Two years after the height of the financial crisis, the American economic landscape still bears resemblance to a war zone: You never know when you’re going to step on another land mine.
Case in point: The nation’s credit unions, many of them tiny outposts in a realm of banking giants, some so small they can barely make a new car loan, let alone a mortgage. If you are looking for financial villains, you won’t find many in that world.
As a group, the credit unions make up a small part of the nation’s financial industry. Together, the 7,500 retail credit unions have about $729 billion in deposits, compared with about $9.3 trillion for the nation’s 7,800 banks. The four largest banks each have more deposits than all the credit unions combined.
But every credit union in the country finds itself paying to clean up a multibillion-dollar mess created by a handful of failed “corporate” credit unions, which invested heavily in now-toxic mortgage-backed securities peddled by Wall Street during the housing boom. The losses were allowed to continue as federal credit-union regulators paid too little attention, according to the regulators' own inspector general.
The wreckage is likely to restrict the ability of credit union borrowers to get loans to consolidate debts, to fix up their homes or to buy cars, boats and RVs. The number of credit unions is expected to continue to fall sharply, as it takes a decade for the credit unions to pay for a brief binge by just a few credit unions.
The cost so far
Credit unions are stuck with a tab of $8.3 billion to $10.5 billion from the recklessness of just a few huge credit unions. So far, assessments to credit unions have covered only $1.3 billion, with the rest of the cost to be spread over a decade. Then there are the costs from the failures of smaller credit unions: another $1.3 billion from Jan. 1, 2009, through the first three quarters of 2010, according to the National Credit Union Association.
The effect on credit unions is clear. Through the first three quarters, credit unions made about $3 billion in profits. Before the assessments, that would have been $4.1 billion. About 640 credit unions that would have been profitable posted losses after taking the assessments into account, according to an analysis of credit union financial reports by the Investigative Reporting Workshop at American University.
The regulatory responsibility for solving this problem falls to the National Credit Union Administration, which oversees the industry and manages its deposit insurance fund. The NCUA is in the midst of restructuring the corporate credit unions but also is trying to limit the damage to the retail credit unions that serve about 90 million Americans.
Just how successful the agency will be in this balancing act remains to be seen. Much depends on how the economy performs, especially whether housing prices recover and how quickly that happens. In addition, credit unions will have to pay a substantial amount of their profits over the next few years to cover failures in the industry.
Corporate credit unions were established to provide services to the retail credit unions that work with individual consumers. There are 27 currently chartered, with most serving credit unions in one state or region.
In some ways, the corporates function somewhat like the Federal Reserve System does for banks. They provide clearing services that allow payments to flow between credit unions and other entities. They also take deposits from the retail credit unions that have excess funds. Some of those excess funds are lent to other credit unions, which might have more loan demand than they can meet. And some of the funds are invested, usually in short-term, highly liquid securities so that the corporate can easily meet cash demands. The risk profile of a corporate credit union should be low, which means the returns also would be low.
What went wrong
But in a microcosm of what was happening elsewhere in the banking industry, some of the largest corporate credit unions, notably Western Corporate Federal Credit Union, based in Los Angeles, and U.S. Central Federal Credit Union, based in Lenexa, Kan., veered sharply from that profile. In the middle part of the decade they began to chase higher profits by investing in mortgage-backed securities, including “private label” securities sold by some of the nation’s biggest financial firms, such as Countrywide Financial. Some of these securities were backed by so-called “Alt A” and subprime mortgages, and many were supported by mortgages in high-risk states such as California.
When the housing bubble popped in 2007 and 2008, the market for these securities evaporated. WesCorp, U.S. Central and others began recording frightening losses.
Much of the problem was caused by extraordinarily bad management decisions. Some of the blame can be laid to insufficient regulation and oversight by the NCUA and other regulators. But there is no question that the industry and the government found themselves facing potentially devastating losses of historic proportions.
At the height of the crisis in late 2008 and early 2009, NCUA figures show, corporate credit unions had losses amounting to perhaps $30 billion, about a third of the approximately $90 billion in total credit union capital.
Those potential losses presented “unprecedented threats” to the entire credit union system, NCUA Chair Deborah Matz told the Senate Banking Committee this month.
The agency decided it could not deal with those losses all at once because they “would have resulted in the failure of approximately 1,000 consumer credit unions,” Matz said in testimony prepared for the Senate panel. And when the insurance fund started charging credit unions for the cost of those failures, up to 1,200 more would have collapsed, according to NCUA estimates.
So instead of immediately shuttering the failed corporate credit unions, the NCUA embarked on a “stabilization” strategy to buy time while it crafted a longer-term solution and while it hoped the markets would right themselves.
In March 2009 the NCUA took over management of WesCorp and U.S. Central, continuing to operate them instead of closing them. It guaranteed all retail credit union deposits in the corporate credit unions, which helped stem withdrawals. It got new regulatory powers from Congress. And it borrowed as much as $20 billion from the Treasury to provide liquidity to the corporate credit unions, which has since been repaid.
Finally, in September of this year, the NCUA closed U.S. Central and WesCorp and three other corporate credit unions, creating “bridge corporates” to continue serving their members. It sold $10 billion worth of good assets held by U.S. Central and WesCorp to raise cash to repay the Treasury loan.
System still needs to absorb losses
That leaves the NCUA with a portfolio of mortgage-backed securities. Instead of selling them outright at current, highly depressed prices, it created federally guaranteed bonds supported by the income streams from those securities. In September the portfolio consisted of about 2,000 securities that carried an unpaid principal balance of about $45 billion, but no one believes they are worth nearly that much. The NCUA will hold the securities until they either mature or default.
The agency now estimates the losses from the corporate credit unions’ mortgage-backed securities portfolio ultimately will be in the range of $14 billion to $16 billion, which means the NCUA thinks it will collect about $30 billion, or about 66 cents on the dollar. The losses will occur if and when, as expected, many borrowers on the underlying mortgages default.
How accurate the loss estimate turns out to be depends on a lot of variables, primarily what happens to housing prices and the overall strength of the economy. Higher home prices and more people with jobs would mean fewer defaults and lower home prices and continuing unemployment would mean more defaults.
Larry Fazio, NCUA’s deputy executive director, defends the estimate, which was compiled with the help of several financial companies, including PIMCO and Barclays.
“We have a pretty strong confidence level” that the final tally will be within the range, Fazio said.
For one thing, the estimate is based on the assumption that housing prices will fall another 10 percent, with even bigger losses calculated for mortgages in California, and other hard-hit states, where a disproportionate share of the underlying mortgages were written.
“Experts in the credit union system say we’ve exaggerated the losses,” Fazio said.
Sharing the pain
It is easy to understand why credit union executives hope the losses will be smaller.
Because of the way the credit union industry is structured, those losses can only be covered by “assessments” against all credit unions. In other words, everybody pays for losses anywhere in the system. There are no stockholders to wipe out and there is no easy way to force a credit union to raise capital.
Of the $14 billion to $16 billion, the NCUA says about $5.6 billion was covered by the member capital in the failed corporate credit unions. That leaves a bill of somewhere between $8.3 billion and $10.5 billion, of which credit unions already have been assessed $1.3 billion. So, according to the NCUA’s estimates, credit unions are still facing another $7 to $9.2 billion in assessments to cover the corporate losses, payments that will be spread over the next 10 years.
In addition, credit unions are paying assessments to cover the cost of retail credit unions that have failed. From Jan. 1, 2009 through Oct. 31, 2010, the insurance fund absorbed more than $1.3 billion in costs to cover the failure of 54 credit unions.
Compared with bank failures, credit unions failures have been fewer and smaller. The FDIC has taken over 297 banks since Jan. 1, 2009, at a cost to the insurance fund of $82 billion.
All told, the current and future assessments are “a pretty big hit to credit union earnings,” Diana Dykstra, president of the California and Nevada Credit Union Leagues, an industry trade group, said in an interview.
Her group’s members have been especially hard hit, because WesCorp was the corporate credit union serving them and because so much of the housing and mortgage problems have been centered in California and Nevada.
Dykstra said she thinks conditions are beginning to improve in the coastal areas of California, with housing prices stabilizing. Credit unions are starting to see loan delinquencies decline.
But, she cautioned, the real solution is for more people to find work. “We need to fix the employment side before we see any improvement in residential housing,” Dykstra said.
Who’s to blame?
The NCUA’s inspector general, in recent reports, has found that while the firms’ officers and directors made unwise investment decisions, NCUA regulators were asleep at the wheel as the risky investments piled up.
Among other things the inspector general’s investigation found, U.S. Central’s management “implemented a growth strategy that included offering highly competitive rates in order to attract and maintain a greater market share of the liquid assets of the retail corporate credit unions. Subprime mortgage-backed securities were purchased for U.S. Central’s investment portfolio in order to achieve this objective.”
In pursuing this strategy, U.S. Central acted contrary to its “fundamental purpose (to serve) …as a secure investment option and a source of liquidity” for its members, the inspector general found.
And this happened under the noses of the NCUA regulators. NCUA staff “failed to adequately identify and timely focus on U.S. Central’s investment portfolio related to the concentration of mortgage-backed securities until it was much too late,” the report concluded.
Even though the buildup in subprime and Alt A mortgage-backed securities was evident in 2007, the NCUA took no enforcement action. After a 2008 examination, when losses were already mounting, the NCUA issued a fairly mild recommendation that the credit union re-evaluate its investment strategy.
“We believe stronger and timelier supervisory action … could have resulted in a reduced loss" to the insurance fund, the inspector general’s report says.
The inspector general made similar findings with regard to WesCorp.
“Management implemented an aggressive investment strategy with unreasonable limits in place that allowed for excessive investments in privately issued residential mortgage-backed securities.” In particular, the report said problems were caused by excessive purchases of mortgages originated by Countrywide, with a particular concentration in California housing. Countrywide eventually was taken over by Bank of America after suffering huge declines in the value of its mortgage portfolio.
And again, the inspector general found that NCUA examiners “did not adequately and aggressively address WesCorp’s increasing concentration” of these private label securities.
What’s next for credit unions
There is no question that the next several years will present severe challenges to credit unions, especially if unemployment persists at high levels and if the housing market doesn’t improve. Current results show that effect. According to NCUA reports, 3,300 credit unions posted net losses in the first nine months of this year. The NCUA now lists 363 credit unions on its troubled list. About five percent of credit union assets are held by institutions the NCUA classifies in its two riskiest categories. Two years ago, less than one percent of assets were held by institutions in those categories.
The bottom line is that almost everyone expects the number of credit unions to decline – it already has tumbled from more than 22,000 in the 1970s to its present level of 7,500. Some of that will occur through mergers and consolidations. And, in some cases, credit unions may decide to convert their charters so that they can operate as banks, with FDIC insurance. If many choose that route, it would have an impact on the remaining credit unions, because they would find themselves responsible for an even larger share of the assessments.