York and broader credit union community? The possibilities are out there. These could include proven, retired leaders such as Rudy Hanley, Gordan Dames, Gary Oakland, Jeff Farver, Steve Winninger or other equally capable and astute individuals whose reputation and knowledge of credit unions and the system would give them a running start. They would not be seeking another job, but have the energy and foresight to bring the credit union members confidence that their future was in good hands.

NCUA has provided no updates on this unprecedented conservatorship of a solvent credit union. But one will know the future when the next acting CEO is named. Will it be a caretaker following direction from examiners who are anxious to get rid of a problem, or will it be a proven credit union leader who can restore the credit union for its members? Chartered in 1916, Municipal is the oldest state charter in New York. Can NCUA make decisions that will sustain this cooperative now serving its fifth generation of members, or will it just fulfill Summers’ bleak assessment of what happens when government takes over a financial institution?

Municipal Credit Union faces Hamilton’s challenge: You have no control, who lives, who dies, who tells your story? Every credit union today should care about this situation.

If a sound, long-established, and well-capitalized credit union can be dissolved without any role for members, what prevents the regulator/insurer from doing the same when your credit union faces a transition?

A Top Priority for New NCUA Chair Hood: Lead the Way in Setting a New Tone

While NCUA Chairs have different leadership approaches, all share one common challenge: setting the “tone” for the relationship between the regulator and the regulated.

Whether a chair is a hands-on manager or distant from operations, the chair’s attitude toward the industry will be seen and heard by all within and without the agency.

For the past decade the relationship between NCUA and credit unions has varied from openly adversarial to indifference to credit union knowledge and judgments. There has been a lack of respect for the experience, capabilities, and analysis of credit union professionals. This attitude is still present in some exam confrontations, and at the board level, in the total dismissal of required credit union commentary on issues such as the merger of the TCCUSF and NCUSIF.

The Relationship Needed

Chairman Hood enjoys opera. He is not tone deaf. His professional experiences focus on outreach efforts. The tone needed between NCUA and the regulated is one of mutual respect.

This is more than public speeches or a specific set of policy initiatives. NCUA should acknowledge the overwhelmingly positive track record of credit unions and their leaders’ deep, proven, expertise: wisdom and commitment to cooperative evolution.

A Place to Start with a New Tone

On May 7, NCUA released the names of nine credit unions who were fined a total of $4,069 in civil money penalties for late filing of the September 2018 call report, which was due at the end of October.

For nearly four decades NCUA had never fined a credit union for a late call report. During this time the report was extended semi-annually to quarterly, and the data requested increased exponentially.

NCUA’s rationale for public fining was in part because the late filers were holding up the timely release of all credit union data.

So, six months after the deed has occurred, NCUA releases the names for public shaming and sends the pennies collected to the US Treasury.

Timely submission of call reports is critical. But instead of fining shouldn’t the agency just send to all examiners the day after each filing deadline all reports not received? Examiners make a follow up phone call, and if not filed promptly, that would warrant a special visit.

Why the delay? Is it due to bookkeeping shortcomings (no timely cash reconciliations), personnel issues, or even operational problems?

How much staff time and effort has been wasted analyzing each late report with the three criteria below—and how many were not fined as a result of these investigations?

Mutual respect would direct that the agency use any report delay as a signal for examiner follow up. Get the data, forget the shaming and get on with the process of ensuring a safe and sound credit union operation.

Stop the penny ante, power trip of imposing a “parking ticket” fine. Treat credit unions with respect knowing that problems occur all the time that should be looked into.

Putting a CMP scarlet letter stamp and publishing the name of credit unions as an example of effective regulatory oversight is not professional. Some in authority may believe acting tough makes them effective. Most will see it as lacking grasp of the situation.

Regulators live in a glass house. Until McWatters became Chair, NCUA had failed to meet the statutorily deadline of April 1 for submitting its Annual Report to the President and Congress for decades–even missing the filing entirely in one year.

Chairman Hood, take away the CMP stamp and ask examiners to do their job. It would be a small, but important first step, in making the system more cooperative.

Why Financial Disruption is an Attractive Fintech Opportunity

Many factors are powering the multiple fintech startups in the financial sector.

The advantages of internet-based platforms are clear: low startup costs, rapid and continuing market responsiveness, easy scalability, preferred channel for younger demographics just entering markets, etc.

An example of the fintech ecosystem’s many segments can be read here.

But another reason financial services are subject to such extensive external disruptive efforts is that the barriers to entry for traditional charters are enormous. New charters for both banks and credit unions are costly, time consuming and closely monitored.

As a result, de novo charters are few and far between. Five new CU charters have been approved by NCUA in the last decade. The average organizational effort is more than four years, and often longer.

For cooperatives, incumbent credit unions are protected from new entrants by a massive regulatory chartering obstacle that effectively prevents new competitors, no matter how much needed by organizers.

However, if one looks at the number of new and innovative CUSO startups by credit unions, the appetite for innovation and new solutions is clearly understood. But without an openness to new charters, these ventures will be outside the traditional charter structure. While that may be a necessary short-term path for innovation, is that approach hindering a credit union’s ability to change themselves?

Outsourcing technology innovation and solutions to new organizations is expedient. But will it stymie more dynamic and necessary approaches in traditional credit union operations and services?

Understanding Disruption Within a Full Economic Cycle

At the FDIC’s April 23 Fintech conference, frequent reference was made to the growing role of “marketplace lenders”; firms using internet technology to reach customers directly versus traditional branch based, depository strategies.

Two frequent credit disruptors were cited: Quicken and peer lenders such as Lending Tree, Sofi, etc.

One estimate is that 40% of unsecured consumer credit was provided by fintech firms last year. Quicken was the number one mortgage originator in 2018.

While the advantages of internet based providers were easily listed–convenience, speed, ease of use, targeted market capabilities–the potential challenges were also noted. Most internet providers rely on external funding, which could disappear in a sectoral or broader economic downturn. Moreover the majority of marketplace lending innovation has been done in the very low and benign post-2008-crisis interest rate environment. Would their funding strategies be as viable in a higher or more volatile rate climate?

More importantly, the credit quality of most unsecured consumer lenders has not been subject to the stress of a economic downturn with rising unemployment. This part of the cycle is when capital adequacy is most tested.

There are real consumer benefits from financial innovation. However the lesson is to be careful about concluding that disruption in the short term will necessarily reshape markets over a full cycle. Market shakeouts may seem immediate, but the ultimate restructuring may not be known until incumbent firms and innovators experience a full cycle of financial competition.

Might such a perspective have informed credit unions’ and NCUA’s responses to the disruption of the taxi medallion industry? A subject for ongoing examination.

Treasury Secretary Mnuchin Says Financial Regulatory Consolidation Not an Administration Goal

As the opening speaker at the FDIC’s Fintech conference on April 23, Treasury Secretary Mnuchin was asked by an attendee if consolidation of the financial regulatory agencies was an administration objective. He replied that it had been evaluated early on in the administration but was no longer an issue.

If the topic of regulatory consolidation arises, NCUA might be the most vulnerable of the independent agencies. A precedent has been set by the Savings and Loan industry in which FSLIC was merged into the FDIC and the OCC became the chartering, supervising authority for federal charters. The FHLB system was “spun off” the S&L system in the late 1980s when its charter was opened to serve all mortgage related financial providers.

When asked to comment on the recent OMB suggestion that all independent agency rules be submitted for review prior to issuance, Mnuchin suggested this was not an area for him to comment.

So the question remains: to whom is the NCUA answerable to, if anyone? Or does independence imply free of all accountability?