Union Yes FCU Seeks to Raise $4 Million in Secondary Capital

The American Banker is reporting that a undercapitalized credit union in Orange, California, is looking to raise $4 million in secondary capital.

The $63.4 million-asset Union Yes Federal Credit Union recently launched a capital campaign, offering subordinated debt with fixed and variable interest rates of 4 percent to 4.5 percent with maturities of five to seven years.

The minimum size of the investment is $250,000.

While many credit unions can only build capital through retained earnings, low-income credit unions, such as Union Yes FCU, are permitted to raise secondary capital from investors.

According to the prospectus, the credit union has been experiencing very strong growth and needs the capital to fund new membership growth.

However, investors are going to receive a higher rate of return on their investment than credit union members. For example, the highest current rate for the 60-month CD is 0.35 percent.

This higher rate of return is compensation to investors for potential credit risk, if the credit union fails.

But it also means that the credit union tax subsidy is going to investors instead of the members.

Read the article (subscription required).

NCUA to Fast Track Alternative Capital for CUs

The Credit Union Journal is reporting that the National Credit Union Administration (NCUA) may fast track a proposal to give complex credit unions access to alternative capital.

Complex credit unions have at least $500 million in assets and are subject to the agency's risk-based capital requirement, which will become effective on January 1, 2020.

The agency on December 13 approved a report calling for action on alternative capital by May of 2019.

Currently, only low-income credit unions have the authority to issue secondary or alternative capital.

While granting credit unions access to alternative capital will generate strong support from the credit union trade associations, the proposal, when issued, will also fuel vehement opposition from banking trade groups.

Alternative capital could become the Pandora's Box for credit unions. Once opened, it will become a curse for the credit union industry.

Read the story (subscription required).

McWatters Makes Legislative Recommendations

National Credit Union Administration (NCUA) Chairman McWatters on October 2 in testimony before the Senate Banking Committee recommended four legislative priorities for the agency.

The four areas involve modification of provisions related to field of membership, granting the NCUA vendor authority, authorizing alternative forms of capital, and giving the NCUA Board broader authority to establish a maximum loan rate ceiling for federal credit unions.

Field of Membership

• NCUA is recommending that all types of federally chartered credit unions, not just multiple common bond charters, be allowed to add underserved areas to their fields of membership. 
• NCUA urges Congress to consider allowing federal credit unions to serve underserved areas without also requiring those areas to be local communities. 
• NCUA recommend that Congress simplify or remove the “facilities” test for determining if an area is underserved. 
•  Congress consider eliminating the Federal Credit Union Act’s requirement that a multiple common-bond credit union be within “reasonable proximity” of the location of a group to provide services to members of that group.
• Congress should grant explicit authority for web-based communities as a basis for a credit union charter. 
• Congress should consider providing greater flexibility for low-income individuals to join federal credit unions. Specifically, NCUA believes that Congress revise the Federal Credit Union Act to allow the NCUA to permit federal credit unions to add anyone residing in a census tract where current projections indicate he or she qualifies as low-income.

Vendor Authority

The NCUA is requesting that Congress consider legislation to provide the agency with examination and enforcement authority over certain third-party vendors — including credit union service organizations (CUSOs).

Currently, the NCUA may only examine CUSOs and third-party vendors with their permission and cannot enforce any necessary corrective actions or share the results of a voluntary review with customer credit unions of the third-party vendor. This lack of vendor authority stands in contrast to the powers of the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and most state regulators.

In making his case for the authority to examine third-party vendors, McWatters noted that the top five technology service providers serve more than half of all credit unions, representing 92 percent of the credit union system’s assets. Data from the fourth quarter of 2017 show that credit unions using the services of a CUSO accounted for $1.375 trillion in assets or 99.7 percent of the system’s assets.

He also stted that a failure of even one of these vendors represents significant potential risk to the Share Insurance Fund. For example, since 2008, CUSOs have caused more than $500 million in losses to federally insured credit unions, and they have contributed to the failure of 11 credit unions.

Alternative Forms of Capital

Under the Federal Credit Union Act, only low-income credit unions are able to include secondary capital (a form of alternative capital) in the calculation of their statutory net worth ratio. NCUA wants Congress to authorize alternative forms of capital that would count towards the statutory net worth ratio of a credit union without a low-income designation.

Maximum Interest Rate Ceiling on Loans

Federal credit unions are currently subject to a statutory usury rate on loans. The NCUA Board is seeking broader authority to establish a maximum loan rate ceiling for federal credit unions based on financial criteria and for periods as the NCUA Board may determine. McWatters believes this would dramatically simplify the administration of interest rate changes and make it much easier for credit unions to comply.

However, McWatters' testimony does not address reforming the National Credit Union Share Insurance Fund. It also fails to make any recommendations regarding the Central Liquidity Facility.

Read the testimony.

Taxation and Supplemental Capital

In its advanced notice of proposed rulemaking (ANPR), the National Credit Union Administration (NCUA) Board expressed concerns that supplemental capital could adversely impact the credit union industry's tax exemption.

The Board speculated that accessing Wall Street for capital could cause Congress to reconsider the credit union industry's federal tax exemption.

According to the ANPR,

"[T]he Board is aware that part of the basis for the credit union tax exemption was that Congress recognized most credit unions could not access the capital markets to raise capital. If all credit unions ... have the ability to access the capital markets to meet capital standards, it could call into question one of the bases for the credit union tax exemption."

The Board also pointed out that state chartered credit unions could be at risk of losing their tax exemption if they issue capital.

Section 501(c)(14)(A) of the Internal Revenue Code exempts state chartered credit unions from federal income taxation because they are without capital stock organized and operated for mutual purposes without profit. But the ANPR noted that the Internal Revenue Service has not defined "capital stock."

The Board wrote that "it is possible federally insured state chartered credit unions in some states will have broad authority to issue supplemental capital instruments that have the characteristics of capital stock, and by doing so could subject themselves to taxation."

So, the credit union industry's tax exemption could be at jeopardy if credit unions can access financial markets to raise capital.

Disclosures, Supplemental Capital, and Material Risk

The National Credit Union Administration (NCUA) is seeking input regarding disclosures for credit unions issuing supplemental capital.

The credit union Call Report does not provide adequate disclosures about material facts affecting a credit union to protect investors.

According to the Advanced Notice of Proposed Rulemaking, "[t]he disclosure must not contain any untrue statement of a material fact and must not omit to state a material fact ... the disclosure must be clear, accurate and verifiable."

Topics that should be covered in the disclosure include:

• Material risks relating to the issuer and the industry in which the issuer operates;
• Material risks relating to the security being offered;
• The issuer’s planned uses for the proceeds of the offering;
• Regulatory matters impacting the issuer and its operations;
• Tax issues associated with the security being offered; and
• How the securities are being offered and sold, including any conditions to be met in order to complete the offering.

In other words, credit unions issuing supplemental capital will be required to provide details about their business models. This would include discussion about the type of lending by credit unions, risk profile of these loans, geographic diversity of loans, any legal actions that could materially impact the operations of credit unions, and so on.

In addition, to protect investors, credit union regulators will need to end their practices of not publishing enforcement actions. In 2015, there were 286 outstanding unpublished Letters of Understanding and Agreement. These unpublished enforcement actions identify material risks that are affecting the operation of credit unions. This is information that investors would find important.

Moreover, credit unions will be expected to provide "ongoing communications with investors, reporting of compliance with the contractual covenants, and sharing of information with current and prospective investors."

The Board notes that "[f]ailure to comply with the investment contracts or to properly monitor communications and sharing of information could subject the credit union to liability, which could negatively impact the Share Insurance Fund."

Who Should Be Allowed to Purchase Alternative Capital?

The National Credit Union Administration (NCUA) Board is requesting comment on whether the sale of secondary and supplemental capital should be limited to only institutional investors, include accredited investor, or allow for anyone to purchase.

I do not believe that the NCUA Board should allow anyone to purchase secondary or supplemental capital.

Many people lack financial sophistication. For people lacking financial sophistication, this product would not be suitable.

NCUA should either require credit unions issuing alternative capital to comply with the Security and Exchange Commission's Regulation D or issue regulations comparable to Regulation D.

Under Regulation D, an organization can issue debt or equity through a private offering without officially registering the offering to “go public”. This exemption reduces the amount of paperwork required, lessening the time and money it takes to actually raise capital.

However, the Securities and Exchange Commission encourages or requires companies to work with accredited investors when raising capital through a private offering. The rule gives room for 35 non-accredited investors to participate so long as disclosure requirements are met and any non-accredited investor must be a sophisticated investor.

Accredited investor is defined as an individual that has made $200,000 or more on an annual basis for the past two out of three years and is likely to make that same amount this year. If it is a couple qualifying together that amount is raised to $300,000. If they do not meet the income requirements, they can qualify using a net worth of over $1 million excluding their primary residence.

A sophisticated investor is defined as someone that has superior knowledge of business and financial matters.

Supplemental Capital and Corporate Governance

The National Credit Union Administration (NCUA) Board is inviting comments on the potential effect supplemental capital may have on the
mutual ownership structure and governance of credit unions. Specifically, the Board is exploring whether it should impose restrictions, such as non-voting and limits on covenants, in the investment agreement that may give investors levels of control over the credit union.

The Board believes that federal credit unions can issue supplemental capital only as subordinated debt. Debt holders do not have an ownership interest and cannot vote. It would not endanger the one member one vote structure of credit unions. So, the issuing of supplemental capital will not affect the mutual ownership structure of the credit unions.

However, the Board should not seek to limit covenants in the investment agreement. These covenants are the only way to protect the interest of the investors in supplemental capital. These covenants should be the result of private negotiations between investors in supplemental capital and the credit union and NCUA should not seek to abridge the rights of investors.

The Board should address what happens to a credit union if it is in violation of its covenants in the investment agreement.

Will Complex CUs Issue Supplemental Capital?

If complex credit unions get the authority to issue supplemental capital, will they use it?

The National Credit Union Administration (NCUA) Board believes that federal credit unions can only issue supplemental capital as subordinated debt.

I don't expect there will be a large number of credit unions scrambling to issue supplemental capital.

Let's look at the evidence.

Currently, most credit unions have enough capital to meet their organic growth and don't need additional capital.

In addition, low-income designated credit unions already have the statutory ability to issue secondary capital, which counts towards a credit union's net worth. But only 73 low-income designated credit unions (or 3 percent of low-income designated credit unions) reported holding secondary capital, as of June 30, 2016. Since December 31, 2011, the number of low-income designated credit unions with outstanding secondary capital ranged between 72 and 79.

Furthermore, supplemental capital will not count towards a complex credit union's net worth. According to the NCUA's Advance Notice for Proposed Rulemaking (ANPR), supplemental capital would only count towards a complex credit union’s risk-based capital ratio.

The NCUA Board believes that the "most likely users would be those credit unions with net worth ratios above the well capitalized level but with a risk-based capital below or near the minimum needed to be well capitalized." NCUA estimates that 140 credit unions might issue supplemental capital to boost their risk-based capital ratio.

Moreover, supplemental capital could be very expensive for credit unions, limiting its attractiveness. The ANPR states that the interest rate paid by community banks on subordinated debt was 300 to 400 basis points above the interest rates on ten-year treasury note. Additionally community banks report expenses associated with sales commissions, ranging from 1.25 percent to 3 percent, and fees along with legal and operational costs.

Therefore, the available evidence would suggest that credit unions will not be beating down the door to issue subordinated debt.

NCUA Seeks Comment on Alternative Capital

The National Credit Union Administration (NCUA) Board issued for comment an advance notice for proposed rulemaking (ANPR) on alternative capitl for credit unions.

The NCUA Board is considering changes to the existing secondary capital regulation and whether to authorize federally insured credit unions to issue supplemental capital instruments that would only count toward a credit union’s risk-based net worth requirement.

The ANPR identifies two categories of alternative capital: secondary capital and supplemental capital.

The Federal Credit Union Act currently permits low-income credit unions to issue secondary capital. By law, secondary capital counts toward both the net worth ratio and the risk-based net worth requirement of NCUA’s prompt corrective action standards.

The Board is considering whether non-low income credit unions can issue supplemental capital to meet their risk-based capital requirement. Also, can low-income credit unions issue supplemental capital.

The ANPR seeks comment on a wide range of issues regarding alternative capital, including:

• Associated regulatory changes that would be necessary;
• Potential tax implications related to issuing alternative capital, particularly for state-chartered credit unions;
• Potential director and management liability issues from issuing alternative capital;
• Investor protection issues and whether the sale of secondary capital, like supplemental capital, should be restricted to knowledgeable institutional investors;
• The impact of alternative capital on the mutual ownership structure of credit unions;
• Limiting the amount of supplemental capital issued by credit unions;
• Loss absorbing capacity of supplemental capital;
• The treatment of reciprocal holdings of alternative capital; and
• The application of securities law to both supplemental and secondary capital.

The comment period will be for 90 days after the ANPR is published in the Federal Register.

Over the coming months, I will comment on various aspects of the ANPR.

Read the ANPR.

Credit Unions Face A Regulatory Tax Because of Their Tax Exemption

Last week, I spoke at the Credit Union Water Cooler Symposium in Nashville, Tennessee.

Below is a video segment from the Conference where I told the audience that the preservation of the credit union tax exemption has imposed a regulatory tax on credit unions. This regulatory tax appears in the form of business lending and capital restrictions.

I know that some within the credit union industry would like to have their cake and eat it too. But that is unlikely to happen.

Should Credit Unions Pay to Play?

Here is an idea that deserves debate by banks and credit unions alike.

Is it time to reconsider the tax exemption for credit unions that want to act like banks?

There are some credit unions that are seeking powers that go beyond the current charter for credit unions. These institutions want to do more business lending, to have access to alternative capital, and to engage in other activities that are currently not permissible or limited by the credit union charter.

However, these expanded powers move a credit union further away from its original purpose and the rational for the tax subsidy.

If a credit union wants greater ability to make business loans – in other words, exceed the aggregate member business loan cap of 12.25 percent – or the ability to raise alternative capital, the trade-off is that a credit union voluntarily surrenders its tax exemption. On the other hand, if a credit union is content with the limitations of its charter, its tax exempt status would be preserved.

Pay to play is a win for traditional credit unions, because they keep their tax exemption. It is a win for credit unions that want greater authority, because it creates a pathway to engage in those powers.

I would be interested in hearing what credit union leaders think.

NCUA Issues White Paper on Supplemental Capital

NCUA’s Supplemental Capital Working Group (the Working Group) issued a White Paper on supplemental or secondary capital for credit unions.

The White Paper states that credit unions rely almost exclusively on retained earnings to build capital. Currently, only two types of credit unions can issue supplemental capital – low-income credit unions and corporate credit unions. Congress in 1998 limited credit union net worth to retained earnings as defined by generally accepted accounting principles. Therefore, the Federal Credit Union Act would have to be amended to allow federally-insured credit unions to count supplemental capital as part of their net worth.

“The Working Group concluded that any form of supplemental capital for credit unions should adhere to three key public policy principles: (1) preservation of the cooperative mutual credit union model; (2) robust investor safeguards; and (3) prudential safety and soundness requirements.”

There are two important characteristics associated with supplemental capital – 1) the source of supplemental capital and 2) the equity characteristics of the supplemental capital.

The Working Group identified three alternative forms of supplemental capital that meet the aforementioned principles – Voluntary Patronage Capital (VPC), Mandatory Membership Capital (MMC), and Subordinated Debt (SD).

“ VPC would be uninsured and subordinate to the National Credit Union Share Insurance Fund (NCUSIF), and would be used to cover losses that exceed retained earnings. These instruments are intended to allow members with the financial wherewithal, under strict suitability and disclosure standards, to support the credit union by contributing capital. Purchase of this type of supplemental capital instrument would be optional for natural person members, but not available to institutional members. Voting rights and access to all credit union services otherwise available to members may not be contingent in any way on the purchase of VPC. This type of supplemental capital would function as equity, not debt, as it is a very long term, noncumulative capital instrument. Given its utility as capital, VPC would count toward both the net worth ratio and the risk-based net worth ratio, but subject to certain limits given mutuality and risk considerations.

MMC would function as equity, not debt, as it approximates a perpetual, non-cumulative capital instrument. Purchase of this type of supplemental capital would be a condition of membership for any person or entity eligible to join the credit union. The idea behind this form of capital is to allow credit unions to convert the par value share currently required to be a member of the credit union in good standing to a form of supplemental capital. Specifically, the minimum single par share which a member is required to “purchase” to be a member of the credit union would be uninsured and subordinate to the NCUSIF. Subject to prior regulatory approval, individual credit unions would opt-in to this type of membership structure by adoption of a standard bylaw amendment.

Given its utility as capital, MMC would count without limit toward both the net worth ratio and the risk-based net worth ratio. It is intended to reflect the cooperative “ownership” and voting rights every member of the credit union has, without changing the one member-one vote principle. It more explicitly reflects each member’s ownership stake in the credit union.

SD is the third general category that could satisfy to various degrees the key public policy principles. SD would be uninsured, subordinate to the NCUSIF, and would be used to cover losses that exceed retained earnings and any MMC or VPC capital. It would have a 5-year minimum initial maturity or notice period with no early redemption option for the investor. Credit unions issuing SD would need to be subject to standard marketplace investor suitability standards and disclosures. SD may not convey any voting rights, involvement in the management and affairs of the credit union, or be conditioned on prescriptive measures directing the credit union’s business strategies. This type of supplemental capital would function as a hybrid debt-equity instrument. It is the Working Group’s belief that this type of capital instrument should be limited to institutional investors, regardless of whether such investors are members of the credit union or external. Given the debt characteristics and shorter minimum initial maturity, SD would only count toward the risk-based net worth ratio, and only up to 50% of capital instruments (including retained earnings) counting toward the net worth ratio.”

Alternative Capital – Not A Panacea

Alternative capital may not be a panacea for the capital woes of credit unions.

In a December 7, 2009 letter to Chairman Barney Frank, NCUA Chairman Deborah Matz noted a trend where some well-capitalized credit unions were discouraging consumer deposits because rapid deposit growth could negatively impact their net worth ratio subjecting the credit unions to prompt corrective action. With the exception of low income credit unions, the only vehicle for credit unions to build capital or net worth is retained earnings. Chairman Matz proposed allowing qualified credit unions to issue some form of alternative capital to supplement retained earnings.

What is alternative capital?

Alternative capital may include – uninsured certificate of deposits, subordinated debt, membership capital shares (MCS), and members’ paid-in capital.

However, under Basel capital rules, uninsured certificates of deposit and subordinated debt would not count as core capital, but rather as tier 2 capital. This would not provide the capital relief that credit unions are seeking.

The capital instruments that would most likely be viewed as core capital are membership capital shares and members’ paid-in capital.

Membership capital shares have some of the prerequisites to be counted as core capital: MCS can only be withdrawn, when membership is terminated. Moreover, credit unions have a legal right to refuse to pay out these minimum amounts if net worth levels are inadequate. However, MCS are currently covered by federal insurance from the NCUSIF, which disqualifies MCS as core capital. To be counted as capital, membership capital shares would have to become uninsured.

Therefore, member paid-in capital appears to offer the best prospect as a source of core alternative capital. Member paid-in capital is permanent, perpetual, and uninsured. Also, dividends would be treated as non-cumulative. Since, these funds are at risk, credit unions would have to pay a significantly higher dividend rate to compensate these investors for their risk.

However, several aspects may make members’ paid-in capital unattractive to credit unions.

First, in general, depositors are risk-averse. Therefore, credit union members are unlikely to put their money at risk.

Second, members’ paid-in capital is illiquid, because this investment cannot be sold.

Third, members’ paid-in capital may attract professional depositors who would want to force the credit union to go public.