As the September deadline for corporate capitalization plans nears, credit unions are conflicted. Some want to move on and not participate at all. Others see it as a cooperative duty. Many aren’t even sure what’s at stake given differing past experiences and views of the future.
Events in recent weeks have dramatically changed the context for this decision. These new circumstances provide the chance for credit union volunteers and professional managers to evaluate their participation in a different light.
The corporate system was built in a time of great need and uncertainty as credit unions entered a new era of deregulation. Back then, as it is now, the old order was gone. Today, this system redesign opportunity is more important than ever. And the timing couldn’t be more fortunate.
Two Compelling Events
Last week the Federal Reserve announced it will keep short-term interest rates at their current level, near zero, for at least the next two years. This means the opportunity cost of capital invested in a corporate is low, but the potential return is significant.
Second, Standard and Poor’s lowering of the United State’s credit rating highlighted the messy — some would say dysfunctional — governmental response to the nation’s fiscal and economic challenges.
Credit unions create member-centric solutions, not government-sponsored or private-market-driven ones. The events of the Great Recession are still fresh — both the reliability of corporate lines of credit alongside the well-publicized investment problems. The systems, experiences, knowledge, and payment networks still available are valuable resources in revising the corporate model.
By acting now, when a liquidity crisis seems remote, credit unions can respond with minimal costs and careful deliberations versus responding to an emergency. The foundations for the future can be grounded and not left to an open-ended timeline.
The political theater in Washington, DC, over the debt ceiling has been unsettling. Many Americans have lost confidence that Congress and the President can take meaningful actions to address the country’s growing debt. Standard and Poor’s downgrade on U.S. debt was not because of the country’s inability to pay but because of uncertainty about its willingness to solve the underlying structural fiscal challenges.
In contrast, the credit union system has used its cooperative capabilities to fix problems without depending on market-provided, for-profit, or government-financed solutions.
This is an opportunity facing the credit union system. Cooperative leaders are in a position to take action on a critical pillar for their own institution's and system’s future. Can they avoid the divided assessments, polarized judgments, and inactions that are apparent on the national stage?
Critical Role Of Liquidity In Financial Integrity
Liquidity is the most important pillar of safety and soundness in a crisis. Financial institutions are especially vulnerable when uncertainty hits. Their business is to raise short-term deposits to fund longer term assets and make money from the spread. Financial institutions can hedge interest rate risks but not liquidity risks.
When a financial or economic crisis occurs, asset values become uncertain, advised lines of credit reconsidered, if not suspended. New sources of liquidity are unavailable or on terms that exacerbate the financial challenges facing the firm. Uncertainty causes everyone to reassess business commitments made in better times.
Capital ratios and regulatory oversight do not bring liquidity — only external sources can provide that. Numerous institutions have failed from liquidity runs even though they were considered solvent up to their demise. Public confidence was lost and funding could not be rolled over or deposits replaced. It’s demonstrated in the history of bank failures, from Continental Illinois National Bank in 1984 to, more recently, Indymac Federal Bank, Wachovia Bank, Bear Stearns, and Lehman Brothers.
Even with the investment wounds inflicted on the corporates during the 2008-2009 financial crisis, credit unions loaned a record amount of more than $525 billion to members. Credit unions remained confident in their liquidity support while national and global external markets suffered severely.
In September 2008, corporates reported more than $72 billion in advised lines of credit to their members. As Warren Buffett said, credit unions were able to carry on their critical credit granting role in the worst financial crisis ever because they did not “rely on the kindness of strangers.”
System liquidity has not been an issue in the periodic economic crisis of the prior 25 years since the corporate network was built. Even today it is hard to recall the pre-corporate/CLF era in 1980 and 1981 when credit unions routinely closed the loan window because they were worried disintermediation would create funding shortfalls during the economic downturn. The primary source for loans was banking system competitors.
The irony in the new 704 corporate investment regulation is that although it has reduced corporate investment risks, it might create a more severe, but yet unrecognized, system liquidity risk.
The Liquidity Situation Today: A Dismantled System
By the end of September, credit union Boards must decide whether to capitalize a corporate partnership or rely on alternative solutions. Some corporates have met the new capital goals, others are close, and some are short of where they want to be.
Credit unions are awash in liquidity earning at most 25 basis points. Continuing market volatility and member trust have led to ongoing deposit growth of more than 5% at mid-year 2011. A liquidity crisis seems the most remote of risks today given all of the other economic issues and priorities facing management.
The urgency might be gone, but the importance of the liquidity pillar still remains. Financial integrity depends on the underlying structure and intra-system capabilities, not the intent to rally a temporary solution when one is needed.
A Funding Shortfall In The Midst Of Plenty
The funding shortfall facing NCUA in the midst of the liquidity flood shows this concern can arise suddenly and unexpectedly. When NCUA stripped the five corporates of their assets and collateralized $28.5 billion of NGN funding with $40 billion of investments, it created a funding shortfall of $12 billon.
NCUA must pay the book value of these investments to the bridge corporate depositors, but it has raised only $28.5 billion in refinancing to do so. These depositors are the credit unions that responded to NCUA’s appeal in 2009 to support the corporates. Even with $10 billion in the NCUSIF, $1.9 billion in CLF equity, another $41 billion in borrowing authority, $30 billion in TCCUSF authorization, plus Wall Street’s $28 billion cash, NCUA still needs liquidity.
NCUA’s solution, now that the voluntary prepaid assessment has failed, is to charge an insurance expense to pay off this funding obligation. Insurance assessments are supposed to cover losses, not provide liquidity funding.
Liquidity is abundant, but the system’s capability to aggregate and disperse it is broken. This is what credit unions can fix, corporate by corporate. When these institutions are in place, credit unions can develop the means to manage the flow of intra-system funds.
The Arguments Against Funding
In addition to an emotional "never again" stance after writing off corporate losses, the major reasons for not supporting a corporate include:
1) We don’t need corporates. This position says there are plenty of substitute solutions, private and quasi-governmental firms, so there is no need to invest in a corporate option.
The use of alternatives institutions affirms, not negates, the need. The requirement for correspondent services including payments, settlement, and network connections have not gone away. In fact network connectivity will be an even more vital factor for every financial institution’s payment transaction services. Alternative payment technologies will continue to explode in an Internet connected world.
2) Substitute providers are available. Why invest in a corporate option? Without exception, substitutes are not the same as cooperative alternatives. The corporates have done a good job of comparing their cooperative pricing and service solutions with both private and Federal Reserve options.
According to one external study summary, most credit unions would be better off with a corporate settlement solution. The only way to improve that approach would be to make an investment in hardware, software, and internal processes that offset the corporate capital requirement — assuming there was never any return on the capital invested.
The most critical point is that no substitute provider has as its primary organizational goal, the financial well-being of credit unions. Private firms can provide excellent service, but they must provide a return to their owners first and foremost. Governmental agencies are charged with broader public policy and institutional priorities, not the credit union system’s stability.
The Federal Home Loan Banks call themselves “cooperatives,” but the governance structure, historical purpose, and regulatory assessment make their future support for credit unions, at best, a secondary priority. As of December 31, 2010, 10 bank owned 40% of the FHLB system’s total regulatory capital stock. It is this ownership that determines Board representation, governance, system priorities, and structure. Credit unions owned less than 5%. The FHLB system is a subset of the banking system, not an independent cooperative alternative.
3) Not enough value to capitalize. The new corporate rule may reduce previous risks for a simpler business model, but there isn’t enough value to capitalize a more limited, even declining, service profile. The quick answer is that the corporates created today will not be the same businesses that exist in three to five years. The same is true of many credit unions.
Not only will member needs evolve, but the dynamics of innovation and competition will also provide corporates the opportunity to support and, in some cases, lead innovation. Corporates were critical contributors for credit unions’ adoption of electronic settlement, remote deposit capture, home banking, online bill payment, and dozens of other member initiatives. That is what a cooperative must do for its members: Create new solutions or fall prey to competitors.
The Capabilities Of The Cooperative System
Facts alone might not change the emotional opposition to supporting corporates, but there are two final points to consider:
1) The relative size of the actual corporate losses. The corporate network over the three years from mid-2007 through mid-2010, expensed in anticipated investment losses, called OTTI, more than $12 billion.
The actual losses during this same three-year period were slightly more than $1.0 billion, with $11.0 billion in reserves still available when NCUA took over the five corporates in September 2010. We don’t know actual losses since then. What we do know is for those corporates that still publically track OTTI, the projected losses have been pushed further out into the future and the total loss estimates have decreased by 10-15%.
During the same three-year period credit unions wrote off more than $4.6 billion in real estate losses. The allowance account was increased by another $2.8 billion to provide for additional losses on the $6.6 reportable delinquent mortgage loans at December 31, 2010. In the most affected states, losses on real estate were far greater than those from their corporate capital plus NCUA assessments (some West Coast credit unions excepted).
Although frustrating and disappointing, credit unions are not getting out of the real estate business because of their losses during this economic cycle. No one likes losses, but the response is to reassess risk management, not leave the playing field all together.
2) Credit unions have a different model. In the credit union model, the concepts of self-help and self-funding are critical components that support the tax exemption. The regulatory common resources in the CLF and NCUSF are credit union funded. Credit unions do not have access to outside capital. They rely on member loyalty and the ability to create retained earnings over time.
If the system is unwilling, or unable, to recapitalize its own institutions — and instead relies on private sector capital, FHLB resources, or the Federal Reserve, can it sustain the design and capabilities of the cooperative sector?
It the credit union system’s dependency on other financial institutions increases, does it lose its identity and become just another subset of the financial services sector? One way of understanding the demise of the thrift industry, whose assets fell 34% during the great recession, is its loss of independent purpose and capability during the 1980’s deregulation crisis.
Americans have been watching the political posturing in Washington, DC, with increasing irritation and sometimes condemnation. Now a difficult decision, but timely opportunity, confronts every credit union Board, every credit union volunteer, and every credit union manager that recommends courses of action. Will they make the hard choice to re-engage, recommit, and redesign a system that enhances cooperative capability? Or will they push the consequences down the road, knowing they can get by for now with the solutions at hand, and leave it to someone else to figure out what to do when the next liquidity crisis occurs?
I recommend taking the reins today to design cooperative solutions even in the face of uncertainty. Don’t leave this critical operational and liquidity need in the hands of governmental resources or private sector providers.