Letter to NCUA re: the Math on the $9 Billion Credit Loss Estimate

The industry is deeply concerned about the numbers used in taking the decisions to conserve Wescorp and US Central. I would like to explain the basis for this concern. I have attempted to describe the situation in a way that a lay person, the press, or any other interested party might understand the implications from the conclusions you reached.

To: NCUA Board Members
From: Chip Filson

The industry is deeply concerned about the numbers used in taking the decisions to conserve Wescorp and US Central. I would like to explain the basis for this concern. I have attempted to describe the situation in a way that a lay person, the press, or any other interested party might understand the implications from the conclusions you reached.

The $9 Billion Credit Loss Estimate

The following is for US Central only, but we have completed the same analysis for Wescorp and would be glad to send it to you.

In our analysis we have used the entire investment portfolio, even though we understand that the focus of the PIMCO study and the primary source of the risk and loss was in the private-label mortgage backed securities ($13 billion).

The rounded numbers use US Central's Feb 28, 2009 balance sheet with the losses then calculated using the Agency's explanations as follows:

US Central's investment portfolio: $24 billion

To be insolvent in the most likely base case the following would have to have occurred:

  1. The entire credit enhancement of 43% on only the Non-Agency RMBS would have been lost. This amount equals $5.2 billion;
  2. The entire capital of US Central would be wiped out: $ 2.5 billion;
  3. The Insurance Fund's case-specific loss reserve, for which the industry is being billed, of approximately $1.5 bn to USC (balance of $5.0 billion to Wescorp) is then added to the above.

This means the Agency is estimating, using various models, a most likely loss on the entire portfolio of $9.2 billion. What does that number imply about future conditions for that to be a reasonable and probable outcome?

Two factors primarily determine the outcome of MBS and other ABS modeling: the rate of default (how many homes go into foreclosure) and the loss severity on each defaulted loan across the portfolio.

Are 60%+ Defaults and Loss Severities Reasonable?

To arrive at the total $9.2 billion for the entire portfolio, not just mortgage securities, the default rate would have to average 62% and the loss on every loan the same number, 62%. Any combination of these two factors that results in a $9.2 billion number is feasible, so we have just shown an average for each dimension.

The board is being asked to approve actions today based on a scenario that assumes 62% of loans go into default and there is a 62% loss rate. Is that a reasonable outlook for the actions you took?

Again, I would stress that in the Agency's discussions the focus was on the mortgage-backed securities from which statements I conclude that the default rates and loss severity numbers actually "determined" were much higher. For example, if most of the $9.2 billion projected credit losses were in the $13 billion private label MBS, does that level of defaults and severities (in the mid 70's) seem reasonable? I understand the bottom up approach, but even that can be summarized into these two numbers.

What Should the Board Do?

Therefore, I believe the question you want staff to clarify quickly is what are the average default rates and loss severities from their analysis? The question is not how does the computer work to get the numbers, but is the outcome a reasonable future assumption to take the actions you did. Is there any contemporary actual evidence from payment streams or specific bonds that would support such a scenario where 62% of loans are in default and the losses average 62% on each such default? Are market prices anywhere near the values implied by this analysis?

There are two kinds of errors that can be made in a situation like this. The first is a factual error, for example how were the credit enhancements factored in—by NCUA or PIMCO; were they assigned at the loan level? bond level? etc. The second error is in making a judgment based on the model and the likelihood of the projections occurring.

I am not sure where an error may have occurred; but I do not believe the default and loss severity are in line with anyone's view of the future.

I believe you should initiate a dialogue immediately about the appropriate way to modify your actions.

If the logic or facts above are faulty, however, I would be more than happy to learn why that is the case. This is not about access to PIMCO's model; rather, it is using the output from any model with intelligence, care and common sense. These are the numbers, along with those for WesCorp, that I think need to be published as soon as possible.

Let me close with two final points. No one is objecting to paying the bill. Everyone agrees this is a systemic crisis. However, given future uncertainties, the reasonable way to pay the bill is by aligning the actual loss discovery with the premiums. No one would object to a process of expensing real losses as they occur assuming the wind downs are done in an orderly and temperate manner.

I will be in the office until 2:30 today and then back by next Tuesday if you would like further clarification on information about the above.





March 23, 2009


  • Thank you.
    Heken V. Edwards
  • I hope someone will clear up the reason why the PIMCO study is kept under wraps. Certainly someone at a higher level than NCUA will demand to see it.
  • Great article! I think that NCUA should look at all the data and test for reasonableness and not just depend on one source. Especially with so much at risk. Unrealized losses really shouldn't equate to real dollar losses for the entire industry based on one source.
    Dennis Barta
  • Arrest Bill Gross.
  • Why the rush to make a decision? It seems like everyone is running around with their hair on fire and that we MUST make a decision immediately or the world will end. How about a transparent open discussion on the methodology and calculations used, and some common sense in creating a solution we can live with? We are big boys and girls, and you can tell us the truth... we do not need to be spared the facts.
    David P. Dally
  • Well written, except I DO object to "paying the bill." Many credit unions are unable to bear the financial burden.
  • What an intelligent, rational approach. Surely NCUA considered average default rates and loss severity in their calculations? If not, they should have done so.
    Lois Weathers
  • Feet to the fire - GO CHIP!
    Chris Owen - Meriwest
  • Is it time for the movement to reconsider where its political support goes? If push comes to shove, we can pay tax and compete with the banks - as long as we are delivering in line with the mission. But how can we compete with a bureaucracy that has all the authority and none of the industry knowledge/savvy? And worse, will not listen to those who do? Perhaps some sympathy for the energy companies is in order. When we go to the ballot box we must be careful what we wish for - we just might get it.
    political thought
  • Chip and I got off to a rocky start in January as his view and my view of the corporate bail out differed significantly, but I must say Chip’s stock has risen in late March. However I still have one remaining significant difference with Chip. I do object to paying the bill. Pillaging the NCUSIF fund to cover non-cash accounting only losses related to OTTI is not what the fund was intended for; that is however, exactly what TARP was intended for. The NCUA Board and perhaps many reading this article somehow have convinced themselves that not taking TARP money (which is a taxpayer loan, not a handout) will some how allow the NCUA to remain independent. This is and in my view has always been fiction. However the NCUA Boards very actions, lack of foresight, lack of understanding financial markets and just plain stubbornness have in my view guaranteed the NCUA will be absorbed by a regulator that is directed by a more competent Board. Look to Citibank, their situation is very comparable to WesCorp and USC, yet Citi’s regulators actions have not jeopardized the entire banking sector.
  • Chip, another great article! Thank you.
    Kevin Stang
  • Well written and thought out. This letter helps me understand the need to see the PIMCO and the NCUA assumptions, if not the report itself. This info would help us all look at this with open eyes and understanding. Not as commandments from on High.
    James Wileman
  • I don't think you are asking anything unreasonable and I appreciate your doing the review. Thanks, DDD
    Dennis D Degenhardt
  • Chip, you have fairly and accurately hit the nail on the head. The NCUA, not only should, but must publish the PIMCO analysis. This will serve two purposes, it will either support or show the NCUA to have made a bad decision, and it will give others the ablility to do their own similar analysis. Keep up the good work.
    Stuart Weiner
  • Thank you Chip, Your assessment taken in concert with President's Obama's recent predictions of a 2.6 to 2.9 percent growth in GDP in the short run puts the NCUA board actions at odds with common sense, the CU Movement and the new administration. Thank you for your leadership and brilliance.
    Sarah Bang
  • Assuming Pimco's numbers for AAA MBS is what every FI will have to record, will the FFIEC be using the same numbers for all FI's?
    Dan Paulson
  • We knew we were being lied to and your analysis shows how impossible it is that anyone with industry knowledge could have believed Wescorp and USC needed to be seized. We still need to know why NCUA used this crisis as an excuse to take over the corporates. What is their ultimate objective, the one they won't tell us about.
  • I recall a presentation by WesCorp, perhaps from one of their Safety and Soundness presentations (surely somebody has this around), that tried to establish a breakeven for their mortgage types. In other words, what percentage of defaults and with what severity would need to occur in order for their portfolios to be impaired. I believe this analysis was in the last couple of years. A number that I recall was that for their subprime portfolio they would need to incur 30% default rates with over 50% severity. I bring this up for two reasons. First, WesCorp routinely applied this kind of analysis to their own portfolios so the work that PIMCO conducted, while stunningly expensive, will not yield much information. As Chip points out, IT IS ALL IN THE ASSUMPTIONS, which must be draconian for this level of losses to occur. WesCorp could have done this analysis on their own, as could the NCUA. This is why it is critical that the details of these portfolios be released. Second, any characterization or accusation that they (and, I suspect US Central) were providing untrue numbers flie in the face of the facts; WesCorp could not have provded this information in a presentation absent this analysis. If the NCUA was not aware of the potential losses in the types of severe default and impairment scenarios, it was only becasue they dodn't ask for it. In spite of what some have said, It is really just very basic math that is needed to anayze the profit/loss on these portfolios. Finally, an additional implication of Chip's analysis is that in order for these very high default/impairment assumptions to be met, it seems that prepayments would need to slow down dramatically (There are some details that go into this assumption that I won't go into). And while it is always possible that prepayments will go down, IN ONE OF THE LOWEST RATE ENVIRONMENTS ON RECORD, it seems unlikely. Higher prepayments means shorter average lives, and less chance of impairment. The answer lies in the assumptions. Second,
  • Took our first look at premium bill and status lat last ights board meeting. We are confortable with what we decided but Chips letter makes a lot a very clear case forthe "fuzzieness" of this that I have unconfoorable when . Will be intersting to see how this all plays out. Hope it is not mini-happening that resembles that which is going on in DC. KRH
    Ken Hill