Cooperative design is a unique competitive advantage in a capitalist society. The success of for- profit firms is based on their ability to extract value from their customers to create maximum return for their owners.
In coops the owners are the customers. This alignment creates a financial and a trust superiority versus competitors when the model is managed well.
In 1984 the NCUSIF was redesigned following coop practice. This change drew from the experiences of over a dozen successful state chartered insurance funds. The design’s core feature is the 1% deposit perpetual underwriting with explicit checks on the oversight and management of the fund by NCUA.
One of these oversight tools is the monthly posting of the full NCUSIF financials on NCUA’s website. This is the same regular reporting NCUA requires by credit unions to their member-owners.
Quarterly the NCUSIF Board is publicly briefed on staff’s management of the fund. This provides the credit union owners insight into the Board’s oversight of credit union members’ funds.
The June 2023 financials have been posted. There will be additional numbers such as CAMELS score distributions, projections and updates on investment management-the Fund’s largest asset in the meeting.
What should credit unions look for in the briefing? How do board members query staff’s performance?
What NCUA Staff Manages: Retained Earnings
The primary indicator of the Fund’s performance is retained earnings. The responsibility is to maintain a retained earnings ratio of .20% to .30% (the traditional floor and cap) of insured savings. This ratio can be tracked every quarter as the industry reports its insured share total in the 5300 call reports, and NCUA reports NCUSIF’s retained earnings for the same quarter end.
The history shows this ratio tends to be very stable with minimal change even when some factors, such as share growth, show wide fluctuations. Below are the actual results of this ratio over the past three and a half years:
Dec ‘20: .3179%
Dec ’21: .2942%
Dec ’22: .2922%
Mar ’23; .2883%
Jun ‘23: .2908%
Adding the 1% of insured savings as of the same date shows that the normal operating level (NOL) has been very steady at the upper end of its traditional cap of 1.3%.
In the May 2023 NCUSIF board update as of March, staff projected an NOL of 1.25% at June, down from the December ’22 ratio of 1.3%. This hypothetical forecast suggested the retained earnings “cushion” would fall by half in just six months. It was misleading and incorrect.
This 4 basis point error was due to two inaccurate projections in the presentation: the retained earnings for June came in $31.3 million higher and insured share growth $32.3 billion lower than the forecasted numbers. This outcome should be a caution about future projections. This estimate was provided just 45 days before the June month end with recent trends readily available.
Managing the Retained Earnings Outcome
One revenue and two expense items are management’s responsibility in achieving retained earnings.
The first and most immediate is operating expenses. Through June the NCUSIF expenses have grown 13.7% or $14 million more than expended through the first six months of 2022. This is double the Fund’s long term rate of expense growth since 2008 of 6.9%. Across all three credit union provided funds, the combined expenses grew 14% in the first six months of 2023, an indication of government’s ability to spend when checks and balances are lacking.
The second factor is the expense provision for insurance loss. To date in 2023 the fund has added $20 million in additional provision expense versus actual losses of just $1 million. The June 2022 reserve was $169 million increased to $204 million one year later.
The reserve expense comes out of retained earnings. Currently it equals 1.2 basis points of total insured risk. Since the taxi medallion losses, the NCUSIF has not reported net cash losses for an entire year exceeding 1 basis point since 2013. If there is a formula NCUA uses in preparing this reserving level, then that should be published so the assumptions can be validated with actual experience.
The Single Revenue Driver
The third factor and only revenue item other than an infrequent premium, is the earnings on the $22 billion par value investment portfolio. By law, no premium can be charged if the NOL exceeds 1.3%.
Since December 2021 the NCUSIF’s portfolio market value has been below book. The market loss was $1.7 billion at Dec ’22, $1.3 billion at March ’23 and then rising back up to $1.5 billion at June.
The year to date yield is 1.79% but is slowly rising and was 1.95% for June. At the close of markets yesterday, short term treasury rates up to one year were in the 5.5% range. The seven year bond closed at 4.47%. The inverted yield curve started in July 2022 when short term rates were higher than longer maturities. NCUA announced a change in its short term liquidty target in November of 2022.
The NCUSIF’s investment strategy is to provide sufficient funds “to meet operating costs and liquidity needs without having to sell investments at a loss or use the agency’s borrowing authority.”
The market loss at every investment bucket except overnights at June monthend, shows this objective has not been met. If even half of the $22 billion investments were short term, the yield of over 5% would produce revenue of $550 million and result in more than sufficient income to meet the fund’s operating needs, sustain a 1.3% NOL and pay a significant dividend to the credit unions underwriting the fund.
The NCUSIF’s current weighted average yield is 2.85 years. Should market rates stay at this level, that is the approximate time it would take for the entire portfolio to return to par. This would result in a market underperformance of five years or more from the time the first time the fund showed a combined value below market.
Tomorrow’s meeting will be a critical time to see how staff has evaluated this extended period of below market performance. What changes do they anticipate going forward to better align performance with the two policy goals? What interest rate risk monitoring enhancement is needed to avoid this situation in the future?
What about Share Growth?
The only other factor affecting the retained earnings-NOL ratio is credit union share growth. To maintain a stable .2 to .3 ratio, the net income must grow at the same rate as insured savings.
But NCUA staff do not control share growth, only the three factors above. In the second half of 2022, insured savings had a negative growth of $5.0 million. That could be the outcome again in 2023. For example the second largest credit union, SECU NC, had a negative share growth of 8% for the 12 months ending this June.
Fortunately it is very easy to model all four variables in a dynamic spread sheet through the end of the year. For example if one assumes fund expenses of $220 million, insurance provision of .5 basis point of insured shares, 2% annual share growth, a 1.85% portfolio return, then the current retained earnings ratio would increase from the June level to .2969 or just short of the .30 historical cap triggering a dividend.
Here is the model anyone can use. Any of the four variables can be changed, even the yearend retained earnings currently at .30%. The latest actual data can be input daily if necessary.
One option is to run what ifs and breakeven analysis. For example if the fund’s investment yield had been 2% higher for this year (3.85%), and all else the same, the yearend outcome would be an retained earnings ratio of .3225 or $387 million above the .3% traditional cap resulting in a dividend for credit unions.
The 1% True up Calculation
At the current time, NCUA uses a bifurcated ratio calculation for the yearend NOL. It uses the most recent retained earnings and insured shares. However staff, instead of recognizing the 1% statutory liability from credit unions, includes a six month old figure from June in the denominator.
The currrent NOL number is an inaccurate and misleading presentation of the fund’s real financial position.
For example using the current June 1% capital deposit number omits entirely the obligation of 49% of credit unions with assets less than $50 million. These are not required to submit a June 1% trueup.
In the past, the use of a six month old total 1% deposit amount has led to an understatement of the actual NOL calculation at yearend. This underreporting keeps credit unions from a potential dividend which was the commitment made for their open-ended perpetual 1% underwriting.
If that same method is used at 2023 year end and there is a major runoff in insured savings in the second half, then using the six month old 1% deposit will overstate the NOL and potentially trigger a dividend from a ratio six months out of date. If the 8% decline in SECU’s 12 month share growth were to occur across the industry, a dividend would be likely even with the 1.33% NOL.
This 1% late trueup recognition has been raised in Board meetings for almost 2 years. Staff has promised to provide options from an outside CPA firm’s review. Board members have referred to recommendations in the study that provide ways to better present the actual ratio. It’s time the NCUSIF bring this ratio into a better presentation of the fund’s stability and strength.
The NCUSIF is a Cooperative Advantage
When well managed the NCUSIF is a competitive advantage for credit unions versus FDIC insured institutions. The FDIC ratio of fund balance to insured savings was 1.10% at June 2023. Banks are facing increasing insurance premiums far into the future to bring the ratio back to the immediate goal of 1.35%. For cooperatives, the 1% deposit ensures the NCUSIF size is always relatively constant to the insured shares risk.
Since the 2008/9 financial crisis and the Federal Reserve’s quantitative easing to sustain the economy, short term rates have fallen to historic lows. Folling the Covid shutdown this resulted in ZIRP, or zero interest rate policy, leading to the subsequent inflation.
The Fed has made clear its intent to return to a 2% inflation level with real interest rates in excess of that goal. During this time of near zero rates, the NCUSIF, like many credit unions, went long hoping to pick up yield. In doing so it fell short of its two primary objectives of liquidity (without resorting to borrowing) and easily covering operating expenses.
This Thursday’s board meeting is an opportunity to see how Board members and staff react to the changing rate environment and their role overseeing the fund’s performance. Tune in.