CUs Brace for Negative ROA in ’09

CU360
May 22, 2009 | COMMENTS

Credit unions have largely escaped the nastiest consequences of the current economic and financial market turmoil. That has allowed them to continue to do what they do best—serve members. But the recent difficulties in corporate credit unions seriously jeopardize this record. Many wonder if they'll be able to continue to serve at high levels given the challenges.

By now you're familiar with the background. In mid-January 2009, U.S. Central announced that it recorded OTTI (other than temporary impairment) in its investment portfolio totaling $1 billion. That announcement increased the likelihood that the corporates would suffer deposit outflows as nervous natural-person credit union investors removed deposits from the system. That in turn increased the danger that some of those potential outflows would need to be funded by selling securities with unrealized losses—turning big paper losses into big real losses.

CU360 is an online portal for benchmarking tools, market insights, industry data, and analytical information. This article was orginally published online by CU360 at cu360.cuna.org. Reprinted with permission.

To head off potential liquidity issues, NCUA decided it was necessary to guarantee all corporate deposits through a corporate stabilization program. At the time, the cost of that action was estimated at $3.7 billion, bringing the total cost of the stabilization effort up to $4.7 billion. Federally insured credit unions would pay the price.

NCUA subsequently hired a third party to evaluate corporate bond holdings and obtain a more precise estimate of the movement's exposure. After thousands of pages of analysis of the corporate system's investments, Pacific Investment Management Company (PIMCO) provided a baseline estimate that suggested the NCUA's initial $4.7 billion stabilization effort was insufficient. The analysis found bond credit losses could total $5.9 billion. (A summary of the PIMCO analysis can be found online here)

Results of the PIMCO analysis increased system-wide costs to credit unions from an average of 81 basis points on insured shares to 99 basis points on insured shares. That translates to an increase from 62 basis points of average assets to 78 basis points of average assets.

In comparison, credit unions recorded earnings of 31 basis points of average assets in 2008, and 23% of credit unions recorded negative earnings in 2008.

Overall Effects

CUNA economists estimate—in a very conservative scenario—that about 90% of all U.S. credit unions will record negative earnings in 2009. This assumes the current stabilization cost estimates hold, the expense is borne all at once, and all corporate credit union paid-in-capital (PIC) and member capital shares (MCS) are written down.

Of course, net worth would decline as well. A conservative estimate (again assuming current cost estimates don't change and all PIC and MCS are written down) suggests that nearly 500 credit unions would fall into some level of concern with Prompt Corrective Action requirements.

If there's a silver lining it's that the vast majority of credit unions (92%) will remain well-capitalized with net worth ratios exceeding 7% of total assets. In addition, the agency has signaled that earnings and net-worth declines attributed to stabilization efforts will be viewed as an extraordinary one-time event and will be treated less harshly than if those declines arose from normal credit union operations.

Of course, the costs of the NCUA's corporate stabilization efforts are not fixed. Further significant deterioration in market conditions could drive the costs higher. Large deposit outflows could cause additional losses. Conversely, improvements in credit markets could lower the costs.

CUNA is working diligently to encourage the agency to seek ways to minimize costs, obtain authority to spread expenses over multiple years, ensure transparency, secure a commitment to hold the securities to maturity, and to preserve ownership rights and avoid extinguishment of capital. Success in these efforts, in both the regulatory and political arenas, will be crucial to thousands of credit unions and millions of credit union members.

The CU Difference

It's important to remember that credit unions didn't cause this mess. They have become collateral damage. Corporate credit unions invested in investment-grade securities that had the blessing of national ratings agencies. Natural person credit unions didn't saddle consumers with toxic mortgages.

They are, however, helping to solve the current problems in direct, obvious ways. Credit unions remain “in the game.” They're helping members who obtained toxic mortgages outside the movement refinance those mortgages, and they're assisting those who find themselves in tough financial predicaments.

Similarly, small businesses complain that their banks won't give them financing.

The anecdotal evidence is backed up by facts from the Federal Reserve. Indeed, the Fed's Senior Loan Officer Survey shows that the vast majority of surveyed lenders (approaching 90% in many cases) say they've significantly tightened underwriting standards. Bank business loans grew by nearly 20% in 2007 but that growth shrunk to only 4% in 2008.

Meanwhile, credit union member business loans increased by 18% in 2008—about the same increase logged in 2007. The numbers make it abundantly clear: While other lenders are pulling back and licking their wounds, credit unions have continued to lend. Credit unions are structurally different than other financial institutions and the importance of that difference is increasingly apparent.

As not-for- profit cooperatives, owned by their member/depositors and borrowers, credit unions have an incentive to “do the right thing.” They're in business to maximize service to members and are especially keen to make sure members are satisfied.

In addition, credit unions are largely portfolio lenders. They keep about 75% of the mortgages they originate in portfolio. And outside the mortgage arena, the percentage kept in portfolio is even larger. It's no surprise then that credit unions care deeply about what ultimately happens to the loans they make.

In contrast, other financial institutions focus on maximizing profits, and this often means that shareholder wealth is built on the backs of consumers. Many of the bad actors who contributed to the current crisis attempted to make a quick profit by peddling loans that were clearly inappropriate for most borrowers. Common to these lenders were dubious products such as no documentation or “liar” loans, interest-only loans, and adjustable rate loans that became unaffordable after rate resets. And many of these bad actors securitized and sold their toxic assets into the secondary market.

The credit union difference becomes obvious when examining credit quality statistics. Credit unions have a record of safe lending. This conservative, consumer-friendly approach means credit union capital levels remain at all-time highs despite recent challenges.

The year-end 2008 aggregate net worth ratio of 10.8% is only marginally lower than the all-time high of 11.5% recorded at year-end 2006. And the high levels of capital mean that despite the market turmoil and challenges related to the corporate system, many credit unions will be able to continue to stay in the lending game.

The not-for-profit cooperative structure also means consumers tend to find credit unions are a better deal. Rates on credit union loans tend to be lower than at other financial institutions and yields on credit union savings accounts tend to be higher than yields at other financial institutions.

In 2008, CUNA economists estimate that credit unions delivered $9.2 billion in direct financial benefits to consumers. Those benefits arose from lower loan rates and higher savings account yields compared to banking institutions, and the imposition of fewer and lower fees. Can this continue given the corporate challenges? Chances are it will.

A good analogy was recently offered at a credit union board meeting I attended. Credit unions collectively have a flat tire. Credit unions didn't cause the flat. Someone else put nails on the road. The flat tire means we'll have to drive carefully. Perhaps a bit slower. We risk ruining the rim, but that might be OK. It's important we get people to their financial destination. The key points to remember are flats can be fixed, the mechanicals are in fine shape, and the engine still purrs.

With that in mind, CUNA economists' baseline forecast calls for credit unions to increase their overall lending by 6% in 2009, despite the difficult financial environment. We foresee the eco- and for small but measurable growth in GDP by the end of the year, as stimulus funds work their way through the economy.

Credit union lending is expected to increase across all loan categories, including annual growth in:

• Real estate lending by 12.1%.
• Business (primarily small business) loans by 13.8%.
• Credit cards by 7.5%.
• Consumer loans (including auto loans) by 1.2%.

Credit union lending is expected to increase because credit unions overall remain highly capitalized, well above their federal regulatory minimum requirement. Lending is also expected to increase because many banks and other lending institutions are reducing their lending activity, forcing consumers to seek other alternatives.

Our current economic forecast also predicts U.S. GDP to contract by 3% this quarter, slow its rate of contraction to 1% by the third quarter, and then begin growing by 1% in the fourth quarter. There are glimmers of hope on the horizon. We're definitely not out of the woods yet, but we believe government policy will have a large positive impact on the economy later this year.

Credit unions looking for information on the current status of the corporate stabilization plan, including news, talking points, calculators and analysis should visit the CUNA Web site here.

Mike Schenk is vice president of economics and statistics for CUNA. Contact him at mschenk@cuna.coop.