Face of Market Turmoil, Credit Union Regulation Helps Institutions Weather the Storm

President John F. Kennedy once famously remarked that “a rising tide lifts all boats.” As the financial crisis of 2008 reverberated from the banking sector throughout our economy, perhaps a more apt nautical metaphor is that this uniquely challenging economic climate has provided “no port in a storm.”

Although the vast majority of credit unions remain well-capitalized and well-positioned for the future, the National Credit Union Administration (NCUA) faces real and tangible challenges to ensure the long-term success of the credit union industry and to enable credit unions to continue providing cooperative financial services to America’s consumers. With foresight and strict adherence to the sound, prudent principles that have always been the hallmark of credit unions, NCUA is well positioned to meet those challenges.

For nearly 100 years, credit unions have provided consumers with a consumer-friendly alternative to commercial banks. With a unique not-for-profit member-ownership structure, credit unions have historically been able to provide a wide range of financial tools and excellent rates, particularly to consumers and small business people who are underserved by banks.

Chartered first at the state level in 1908, credit unions’ oversight at the federal level began in 1934, when President Franklin Delano Roosevelt signed the Federal Credit Union Act into law. With the national unemployment rate well north of 20% and frozen credit markets threatening to derail any hope of economic recovery, credit unions proved their worth to consumers.

Credit unions continue to do so to this day. Drawn by these consumer-first practices, Americans have broadly embraced credit unions. Today, NCUA oversees more than 7,600 credit unions with a total membership of more than 90 million Americans.

NCUA (and its predecessor agencies) has been a strong and credible federal regulator for eight decades. Since 1970 NCUA has administered the National Credit Union Share Insurance Fund (NCUSIF), the federal deposit insurance fund that serves the same purpose for the credit union industry that FDIC does for banks and thrifts.

In today’s challenging economy, the industry that NCUA oversees presents a “good news/ bad news” picture. The good news is that 96% of credit unions today are well-capitalized, and the industry-wide aggregate capital level stands at a respectable 10%. Credit union lending over the last two years has increased despite a very adverse financial marketplace.

The bad news is that the costs associated with even a relatively small number of failures, coupled with the potential for further economic setbacks weakening credit unions now considered healthy, make this one of the most challenging and consequential times in the history of the credit union industry—both for credit unions and for those who regulate and insure them.

The potential for the broader financial collapse to affect credit unions was first widely reported on August 11, 2008, in a front-page Wall Street Journal article entitled “Mortgage Market Trouble Reaches Big Credit Unions.” This article broke the news that five of the nation’s largest corporate credit unions had reported large unrealized losses due to investments in mortgage-related securities.

Unlike retail credit unions, the 28 corporate credit unions do not deal directly with consumers. Rather, these wholesale institutions provide investment, liquidity, and payment system functions to the retail credit unions. In doing so, corporate credit unions enable retail credit unions to better serve their members. Corporate credit unions have been tightly regulated, and are limited to investing in safe, highly rated assets. Indeed, as the Wall Street Journal pointed out, nearly all of the investments made by corporate credit unions carried AAA ratings. However, even these highly rated securities were not immune to the market contagion. Similar to other financial institutions, this created the potential for a major liquidity crisis that could have forced corporate credit unions to sell deteriorated assets and realize enormous paper losses.

NCUA was proactive, not reactive, in dealing with the situation that loomed in the later months of 2008.

First, NCUA asked Congress for an increase in the borrowing ceiling for the Central Liquidity Facility (CLF). As the name suggests, the CLF is an NCUA-administered source of backup liquidity. Fortunately, and understandably given the stability of the credit union system for most of its history, the CLF has been lightly used. Nonetheless, when serious liquidity pressures built up throughout the corporate credit union sector, NCUA took swift and appropriate steps to mitigate the problem by gaining additional liquidity assistance through the CLF. In September 2008, Congress removed the cap on borrowing, which had stood at $1.5 billion, thereby making up to $41.5 billion in contingency liquidity available. Of that, over $21 billion in liquidity has been infused into the system, stabilizing both corporate and retail credit union ledgers and demonstrating the durability of this contingent structure.

Next, NCUA introduced the Temporary Corporate Credit Union Liquidity Guarantee Program in October 2008. Under this program, the NCUSIF guarantees the timely payment of principal and interest on certain unsecured debt of participating corporate credit unions.

Third, NCUA devised the Credit Union Homeowners Affordability Relief Program (CU HARP) in December 2008. This program allows credit unions to help eligible members keep their homes while also maintaining liquidity in the credit union system.

Fourth, NCUA adopted the Credit Union System Investment Program (CU SIP), also in December of 2008. This program provided credit unions with an advance through the CLF, which, similar to the CU HARP program, provided a source of liquidity to corporate credit unions.

And finally, the Temporary Corporate Credit Union Share Guarantee Program was adopted in January 2009, utilizing the NCUSIF to guarantee all shares (excluding paid-in capital and membership capital accounts) in corporate credit unions.

Without these effective emergency steps, it is very likely that some corporate credit unions would have been forced to liquidate their mortgage-backed securities at deeply depressed market prices, which would have had a devastating effect on the credit union system.

Once these initial measures were taken, it was a top priority of NCUA to begin an intensive review of all corporate credit unions in order to assess their soundness and identify potential weaknesses. Beginning in January 2009, NCUA contracted for an independent third-party evaluation of the credit risk in mortgage-backed securities held by the corporate credit unions. Among other findings, this survey determined that the portfolios of U.S. Central Federal Credit Union and Western Corporate Federal Credit Union (WesCorp) were sufficiently deteriorated that NCUA placed them into conservatorship on March 20, 2009.

While the steps taken by NCUA helped stop the bleeding, it is clear that the crisis has not passed. Each quarter for the past year, modeling on investment portfolios has reflected additional losses by the corporate credit unions. While it appears that we are now seeing a slowing of the rate of loss, there may be additional investment losses in the future.

Unfortunately, brick-and-mortar retail credit unions have not been immune to the losses suffered by corporate unions. As the balance sheets of corporate unions declined, the losses flowed through to retail credit unions. Where losses exceeded retained earnings at the corporate credit unions, the paid-in capital and membership capital account investments by retail credit unions were depleted.

Retail credit unions have also faced increased losses as a result of the tenuous lending environment. Since the end of 2006, the aggregate delinquent loan ratio has been steadily increasing, from 0.68% to a high of 1.58% as of June 2009. The aggregate net charge-off ratio for all loans also increased during the first half of 2009, from 0.85% to 1.15% of average loans. Similar to corporate credit unions, the elevated level of provisioning for loan losses may continue as the industry works though the current economic climate.

Despite these abundant challenges and the potential for further deterioration, NCUA remains extremely confident in the health of the credit union system and in the ability of credit unions to continue helping American families and small businesses invest in our economy. Through the first half of 2009, credit unions reported an annualized return on average assets of 0.28%. Additionally, aggregate net worth increased during that time period by $1.11 billion—representing the highest net worth in credit union history.

As referenced earlier, the overwhelming majority of credit unions remain healthy: As of June 30, 2009, 98.3% of all credit unions were at least “adequately capitalized,” while 96.1% were “well capitalized.” As a result, unlike many other financial institutions, credit unions have had the resources to continue responsibly lending money during the economic downturn.

But NCUA recognizes that vigilant oversight will be necessary going forward to monitor the health of credit unions and guard against further systemic threats. In addition to addressing the financial side of the equation, NCUA has also made it a priority to protect and enhance consumers who make up the credit union system. One of the most visible ways in which NCUA has accomplished this is through an extensive public awareness campaign centered on the safety and soundness of credit union share insurance. Beginning last fall through a series of newspaper ads in over 20 markets plus the USA Today, New York Times, and Wall Street Journal, and continuing throughout this year in television commercials featuring nationally known financial writer Jane Bryant Quinn, NCUA reminded consumers that their funds in a federally insured credit union were safe and backed by the full faith and credit of the U.S. government.

Of perhaps longer-term significance is the planned creation of an Office of Consumer Protection within NCUA. While supervision and enforcement of consumer laws and regulations has always been a priority for NCUA, I believe that an office solely dedicated to the consumer is an important and overdue demonstration of our commitment to this important function. Regardless of whether the Congress decides to create a new consumer-focused agency for financial services at the federal level, this NCUA office will serve as a focus of our efforts in this area. Credit union members deserve nothing less.

Moving forward, NCUA will focus on three areas of particular concern:

Interest rate risk. As is to be expected in a period of low interest rates, credit unions have experienced an increasing level of fixed-rate real estate loans to a current rate of 64% of all mortgage loans. While this is a positive development for credit union members who are able to borrow for purchases at favorable rates, it does raise the prospect of increased interest rate risk associated with a high level of fixed-rate, long-term assets should rates rise rapidly.

Member business lending. Subject to established regulations and a statutory lending limit, credit unions are permitted to maintain a member business loan portfolio. NCUA supports a proper balance of serving members’ business lending needs with a prudent regulatory framework to safeguard the NCUSIF. While business loans currently represent only 3.11% of total credit union industry assets, NCUA is concerned with the increasing levels of delinquent member business loans, as well as an increasing concentration of large credit unions with supervisory concerns that are holding member business loans.

Increasing numbers of troubled credit unions. As of October 2009, there were 326 troubled credit unions holding $42.2 billion in assets. This represents 4.2% of all credit unions and 4.9% of credit union assets. In response to this concern, NCUA has been adjusting supervision programs and staffing levels. It is likely that the number of troubled credit unions will increase through 2010 and into 2011.

It will also be critical for NCUA to continue close monitoring of the NCUSIF, the fund that insures member share deposits in all federal and most state-chartered credit unions. The NCUSIF is comprised of the 1% insured share deposit contributed by each credit union, as well as the retained earnings of the fund. By statute, the NCUA Board is required to maintain an equity ratio between 1.2% and 1.5% of insured shares. As of December 31, 2008, the NCUSIF’s equity ratio was 1.27%. However, the increased limit on share insurance, high levels of share growth, and increased levels of real and potential losses have resulted in a reduction in equity ratio during 2009. In response, NCUA assessed a 15-basis-point premium on the insured shares of all credit unions to restore the equity ratio to 1.3%.

In response to the financial crisis, NCUA has also performed a broader and more detailed series of stress tests to measure the health of the NCUSIF. The tests analyzed a wide range of scenarios, including further declines in the real estate market, the impact of potential exposure to losses in the corporate credit union system, and the possibility of both of these circumstances occurring simultaneously.

Not surprisingly, the results of the stress tests indicated a wide range of potential losses. At baseline stress levels, these losses are well within the ability of the NCUSIF to absorb, although this scenario could create resource challenges associated with additional supervision. Should economic conditions significantly deteriorate, the stress tests indicated a possibility that losses could exceed the NCUSIF’s current retained earnings, which would result in the need for credit unions to expense and fund part of the 1% contributed capital deposit. Armed with this information, NCUA is prepared to respond to this spectrum of possible outcomes in order to protect the health of credit unions and credit union members.

The results of the stress tests also help quantify and define NCUA’s governing philosophy: we are committed to the safe and sound operation of the nation’s credit unions in order to protect the funds of their member-owners.

I am optimistic about the future of the credit union system. We have seen the vast majority of credit unions weather a virtually unprecedented storm of economic crises with strong capitalization and an uninterrupted capacity to make loans. Yet we are keenly aware that America remains in a state of tremendous financial uncertainty. While economic conditions as of this writing appear to have stabilized, a wide range of circumstances could compromise future recovery. Therefore, in keeping with the longstanding traditions of the credit union structure, we continue to execute our oversight responsibilities in a diligent and careful manner.

NCUA is confident that regardless of the economic conditions our nation may face in the coming months and years, credit unions will continue to be a safe, strong, and secure place for Americans to borrow, save, and pursue financial independence now and into the future.