Raising The NCUSIF’s NOL: Smoke And Mirrors At The NCUA

This is the second in a series of articles analyzing the NCUA’s closing of the Temporary Corporate Credit Union Stabilization Fund (TCCUSF) and retaining the majority of surplus funds for its own use. Read Part 1: The Most Important Audit Ever. Read Part 3: Save The NCUSIF Model From The NCUA. Read Part 4: Think What $2.5 Billion Could Do In The Movement’s Hands.

In 1984 and 1985 credit unions designed and implemented a radical change in how cooperative deposit insurance coverage should be provided by the NCUA.

Before this innovation, the fund’s Normal Operating Level (NOL) was 1% and the agency was limited to a maximum of two insurance premiums (1/8 of 1% each) per year to raise fund balances to this level.

The new design required a 1% deposit plus .3% equity to lift the NOL to a cap of 1.3%. Federally insured credit unions voiced one overriding concern about that: If we keep sending money (to maintain the 1%), how do we know the NCUA just won’t spend it?

Thirty-three years later, that concern seems prophetic. Credit unions funded the bailout of corporate credit unions summarily executed by the NCUA and now, additionally, see the surplus proceeds of that bailout merged into the National Credit Union Share Insurance Fund (NCUSIF) to vanish into ever-increasing agency budgets. ContentMiddleAd

For a full discussion of the change and the safeguards NCUA put into the design, see How To Keep Your Insurance Fund Strong And Cost Effective on page 18 of the NCUA’s 1984 annual report.

Raising The NOL To Retain TCCUSF Recoveries

That 1.3% NOL cap was a critical safeguard against profligate spending by the agency. Now, that cap has been raised to 1.39%, in that same NCUA board vote last fall that ended the Temporary Corporate Credit Union Stabilization Fund (TCCUSF).

The NCUA is required to return to credit union members as a dividend any equity that exceeds the NOL cap. Furthermore, the law requires that raising the NOL cap can only be done though retained earnings, not via a premium. In other words, the board must manage the fund’s expenses and problem resolutions cost effectively should they decide to raise the 1.3% cap. This was to constrain government’s instinctive tax and spend mentality. Premiums should be required only in extreme circumstances.

There is an initial TCCUSF surplus distribution of more than $2.5 billion, out of a projected $3.0 billion, available to be returned to its rightful owners upon closure of the fund. Yet the NCUA is raising the cap that has been in place since 1984, thus avoiding paying out that surplus as a dividend.

The NCUA gave three reasons for raising the NOL to a new cap of 1.39%. Two are contradicted by its own data. The third is contradicted by comparing the NCUA’s assumptions versus reality.

The first reason was to establish a contingent liability (4 basis points or $400 million) for the guarantee of the NCUA Guaranteed Notes (NGN) that fund the legacy assets owned by the five corporate estates. This guarantee contingency is now transferred to the NCUSIF when closing the TCCUSF.

Anyone claiming to make financial decisions on these assumptions in today’s known environment would be considered at best foolish or at worst totally inept.

For the past five years, KPMG, the outside auditor in their annual reports have made it clear that the NGNs have no basis for such reserves. Quoting from footnote 7 of the most recent audit, released in November 2017: There are no probable losses for the guarantees of the NGNs associated with the re-securitization transactions.

This same opinion in the previous four annual audits is supported by documenting the legacy asset surplus based upon the valuations of the residual interests in the NGN trusts, which was $2.2 billion at Sept. 30, 2017.

This opinion is also supported by a review of multiple models which estimated cash flows from the collateral, and by incorporating the NCUA’s expectations and assumptions about estimated cash flows from the collateral that supports the legacy assets, and the priority of payments and estimated cash flows of the legacy assets pursuant to the governing documents for the respective legacy assets.

That’s from the same extensive footnote 7 from the 2017 audit. It strains credulity to assert that closing the TCCUSF and transferring this long-audited, non-existent contingent liability to the NCUSIF now results in a required financial holdback of $400 million (4 basis points).

Also read: Seek Change From The NCUA!

The NCUA is moving toward that new 1.39% cap, and it’s doing that by double counting to raise the NOL by 2 basis points to make up for an anticipated decline in its NOL from 1.33% to 1.31% over the final two years in the five-year base case scenario. However, that core NOL of 1.33% was arrived at using the adverse economic scenario, which already included the base trend, thus counting the later year’s 2bps decline twice.

Finally, how valid is the assertion that a new NOL cap of 1.33% is needed for natural person losses?

Cooperation Begets Cooperation? Not So Much

Here’s a summary of what happened last fall:

• On Sept. 14, the House of Representatives, following extensive credit union lobbying, voted to leave the NCUA out of the congressional appropriations process, something that would have subjected NCUA financial decisions to congressional oversight, and potentially to Congress asking why the NCUSIF should not be merged with the FDIC.
• On Sept. 28, the NCUA board then voted to merge the TCCUSF into the NCUSIF, despite widespread concern. The regulator is keeping about $2 billion for itself. The remaining balance after NCUA takes its portion off the top would return about $600 million to credit unions and their members. Members funded the entire corporate credit union losses in the first place. The board also approved raising the NCUSIF’s Normal Operating Level (NOL) from 1.30% to 1.39%. This increase enables the NCUA to continue to transfer increased operating expenses to larger share fund without raising the overhead transfer rate (OTR).
• On Oct. 6, the NCUA released its proposed 2018 operating budget, giving itself a $6.1 million raise. For the past eight years the NCUA has transferred virtually all increases in annual costs to the SIF, resulting in a compound annual growth rate over 11%.

The NCUA says that it has used the latest Federal Reserve stress test parameters in its models. It selected the adverse scenario assumptions, not the base case or the severely adverse outcomes to justify the new core NOL cap at 1.33%. However, this adverse stress testing of the NCUSIF for the next five years is questionable for multiple reasons:

Reason No. 1

In choosing the adverse scenario to retain current surplus funds, the following were the economic assumptions used for 2018 and next year:

• Higher, steadily rising unemployment averaging more than 7%;
• Short-term interest rates near zero;
• Long-term rates slowly rise, but with 10-year rates always below 3%;
• Sustained declines in housing prices, resulting in a 17% decline from the base year.

Anyone claiming to make significant financial decisions based on these economic forecasts in today’s known environment would be considered at best foolish or at worst totally inept.

Reason No. 2

The NCUA does not identify what assets it’s stress testing to project credit union losses in its adverse scenario over the next five years. Is it the consolidated balance sheet of all insured credit unions? Is it the NCUSIF securities which are only Treasury notes and bills?

To evaluate the NCUA’s ability to accurately forecast actual insured losses, one need only review the last eight years of NCUSIF’s loss provision expense and the resulting loan loss allowance. At no time from 2009 through 2016 have these numbers shown any correlation with actual net cash losses. For the latest year 2016, the year-end allowance account of $196 million ($193 million for general losses) was 1,500% greater than actual net cash losses of $12.7 million.

Moreover, the primary means to account for losses is the loss allowance created by the provision expense, in which set-aside amounts are not included when calculating the NOL equity ratio. So, the NCUSIF is regularly accruing provisions for all known losses in which reserves are over and above the NOL.

The NOL is not a specific point. It’s a range set in statute at 1.2% to 1.3%. At today’s fund size, this provides up to a $1 billion loss cushion at the 1.3% level, before any premium to prevent falling below the 1.2% lower end of the range is required.

From all historical data, this range would seem more than adequate. To wit: the total cash losses for all natural person credit unions from 2008 to 2016 was $1.033 billion. This period covers the worst economic downturn experienced in the U.S. since the Great Depression.

Reason No. 3

Board chair Mark McWatters is quoted in a press conference after the September board meeting as to how he responded to concerns about raising the NOL. I talk about how we came up with our number, and talk about BlackRock (the giant money manager who valuates the NGNs). We didn’t give them a number, they gave us a number.

However, when I filed a FOIA request asking for details about how the NCUA arrived at their number, the agency would only refer to material already presented at board meetings.

Why Raising The NOL Is Critical This First Time

Increasing the NOL is clearly within the board’s discretion. But doing so has enormous consequences for credit unions and the cooperative fund design. If the methodology cannot be reviewed, audited, and back-checked, then the process becomes simply an arbitrary board decision.

This would be similar to how the board has unilaterally changed the overhead transfer rate (OTR) from 52% in 2008 to 73.1% in 2016 without an externally verifiable, reviewable process. This has resulted in a compounded NCUSIF overhead expense growth of 11%, from $79 million to $203 million, in the nine-year period.

Raising the NOL to 1.39% will sequester a minimum of a $1 billion in credit union capital, prevent dividends from being paid when the NCUSIF equity surplus is above 1.3% and, as now presented, provide no objective process for external validation.

Don’t set the fund up and forget about it. It’s unique. It’s a better way. But just as important, it’s your responsibility to keep it working, because if you don’t, it will go just like everything else government touches. When government gets more money, it wants to spend more.

The Credit Union Response: Which Chair’s Advice Do You Follow?

In responding to credit union concerns about topping up the 1% the insured deposits every year by sending more money to the NCUSIF, NCUA Chairman Ed Callahan replied in 1984:

It means you have an investment in your fund instead of your local bank. Can you forget about it? Well I’d have to ask do you ignore your other investments, or do you monitor them? We tried very, very hard to build in safeguards so you would treat your investment in the fund just like any other investment.

One safeguard is the 1.3% cap. Don’t set the fund up and forget about it. It’s unique. It’s a better way. But just as important, it’s your responsibility to keep it working, because if you don’t, it will go just like everything else government touches. When government gets more money, it wants to spend more.

Current chair McWatters responded to credit union concerns about the new 1.39% percent cap saying this: My term runs through August 2019. There will be a detailed review of the NOL as long as I’m around. After that it will be subject to future boards. Prudence would dictate that future boards assess that.

But of course, future boards are not required to do so. Within 90 days of the above assurance, McWatters’ name was widely circulated in the press as a possible new administrator for the CFPB.

The question for credit unions, which counsel do you follow?

This is the second in a series of articles analyzing the NCUA’s closing of the Temporary Corporate Credit Union Stabilization Fund (TCCUSF) and retaining the majority of surplus funds for its own use. Read Part 1: The Most Important Audit Ever. Read Part 3: Save The NCUSIF Model From The NCUA. Read Part 4: Think What $2.5 Billion Could Do In The Movement’s Hands.