My earlier blog today about Fellowship Credit Union (now BECU) contains an even more powerful message than acorns becoming tall oaks.

It is the example of people willing to put limited resources to the aid of their fellow human beings in difficult circumstances. That is, the many giving others the opportunity at a better life—during the hard times of the depression.

Another Reality: Disposable Members

Last year when walking in downtown Chicago, the following message on the side of a public trash unit caught my eye.

This is unfortunately one of the consequences of NCUA’s current practice in problem credit union resolution. Members with savings receive all their money back at full value. Borrowing members are sold off to the highest bidder. For savers this would be the same as NCUA transferring members’ insured balances to Wells Fargo or a finance company. Sell savings accounts for the best price and then let members work out their future relationship on their own.

Borrowers are the primary reason for a credit union. They provide the most important source of revenue. But in problem situations, the borrowing members’ fate is not NCUA’s concern. Loans are only an asset to be rid of.

This practice was most dramatically illustrated in the NCUA’s February sale of over 4,500 member taxi medallion loans to a hedge fund seeking to build a dominant share of the NYC taxi medallion market.

How This Topic Came Up Last Week

At NCUA’s Wednesday 2021/22 budget hearing, this issue was raised when one of the presenters gratuitously congratulated his organization and the Agency on this action, according to the CU Times.

The reported statements were:

“As NAFCU’s SIF Committee pointed out prior to the sale the unusually large taxi medallion portfolio would strain agency resources and pose a risk to the credit union community so long as it remained under management by the Asset Management and Assistance Center.

“While NAFCU did not anticipate a global pandemic at the time we offered this advice, we believed that retaining the portfolio in the hopes of extracting a higher sales price presented unnecessary risks, and recommended that the agency divest the portfolio at the earliest opportunity so long as it received a fair price.”

No facts were offered to support this position. The idea that the portfolio would “strain agency resources” in a $19 billion dollar fund is nonsensical. The agency two years earlier had expensed all the estimated loss–at a magnitude 4 times ($750 million) the last reported deficits ($150 million) in conservatorship.

The return on this additional cash in the NCUSIF is under 10 basis points.

Why this superfluous statement was made in a budget hearing is unclear–a crude attempt at sucking up to the Agency or poking a sharp stick in the eye of a group that challenged the sale. Whatever the reason, it not only undercuts the credibility of the presenter, but more critically it supports the unfortunate Agency practice that member borrowers are not NCUA’s responsibility, just savers.

Hiding the Truth on the Taxi Medallions

NCUA has repeatedly refused to present any details that would support its sale as in the best interests of the members. Or even the best financial outcome for the NCUSIF.

At least three organizations requested FOIA information on the sale; all denied. Some of the sale details were already published in a Feb. 20, 2020 WSJ story on the hedge fund’s purchase.

The Journal reported the price of $350 million for a portfolio of 3,000 New York medallions, 900 Chicago medallions, 500 Philadelphia medallions and 100 from other cities.

This is an average loan value of $77,800 each, all secured by medallions. An estimate of the average book value of these loans is the purchase price of $350 million plus the loss NCUA says it has taken on the portfolio of $760 million. These numbers combined total $11 billion and suggest an average book value of $245 thousand per loan. The cash received would be a payment of 31 cents per loan dollar.

What’s Wrong with Cashing Out?

The challenges of the New York taxi medallion market continue to be tracked. One example is the 2015-2020 chart below which shows the rider volumes as the uber/lyft new entrants disrupted the taxi industry. So, wasn’t 31 cents better than holding on? That is the question which NCUA and the presenter have failed to offer any factual information.

For some the chart may be a sufficient justification forgetting the fundamental rule of markets, what goes up must come down and vice versa. Cashing out at the bottom is generally the highest cost strategy—just remember the five corporate liquidations, all supposedly insolvent, whose estates have generated a surplus of over $6 billion so far.

Better options for members are what the Taxi association, CUNA and others offered to present to NCUA which refused to consider all offers. Medallion drivers, one of the most diverse group of credit union members, include many individual entrepreneurs. They were denied any ability to negotiate their own future. The sweat equity that they hoped to build was turned over to a firm that specialize in profiting from others in financial difficulty.

One Easy Solution for a Win-Win

Instead of turning its back on members striving to realize the American dream through their own labor, what if the agency had offered to discount the members’ loans to the same level that the hedge fund bought them? Furthermore, these rewrites could include a contingency that if the borrower was able to sell the medallion for more in the future, the gain could be split between the borrower and the fund.

More proposals for assistance continue to be drawn up today by the alliance and New York city leaders. Some taxi owners were able to receive help from financial programs in the CARES act. But NCUA washed its hands and walked away from the members in trouble as others attempted to find solutions.

NCUA’s lack of transparency suggests there is much to hide in its failed supervision of the taxi medallion situation and sale. The agency used money due credit unions from the TCCUSF surplus to expense $750 million to cover up their inability to carry out basic responsibilities for problem supervision and resolution.

The most unfortunate aspect of the taxi medallion sale was that it proved again that NCUA views credit union borrowers as disposable. This is exactly the opposite of the founding spirit of the Fellowship CU and the purpose for which all credit unions were formed.

December 7^th is also a day that no one will forget because it brought America into WWII. A basic code of honor in the US military is that no one gets left behind whether as POWs or MIAs. Decades, even generations later, the US government sends teams to recover the remains of missing from Korea to Vietnam and other places of combat. No one is forgotten, whatever the circumstances.

That is the heart of the American democratic commitment to each other. It’s the motivation for Fellowship Credit Union, begun this day four generations ago.

Isn’t it time NCUA followed this same principle when performing its responsibilities?

An easy but critical first step for a new NCUA board for insight into the agency would be to change the current auditor, KPMG, of its three credit union financed funds. This is normal good business practice as NCUA documents in its examination recommendations cited below.

It would bring a fresh set of eyes and objective rigor to a series of events such as the ambiguities in managing the corporate AME assets and the inexplicable annual accounting for loss reserves in the NCUSIF.

It would also bring much needed review for how the Inspector General’s office performs both its internal and external audit oversight.

Finally, it would replace a firm whose professional integrity and competence have been publicly and repeatedly called to account in the past three years by both regulators and the financial press.

KPMG’s Recent Press Reports

For several years the business press has reported on the professional and ethical failures at KPMG. The following are a few of the public stories about events from 2016 through this year.

1. The KPMG cheating scandal was much more widespread than originally thought

Jun 18, 2019 — A $50 million fine against KPMG LLP for its use of stolen regulatory information to cheat on audit inspections wasn’t a surprise: The Wall Street Journal warned last week that the Securities and Exchange Commission was ready to impose such a move, and the scandal had been known about for more than a year.

https://www.marketwatch.com/story/the-kpmg-cheating-scandal-was-much-more-widespread-than-originally-thought-2019-06-18

2. KPMG reveals eight audit clients collapsed

Updated Feb 18, 2020 

KPMG has revealed it failed to flag problems with the financial statements of two of the eight collapsed listed companies it audited over the last 10 years.

https://www.afr.com/companies/professional-services/kpmg-reveals-that-eight-audit-clients-collapsed-20200203-p53x6l

3. Accounting Watchdog Finds Ongoing Problems at KPMG

The Public Company Accounting Oversight Board (PCAOB) said half of the 52 audits it inspected from top accounting firm KPMG were seriously deficient and KPMG was not as committed to quality as the accountancy claimed.

“In 26 audits, certain of these deficiencies were of such significance that it appeared to the inspection team that the firm, at the time it issued its audit report, had not obtained sufficient appropriate audit evidence to support its opinion,” the PCAOB said in its report.

The accounting watchdog also released a revised inspection report for 2016 that found deficiencies in 22 of 51 engagements.

Some of the most common deficiencies occurred in the area of revenue and included failures to sufficiently test the design or effectiveness of controls.

https://www.cfo.com/auditing/2019/01/accounting-watchdog-finds-ongoing-problems-at-kpmg/

4. SEC Charges Three Former KPMG Audit Partners for Exam Sharing Misconduct

Washington D.C., May 18, 2020 

The Securities and Exchange Commission today announced settled charges against three former KPMG LLP audit partners for improperly sharing answers to internal training exams and for subsequent wrongdoing during an investigation of exam sharing misconduct at the firm. The SEC previously charged KPMG with violations concerning the exam sharing misconduct, as well as for altering past audit work after receiving stolen information about inspections that would be conducted by the PCAOB.

An NCUA Examination Comment On External Auditing

Following is an excerpt of standard wording NCUA provided one  credit union’s supervisory committee about managing their external audit process: (emphasis added)

Examiner’s Observation: As standard exam procedure, we conducted a meeting with the supervisory committee chair during this year’s examination. We inquired about the process of soliciting bids from audit firms prior to the end of the engagement period, to select the audit firm for the next engagement period. Our discussions with the supervisory committee and review of policies and procedures noted that there is no documented bidding process and that the audit committee has not solicited bids since 2010.

It also appears that the audit committee had no defined timeline as to when they would solicit bids in the future. While specific limits are not required, recent accounting and auditing scandals highlight the importance of rotating audit firms periodically. Otherwise, auditors and clients could loose independence and overlook areas of concern.

Prudent and standard business practices recommend the development of written processes and procedures, outlining the steps the supervisory committee needs to follow when engaging an audit firm to complete the annual audit. The supervisory committee needs to follow the guidelines when soliciting and reviewing bids from audit firms.

We recommend the supervisory committee develop, approve, and implement written procedures for reviewing proposals for the annual audit. Furthermore, the audit committee must understand and implement the procedures as intended, as this is among the most important functions of the committee. It is imperative the supervisory committee maintain documentation to support their review and selection of the audit firm. Furthermore, we recommend that management and the board consider periodically rotating audit firms. It is important to note we are not taking exception to or criticizing the quality of the annual audit report or the audit firm.

An Example of a Board Policy Statement of a Co-op’s Audit Process

Effective audit controls include review as to whether internal and external audits are effective.

• • The Board of Directors and Executive Management of XYZ expect to be apprised of the condition of the organization, including the system of internal controls.
  • On an annual basis the Board of Directors is asked to approve the Risk Based Audit Plan. The Audit Plan describes the internal and external audits designed to prove the adequacy and effectiveness of internal controls and policy, as directed by the Board of Directors and Executive Management of XYZ.

Board Action Required

This brief policy statement should be the starting point for a new NCUA Board to better monitor and understand the effectiveness of the Agency’s management. It is what the agency expects of credit unions. Should it not hold itself to the same standard?

At the November NCUA board meeting, two members responding to the NCUSIF update made “the sky is falling” projections about whether the fund will have adequate resources in 2021.

One board member confidently predicted that the assessment of a premium is not a question of if, but when.

Neither forecast was supported by factual analysis.

Relevant Facts

Before offering a simple, immediate solution to these future seers’ concerns it is important to affirm basic facts about the NCUSIF’s financial strength and record.

• As reported by Chairman Hood to Congress the fund’s NOL is 1.32, which is above the legal cap of 1.3%. Anytime the fund exceeds this cap, a premium cannot be charged.
• The current NOL is 12 basis points above the 1.20 floor below which a restoration plan must be prepared. This is a financial margin of almost $2 billion.
• In the last 12 years of operations, the total insurance losses for the entire period Is $1.887 BN or less than the current NOL “surplus” margin.
• NCUA’s transfer of its fixed operating expenses to the NCUSIF via the overhead transfer rate (OTR) in this same 12 years is $1.968 BN or more than the total insurance losses.
• NCUSIF’s operating expenses have grown at a CAGR of 8.06% versus the growth of insured shares of only 5.6% in this time span. It is this fixed operating expense, not insurance losses, that eat up the fund’s revenue.
• The fund’s average insurance 12-year loss is 1.727 of insured savings. This includes the entire years of the Great Recession. The current 12 basis point NOL margin is seven times (700%) this average annual rate of loss.
• The September 2020 NCUSIF financials show an allowance reserve already funded for both general and specific losses. Moreover, the total assets of all code 4 and 5 credit unions is only .64% of the industry’s assets, that is less than 1%. This is the lowest level in the past decade.

Full details of the NCUSIF’s operations can be found on this spread sheet.

2019 NCUSIF Performance Spreadsheet_AJ1

 

The NCUSIF 1% semi-annual deposit “true up” underwriting means the NCUSIF is entirely countercyclical in its structure. The NOL range of 10 basis points(1.20 to 1.30) provides flexibility no matter the uncertainties that might occur. It is the ever-increasing fixed expense charged the NCUSIF in the OTR, not the variable insurance losses, that take the majority of NCUSIF income.

The fund’s financial architecture has proven its resilience since 1984 a period of time in which the FDIC has gone negative three times. The FSLIC failed and was merged into the FDIC in the 1990’s. In spite of these failures, the FDIC is still based on the same premium financial model that has led to its repeated failure.

A Ready, Easy Source of Additional Revenue-Not Premiums

As of September 30, the market value of the NCUSIF investment portfolio exceeded its book value by $586 million. This is due to the precipitous fall in interest rates engineered by the Federal Reserve at the beginning of March responding to the pandemic and economic shut down.

By selling these securities and staying short, the fund would book immediate revenue in the hundreds of millions, become more liquid and be better positioned for the inevitable rise in rates from present historic lows.

This market premium disappears if the securities are held to maturity. The time to realize this gain is now. It will add immediately to equity if the board truly believes the NCUSIF must sustain an NOL above 1.3. A premium cannot be levied if the NOL is above 1.3%

But what about the future revenue possibly foregone when the bonds are sold and reinvested at today’s lower rates? That is a contingency easily modeled, but ultimately relies on the assumptions made about how long the current rate environment is likely to continue.

The NCUSIF reported the following fixed rate investments by the NCUSIF in September:

Term   Rate
4 yrs    .20%
5 yrs    .27%
6 yrs    .36%
7 yrs     .45%

Is there any CFO or CEO who would make investments for their credit union at these terms and fixed rates into the future? While no one knows the future, the preponderance of experience suggests that it will take only one move by the Fed from its current 0-25 bps overnight range, to a first step raising it to 25-50 bps, for all of these investments to be underwater, that is less than book value.

Yes, there is a risk of some foregone revenue next year, but a reasonable forecast suggests that a strong recovery will bring with it higher rates. And if the opposite happens and economic disaster occurs, then the liquidity would be readily available.

The Action Needed and the Precedent

If the NCUA board decides to keep the NOL above the 1.3% current cap, then sell some of its investments, take the gains and recognize the revenue now. When rates rise, the market premium goes away. This is an opportunity that will decline if not disappear in the not-too-distant future.

The precedent is 2008 when the NCUSIF sold longer term securities to prepare for the potential contingencies brought by the Great Recession. This boosted income so that no premium was necessary with the fund reporting net income of $24 million and an NOL of 1.26.

In an October 6, 2015 CU Times op ed, then new board member McWatters presented his approach to credit union regulation. He resigned his board seat last Friday. Below are selected verbatim excerpts of his original policy priorities that I believe should stand the test of time and party.

Credit unions are best served by having a regulator that understands the not-for-profit, cooperative business model. . .

Rick Based Capital Rule

Last week, by a bipartisan margin of 50-9, the House Financial Services Committee sent an undeniable message to the NCUA: Take more time to review the law, assess the need for additional regulation, evaluate alternatives and consider the real impact now and into the future before moving ahead with the Risk-Based Capital 2 final rule.

This is a message I welcomed and championed in my written dissent (available on the agency’s website) to the issuance by the agency of its proposed RBC2 rule last January as contrary to a plain reading of the Federal Credit Union Act.

Regulatory Burden

I think the agency would do well to heed this message for other major regulatory issues as well, most notably how the agency deals with the growing regulatory burden confronting credit unions, particularly small credit unions. The increasing number, scope and costs associated with regulatory requirements, not just from the NCUA but from all agencies, that credit unions must manage is a concern that the NCUA must take more seriously and devote more resources toward addressing in a meaningful way. , ,

Fraud Losses Cost to NCUSIF

We should also more rigorously address the dramatic losses, year in and year out, to the National Credit Union Share Insurance Fund caused by fraudulent activity committed by a limited number of bad actors within the credit union community. . .

Editorial note: All these issues are still live in the industry today.

To ensure a safe Thanksgiving, my wife and I lined up Friday night for our Covid tests at the county recreation center. The test was free. The line took about an hour. Everyone stood six feet apart as the temperature got cooler as night came.

We were given clipboards to complete our registration—name, email, age, race. One of the staff helping with sign ins came by to ask the obligatory questions. Have you had any Covid symptoms? Been around anyone who has tested positive?

It was the last question that was memorable, however. She qualified it by saying “I think I know the answer, but I have to ask anyway. Are you pregnant?”

An NCUA Exam Risk Rating

The predictable routine of bureaucracy is an important factor in performance. We rely on formulaic responses especially by those in authority. But it can also result in actions that contradict common sense.

In a conversation with a CEO about how to respond to his most recent exam, this same anomaly was present.

The credit union has been a CAMEL 1 for almost two decades. It has navigated the pandemic with improving performance. Liquidity is 500% the policy minimum, delinquency is down and most loans in forbearance are back making payments. ROA and net worth are way above peer averages. A consistent track record of exceptional performance in the present and the past, through thick and thin.

So, I asked given these documented facts why the risk rating for “credit” and “liquidity” were judged “moderate” versus the “low” ranking on every other factor. The CEO’s observation was “It feels like we are being punished for what could happen in the future.”

The Culture of Bureaucracy

This is the difficulty with bureaucratic culture. When facts don’t fit a program’s priorities, the instinct is to assert future scenarios that do. This tendency is not limited to examiners. Listening to last week’s NCUA board meeting, two members confidently predicted the future financial downturn of credit unions in 2021 and with it, the necessity of collecting more money for the NCUSIF. This was after the staff updated the distribution of CAMEL ratings that showed the continuing reduction in code 4 and 5 classifications in both total assets and number of credit unions.

Facts will not deter the inevitable government instinct to always seek more money. This prediction of future NCUSIF premiums reflects a bureaucratic mindset similar to asking all males if they are pregnant.

After getting our Covid tests, we walked out by the admin line and everyone wished me a safe pregnancy. For I had answered yes to the question. We all enjoyed the humor of this bureaucratic incongruity.

Common sense, humor and a negative test. Good ingredients for a safe 2020 Thanksgiving. For it is my hunch that 2021 could be the best year credit unions and their members have ever enjoyed.