IG Report: Key Risks Not Adequately Identified or Corrected in U.S. Central's Failure

A report on the failure of U.S. Central Federal Credit Union from the National Credit Union Administration's (NCUA) Inspector General (IG) found that examiners from the Office of Corporate Credit Unions (OCCU) and staff from Office of Capital Markets (OCM) failed to "adequately identify or correct key risks to U.S. Central's investment portfolio." As of June 30, 2010, NCUA stated that the Temporary Corporate Credit Union Stabilization Fund had recorded a loss of $1.45 billion for U.S. Central.

Excessive exposure to risky securities caused U.S. Central's failure.

The study largely did not reveal anything that was not already publicly known about the demise of U.S. Central. The failure of U.S. Central arose from its excessive holdings of private label sub-prime and Alt-A mortgage-backed securities (MBS).

The report noted U.S. Central's business strategy shifted in 2006 towards more aggressive growth. To help fuel this growth agenda, the IG report states that twice in 2006 at the recommendation of management, the Asset/Liability Committee and the Board approved increasing the limits on non-agency MBS that could be held in portfolio. In April 2006, the limits were increased from 7 times capital to 8 times capital. Later that year, limits rose from 8 times to 10 times capital. Setting the limit at 10 times capital meant that approximately half of U.S. Central's assets were in non-agency MBS. In other words, U.S. Central was increasing its exposure to these non-agency MBS just at the time the market for non-prime, non-agency MBS became dislocated.

The report also states that management did not recognize the impact of potential deterioration of the value of the underlying collateral on U.S. Central’s capital and ability to meet its liquidity needs. As U.S. Central’s investment portfolio declined in value, so did its borrowing capacity, as established lenders reduced their lines. As result, U.S. Central became heavily dependent on discount window borrowings from the Federal Reserve Bank of Kansas City in 2008. The report further discloses that the NCUSIF was required to lend U.S. Central $3.7 billion in December, 2008 to ensure that the U.S. Central could met year end liquidity demand.

An interesting nugget from the IG study is that in April 2007, U.S. Central launched Sandlot Funding LLC (Sandlot), an off-balance sheet asset-backed commercial paper (ABCP) conduit, which was the first of its kind in the corporate credit union network. Aside from the bad timing to form an ABCP conduit in 2007, the report questions "whether U.S. Central’s management and Board had the expertise to venture into the business of issuing commercial paper and managing an ABCP conduit."

The IG report concluded: "[W]e believe this growth strategy and accompanying investment decisions to purchase higher yielding securities to such extraordinary levels was contradictory to U.S. Central’s fundamental purpose as a wholesale corporate credit union, which was serving as a secure investment option and a source of liquidity for retail corporate credit unions, and support for the not for profit credit union structure." (page 2).

Examiners failed to identify and correct key risks in timely manner.

The study points out that a corporate credit union that qualifies for Type III supervision, which U.S. Central met the requirement, is assigned an on-site capital market specialist on a full-time basis to monitor and evaluate the corporate credit union's financial condition. (see footnote 7 on page 7)

Prior to the March 2008 examination, there were few criticisms of U.S. Central's management or operations. In fact, OCCU examiners and OCM staff noted no significant concerns regarding U.S. Central’s investment function or its strategy to purchase large amounts of securities backed by sub-prime residential loans. The report cites the following from an earlier exam report.

“U.S. Central’s investment function remains conservative with the portfolio consisting of primarily the highest rated securities. Investment transactions are subject to reasonable pre-purchase analysis in accordance with regulatory and policy requirements. Additionally, U.S. Central’s credit function provides adequate ongoing monitoring of all investment exposures which subject the corporate to credit risk.”

By the time the OCCU examiners and OCM staff identified and required corrective action on U.S. Central’s investment portfolio related to its concentration of mortgage-backed securities, it was too late. The IG report states that when the Document of Resolution was issued in July 2008, the MBS market had deteriorated to the point where these securities were no longer being actively traded.

The report is critical of the heavy reliance by OCCU examiners and OCM staff, as well as U.S. Central's management, on high credit ratings to determine credit risk in the portfolio.

However, the report does strike a somewhat sympathetic tone noting that NCUA examiners and staff did not have the appropriate regulatory support, such as more specific investment concentration limits, and lacked the regulatory leverage to limit or stop the growth of U.S. Central’s purchase of sub-prime MBS.