Since the 1990s, the federal government has allowed low-income credit unions (LICUs) to accept non-member deposits and secondary capital. Secondary capital gives credit unions a shot to their net worth and opens options to expand loan portfolios, assets, and services, thereby allowing cooperatives to stimulate the economies of the low-income communities in which they operate.
As of June 30, 2019, more than 40% of all credit unions held a low-income designation; however, only 68 reported using secondary capital. That number might reflect regulatory hurdles more than strategic interest, though. According to CU Capital Market Solutions, a CUSO that supports secondary capital applications, the NCUA has denied 15 of 18 secondary capital requests it has made since late 2017.
Proponents say secondary capital could potentially inject $16 billion in capital and $160 billion in asset growth to eligible LICUs. Regulators are pushing back on the size of the secondary capital requests, growth projections, and investment strategies denying them on safety and soundness reasons.
NCUA Guidance
In September 2019, the NCUA staff released 23 pages of guidelines that feature more stringent requirements for secondary capital. The new guidance came a week before the NCUA board heard its first-ever appeals from credit unions whose plans the regulator denied in closed-door hearings. The NCUA board upheld both denials in October.
At stake is the role of secondary capital across the industry.
Is it best-suited to shore up undercapitalized credit unions or support smaller, more targeted LICU endeavors? Or, should it be used to ignite growth plans for growing, well-capitalized cooperatives? How much debt should credit unions be allowed to leverage? Are regulators being cautious, or are they overreaching their authority?
“The application of the rules by the NCUA regional directors is disenfranchising poor people and
minorities” says Scott Garrett, CEO of Freedom Northwest Credit Union ($186.3M, Kamiah, ID), located in northern Idaho on the Nez Perce Indian Reservation. “We are not asking for charity. We simply seek to allow capital investment from qualified investors. They believe in our Idaho business and the investment is at their own risk, which further insulates the taxpayer.”
According to the NCUA, regional directors are assessing the credit unions’ due diligence and focusing on the scope, complexity, and risk of secondary capital plans.
“In recent years, there has been an increase in both the number of requests and the relative scope, complexity, and risks of planned uses” says John Fairbanks, NCUA public relations specialist, in a prepared statement. “The NCUA approval process is based upon safety and soundness considerations. Each application is unique and based on the individual facts and circumstances for the applicant.”
Who’s Using Secondary Capital?
Secondary capital loans are relatively simple and governed by federal law. Terms typically last 10 years, with recipients making interest-only payments for the first five years. They must then reduce the portion of the investment counted as net worth by 20% each year as the loan is paid off over the last five years.
Secondary capital is not covered by the Share Insurance Fund, and credit unions must list it as subordinated debt, which means the investor assumes all risk. But to fully understand the secondary capital debate, it’s important to understand who’s using it and how much impact it’s having on the credit union mission.
The first secondary capital investment was made in 1997. By the end of 2000, 25 LICUs had secondary capital on their balance sheets, with most of the loans made at a 5% interest rate. Its popularity surged a decade ago as credit unions viewed it as a way to extend credit in low-income areas during the Great Recession. The amount of secondary capital across the industry grew from $88.2 million as of March 31, 2010, to $257.9 million three years later. However, growth has slowed significantly since then, with secondary capital reaching $292 million as of June 30, 2019.
Secondary Capital By The Numbers
- Secondary capital grew 13% between 2013 and 2019. By comparison, the total amount of loans outstanding grew 77% in the same period.
- The number of credit unions using secondary capital declined from 73 in June 2016 to 68 in June 2019. That’s fewer than 3% of all eligible LICUs.
- Of the 68 credit unions with secondary capital on their books, the top 13 hold 88% of the market. The remaining 56 hold an average of $624,892 each.
Self-Help Credit Union (1.0B, Durham, NC) was the first credit union to receive approval for secondary capital. Self-Help which has both LICU and CDFI designations was created out of a coalition of cooperatives that support workers, food, housing, and farms. These cooperatives invest capital in the form of non-voting preferred stock through a charitable foundation. Combined with Self-Help Federal Credit Union ($1.2B, Durham, NC) a second entity formed in 2008 to serve the West Coast the two credit unions hold $148 million in secondary capital, nearly half of all secondary capital in the market.
In contrast, some small LICUs struggle even after the infusion of secondary capital. According to a 2017 NCUA report, the average annual failure rate for LICUs with secondary capital was 2.9% from 2000 to 2013, compared with 0.8% for LICUs without it. Without secondary capital, approximately one-third of the 73 credit unions that used it in 2016 would have had a net worth ratio below 7%.
“Secondary capital is like a surgeon’s scalpel” says Martin Eakes, CEO of Self-Help. “It can be used for good or it can cut you badly. The details matter.”
Funding sources for secondary capital vary, but most are industry groups such as Inclusiv (the former National Federation of Community Development Credit Unions), the National Community Investment Fund (NCIF), and the Community Development Financial Institution Fund (CDFI Fund). Banks often funnel funds into these groups to meet Community Reinvestment Act obligations.
Inclusiv, alone, has issued more than $50 million in secondary capital since 1997. Eben Sheaffer, chief financial officer and chief investment officer at Inclusiv, says although some loan approvals have faced delays, the NCUA has approved 19 of its secondary capital plans, and issued no denials, since 2015. According to Sheaffer, secondary capital supports Inclusiv’s mission to help low- and moderate-income people and communities achieve financial independence. He cited Inclusiv’s $2 million secondary capital investment in 2018 in Park Community Credit Union ($955.7M, Louisville, KY), which used the capital to support first-time home mortgage borrowers and payday lending alternatives.
Learn how Self-Help uses secondary capital to fight predatory lending and protect financially vulnerable consumers in How Martin Eakes Became The Most Hated Man In America (By Payday Lenders).
“Secondary capital should be considered by all credit unions” says David Shadburne, executive vice president at Park Community. “The credit unions who will be successful in implementing secondary capital are the ones that have an intentional mission of serving the underserved; the credit unions that want to reach deeper and make a difference.”
A New Class Of Secondary Capital Borrowers
Of the 68 credit unions that held secondary capital on their books as of June 30, 2019, the top 13 accounted for 88% of the market. The remaining 56 each held an average of $624,892 in secondary capital. But demand for larger amounts of secondary capital in the range of $5 million to $12 million has been growing among larger LICUs.
Mark Rosa, CEO of Jefferson Financial Credit Union ($888.8M, Metairie, LA), says his interest in secondary capital was piqued in 2016 at a conference of CEOs. Among the presenters was a university professor who explained how secondary capital supports growth strategies, but the response from many in the room was that a small secondary capital loan is more trouble than it’s worth, and that’s why a lot of people don’t have it. In early 2017, Rosa began working with his CUSO, CU Capital Market Solutions, on a plan to borrow $12 million in secondary capital.
The NCUA approved Jefferson Financial’s plan in March 2017, and the credit union borrowed $12 million in secondary capital from Greater Nevada Credit Union ($1.1B, Carson City, NV) that November. Around the same time, the NCUA also approved Jefferson Financial’s $103 million acquisition of Coastland Credit Union in Metairie, LA, and made Jefferson Financial conservator of Riverdale Credit Union in Selma, AL, after the NCUA ordered the liquidation of its $54.92 million in assets in 2017.
“In one year, the credit union’s assets grew 84% from $504 million to $929.8 million. Jefferson Financial built a new loan center, grew its loan program, and began plans to expand in Alabama through the acquisition of three Synovus bank branches around Mobile and Mobile Bay” Rosa says.
“We were able to buy loan pools and investments such as Ginnie Mae bonds” Rosa says. “And, we were able to leverage that capital to bring more wholesale-type income into Jefferson Financial for very little work.”
On the heels of that deal, CU Capital Markets worked with Notre Dame Federal Credit Union ($648.3M, Notre Dame, IN) on a plan to borrow $12 million in secondary capital at 6.31% interest.
“We were one of the first healthy credit unions to say we want to use secondary capital to grow and expand our markets and help our membership” says Tom Gryp, president and CEO of Notre Dame FCU.
Based on a target capitalization ratio of 10%, Gryp says Notre Dame FCU can leverage that $12 million in capital to add $120 million in assets and make $80 million in new loans.
“For every dollar, I’m able to bring in $9 of traditional checking account balances at around 1% or less” Gryp says. “So, at the end of the day, we were able to get our incremental costs down to or below 2%.”
Robert Bob Colvin, president and chief strategist at CU Capital Market Solutions, says his CUSO is working to deploy this same business model among LICUs with $100 million or more in assets.
Putting The Brakes On Secondary Capital
The CUSO’s first three secondary plans received NCUA approval with minimal revisions. That changed in late 2017, when regional administrators denied requests on a variety of safety and soundness reasons. Colvin says the NCUA has denied the past 15 secondary capital applications the CUSO has submitted.
Secondary Capital Legal Requirements
The enabling legislation 12 CFR 701.34 says credit unions must submit a secondary capital plan to the NCUA for approval that at a minimum:
- States the maximum aggregate amount of uninsured secondary capital the LICU plans to accept.
- Identifies the purpose for which the aggregate secondary capital will be used and how it will be repaid.
- Explains how the LICU will provide for liquidity to repay secondary capital upon maturity of the accounts.
- Demonstrates that the planned uses of secondary capital conform to the LICU’s strategic plan, business plan, and budget.
- Includes supporting pro forma financial statements, including any off-balance sheet items, covering a minimum of the next two years.
The NCUA declined to comment on the total number of denials, but said in its prepared statement: The NCUA has always scaled agency expectations and review to the complexity and risk associated with a particular credit union and its planned use of secondary capital. Our review is fact-specific.
According to redacted decisions on NCUA’s website, at least six credit unions have appealed denials over the past year, but all six denials were upheld. The appeals process begins with regional administrator reconsideration, then review by the Director of the Office of Examination and Insurance, an appeal to the Supervisory Review Committee (SRC), and ultimately an appeal to the full NCUA board. It can be a lengthy process with one 2017 appeal taking 18 months from application to final SRC denial.
In September, the NCUA board heard the first of two appeals in a closed hearing. The second appeal, from Pinal County Federal Credit Union ($155.6M, Casa Grande, AZ), was considered in writing because of the similarities between the two cases. The NCUA, which declined to identify the credit unions, upheld the denial of the first credit union on Oct. 11 and the denial of the second credit union on Oct. 24.
Most of the appeals argue that if a submitted plan meets the five criteria of information required by federal law in 12 CFR 701.34, the regional administrators must approve the request. The NCUA board, however, found that the review requires more than a checklist of required information, noting that the region must conduct a meaningful assessment, evaluation, and critique of the contents of the submitted SC Plan, including its underlying safety and soundness. To deny the region the ability to exercise reasonable discretion in assessing, evaluating, and critiquing the contents of a submitted SC Plan would be to render the rule’s preapproval requirement essentially meaningless.
The board also said it would not intervene in judgments of the SRC, whose panel has a collective 84 years of experience with credit unions, or for that of the region, a team of competent and experienced professionals responsible for making informed predictive judgments like the one under appeal in this case.
The regional administrator found that the plan lacked detail and had material omissions, which did not allow the agency to properly evaluate the safety and soundness of the plan, and cited a negative spread between the projected interest rate for the secondary capital loan and the average rate of return for the assets in the safety net plan that will become a stress on earnings and a duration mismatch between funding sources.
Colvin at CU Capital Market Solutions declined to discuss the details of the appeals, but says the denials represent a fundamental lack of understanding of how secondary capital is implemented. According to Colvin, it’s impossible to project a credit union’s loan portfolio makeup 10 years in the future because the market is constantly changing. Secondly, he adds, the reference to a negative spread in interest rates assumes that credit unions would implement the capital on a 1-to-1 ratio of capital to assets, when in fact it’s a common practice to implement capital on a 10-to-1 ratio.
We put credit unions into securities and risk-free assets, and they’re staged out over the next few years so that they can grow into the loans, Colvin says. They have a narrow margin out of the gate, but that narrow margin is enough to cover the cost of the capital. As the credit union grows with member deposits and member loans, the spread widens back to the normal net interest margin and earnings improve.
The NCUA board did encourage the credit unions to reapply for secondary capital and work with the region to address deficiencies. Colvin, however, says he doesn’t have much faith in the outcome, noting that plan development and NCUA review has taken a huge commitment of time and effort for these credit unions and their boards. In one case, the regional administrator denied the plan in November 2017 and two subsequent revised plans over the next 13 months. The regional administrator then conditionally approved the request, contingent on the credit union borrowing less capital, reducing its real estate concentration and abstaining from making unsecured secondary capital loans to other credit unions. The SRC finally denied the appeal in May 2019.
“They are denying these on safety and soundness rules, but nobody will define what that safety and soundness is” Colvin says. “They say it is unique to each institution.”
Inconsistency In Following The Rules
Freedom Northwest Credit Union applied for $7.5 million in secondary capital in mid-2018, then reduced the request to $5 million. It still hasn’t received NCUA approval.
CEO Garrett says he’s frustrated because banks have easier access to secondary capital. Community banks held $831 million in subordinated debt in 2016 more than four times the amount borrowed by credit unions.
“It’s a customary move in banking, but we have three regional directors demonizing it because they don’t have much experience with capital, they apparently don’t know how to read a balance sheet, and they just don’t like it” Garrett says.
The CEO adds that the NCUA is overlooking the fact that all of the credit unions with $100 million or more in assets that are applying for secondary capital are well-capitalized and have a proven track record of growth. Freedom Northwest, which also has CDFI designation and provides needed services to low-income communities in and around the Nez Perce Reservation, grew its assets 300% from $39.19 million as of March 31, 2010, to $186.25 million as of Sept. 30, 2019, with an ROA of 2.03%. The credit union had a 9% net worth ratio making it a well-capitalized institution according to the NCUA definition when its secondary capital request was denied.
Garrett says he was willing to accept the NCUA’s decision until he received a letter from Union Yes Federal Credit Union ($78.4M, Orange, CA) soliciting an investment in that credit union’s secondary capital plan. Turns out, the same NCUA western regional director who rejected his plan, Cherie Freed, approved $4 million in secondary capital for Union Yes.
“We went a little loco when we found out they approved Union Yes” Garrett says.
The credit union, formed in 1981 to serve union workers and their families, grew 26.5% between 2010 and 2019 and its net worth fell from 6.73% to 4.62%, making it one of the most undercapitalized credit unions in the country and subject to Prompt Corrective Action (PCA) by the NCUA. According to the NCUA guidelines in place at the time, using secondary capital to avoid PCA is a poor practice that could only serve to delay failure. Further, the NCUA’s 2015 secondary capital best practices guide in place at the time stated, A credit union must have an investor, and the proposed amount and terms of the secondary capital first before submitting its plan. However, Garrett said Freedom Northwest received the solicitation letter months after the Union Yes plan was approved in December 2018.
The NCUA’s review of the Union Yes request was nowhere near the standard that was applied to us, Garrett says. Apparently they think if you’re doing well, you don’t need secondary capital, but if you’re failing, then you do, which is the exact opposite of what the law was passed for.
Both Union Yes CEO Bill Byerly and the NCUA declined comment.
When Freedom Northwest tried to review the 2015 Secondary Capital Best Practices Guide, the document was missing from the NCUA’s website. The credit union filed a Freedom of Information Act request to find out who removed the guide and under what authority. Upon receiving the NCUA’s response, there are no records responsive to your request, the credit union filed a FOIA lawsuit asking the federal court to intervene. The case is expected to go to court this fall.
“You have rogue agency employees who think they’re in charge” Garrett says. “They’re not following their own rules, and if they get caught, they just delete the rules. They make up new rules that match what they’re doing and try to intimidate credit unions into staying silent.”
Mixed Signals From The NCUA
On Sept. 16, 2019, with no advanced notice or request for public comment, NCUA examination director Larry Fazio released a supervisory letter on secondary capital to replace the missing 2015 Best Practices Guide. The 23-page set of new guidelines outlined new requirements for plan approval but removed the requirement for the NCUA to respond to requests within 45 days for state-chartered credit unions.
The new guidelines differentiate between straightforward plans with one-for-one redeployment of secondary capital proceeds into cash and loans and complex plans with a combination of additional borrowings and asset redeployments, increasing risk, and larger balance sheets. The guidelines describe higher-risk growth strategies as those with a high degree of leverage.
The term leverage is defined as funding activity outside a credit union’s customary deposit base, but no guidance is provided on how to measure leverage in a debt-to-equity ratio.
The guidelines say “The riskier or more complex a plan becomes (for example, heightened leverage, high-yield strategies, etc.), the higher the expectation for the LICU’s analysis.” The NCUA says it may require more than two years of projections and proof of due diligence in hiring third-party advisors and set the maximum aggregate amount of secondary capital that applicants can borrow.
“It’s almost like the NCUA examiners don’t have confidence that management knows how to deploy the capital and the investors must not have known what they were doing to give them the capital” says Colvin at CU Capital Market Solutions. “It’s not warranted. There hasn’t been a cascade of losses. The only losses have been from small institutions that probably shouldn’t have gotten the capital to start with. It’s as if the industry has outgrown the regulatory regime.”
Inclusiv CFO Sheaffer called the new regulations a positive step, adding that to the degree that credit unions are changing their organic business model or engaging in high-leverage transactions, more scrutiny can be warranted.
“Although” Sheaffer adds “the NCUA could also improve its process for streamlined repayment approval of amortized secondary capital with additional clarity, consistent application across regions, and expansion of eligibility.”
The new, more rigorous guidelines come at a time when NCUA board members have pledged to Congress and members to make more secondary capital available. In fact, the board’s key reform initiatives include increasing the cap on non-member deposits from 20% to 50% and making supplemental capital available to all credit unions.
“It’s very important that the NCUA stay away from you executing your business models” Mark McWatters, then-acting chairman of the NCUA, told a group of Inclusiv credit unions a year ago. “You’re the pros you know what the specific needs are in your field of membership, who your members [are], what they need [and] how can secondary capital and supplemental capital help you better do your job. Everyone has a different story to tell. For me or anyone else at NCUA to second guess your business model, I don’t think it’s my place.”
McWatters recused himself from board consideration of the two denials in September and declined requests for interviews.
Colvin says the lack of secondary capital at credit unions demonstrates it’s not working for the industry, and he fears NCUA overregulation will kill one of the few growth levers available to LICUs.
“They’re micromanaging these institutions” Colvin says. “They want to act not only as regulator but also as the board of directors and the CEO. This program is probably going nowhere until there’s a radical shift in the people implementing this for the NCUA.”