Mortgage-Market Trouble Reaches Big Credit Unions
By Mark Maremont, WSJ | 11 August 2008
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"This is a serious situation," says Gerald Hanweck, a finance professor at George Mason University, who studies the banking industry and is a visiting scholar at the Federal Deposit Insurance Corp. Mr. Hanweck believes the five firms have sufficient access to funding to handle a deeper downturn, but he worries that perceptions of added risk could lead to a run on one or more of them. Credit unions are not-for-profit, member-owned cooperatives that take deposits and lend money like banks. The mortgage problems are focused on so-called corporate credit unions, which are key players in the industry. They don't deal directly with consumers, but provide investment services and financing to regular credit unions, which do.The five corporates showing big mortgage-related losses, according to federal regulatory filings, are U.S. Central Federal Credit Union; Western Corporate Federal Credit Union; Members United Corporate Federal Credit Union; Southwest Corporate Federal Credit Union; and Constitution Corporate Federal Credit Union. Together, they reported about $5.7 billion in "unrealized" losses as of the end of May, the filings indicate. Unrealized losses happen when the market value of a security falls, even if it hasn't been sold.
Credit unions in general are among the most conservatively run financial institutions in the U.S. That some are showing strains indicates that almost no financial sector is immune from the mortgage meltdown that has caused widespread [[and unremitting: normxxx]] carnage among commercial banks and on Wall Street. Financial-services firms have already taken write-downs of more than $300 billion in connection with the mortgage mess. "We're not much different from any financial institution," says Michael Kinne, chief financial officer of Constitution Corporate in Wallingford, Conn. "Nobody is insulated from this. It seems like every time you turn around, somebody else is taking a billion-dollar write-down."
Kent Buckham, director of the office of corporate credit unions for the National Credit Union Administration, the federal regulator, says the mortgage investments held by corporate credit unions are safer than many that are causing havoc on Wall Street, and are very likely to rebound in value. In his view, the paper losses reported by the corporate credit unions reflect unrealistically low market values for mortgage investments, in part due to investor nervousness about the sector. He says he doesn't expect the firms will have to sell those assets at "fire-sale prices." There have been predictions for months that the mortgage-market turmoil was coming to an end, and that mortgage-related assets would bounce back in value. So far, that hasn't happened.
Negative Equity
The paper losses of the five big corporate credit unions are large enough to wipe out the net worth of each of them. Added together, their negative equity totals $2.9 billion— meaning, in theory, that their debts exceed the current market value of their assets by that amount. That would be a troubling situation for a commercial bank. But credit unions say their balance sheets are a lot stronger than they appear because current accounting rules don't allow them to show a key source of capital— certain funds parked with the corporates by regular credit unions.
To address what it says is a misleading financial picture, the federal regulator, the NCUA, plans this month to revise an accounting rule to allow corporate credit unions more clearly to highlight these funds, called membership capital, in their federal filings. The corporate credit unions showing the biggest losses, U.S. Central and Western Corporate, reacted to the mortgage-market turmoil with an unusual accounting change. They reclassified some assets in a way that allows them to avoid recording any more unrealized losses.Executives at those firms say the shift, which was reviewed by regulators, frees them from reporting losses on investments they have no plans to sell. Critics say the move is accounting window dressing that covers up real problems. "What all of a sudden changed?" says Lynn Turner, a former chief accountant at the Securities and Exchange Commission. "The only reason to do it is to avoid reporting further losses in the financial statements."
Little Impact
So far, the troubles of the corporate credit unions appear to be having little impact on regular credit unions. Executives at several of the regular firms say they are closely monitoring the financial condition of the corporates, but that they remain confident and haven't reduced their funds on deposit with the corporates. There were about 8,400 credit unions holding more than $775 billion in assets at the end of last year, according to an industry trade group. Many serve employees of a specific company, members of occupational or other groups, or a geographical area. Some have expanded greatly in recent years, adding branches and competing more directly with commercial banks.
Corporate credit unions were founded to serve regular credit unions, many of which are too small to engage directly in sophisticated investing. Regular credit unions park a portion of their funds with one or more of the corporates, which in turn invest the money. In total, the 28 corporates, which are owned by their member credit unions, have about $90 billion in assets. (U.S. Central serves as a credit union for corporates, providing them with similar investment services.)
By regulation, the corporates are supposed to invest only in safe securities that are highly liquid, meaning easy to sell. In recent years, some have made investments backed by subprime and so-called Alt-A loans extended to buyers with poor or spotty credit. Despite the risky underlying loans, Wall Street had concocted ways to package the loans so that slices of the investments appeared ultrasafe. Most bought by the credit unions initially carried top credit ratings of AAA. The big credit unions, like other investors, generally were caught unprepared for the meltdown in mortgage markets that began in mid-2007. Buyers became scarce, and even some high-rated investments dropped sharply in value.
The result: Some corporate credit unions have been forced to record large unrealized losses on their assets, even though they continue to own the securities. For example, Southwest Corporate reported $672 million in such losses as of the end of May. The Plano, Texas-based company, with $12.2 billion in total assets, says the problems are centered on about $2.5 billion in securities backed by subprime or Alt-A mortgages and home-equity loans.
Bruce Fox, Southwest Corporate's chief investment officer, says the securities it holds generally are safer than the ones causing massive losses on Wall Street. "These are very high-quality assets, and all of them are paying principal or interest at the moment," he says. As of the end of May, 94% of its mortgage-related securities were still rated AAA. Instead of selling at what it views as distressed prices, Southwest plans to hold the investments until they recover or until maturity, he says.
Crucial Contention
The contention that the mortgage losses are temporary is a crucial one for the corporate credit unions. Under accounting and regulatory rules, temporary losses don't eat into earnings or capital, while permanent losses do. (Financial institutions are required to have adequate capital, usually expressed as a percentage of assets.) In the case of Southwest Corporate, if it counted as permanent $100 million of its $672 million in "unrealized" losses as of the end of May, it would have fallen below the minimum capital threshold set by the NCUA. Unlike banks, credit unions can't easily raise new capital, which they generally get from accumulating earnings over the years.
Mr. Fox says there's "a very low probability" of any significant permanent write-offs. Southwest's capital, he adds, continues to grow with strong earnings. Todd Adams, chief financial officer of Members United— another of the five firms— also says that any unrealized losses are likely to be temporary. But "if market conditions continue to deteriorate," he says, "some of [the investments] could see real cash losses." He adds that "it would take a lot to do that, but there's a lot of bad news in the market right now."
Reclassified Assets
Starting early this year, the two biggest corporates, Western Corporate and U.S. Central, reclassified a large portion of the mortgage-related assets on their balance sheets from "available for sale" to "to be held to maturity." The NCUA says no corporate credit union had ever done that. Under accounting rules, if a firm says it plans to hold an asset until it matures, it doesn't need to record any temporary swings in the asset's market value. The move allowed the two firms to avoid taking further unrealized losses on those holdings, although they would have to write off any permanent or realized losses.
At the end of May, Western Corporate had moved $9.6 billion to the new category— about one-third of its total investments— including all its Alt-A mortgage-related assets. Chief Financial Officer Jim Hayes says the shift "wasn't a matter of jury-rigging the accounting." He says the securities chosen were ones for which the firm had difficulty getting accurate pricing. "We never felt like we had to do it before, because we didn't feel like we had the pricing dislocations before." He adds that Western [always intended] to hold the securities to maturity, which the new category more accurately reflects. He says the company consulted with its outside auditors and the NCUA before making the change.
U.S. Central, which shifted a big batch of assets to the new category in June, had $10.9 billion of its $35.3 billion of investments in that grouping at the end of that month, compared with none at year-end 2007. Chief Financial Officer Kathryn Brick says the decision stemmed partly from "the negative perception of these unrealized losses, which are paper losses....We just wanted to cap the unrealized losses." A bigger factor, she says, is that U.S. Central arranged new sources of financing, including credit lines with federal agencies, so no longer needed to consider all of its holdings as available for sale. Ms. Brick says the shift is allowed under accounting rules.
Other corporate credit unions haven't followed suit. Mr. Adams, the finance chief at Members United, says the traditional accounting better shows his firm's members where the problems are in its portfolio. "We had selected available-for-sale before, and we should stay consistent, even though we're going through an historic situation in the market," he says. The accounting shift has a potential downside for the two big credit unions. If the market value of the reclassified investments starts to climb, they won't be able to show that increase on their balance sheets.
As with banks, credit unions are federally insured up to $100,000 per account and $250,000 per retirement account. So far this year, nine regular credit unions have failed, including at least two due to mortgage-related problems. Seven failed in 2007. In theory, the failure of a corporate credit union could lead to losses for any regular credit union that has deposited money with the corporate, and ripple down to individual depositors. The last time a corporate credit union failed was in 1995. Ultimately, the regular credit unions that were involved recovered their money.
The NCUA's Mr.Buckham says the possibility that a corporate credit union might fail now is "so remote" that "I can't even imagine that happening."
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