Category: NCUSIF

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)

From NCUA board members’s statements in Senate confirmation hearings  to the examiner on the street, the most frequently stated goal stated by NCUA staff is  to “protect the insurance fund.”

This goal is repeated even though the NCUSIF is a means and not an end in itself.  The ultimate purpose of NCUSIF is to safeguard member assets.

The primary venue in which Board members demonstrate their responsibility to “protect the fund” is the quarterly statistical report  provided by staff and discussed in an open meeting.

The NCUSIF’s status was the principal topic of May’s board meeting.   I was unable to listen to the live broadcast.  All I have is the  slide deck from the agenda and posted board statements, not the actual live exchanges  that took place.

Questions on the NCUSIF’s  from the March Update

Here are some  initial questions from the  information presented.  I would hope that some or many of these would be  part of the dialogue in the Board’s duty “to protect the fund.”

1. Since December 2021, total NCUSIF assets have declined by $130 million even after recording $578 million in new capital deposits receivable. The cumulative results of operations (equity) shows a decline of $727 million in the first quarter.  How did these declines occur?  How should users of this data understand Fund performance?
2. The March report shows that the market value of the portfolio has fallen $806 million below cost or book value. What does this decline indicate about the management of the Fund’s interest rate risk?
3. The Fund’s yield year to date is only 1.22% What is the required breakeven yield to cover the Fund’s operating expenses?  How large is the revenue loss in the next 12 months as indicated by the current and  continued decline in market value?
4. How did the Fund’s investment committee modify their approach after  the rise in rates initially forecast last October/November  by Chairman Powell?
5. How will the investment committee deploy the approximately $4.0 billion in funds arriving in the next 12 months from maturities, new capitalization deposits and interest payments?
6. The Fund reported net income of $54.4 million in the 1^st However Slide 13 shows estimated retained earnings of $4.792 billion, or an anticipated loss of $68 million in the current quarter.  That would represent a $122 million net operating decline for the June quarter.  How was this projected?  What is causing this loss?
7. Insured savings growth is estimated at 7.1% at June 30, 2022, down from 14.2% at the June 2021 quarter. Actual twelve month share growth was 9.3% as of March 31, 2022. How much additional growth  slowdown is projected for this year?
8. In Slide 13, the numerator and denominator use data from two different time periods to calculate the NCUSIF’s equity ratio (NOL).  If the same June 30 data were used for both parts of the ratio,  the resulting NOL would be 1.283 % versus 1.25 %.   This three basis point difference is over $500 million at the current level of insured shares.   Shouldn’t this more timely ratio be used in reporting the Fund’s actual financial position?

Fund Performance and Investment Policy

The NCUA’s immediate and ongoing opportunity  to “protect the fund” arises from its  management of its current $22 billion and  ever growing asset base.

The questions above are vital to understanding how NCUA staff implements the Board’s twin NCUSIF investment policy objectives  “To meet liquidity needs” and “To invest. . .seeking to maximize yield.”

The March financial statistics raise critical question of how the NCUSIF responded to the changed interest rate outlook over the past 12 months.  And, more importantly how it will respond going forward.

I will report on Board member’s interactions and assessments to NCUSIF’s   March information  when the May meeting video/ transcript is available.   That dialogue will be a useful example to learn how NCUA board members see their role  “ to protect the fund.”

 

 

Many NCUA management actions have limited direct impact on credit unions.  But when mistakes are made in a critical system component, the NCUSIF,  they can cost credit unions dearly.

The NCUSIF’s sole source of revenue is the earnings on its $20.5 billion investment portfolio of government securities.

The objectives of the NCUSIF’s current investment policy are clear:

The investment objectives of the NCUSIF are:

1. To meet liquidity needs resulting from the operations of the Fund; and
2. To invest, on a daily basis, any excess cash in authorized Treasury investments seeking to maximize yield.

The Investment Committee has fallen increasingly short of these objectives for at least the past 15 months. Results  have been contrary to these clearly stated goals.

The Numbers: $10 billion in New Investments in Two Years

At December 2019, the NCUSIF’s portfolio size was $16.02 billion of which $5 billion matured in two years or less.   At February 2022, the portfolio had increased to $20.5 billion.

Since  interest rates declined to historic lows in March 2020 at the start of the national economic shutdown, the NCUSIF has invested more than $10 billion ( 50% of its current portfolio) following a robotic 7-year ladder.

Today these $10 billion investments are worth less than par.  They cannot be sold without incurring market losses constraining the NCUSIF’s liquidity options as stated in objective 1.

At February 2022, the portfolio reports a total unrealized market loss of $343 million, a decline in value of over $ 800 million since December 2020.   The current unrealized loss will increase as rates  rise.  These declines since December 2020, easy to  see from the monthly market value disclosure. They also indicate that the portfolio’s yield is increasingly  falling behind market rates.

A $45 Million Dollar Mistake and Still Growing

The most recent investment of $650 million on February 15, 2022 for seven years at a fixed yield of 2.01% continues this mismanagement in the face of unanimous market indicators and Fed statements pointing to rising rates.

Today the seven year T-Note is near 3% yield.   Not only is this investment from just 60 days earlier worth less than par, the loss of income over the seven-year term is currently over $45 million. That is 1% (or higher yield pickup) times $650 million times seven years.

Credit unions and their members will pay the cost for these and other misjudgments that have resulted in at least half of the NCUSIF’s portfolio below market.  With a 3.5 year effective price duration, the portfolio will continue to decline in value by 3.5% for every 1% increase in the yield curve going forward.

The NCUSIF Investment Committee

The Board’s Policy delegates the implementation of the its two policy objectives to four of the agency’s most senior staff including:

Director of Office of Examination and Insurance, Chair

Chief Financial Officer

Director, Division of Capital and Credit Markets

Chief Economist

One would have hoped given the first quarter’s “Rout in the Bond Market” (WSJ headline), the continued inflation projections, the Federal Reserve’s frequent announcements of policy change, that someone would have called a timeout on this robotic investing ladder. The declines in market value are in plain sight; but more critical are  increasing constraints on future income possibilities, objective 2.

What Can Credit Unions Do?

The reason for monthly NCUSIF financial disclosures is so the fund’s owners who rely on NCUA management, can see the results and raise concerns with the board.

Credit union’s first responsibility is to speak up.  Directly communicate your views of this performance failure.  For your members will pay the cost of these misjudgments ($45 million and higher) potentially for years.

The reported results fall way short of policy.  What will the board do?   The committee seems unable to follow market trends, its own NEV data or internal IRR analysis (if any), or even to be aware of different portfolio options.

In public board meetings, staff is dismissive of change calling alternatives “market timing” when in fact the real issue is simply “investment management.” This is a responsibility every credit union is expected to perform in all phases of the interest rate cycle.

Assuming the board is incapable of monitoring and implementing its stated policy, then Congress is the next recourse.

The Damage to NCUA and the System’s Reputation

 

When NCUA and senior employees are oblivious to market trends, the situation raises questions about competency in many other areas of operational assessments and regulatory approvals.

Supervision requires judgments.  Policies nor rules can prescribe detailed actions. Ratio calculations can be written down but determining the correct numbers entails seasoned analysis.

The economy is in an inflationary period which some say has not been experienced for 40 years.  The Federal reserve’s balance sheet and its increase in money supply has never been larger.   Short term overnight rates are priced in forward markets as high as 3% in a year’s time.

There will be significant adjustments as credit unions transition their balance sheets to the new environment and as member’s see rising rate options.

There will be lots of hyperbolic forecasts and many forebodings in forthcoming months. After all, “preaching negativity makes you an expert” as one colleague used to say.

But credit union’s track record in the most extreme crises has been one of patient, experienced adjustments even when markets seemed to have lost all logic.

As NCUA’s enters this new cycle of interest rates, will its ability to make reasoned adjustments match credit union’s own track record?  This initial response in the comparatively simple management of a treasury portfolio, with just two clear policy goals, is not encouraging.

Can the agency learn from its own misjudgments?

 

 

 

 

In early January following NCUA’s posting of the September 30, 2021 AME financials for the five corporates, I published an analysis of the forecasted amount to be paid to credit unions.

That analysis showed NCUA projected total distributions of $3.185 billion to shareholders of four of the five estates.  The $569 million in additional payouts NCUA announced on February 28 brings actual payments to $2.010 billion.

Even with  these latest payments, there is still $1.2 billion due to credit union members based on NCUA’s financial projections.

The portion that NCUA announced as dividends on February 28 will go to the former Southwest Corporate shareholders.  They already received their entire capital contribution and are projected to be paid a $330 million liquidating dividend.   After this initial “dividend,” they will be due $120 million more.

Questions Abound

 

The NGN program ended in June 2021.   Why has it taking so long to return the remaining $1.2 billion balance to credit unions?   Will NCUA post a list of the remaining legacy assets and their current market  value with its December 2021 AME financial statements?

The five spread sheets of every legacy asset updated through September 2017 for each estate are already completed.  Shouldn’t NCUA now update these and publish the current market value for every remaining asset?

Is it fair to conclude that 12 years after the 2010 liquidation of the five corporates, only one was actually insolvent?   The other four were deemed insolvent because they were victims of exaggerated and inaccurate loss provisions projected decades into the future?

At this time NCUA forecasts total cash recoveries over $5.7 billion. Of this amount $2.6 billion was the TCCUSF surplus merged into the NCUSIF on October 1, 2017.

Is it correct to say this cash surplus occurred only after the agency subtracted $3.6 billion in liquidation expenses as reported in section B 1 Liquidation Expense in the AME financials?  Are these expenses approximately the same amount as the net legal recoveries?

The so-called legacy assets seized in 2010 have never changed.  Is it reasonable to suggest that this regulatory modeling miss-estimate of $6 to $8 billion was how NCUA determined the corporates to be insolvent?  Moreover, the vast majority of the projected credit defaults had not occurred when the corporates were seized.

If these erroneous projections of at least the $5.7 billion cash surpluses are reasonable, does this suggest why a look back at the entire event should be undertaken?  How can such misleading estimates be avoided in the future?

The Critical Work Still to be Done

 

NCUA’s errors in models and their assumptions resulted in irreversible damage for the credit union system and the individuals involved.   It continues still today in the diminished role of the corporate network.

While many might say let bygones be gone, the processes and powers that created this regulatory debacle have not been assessed or even changed.

The real work of the Corporate Resolution Plan remains to be completed.   Paying out the recoveries from events that should have never taken place should not be the end.  Rather it should compel a thorough look at what caused these errors and miscalculations in the first place.