Subordinated Debt at LICUs Up 57 Percent, Since the End of 2016

Since the end of 2016, subordinated debt counting as net worth has increased by almost 57 percent or $84.4 million.

As of March 2018, total subordinated debt placed with low-income credit unions (LICUs) was $232.8 million. This is up from $148.4 million at the end of 2016.

A number of large LICUs have issued subordinated debt (the dollar amount in parentheses) since the end of 2016, including Advia Credit Union ($5 million), Self-Help Credit Union ($13 million), Self-Help FCU ($5 million), Carter FCU ($6 million), Jefferson Financial FCU ($11,597), and Notre Dame FCU ($12 million).

Carter FCU's issuance of subordinated debt was partially used to repurchase subordinated debt issued from the U.S. Treasury Department as part of the Community Development Capital Initiative.

The following table lists the 10 LICUs holding the most subordinated debt as of March 31, 2018.

It is my belief that this trend of large LICUs issuing subordinated debt will continue.

NCUA Calls on Congress to Give It Regulatory Flexibility

In testimony before the Senate Committee on Banking, Housing, and Urban Affairs on June 22, National Credit Union Administration (NCUA) Acting Chairman J. Mark McWatters requested legislation to ease regulatory burdens on credit unions.

His testimony discussed steps that the agency had already taken or plans to take to provide regulatory relief to credit unions. But he also noted that there are limits on the agency's ability to provide regulatory relief.

Acting Chairman McWatters pointed out that the Federal Credit Union Act contains numerous rigid statutory requirements that ties the agency's hands. NCUA asked Congress to provide it with greater discretion to write rules to limit additional burdens on credit unions.

In addition, McWatters called on congressional action with regard to field of membership issues. NCUA believes that all federal credit unions, just not multiple common bond credit unions, should be allowed to add underserved areas. In addition, Congress should eliminate the requirement that the underserved areas be local communities and Congress could simplify the “facilities” test for determining if an area is underserved.

McWatters further requested that Congress eliminate the provision that requires a multiple common bond credit union to be within “reasonable proximity” to the location of a group the credit union wishes to serve.

He also asked Congress for the explicit authority for web-based communities as a basis for a credit union charter.

Other legislative initiatives advanced in his testimony included support for the Credit Union Residential Loan Parity Act (S. 836) and allowing more credit unions to access supplemental capital.

Read 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.

Supplemental Capital and Interdependency Risk

Low income credit unions can accept supplemental capital as part of their net worth and earlier this year National Credit Union Administration (NCUA) Chairman Matz stated that the agency would issue a proposed rule allowing complex credit unions to count supplemental capital as part of the numerator for their risk-based capital ratio.

However, since supplemental capital is available to absorb losses, NCUA has expressed concerns about the source of this supplemental capital. In other words, does this supplemental capital come from within the credit union industry or outside the credit union industry?

In its 2010 Supplemental Capital White Paper, NCUA wrote that "a supplemental capital structure which allows for investment between credit unions has the potential for increasing systemic risk within the credit union industry without actually producing new capital to buffer losses. The result is increased risk exposure to the NCUSIF without a corresponding increase in new capital."

Therefore, the NCUA needs to adopt measures to protect the credit union industry when credit unions invest in each other so as to minimize interdependency risk.

The simplest way to control for this risk would be to follow the standards set in NCUA's corporate credit union regulation regarding adjusted core capital. According to its corporate rule, if a corporate credit union contributes any capital to another corporate credit union, that corporate credit union must deduct an amount equal to this capital contribution when calculating its adjusted core capital.

But it is not clear whether NCUA has the authority to require such an adjustment via regulation for natural person credit unions.

Matz's Comment Undermines Integrity of Rulemaking Process

Despite being in the middle of the risk-based capital proposal comment period, National Credit Union Administration (NCUA) Chairman Debbie Matz announced on March 9 that the agency will issue later this year a proposal to count supplemental capital in full in its risk-based capital numerator.

This announcement seems to undermine the rulemaking process.

NCUA put out for a 90 day comment period its proposed rule with comments due by April 27.

As part of the risk-based capital proposal, the NCUA Board requested comments to several questions about supplemental capital, including "[s]hould additional supplemental forms of capital be included in the risk-based capital ratio numerator and how would including such capital protect the NCUSIF from losses?"

It appears that the agency has already made up its mind on this topic. It will count supplemental capital as part of the risk-based capital ratio numerator.

So much for seeking input from the public on this issue. This agency is making a mockery of rulemaking process.

The agency should have remained silent on this issue until the comment period ended.

Read the proposed rule.

Read Matz's speech.

Matz: Count Subordinated Debt as Supplemental Capital for Risk-Based Capital Ratio

In a speech to the Credit Union National Association's Government Affairs Conference, the National Credit Union Administration Chairman Debbie Matz stated that in 2015 the agency will allow complex credit unions to count subordinated debt as supplemental capital for the risk-based capital ratio.

She noted that this will require three changes. "First, we would need to provide consumer protections. Second, we would need to change the order of Share Insurance Fund payout priorities to recognize that supplemental capital accounts are not insured. And third, we would need to set prudent standards for credit unions to offer subordinated debt to supplement their risk-based capital."

Furthermore, she stated that the agency is exploring "ways to increase access to secondary capital for low-income credit unions this year. This could include regulatory relief to make secondary capital more attractive to potential investors in low-income credit unions, whether federally or state-chartered."

I will be interested in seeing NCUA's legal analysis on how credit unions, other than low-income credit unions, have the legal basis to count subordinated debt as supplemental capital.

Read the speech.

Are Generals and Admirals Low-Income?

Apparently, National Credit Union Administration (NCUA) Board member Rick Metsger thinks so.

In remarks to the Northern Virginia Chapter of the Virginia Credit Union League in January, Mr. Metsger advocated "[a]llowing active-duty military personnel and their families to automatically qualify as low-income households."

However, I seriously doubt admirals and generals qualify for low-income designation. The same could probably be said for many active-duty military personnel.

This is a cynical ploy by NCUA to expand the number of credit unions that have a low-income designation.

This would exempt these credit unions from the member business loan cap of 12.25 percent of assets and would give them access to supplemental capital.

It is obvious that NCUA is trying to use regulatory fiat to do what it cannot get through legislation.

Read the NCUA press release.

Low-Income Credit Unions and Secondary Capital

The Federal Credit Union Act allows low-income credit unions to count secondary or supplemental capital as part of their net worth.

Seventy-five credit unions, excluding Texans CU (Richardson, TX) and A.E.A FCU (Yuma, AZ), reported holding uninsured secondary capital accounts as part of their net worth as of the third quarter of 2014.

Twelve credit union as of September reported that over fifty percent of their net worth is in the form of uninsured secondary capital accounts. This includes Self-Help FCU (Durham, NC), which reports 78.18 percent of its net worth is in the form of uninsured secondary capital accounts.

However, should there be a limit on the amount of secondary capital that low-income credit unions can count towards net worth?

As I have previously written, regulators are focused on increasing the amount of high quality capital that financial institutions hold.

Retained earnings are high quality capital, while secondary or supplemental capital is not high quality capital; because it lacks permanence.

With the number of low-income designated credit unions almost doubling since the middle of 2012 and with few low-income credit unions currently exercising this authority, this would be an ideal time for the National Credit Union Administration to revisit its net worth requirements for low-income credit unions.

The goal should be to have a majority of low income credit unions' net worth comprised of permanent, high quality capital.

NCUA Clarifies Comment on Supplemental Capital and Risk-Based Capital

NCUA's General Counsel Mike McKenna sent a letter on April 9 to House Financial Services Committee Chairman Hensarling (R-TX0 and Ranking Member Waters (D-CA) clarifying the agency's position on supplemental capital as it relates to its risk-based capital proposal.

During the hearing, Rep. Sherman (D-CA) asked NCUA General Counsel Mike McKenna a series of questions regarding the NCUA's risk-based capital proposal, including one about supplemental capital as it relates to the proposed risk-based capital rule. McKenna stated that NCUA might allow credit unions greater access to supplemental capital as it finalizes the proposed rule.

In the letter, McKenna notes that NCUA has very little authority to establish supplemental or secondary capital for credit unions unless Congress changes the definition of net worth. McKenna states that with the exception of low-income credit unions net worth is limited to retained earnings as defined by generally accepted accounting principles.

McKenna wrote that NCUA will allow low-income credit unions to count supplemental capital as net worth for the purpose of calculating the credit union's risk-based capital ratio.

Below is the letter.

MBL and Supplemental Capital Legislation Introduced

Reps. Ed Royce (R-Calif.) and Carolyn McCarthy (D-N.Y.) yesterday re-introduced an ABA-opposed bill (H.R. 688) that would raise the member business-lending cap for certain credit unions from 12.25 percent to 27.5 percent of total assets.

The legislation would raise the cap for well-capitalized credit unions that have member business loans outstanding at the end of each of the four consecutive quarters immediately preceding their application date; can demonstrate at least five years experience soundly underwriting and servicing such loans; and have the requisite policies and experience in managing them. Credit unions also would have to satisfy other standards that the National Credit Union Administration Board determines are needed to maintain their safety and soundness.

Also, Reps. Peter King (R-N.Y.) and Brad Sherman (D-Calif.) yesterday re-introduced a bill (H.R. 719) that would permit the National Credit Union Administration to allow qualified credit unions to accept supplemental capital. The legislation would require such capital to be uninsured and subordinate to other claims against a credit union. The measure also would authorize the NCUA to set maturity limits on it.

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.

Secondary Capital

Given NCUA's recent decision to designate over 1,000 federal credit unions as low-income credit unions, the agency needs to revisit its regulations governing secondary or supplemental capital for low-income designated credit unions.

Low-income credit unions have the authority to issue secondary capital accounts that are uninsured and subordinate to all other claims, including claims of creditors, shareholders and the NCUSIF.

However, NCUA in a 2010 report noted its experience with the depletion of supplemental capital accounts at corporate credit unions and low-income designated credit unions had raised reservations.

NCUA acknowledged that heighten disclosures may not be sufficient to inform investors about the risk and uninsured status of the secondary capital accounts. Moreover, in an August 14, 2003 letter to Representatives Oxley, Frank, and Sherman, the agency wrote that "experience has shown that when uninsured accounts are offered to natural-person customers of a financial institution, and then the accounts suffer losses, confusion about insured status and issues of reputation risk and systemic confidence result."

NCUA needs to develop and enforce disclosure standards sufficient to inform prospective investors of the risk and uninsured status of such supplemental capital accounts. The agency also needs to put in place suitable standards to protect investors and credit union members.

Furthermore, if credit unions are allowed to offer these accounts to one another, this could increase systemic risk. Ideally, a credit union investing in secondary capital issued by a low-income credit union should be required to deduct this investment from its net worth. However, credit union net worth standards are written into law, so NCUA does not have this discretion. The next best alternative is for NCUA to put into place real and meaningful limits on the amount that credit unions may invest of their net worth in the secondary capital of a low-income credit union.

Additionally, secondary capital is not core capital and no credit union should rely entirely on secondary capital as its source of net worth. NCUA needs to specify a required minimum amount of primary capital that a low-income credit union should hold.

NCUA is well aware of these issues; but has failed to act. NCUA needs to promulgate regulations overseeing these concerns with respect to secondary capital.

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.”