Can the CU Business Model Survive?
SAN DIEGO -- Credit unions must be ready for whatever these tumultuous economic times throw at them, and part of that may mean secondary capital and retooling the business model.
Peter Duffy, associate partner at investment consulting firm Sandler O'Neill & Partners, said he's currently working with 10 large credit unions, restructuring their balance sheets to adapt to Duffy's "state of readiness" plan, which prepares credit unions for what he says are much tougher economic times ahead.
Duffy's state of readiness checklist divides institutions into five categories, with group five the least ready and group one the most. The problem for credit unions is that levels two and one both require access to alternative capital, and only corporates and community development credit unions can access it.
"Credit unions are behind the curve in competitive use of capital, in part due to regulation that requires a minimum level 40% higher than banks but without access to secondary capital," Duffy said. "That's why even the very best run credit union in America only rates a three in state of readiness."
The capital specialist's call for credit union supplemental capital is consistent with that of many industry advocacy groups, especially these days. NASCUS President/CEO Mary Martha Fortney mentioned the topic during her Oct. 30 comments at NCUA's eighth annual Budget Briefing and Public Forum, saying her organization believes it is unwise to delay the discussion any longer.
"The NASCUS Board of Directors and regulators are watching the pressures that are coming to bear on credit unions very closely," Fortney said. "You're seeing negative earnings, flat earnings, and that's why we think this capital issue is so important, because we need the option now before we face dire circumstances."
Some state legislatures and regulators have already agreed to let state-chartered intuitions build the additional capital, she said, but thanks to wording in H.R. 1151, it can't be counted toward net worth.
Many agree the matter is of utmost importance now because if the economy continues to slide, already shaky consumer confidence will slow lending down to a trickle, and Americans will begin socking away extra income. Duffy said lower loan-to-share ratios are inevitable, and not only will credit unions have to contend with the negative implications deposit increases have on net worth, they'll also have to become more astute at investments.
Fortney agreed that deposit growth does have an adverse effect on net worth and said some credit unions will have to lower dividends or even turn away new deposits to maintain safety and soundness.
"Consumers want to flock to the safety of credit unions, but because of net worth implications, credit unions don't necessarily consider that a positive," Fortney said.
Jim Blaine, president/CEO of North Carolina State Employees Credit Union, is an ardent supporter of secondary capital sources. In fact, Blaine has $100 million in secondary capital still on his books after spearheading a secondary capital demonstration project back in 2001.
The capital, which is member-owned but carries with it no voting rights, was approved by SECU's accounting firm at the time, Price Waterhouse, as well as North Carolina regulators and even the IRS, who issued a letter of private ruling, stating the capital did not jeopardize SECU's tax-exempt status.
"We've kept it on the books for six years, because many legitimate questions were raised about going this route," Blaine said. "Will members lose control? Absolutely not, in fact, we think it should only be issued to members. What about voting rights? Well, accounting standards prohibit that. We even covered the tax-exempt question. We felt like we covered every base."
Blaine said he's encouraged by the dialogue NASCUS, CUNA and NAFCU have had recently on the topic and said he thinks Congress is ripe for any reasonable alternative to using taxpayer funds to assist financial institutions. NAFCU has historically said it would not support secondary capital without meeting certain requirements, which it did not see as possible.
And, Blaine said even risk-based capital would be good for members, because at-risk investors would watch credit union balance sheets like a hawk.
"Maybe as a manager I wouldn't want people fussing at me like that, but they do already," he said with a laugh. "If you run a clean shop, they'll sing your praises, so it works the other way, works out just fine for the good guys."
Duffy went even further than industry calls for access to secondary capital, saying the entire retail financial institution business model requires an overhaul if banks, thrifts and especially credit unions want to survive.
There's a serious oversupply of lending institutions, Duffy said, which has "wrung out the margin" on quality consumer loans. Institutions have been patching the hole over the years with innovations like indirect lending, courtesy pay and subprime lending, he said, but masking balance sheet symptoms doesn't solve the basic problem of an unprofitable business model.
Borrowers have been trained to rate shop before choosing a lending institution, which has been good for the consumer, he said, but has driven down loan rates even further, to the point where rates just barely cover cost of funds, if at all.
"The system will not support weak players," Duffy said. "But, while the weak players are still there, they're still posting, in many cases, higher share rates and lower loan rates than margins will allow."
Blaine agreed that covering expenses is a problem for credit unions, pointing to expense-to-asset ratios as proof. SECU's ratio is around 2%, he said, but for many small credit unions, it's closer to 4 or 5% because they lack economy of scale.
"If you're paying out more than you're taking in, there's not a lot you can do with that," he said. "If rates stay low, a lot of credit unions will have to merge or find other alternatives. They'll run through their capital in a few years, which brings us back to why we need more capital tools."
Duffy said he's currently advising his clients who can spare the capital to dump bad loans now, while there's still a bit of a market for them.
"Nobody knows when the music will stop, but if I'm a lender, I'm going to sell off everything below A right now," Duffy said, "because when the music stops and you want to sell it, you won't get a single bid."
Credit unions that can figure out a way to get rid of nonperforming assets without impairing capital too much can focus on serving members and picking up market share, while those caught unaware are consumed with managing bad loans, he said.
"You'll have less ammunition, fewer earnings and capital, but you'll have put the distraction behind you," he said. "Make no mistake, these bad loans can take down an entire institution, and it will eat up your time and energy."
Duffy declined to name the credit unions he's working with, saying part of the strategy is to sell bad loans off quietly, before other institutions figure out the market window is closing.