Last month a credit union tried to buy a bank in order to gain
market share, obtain economies of scale, and to diversify its loan
portfolio. Good strategy, but the effort failed because federal
law prohibits federally insured credit unions from counting anything
but retained earnings as regulatory capital, and the credit union
needed more regulatory capital to do the deal.
The same law might prevent certain credit union mergers since proposed
GAAP accounting rules require a merger to be treated as a purchase
transaction, requiring the retained earnings of the target to be
reclassified. For some, the impact might cause pro forma capital
to be below regulatory minimums.
Managers at fast growing credit unions, large and small, are anxiously
following developments related to secondary capital and GAAP. Those
hovering around 7% capital levels are learning that NCUA must act
decisively to penalize violations - it's the law. Credit union trade
associations are offering ''hope'' that ''secondary
capital'' is a possibility by encouraging state and federal
legislation to allow it. Congress, however, is unlikely to change
public policy on this issue since in 1998 it already voted and passed
an alternative to allow credit unions access to secondary capital
(more on this later). Additionally, for safety and soundness reasons,
policy makers at many agencies remain opposed to allowing nonprofit
institutions (credit unions) access to secondary capital.
Even if ''secondary capital'' became a reality for credit
unions, a critical question remains unanswered. Who would buy these
uninsured investments? Members? Other credit unions? Corporates?
The answer is none of the above.
Members: offering the investment to members, would likely be possible
only after following strict disclosure rules established by the
Securities and Exchange Commission (SEC). Offerings of this sort
are likely to be economical for only the largest credit unions,
say over $100 million, because of cost and liquidity considerations,
and only to the wealthiest members, because of SEC rules. During
the savings and loan crises a certain California thrift, that failed,
offered ''secondary capital shares'' to depositors and many
bank customers suffered. Congress is unlikely to set the stage for
a replay. Even if it did, credit union directors and CEOs may want
to think long and hard about the risks of this scheme. The CEO of
the unnamed California thrift spent time behind bars.
Other Credit Unions & Corporates: No again. The Federal Reserve
Board and other policy makers would oppose a NCUA sponsored program
to ''daisy chain'' insured deposits into credit union capital.
Banks are prohibited from such activities because of the systemic
risk to the FDIC insurance fund. The concept of ''I'll invest
in your capital if you invest in mine'', has been thought of
before. And, like the NCUA proposal to allow credit unions to swap
business loan participations to avoid the business lending cap,
policy makers should oppose these schemes because of the public
relations debacle that would result after a high profile failure.
Potential sources of capital might include, public investors, insurance
companies, foundations, trusts, mutual funds, etc. However, these
investors are often prohibited from owning more than 5% of any single
investment offering with the dollar amount limited to no more than
5% of the investor's funds; minimum investment levels and industry
concentration limitations may also apply. Consequently, obtaining
suitable amounts of investment capital, from these sources, will
involve a significant distribution effort; and since credit unions
remain largely unknown and misunderstood among investors, the amount
of lifting to go from the concept of ''secondary capital''
to the reality could be paramount.
It's already been done.
Congress, in 1998, as part of HR-1151, voted to allow credit unions
access to secondary capital by converting to the mutual bank charter.
In addition to having access to secondary capital, mutual banks
only need a 5% capital ratio (vs. 7% for credit unions) to be well
capitalized. The 40% difference results in a competitive advantage
- eliminating the credit union ''hidden tax'' that impacts
market share and competitive scale.
Mutual banks currently have the ability to increase regulatory
capital in a number of ways. As a mutual bank, subordinated debt
may be offered, but it only counts as capital to meet the risk based
capital requirement - not the ''core'' well capitalized
minimum of 5%. A mutual bank, however, may form a subsidiary (REIT)
funded with mortgages and offer investments in the subsidiary with
the result of generating ''core'' capital. From a cost,
liquidity, and marketing perspective, the minimum size offering
Wall Street pays attention to is $20 million; and since the offering
generally can't exceed 25% of resulting ''core'' capital,
only the near billion dollar credit unions could play in this game.
The most common path for mutuals to raise capital involves organizing
a mutual (non-stock) holding company (HC) [some former credit unions
have done this with the help of CU Financial Services] which would
own all the stock of the subsidiary stock bank. The HC then forms
a ''trust''. The ''trust'' offers (directly or by
pooling with others) shares to institutional investors, and down
streams the proceeds to the subsidiary bank creating ''core''
regulatory capital. Another alternative is for the HC to get a ''commercial
loan'' from a bank, insurance company, wealthy investor, or
pension fund (by pledging the stock of the subsidiary bank) and
the money could then be down streamed into the subsidiary bank,
thus boosting ''core capital''. Some limitations exist,
but the dollar amounts of borrowing and transaction costs are manageable
- even for deals in the million dollar range.
Also, the bank or the HC can sell publicly traded stock in a member
approved IPO. If a HC retains 51% of the stock, member ownership
continues, with the board of directors elected (like a credit union
board) by the depositors of the subsidiary bank.
In conclusion, if your institution is expecting ''secondary
capital'' to be a part of the solution for your future development,
you should take steps to convert to the mutual charter now. The
process of going from a credit union to the marketplace for regulatory
capital requires sound strategic planning, experienced advisors,
and time to execute. To get the facts about these and other opportunities
for your institution, including joining a ''federation''
of former credit unions with economies of scale and ready access
to capital, please call Alan D. Theriault at (800) 649-2741