Category: NCUSIF

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

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

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

General Audit Observations

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

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

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

The NCUSIF’s Audit

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

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

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

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

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

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

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

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

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

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

The All Important NOL

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

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

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

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

The NCUSIF’s Investment Management

 

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

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

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

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

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

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

The Central Liquidity Facility

 

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

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

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

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

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

Operating Holds Fund Balance Exceeding Annual Expenses

 

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

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

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

Transparency Only Matters if Credit Unions Pay Attention

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

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

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

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

 

 

 

 

 

 

 

Last week’s  NCUA board meeting had only one topic: the financial state of NCUSIF.

The interest rate context for this briefing was described by a CNBC commentator as follows:

“What we’ve seen in the last few years was a cost of money that was 0. Throughout history, that’s very rare. Now we have a cost of money that is high and going to keep going higher.”

The implications of this context were  absent in the initial presentation.

A Puzzling Omission

The CFO’s presentation of the September 30 NCUSIF financial position was the routine reciting of numbers on slides, until the questions started.

Vice Chair Hauptman referenced the fund’s cooperative nature and the importance of transparency.  He pivoted to making a pitch for CLF legislation to enhance liquidity for 3,600 small credit unions and “for the NCUSIF.”  His first question was , what is an appropriate liquidity level for the NCUSIF?  The September overnight number was $362 million.

That’s when the bombshell was dropped.  CFO Shied said that the NCUSIF now held $1.7 billion in overnights. This is almost four times the amount initially presented. This increase was partly the result of $650-$700 million in additional 1% deposits.  Partly because the fund was “pausing on long term investments.”

This $1.7 billion yields almost 4% or three times the year to date yield of 1.31%.  For over a year the fund’s declining NEV showed that the robotic laddering over 7+ years was locking in significant NCUSIF underperformance for  years in the future.

Why this  dramatic balance sheet change was not part of the initial update is puzzling.   It marks a change in the year-long investment explanation that changing the ladder approach in the face of the rise in rates would just be “timing the market.”

No one asked the obvious question.  Is this a change of investment tactics to a managed WAM approach?  Or just a temporary pause?

It was  Board member Hood who brought out the impact of the underperformance of the fund.   His three questions follow.

Q. Given how interest rates have increased, every security we have currently is underwater, correct?  

Answer: That is correct Board Member Hood.  The continued and sizable increases in interest rates mean that the entire portfolio other than the overnights is underwater at this time.

Currently the NCUSIF’s portfolio has lost over $2.0 billion in market value(NEV).  The agency continued NCUSIF’s  auto investment policies even when rates were at “historical lows.”

Now every security in the $22 billion portfolio is underwater.   Even long term securities purchased this year in the rising rate environment.

The result will lock in  below market portfolio yields for a long term (up to the WAM of 3.7 years).  This underperformance means credit unions are on the hook should the fund’s operating expenses (liabilities) exceed its annual income.

Q. At a previous board meetings on the status of the Share Insurance Fund, we discussed the outside accounting firm we hired to look at the true-up issue and how this impacts the equity ratio. For the record, at one of the last share insurance board updates, we discussed that the true-up memo by the outside accounting firm states that the timeliness and accuracy of the data is required in the Federal Credit Union Act so this provision in the law, and I quote, “May provide some latitude from a strict interpretation, that the equity ratio must be calculated based on the financial statements amounts, particularly given the knowledge of the timing effect on the calculation of the equity ratio. Accordingly, it may be permissible to use the pro forma calculation of the contributed capital amount when calculating the actual equity ratio.”  In a previous board meeting, I noted that the letter pointed out the current practice understates the equity ratio by several basis points and that there were several options for correcting this understatement.  Can you please provide an update on next steps?

CFO Schied said a committee was studying this issue.  The memo in question was presented a year earlier.  One would hope that this considerable delay would result in a more accurate NOL calculation. For as Hood noted the present calculation  understates the actual yearend ratio by 2-3 bases points.

Q. I see several sizable institutions changed in their CAMELS score.  Is there any takeaway from these data?  Do we think any of this has to do with the new “S” component–or any individual scoring component? 

Answer: This does include elevated interest rate risk, but examiners also noted increased liquidity and compliance risk in these institutions. The downgrade in CAMELS ratings also reflects a lack of governance or poor risk management practices.

Not a Liquidity Issue but Risk Management

Other board members spoke to the importance   of liquidity.  This has become more pressing as any sale of a security from the portfolio would result in a realized loss to the fund.

With an NCUSIF portfolio nearing $22 billion and regular predictable cash flow, the last concern should be liquidity.

Credit union owners should receive more than a perfunctory reading of data on slides when an NCUSIF update is presented.   The critical issues of investment performance, NEV risk management and detailed explanations of allowance expenses should be the routine.

Anyone can read numbers on a slide.  What they mean should be the substance of every update.  It should not require board questions to discover that the data presented was not timely, relevant or representative of current conditions.

Hood’s questions show the need for better risk management in the NCUSIF.  They also demonstrate the need for a more professional and current briefing by staff.

 

 

 

By Sancho Panza

As you might suspect, got a call from Don Quixote after that last opinion piece (“Tilting Windmills”). The Man from La Mancha, Illinois was, shall we say, wild-worded and a bit tilted.  Quixote claimed I had definitely blown any chance of ever serving on the NCUA Board. I attempted to express my regret.

But aghast and inconsolable, Mr. Filson mounted up and charged off into a philippic on another of his favorite windmills, the NCUSIF (a topic about which he blogs incessantly and quite opaquely!).

The National Credit Union Share Insurance Fund is your 1% deposit plus accumulated earnings, which undergirds the federal insurance of member accounts. The NCUSIF (agency staff’s nickname is SIF) is cooperatively owned by credit unions and mismanaged by the NCUA.

The continued mismanagement of the Fund is surprising for two reasons – Rodney Hood and Kyle Hauptman. Both gentleman imply in their resumes to have substantial acumen and experience in finance – Mr. Hood with Bank of America and Mr. Hauptman with Jeffries, a sophisticated, international investment house.

And of course as Republicans, one would hope that both men champion the prudent, conservative investment of your funds while under their supervision. Neither Mr. Hood nor Mr. Hauptman, however, seems to be paying attention. For the Republican-majority NCUA Board members is this yet another RINO  (“Responsible In Name Only”) example?

Robots and Ladders

Case in point, the NCUA’s “investment strategy” for the NCUSIF – your deposit, your investment, your Fund – is to invest the @$20 billion balance in U.S. Treasury securities with maturities “laddered out” over 10 years or less. “Laddering” simply means NCUA robotically spreads out that $20 billion evenly (approximately in this case) over seven or eight years.

NCUA’s investment gurus self-laud their approach, comparing it to “dollar cost averaging”; and pooh-pooh any suggestion of intelligent, strategic flexibility as  “risky market timing”. ‘Course it’s true, you can’t be called indecisive, if you never make any decisions. In investment circles this type thinking is called “real A.I.” – or true artificial intelligence.

But, let’s not argue with the “strategy”, let’s talk about the consequences to you of its’ execution. Any strategy, which defies common sense and ignores major shifts in the national economy, will invariably cause significant losses to the investor – that means you, the cooperative owners of the NCUSIF. How so? Well, did you know that any excess earnings on NCUSIF investments (over and above the legally required “net operating level” (NOL) of the Fund) are required to be paid out to the owners of the NCUSIF – hey, that’s you, your credit union and all 135 million American credit union members. Want an estimate of how much NCUA’s “real A.I.” strategy is costing member credit unions?

The Critical Question

Okay, here goes. First, which way do you believe interest rates are moving – up or down? Right! How did you know? “Because I can read!” is an acceptable, sensible answer. But in addition, you might add 1) because Jerome Powell, Chairman of the Federal Reserve says so, 2) because 10,000 of the world’s finest economists at the Department of Labor say inflation in the U.S. exceeds 8%, 3) because the slope of the yield curve, and lastly 4) because Jerome Powell says so. Everyone in finance, except the folks at NCUA (including RINOs?), knows the axiom “Don’t Fight the Fed” – if you do, you’ll lose!

Second, so if Chairman Powell had been telling you all yearlong that the Fed was going to increase rates rapidly and significantly – a major national policy change – would you rush out to lock in some 7 and 8 year, long term – sure to be underwater losers – investment rates? No, me neither; nor anyone on the planet including Bank of America, Jeffries, and your 6 year old preschooler – that would truly be “real A.I.”

Yet, that is exactly what the pointy-headed, investment gnomes at NCUA are doing with your money in the NCUSIF – evidently with the full support of the NCUA Board, RINO’s [“Relevant In Name Only”) included! Reinvestment activity at the NCUSIF historically occurs around mid-month in February, May, August, and November. In February $650 million was invested for @ 7 years at a yield of 2.01%, in May $650 million for @ 7 years at a yield of @ 2.84%. The August investment results will be released today at the NCUA Board meeting. Surely the folks at the NCUSIF didn’t repeat their mistakes of February and May – right?  (Wanna bet?)

The Cost of A.I.-Artificial Intelligence

Seven-year treasury securities as of 9-19-2022 are yielding 3.62%. Every one of the NCUSIF investments made in 2022 is substantially underwater.  In fact the “unrealized loss” in the NCUSIF portfolio has increased by over $1 billion in 2022 alone, following a similar $1 billion+ decline in 2021 – with much more to follow according to the Fed!

The “real A.I.” investment gurus at NCUA self-importantly and incorrectly point out that “unrealized losses” don’t matter, because the NCUSIF “holds to maturity” all investments. In a sense that is true because “holding to maturity” does wash out all their investment missteps over a 7 or 8 year period – their mismanagement never shows up on “their” income statement, so no big deal – right? No, that’s wrong! NCUA’s “real A.I.” strategy, in the current economic environment, wastes any prospect of your credit union receiving a premium payout of greater NCUSIF earnings – you’re the loser, as are your credit union members..

So, here’s the “real Republican” estimate – well-reasoned, conservative – of what “real A. I.” is costing you and your members. To start, assume Jerome Powell is a man of his word – a real Republican. On August 15, 2022 (the last NCUSIF investment date) the 7-year treasury was yielding 2.86%, the 6-month treasury was yielding 3.13%!. What if that last $650 million had been invested for just 6 months, while we all waited to see where the yield curve settles out? An intelligent, no brainer? An irresponsible, missed opportunity? A RINO alert?

The Lost Opportunity

If one could improve the overall yield of the NCUSIF by just one-half of one percent, the “excess earnings” would exceed $750 million ($20 billion x .50% x 7 years = $750 million). Remember the 7-year yield is now at 3.62% (with Powell promising more to come!), but we’re stuck with the 2.01% February and 2.84% May investments for the next 7 years! Would credit unions have any use for $100 million or so in extra income this year? If not; don’t worry, be happy!

A couple of rhinos skiing downhill in winter is quite an amusing thought. A couple of RINO’s frolicking in “the Swamp”, while ignoring the yield curve in an election year, isn’t quite so funny and could become a slippery slope.

 

 

This coming Thursday the NCUA board will review the agency’s midyear budget.  To do so thoughtfully, it is useful to put the operating budget’s long term and recent trends in perspective.

Below is a summary of the growth rate of NCUA’s operating fund budget from 1999-2001.  The first column shows the compound annual growth (CAGR) for the entire period; the second column for the most recent five years.   Note the annual growth rate is per year.

  Annual Growth of NCUA’s Operating Fund Expenses (1999-2021)

 

Account	CAGR’99-’21	CAGR ’16-’21
Beginning Cash Balance $MN	11.47%	22.43%
Operating Fee Receipts $MN	4.27%	8.97%
Operating Expenses $MN	3.66%	9.48%
Net Fund Bal at Yearend $MN	16.92%	26.01%
Ending Cash Balance $MN	12.32%	21.33%

What the Recent Numbers Mean: Expenses Out of Control

During these 22 years, NCUA has transferred ever higher amounts of its operating expenses to the insurance fund.    This is via the Overhead Transfer Rate (OTR) process. That rate of expense allocation has been as low as 52% in 2008 and as high as 73.1% in 2016.   Currently it is 62.7% an increase from 2021.

This overhead transfer has exceeded 50% even though state charters have always had fewer than 50% of total insured shares this entire time.  NCUA is subsidizing its regulation of federal charters by shifting costs  onto state credit unions.

Following this arbitrary, open-ended expense transfer however, operating expenses still increased 3.66% annually or faster than inflation for the entire period.  Most recently in the five years 2016-2021 this annual growth accelerated to 9.84 % or three times faster than the overall 22 year average.

NCUA invented inflation five years before the rest of the economy could catch up.

After this OTR allocation, the Operating Fee charged to FCU’s exceeded actual operating expenses by an average of 104.5% for this entire period– some years more than 100% and others less. Since 2015 however, the NCUA’s the operating fee collected has exceeded actual expenses every year.

Building NCUA Cash  from Credit Union Funds

The result of these excess fees is that yearend cash on hand has grown from $13 million to $129.6 million (or ten times-1000% ) in this 22 year period.   During these same years, while  annual expenses grew by just 3.6%, NCUA grew cash balances at 12.3%, or four times as fast.

The 2021 year end cash balance of $129 million was 110%  more than that year’s total expenses, and  double the 46% average for the entire period.

NCUA held cash balances for the first 16 years of this analysis  between 30-40% of the actual expenditures.  Since 2016 NCUA has retained  more and more credit union funds.  Yet there has been no change in either the agency’s ability to assess its fee or in its operations to require this ever growing cash and fund balance.

The Latest Numbers: May 2022

As of end of May, cash balances are $191.8 million slightly higher than 12 months earlier.   Operating expenses for the first five months are $48.3 million exactly the same as the prior year.

The net fund balance (equity) is at an all-time high of $141.3 million for this time of year.  In 1999 the net fund balance was just $6 million.   The numbers and trends suggest that  $75 million or more of this excess cash could be returned to credit unions and NCUA still have more than enough to cover all operating expense.

The Board’s Budget Review

American author Edward Abbey observed:  “Growth for the sake of growth is the ideology of the cancer cell.”

This Thursday if expenses lag budget, the NCUA’s habit is to repurpose unspent funds  and/or approve new positions not in the original budget.

Normal business practice would be to reduce the budget, not find new ways to spend a surplus.

How will the board view this ever-growing cash hoard? The traditional government mindset is to spend all the money on hand, whether that is necessary or effective.  Staff is always fearful that if money is left over, it will justify reducing the budget request for the following year.

Chairman Harper has been very public in of his ambition to grow staff, the NCUSIF and the budget at every opportunity.

Will the rest of the board go along with this six-year pattern of uncontrolled operating expenses and buildup of excess cash? Or will they stop the spread of NCUA’s operating fund cancer?

After all this is the members’ money.

 

 

 

 

NCUA’s open board meeting In May had only one agenda item, the quarterly staff update on the NCUSIF.

This was an opportunity to focus on many topics that have swirled around the management of the Fund over the past year.   These include:

• The fund’s investment strategy especially in the rising rate environment;
• The accounting confusions using  Federal not private GAAP presentation;
• Projections for the fund’s operating outcomes later in the year;
• Options to more accurately present the Normal Operating Level (NOL). The ratio now uses two separate accounting period’s data;
• The prospect of lowering the NOL to its historic range of 1.2 to 1.3% from 1.33%.

The NCUSIF’s $22 billion  is its largest asset . The fund’s unique cooperative design means credit unions have a direct financial stake in its performance.  Credit unions  should receive a dividend in years of strong performance and pay a premium in the event of mismanagement or a catastrophic loss.

As noted by Vice Chair Hauptman in the meeting:  it’s a mutual asset of the credit union movement and NCUA. . . it’s worth reminding everybody that every dollar of that one percent contribution belongs to credit union members and no other.  NCUA has the obligation to credit unions and their members to manage that fund prudently and effectively.

Board member Hood reiterated:   The 1% capital deposit which comprises most of the Share Insurance Fund’s equity is also an asset of the credit union.  We should never forget this.

I would add that the unique coop design intended the 1% deposit be an earning asset for credit unions.

The Fed’s Response to the Current Economy

As reported by CNBS:  Minutes from the Fed’s June meeting, which were released Wednesday, revealed that the central bank is prepared to use even more restrictive measures to tame surging inflation. They indicated that July’s meeting would bring another rate hike of up to 75 basis points, and acknowledged that the economy could suffer a slowdown.

“Participants concurred that the economic outlook warranted moving to a restrictive stance of policy, and they recognized the possibility that an even more restrictive stance could be appropriate if elevated inflation pressures were to persist,” the minutes said. Treasury yields, meanwhile, continued to rise.”

This is not new news.   Since October 2021 the Fed has indicated that it would change its accommodative monetary policy in response to signs of growing inflation.   That intent became explicit in December with forecasts of interest rate hikes from the historically low levels engineered in 2020 to respond to the Covid economic shutdown.

The market’s response was swift.   Through this year’s second quarter,  bond  fund valuations have fallen almost 20% in market value. The NCUSIF has gone from a market gain of over $500 million in 2020 to a market valuation loss of $1.1 billion as of the April 2022 NCUSIF report.

The NCUSIF Staff”s Response to Rising Rates

The staff’s response to this dramatic change in rates was provided in May’s presentation:  Extend the investment portfolio further by going from a maximum term of 7 years to 10 years.   Rick Mayfield, capital market specialist. stated  this strategy would place approximately 10% of the portfolio in annual buckets over the 10 year range in a one to two year time frame.

The result would raise the average weighted duration from 3.5 years to almost 6 years—at a time when the overwhelming consensus and Fed intent is that rates will continue to rise.

The continuing decline in the NCUSIF’s market value in the past 18 months shows how far the portfolio is falling short of current rates.  This below market return is lost revenue in the tens of millions of dollars.  The continuing decline is a specific indicator of the portfolio’s performance gap from current market rates.

To mechanically continue  investing in equal “buckets” over ten years is a failure of  management.

This investment extension aligns with neither the current policy nor experienced investment judgment.   No objective data or analysis was offered to support this extension to a 5-6 year duration.

Extending a portfolio does not automatically bring higher rates.  Yield curves do not always slope upward.

As an example, when yield curves invert, that is the two year bond pays more than the 10 year,  how does purchasing the lower return 10 year bond “maximize yield” per fund policy?

Managing the portfolio’s duration is the most critical function to match the liabilities for which the fund is responsible.  These include  paying operating expenses, growing retained earnings in line with insured shares, and if necessary, covering insurance losses.   Those expense liabilities can be easily quantified and monitored monthly to align with investment earnings (yield) decisions.

For example, a 2% fund yield would generate $400+ million in revenue easily meeting the operating expense and projected equity growth goals.  A 3% earnings rate should result in a dividend to the owners if insurance losses are at, or below, long term trends.

This is the integrated ALM/IRR management NCUA expects all credit unions to practice.   This management responsibility is not a fixed formula followed routinely whatever the market conditions or future outlooks.  Rather modeling tools, forecasts and judgment are used to align asset returns and the cost of  liabilities as market events change.

No Free Lunch

Even more disappointing was the assertion by CFO Schied that the portfolio’s new extension to ten years would be initiated this quarter-despite the explicit forecast of further raises from the Federal Reserve.

“ . . .with respect to the investment portfolio and consistent with the existing board approved investment policy. the investment committee has decided last month to begin to extend the portfolio ladder out to 10 years.  This is not reflected in today’s quarter one presentation because the decision to do so does not show up until quarter two which will be evident in my quarter two presentation as well as our monthly reporting that we post on the website going forward.”

Naively extending investments to “chase yield” is a common examiner criticism of poorly documented credit union investing.  Such extensions  may produce a short term income jolt but at significantly increased ALM/IRR risk.

Vice Chair Hauptman remarked:   I can say as somebody who worked in fixed income markets for years you know there is no free lunch.  We can get more income by taking more risk and in no other fashion.

There was no data presented to justify a decision to extend from 7 to 10 years in a rising rate environment, an action contradictory to traditional sound portfolio practice.  This extension was also taken in the face of increasing market losses.  This mechanical approach underperforms in the current interest rate environment.

Making a fixed rate 10-year investment  in the face of inflation and other economic uncertainties, is extremely speculative.  It severely limits management options for responding to market events and any changes in credit union insurance needs. It results in  a fixed revenue cap for an even longer period than the current practice.

The result is that NCUA’s hands are tied responding to events during this extended average life of almost 6 years. The Fund becomes dependent on other sources for liquidity or revenue, a contradiction in the fund’s fundamental financial role.

This extension announcement doubles down even after the mounting evidence of NCUSIF investment management shortcomings.  The investment policy referenced has not been updated since 2013.   But most concerning is that there appears to be no ability to objectively evaluate investment practice.

Projecting the Equity ratio And Slowing Share Growth

In addition to presenting the current investment approach, CFO Schied’s projected the NCUSIF’s NOL to June 30, providing two interesting data disclosures.

The first is that he projects an operating loss of $68 million for the NCUSIF  in the second (June) quarter versus a net income of $54.4 million in the March quarter.  That is a $122 million reversal in operating results.

Since investment revenue more than offsets operating expenses, the only possible reason for such a reversal is insurance loss reserves.  Yet all the CAMEL results are positive.  There was no indication of any major unaddressed issues.  So why this dismal forecast?

Secondly Schied also gave the agency’s 12-month insured share growth forecasts for 2022.  Actual share growth was 9.3% for the March quarter.  The projections are  7% growth at June 30, year over year; and only 4.3% for the full calendar 2022.  A significant slowdown from the past two years.

A Board Meeting with Mixed Outcomes

 

The Agency’s mechanical NCUSIF investing in the face of dramatic rate changes and increasing portfolio devaluations was a disappointment.  Extending the investment duration to almost six years (versus current 3.5 years), will only reduce the Fund’s flexibility responding to changing rates and future industry risk events.

Both Chair Harper and CFO Schied downplayed or even denied there was any real risk to extending the portfolio. Here is the Chairman’s summary observation:

The changes in the value of these(investment) assets were expected. That is because as interest rates go up the value of these bonds go down. I learned that in my finance 301 class back in college.

These unrealized losses fortunately do not impact the equity ratio and do not increase the likelihood of a premium just as unrealized gains do not increase the equity ratio. What the unrealized losses signal is a change in the interest rate environment. We are moving forward to address this issue.   The NCUA is adjusting its investment strategy from a seven year ladder to a ten-year ladder. . .

This observation is incorrect in two respects:

1. Extending the ladder increases the portfolio’s risks, especially as it relates to meeting its matching  liability/expense requirements.
2. As the portfolio continues to carry underwater investments, that is returns below market, then the fund’s revenue is short changed. It is credit unions that may have to pay a premium for NCUA’s mismanagement due to potential  revenue shortfalls.

Confusing Financial Presentations

The staff continues to present financial information following Federal GAAP that both confuses and misinforms readers about the actual state of the NCUSIF.

The federal presentation of the balance sheet shows that both the assets and Fund equity  have fallen this year from yearend.  That is because the decline in market value is is subtracted from both investment assets and the cumulative results of operations (equity) on both sides  of the balance sheet.  This understatement is $1.1 billion as of April 30 and increasing each month as portfolio valuations decline further.

To the user of this information, the NCUSIF appears to be reducing in size and value.

The accounting category, year to date retained earnings, is not reported under Federal GAAP.  Calculating  the Fund’s NOL trends requires this number.  However it  is not  presented in the financial statements, but must be derived from the information presented.

Finally the issue of how the NOL is being calculated using numbers from two different accounting periods was again raised by Board Member Hood. He referenced the Cotton accounting firm’s review from  2021 and its reported description of several ways the 1% true up could be presented in the  Fund’s yearend financial statements.

CFO Schied’s response to Hood’s query was:

We are reviewing and doing the due diligence over alternative approaches including that pro forma idea that you’ve mentioned in order to have a complete picture of the relative costs and benefits and to understand any potential hidden implications of any alternatives. 

Because I’m not sure back then that they realized that the change was going to lead to the timing gap that we have today.  I would look forward to updating you on these findings over the summer.

Credit unions will certainly be looking for this review!

Overall  this single-topic open board meeting identified, but failed to resolve, these ongoing  issues of NCUSIF investment management, fund financial presentation and more accurate NOL calculation.

(Editor’s note:  Later updates corrected earlier spelling error of Vice Chair Hauptman’s name)