Category: NCUSIF

In a Marketplace analysis yesterday, the daily financial update reported how the Federal Reserve’s management of its multi-trillion dollar portfolio can reduce or increase the government’s overall operating deficit.

As reported, for the last 15 years the Fed’s been making about $100 billion a year a profit sent right to the Treasury which, as revenue, reduces the federal deficit.

The “profit” comes from the net spread between what the Fed earns on the trillions of  bonds and mortgage-backed securities that it began purchasing during the financial crisis of 2008 under the policy of “quantitative easing.”

This macro economic policy continued and expanded during the Covid shutdown.   The cost to carry these interest earning assets in the Covid era was near zero.  The majority of funding was from the excess reserves banks kept with the Fed which was paying less than 1%.

Today that spread is upside down as the cost of funds has risen to nearly 5.5% on overnights.  Rates on the portfolio are mostly fixed and at much lower yields as securities were purchased in a much different part of the interest rate cycle. Interest expense is now greater than interest income with the result that “the Fed has lost on the order of $100 billion since last fall,”

Here are the Fed’s total balance sheet holdings as of October 18, 2023 showing almost $8 trillion in total assets.  Tables show that the majority of assets have maturities beyond ten years.

When the Fed has a loss, it files the loss away until it can pay it back once it’s making a profit again. This year’s “loss” will equal about 5% of the total government deficit.  So instead of lowering the shortfall as in prior years, it adds to it.

The NCUSIF Analogy

The largest asset managed by the NCUA is the NCUSIF’s $22 billion investment portfolio.  As of August 30, $4 billion was invested overnight with a yield of 5.4%.  The remaining $18 billion was invested in maturities as long as seven years with a combined yield of 1.4%.

At month end the portfolio’s market value was $1.5 billion less than book.  As short term investments become a greater portion of the total, the duration has declined slightly to 2.64 years.  This is the approximate time that it would take the cash flows from the maturing investments to be at  market–should the current yield environment become the new “normal.”

If the NCUSIF’s portfolio yield were 5% or greater, the fund’s total revenue would exceed $1 billion. This would result in dividends to the fund’s credit union owners. When the portfolio is below market for an extended period this shortfall comes out of credit unions’ pockets.

Time for Credit Unions to Be Alert

It will be critical for credit unions to monitor the monthly updates of the fund. The Agency’s upcoming investment decisions are critical. Its interest rate risk management and duration will  have a critical impact on the Fund’s future.  This includes total revenue, its financial soundness and credit unions’ bottom lines.

In anticipation of the NCUSIF update at last week’s board meeting I described several topics of vital importance. These included the fund’s operating stability, the investment lag from market rates, the loss reserving level and the reliability of projections of future performance.

In answering Board member Hood’s questions, there was important new data from staff.

The Fund’s Normal Operating Level is Stable and Growing

As in any enterprise with a bottom line, NCUA’s outcome is to optimize the fund’s retained earnings. Adding the 1% required credit union deposits, these two factors sustain a stable Normal Operating level.  CFO Schied responded that the actual level of the NOL ratio at June 2023 would be 1.29% if the retained earnings and required 1% trueup were recorded in the same accounting period.

Staff’s NOL projection in May had been for a 1.25% at June. This 4 basis point projection materially understated the Fund’s trends and financial stability.

Moreover, we learned that using a six month old data point to calculate the 1% trueup, overstated the reported December 2022 actual ratio.  There had been a $5 billion decline in total savings in the last half of 2022.  That resulted in  $72 million net returns of the 1% deposits from June’s 2022 total. Using this six-month old 1% datapoint resulted in a higher NOL number than if all three ratio factors were from the same accounting period.

The Fund’s Loss Reserve Equals Four Times Its Recent Loss Rate

CFO Schied reported net cash losses in the fund since the taxi medallion write offs, were just .31 basis points of insured shares.   The current loss provision ($204 million) is 3.8 times this recent experience and equals 1.2% of insured savings.

The actual net cash loss for the first six months of 2023 is only $1 million. However,  over $20 million has been added to the provision expense.  When asked why this difference, Schied replied:  “The general reserve is derived using an internal econometric model that applies estimated probability of failure and loss rates.” 

No details of this model were provided to evaluate  assumptions and whether they were validated by actual experience. This is critical detail for users to have confidence in the financial estimates provided.

The loss provision expense comes directly from retained earnings.  The current level reduces the reported NOL level  by over 1 basis point of insured savings.

The NCUSIF’s Below Market Valuation

Current short-term rates under two years are yielding over 5%.   The NCUSIF’s portfolio has a YTD yield of 1.79%.  This was due to the Fund’s continual investing out to seven years when rates were near zero.  The result was a weighted average maturity for the portfolio of almost three years.  That is the time it will take to bring the portfolio back to par once rates normalize.

The market value of the portfolio went negative in December 2021 and was $1.5 billion below book at June, 2023.   This results in revenue far below current yields.   Investment revenue is the primary driver of retained earnings.  This is the most critical management responsibility in the NCUSIF’s financial performance.

When asked about the status of the investment committee’s  policy review begun early in 2022 Schied’s response: The investment policy has not been updated.  The investment committee has identified a few modest updates and clarification, and is still considering one item.  So again, at this point the policy that is on our website remains the current investment policy.

Is there a more important priority for the board than to understand the reasons for the recent underperformance?  And then to update the NCUSIF’s interest rate risk management policy/practice to avoid this outcome in the future?

The Accuracy of Staff Projections

The June forecast for the NCUSIF’s NOL was 1.25% provided to the  board in late May.  The actual outcome was 4 basis points higher at 1.29%.

The staff gave an updated NOL projection for this December of 1.27%.   Projecting the Fund’s actual numbers at June, this would be a gain of $70 million in net income, or lower than the first six month’s bottom line.  The 12-month growth in insured shares was forecast at 4.2%.   The real growth for the first half of the year was 1.8% from the previous June.  In 2022 last two quarters there was a net outflow of $5 billion.

There was no information to support these assumptions and the NOL of 1.27.   If  share growth is zero from June, and the same net income estimate, the retained earnings ratio would rise to .2948 at yearend. This would be an increase from the actual .2922 at December ‘22.

As with the econometric model used in the loss provision expense, this NOL forecast cannot be evaluated without the underlying assumptions being transparent.

The Board Meeting Process

The board members’ comments, their Q & A with staff and staff’s responses were all scripted.  Board members read their statements, there was no effort at dialogue, there was no learning from the supposedly differing points of view represented.

Only Hood engaged the staff on what the NCUSIF numbers mean.  Chair Harper followed his ever present “MO” of hyping future risks after acknowledging the fund’s sound condition.  Hauptman talked about how interest rates are set by buyers and sellers of money, but did not apply his observation to the current outlook for rates.  And how this might affect future decisions.

Hood’s questions brought out some very important aspects of the NCUSIF’s management.  New information from Schied included a positive  forecast of $12 million in further recoveries from US Central’s AME.

The Q&A highlighted the shortcoming of current accounting presentations and  investment practices.  These can mislead users of the financials statement.

The Fund’s below market investment performance will cause lower revenue for the fund and its credit union owners by hundreds of millions of dollars.

Moreover the investment position compromises the two primary goals stated for the investment committee’s performance.  These are liquidity (never borrowing to meet the fund’s obligations) and meeting all operating expenses, plus dividend.  These two outcomes should be a walk in the park in current conditions.

If the fund were earning 5% on its portfolio, total revenue would be over $1 billion, a result that would pay real dividends to credit unions for their underwriting commitment.

There is great potential for the cooperative structure of the NCUSIF to be a positive contributor to the credit union system.  It will be up to the board to ensure this outcome is indeed realized.

Following are excerpts from two NCUA chairmen on the state of the credit union system.

Both presentations came following severe economic disruption.  In one case the events included double digit inflation and unemployment levels, plus the highest short term Fed Funds rate ever-in the mid teens.

In the second,  the economy had emerged from a post covid shut down with inflation rising to 9% and a Fed once again tightening.

The two updates were in May before Congressional banking committees, but 40 years apart: 1983 and 2023.

One statement expressed confidence in credit unions, with sufficient agency capabilities and a pragmatic approach for the future.  The primary concern was including credit unions in any potential banking regulation.

The second statement suggests inevitable failures, insufficient agency resources and the desire for “parity” with any  changes to banking oversight.

The question for readers:   Two assessments 40 years apart: Which understanding of NCUA’s relationship with credit unions is most likely to enhance the movement’s future?

We know the answer to the first approach.  What will be the outcome of the second?

From May, 1983: Chairman Callahan’s testimony before the Senate Banking Committee:

The overall condition of FCU’s is “quite good” thanks to the grassroots strength of the CU movement and to the freedom CUs have been given to adjust to local market conditions, NCUA Board Chairman told the Senate Banking Committee.

The committee which is conducting oversight hearings into the conditions of the financial system was told by Callahan that “few if any changes should be made in the existing  CU operational and regulatory environment.”

Reporting on 1982 financial performance Callahan said that savings at FCUs grew by 17.2% and assets rose by 16%.  As a result, CUs increased their share of the overall consumer savings market from 4.25% to 4.5%.

“I’m pleased to report that deregulation really works,” Callahan said.  “It’s time to leave the credit union system as it is for a while and observe the results.”

The committee is considering  potential changes in the financial industry and Callahan warned against the tendency to apply these changes to CUs.   “CUs, he said, “come from a different mold.  The biggest threat to the movement is not competition, but homogenization to the financial services industry.”

(Source:  Credit Union Magazine,  June 1983, pgs 19-20)

Excerpts From: Chairman Harper’s Written Statement to the House Banking Committee, May 16, 2023:

Legislative Requests

The recent failures of Silicon Valley, Signature, and First Republic banks are a reminder of the dangers of concentration risk and the need for effective risk-management policies and practices to manage capital, interest rate risk, and liquidity risk. These fundamentals have remained true throughout all economic and regulatory cycles and have recently been areas of supervisory focus for the NCUA. Credit unions that fail to manage these core issues can and will continue to fail. . .

Accordingly, to better manage such liquidations in the future, the NCUA requests amendments to the Federal Credit Union Act to provide more flexibility to the NCUA Board to manage the Share Insurance Fund, bringing the fund’s operations more in line with those of the Deposit Insurance Fund administered by the Federal Deposit Insurance Corporation (FDIC). Likewise, as Congress considers amending federal deposit insurance requirements, the NCUA supports maintaining parity between the Share Insurance Fund and the Deposit Insurance Fund. . .

Specifically, the NCUA requests amending the Federal Credit Union Act to remove the 1.50-percent ceiling from the current statutory definition of “normal operating level,” which limits the ability of the Board to establish a higher normal operating level for the Share Insurance Fund. Congress should also remove the limitations on assessing Share Insurance Fund premiums when the equity ratio of the Share Insurance Fund is greater than 1.30 percent and if the premium charged exceeds the amount necessary to restore the equity ratio to 1.30 percent.

The NCUA’s May board meeting’s most important item was the NCUSIF update.  One slide  highlights why many credit unions are skeptical of the agency’s ability to evaluate its actions as circumstances change.

This  slide states that the Agency’s investment policy will go back to the same 10-year ladder in effect before the current banking and liquidity crises.

Since the March 2022 Federal Reserve  rate increases to counter inflation. many portfolio managers reported large declines in  the market value of  longer term investments.

In most cases, credit unions can  choose to “wait out the cycle” rather than sell and realize an investment loss.  This is because credit unions have multiple balance sheet options to ameliorate the impact on net interest income from holding assets with below market earnings.

However, over this last 18 months of rate increases, many portfolio managers have reviewed their policy assumptions that led to this illiquid situation. When cash flows again generate excess investable funds, I know of no one going back to what they were doing before this cycle began. Lessons are being learned.

This latest interest rate cycle has overturned many market assumptions drawn from the historically low rates in the post 2008-9 financial and then covid crises.  One expected outcome is a higher “normal”yield curve than experienced over the past decade.

The More Things Change  . . .

In the May NCUSIF update, the data show that the NCUSIF’s portfolio has a market loss in each  tranche of its investment ladder. This includes even the very short term amounts under one year.

Yet, as stated in the policy above, the intent is never to have to borrow or sell at a loss.   A difficult goal with ten year investments, a period which will likely experience several interest rate cycles.

The Fund’s  yield for the March quarter is 1.75% or approximately 3% below the overnight rates in the same quarter.

Every 1% below market yield results in an annual revenue loss to the fund of $200 million. NCUA’s only change in its portfolio ladder strategy was announced last fall.  It  paused term investments until the overnights reached $4 billion.  How this amount was determined was not explained.  Nor its impact on overall return or weighted average life.

Below Market Returns Lasting Years

In the May meeting, no board member commented on the Fund’s below market returns and unrealized losses. Board member Hood asked how long it would take for the portfolio to return to par value if the current rate structure became the new normal.  The response was three years, which is the portfolio’s current weighted average life.

Whatever the time frame for a new normal to settle in,  the NCUSIF and its credit union owners are facing below market returns for many more months, if not years.  The portfolio yield is the Fund’s principal, and in most years, only revenue source. The portfolio’s positioning hurts both fund performance and credit union potential dividends.

The only IRR/ALM analysis the NCUSIF provides in its monthly updates is the total portfolio gain or loss versus the current market.  Since December 2021, this indicator has been negative reaching a peak of  $1.8 billion in 2022.  At March 2023 the valuation loss was still $1.4 billion.  Why this very  obvious trend did not cause an assessment of the strategy before the pause in late 2022, is not clear.

The More Things Stay the Same

So what is the staff and board changing as a result of this eighteen months of  NCUSIF’s declines in portfolio value and below market yield returns?

The answer in the Slide is clear: “Once overnight target ($4.0 billion) is met, plan to return to slow buildout of (ten-yer) ladder.”   No board member questioned this approach.  By remaining silent, the board members consented to going back to the same practice that is leading to years of underperformance.

The Distressing Part of NCUSIF Oversight

The dilemma is more than hundreds of millions of lost annual revenue  from a below par portfolio. Those numbers are large and do matter to the Fund’s soundness.

But there is  a much larger challenge: no one is accountable for NCUSIF performance.

Even though CFO Schied presents the numbers he  references other offices when giving specific responses:  the economist for share growth estimates; E&I for the loss expense numbers using an undisclosed model; and legal for lack of clarity for true up options, etc.

The NCUA board  speaks with different views on the fund’s situation.  The Chair says he learned in school that when interest rates rise, bond prices fall. Therefore the Fund’s decline is just what we should expect.  That remark overlooks the whole IRR  risk management responsibility.

Vice Chair Hauptman characterizes any change to the ladder strategy as “trying to time the market.”  Hood’s questions are more targeted, but their import often seems lost on staff.  Example: why the true up mattes.

The distressing aspect is that any real changes to this extended underperformance seem to be fading off into the sunset. In contrast,  the entire industry is actively evaluating its ALM investment assumptions and policies.

Within NCUA committees are formed, policies reviewed, expert and even sometimes cu opinion sought, but there is no person sitting where the buck stops. It’s how bureaucracy functions.  When staff doesn’t know what to do, or the Board can’t agree, nothing changes.

If May’s NCUSIF update is  the best NCUA can do, credit unions should worry about the future of their Fund.

A Past Lesson

After the recapitalization in 1984 there was one practice that may resolve the current status quo approach. One person was responsible for the monthly update and explaining all expenses, reserves and future outlooks.  That person was not the CFO or the head of E&I, but Mike Riley,  He had total performance accountability even when it involved recognizing losses from problem cases.

Today the ideal solution would be for the Executive Director to provide the NCUSIF update. Regardless of how inputs are gathered the process needs a single point of responsibility.

Now no one is accountable.   By dividing NCSIF inputs  into multiple reporting sources, the CFO update  is merely a reporting role.  There is no  responsibility assumed even for accounting issues.

Appointing a single person for Fund accountability is the most critical change the Board could make.  Then the numbers might have real coherence.