Excessive Concentration in Risky HELOCs Contributed to Cal State 9 CU's Failure

NCUA’s Inspector General (IG) issued a report on the failure of Cal State 9 Credit Union. Cal State 9 CU failed because credit union officials had inadequate risk management practices to address credit, concentration, and liquidity risks that arose from the credit union’s indirect subprime home equity line of credit (HELOC) program.

Cal State 9 CU was placed into conservatorship on November 2, 2007. In April 2008, NCUA accepted bids from credit unions that were interested in acquiring Cal State 9. NCUA liquidated Cal State 9 on June 30, 2008 and executed a purchase and assumption agreement with Patelco CU. The cost of this failure to the NCUSIF is estimated at approximately $206 million.

In May 2003, Cal State 9 started an indirect HELOC program with a third-party mortgage broker. The IG concluded that Cal State 9 CU’s HELOC program experienced explosive growth – expanding from $4.6 million in March of 2003 to $357 million in June 2007, when the credit union was placed under NCUA’s Special Actions. As of June 2007, 92 percent of its loan portfolio and 80 percent of its assets were in HELOCs.

Weak underwriting standards of the HELOC program increased the level of credit risk at Cal State 9. Cal State 9 had the right of first refusal on each HELOC presented by its third-party broker. According to the IG report substantially all of the HELOCs funded by Cal State 9 had elements of subprime loans including, stated income loans, high combined loan to value ratios, borrowers with low credit scores, and junior positions behind negative amortization first-lien mortgages.

In June 2006, stated income loans made up 88 percent of the HELOC portfolio. Borrowers with credit scores between 600 and 639 and below 600 accounted for 28 percent and 18 percent of the portfolio, respectively. Sixty-one percent of the loans were junior to negative amortization first mortgages.

Additionally, the IG report faulted the compensation practice of the indirect HELOC program. The credit union’s CFO was the sole person responsible for operations of the indirect HELOC program. The CFO was compensated on the additional net income generated by the program and received almost $400,000 in bonuses between 2006 and 2007. The IG report wrote “this individual had no incentive to ensure the credit union had an effective quality control system in place because any loan turned down from the broker would, in effect, take money directly from his bonus.”

The report also faults management at the credit union for not managing liquidity risk. Management “sold participations, liquidated investments, borrowed funds, and increased dividend rates to attract shares in order to meet liquidity needs.”

For example, three credit unions and one bank bought non-recourse participations from Cal State 9 worth $190 million. The credit union set up a line of credit for $90 million with Western Corporate FCU and the credit union borrowed almost $61 million to fund its HELOC program.

However, the report cites that the liquidity problems of Cal State 9 were made worse in 2007, when Western Corporate FCU reduced its line of credit from $90 million to $25 million. To attract funds, the credit union Started offering high rate share certificates. But this hot money left the credit union as soon as the rates were lowered.

Cal State 9 CU’s appetite for growth, concentration in subprime HELOCs, and lax internal controls coupled with the collapse in the California real estate market assured the demise of this credit union.