August 11, 2008
PAGE ONE
Mortgage-Market Trouble
Reaches Big Credit Unions
By MARK MAREMONT
August 11, 2008; Page A1
Five of the nation's largest credit unions are reporting big paper
losses on mortgage-related securities, a sign that housing-market
distress is spreading even to the most risk-averse financial sectors.
The federal regulator overseeing credit unions says the losses are
likely to be reversed when mortgage markets stabilize, and that the
institutions are sound and adequately capitalized. But some outside
observers are concerned that the credit unions are underestimating the
depth of their mortgage-market problems.
[Banking Alternative]
"This is a serious situation," says Gerald Hanweck, a finance professor
at George Mason University, who studies the banking industry and is a
visiting scholar at the Federal Deposit Insurance Corp. Mr. Hanweck
believes the five firms have sufficient access to funding to handle a
deeper downturn, but he worries that perceptions of added risk could
lead to a run on one or more of them.
Credit unions are not-for-profit, member-owned cooperatives that take
deposits and lend money like banks. The mortgage problems are focused on
so-called corporate credit unions, which are key players in the
industry. They don't deal directly with consumers, but provide
investment services and financing to regular credit unions, which do.
The five corporates showing big mortgage-related losses, according to
federal regulatory filings, are U.S. Central Federal Credit Union;
Western Corporate Federal Credit Union; Members United Corporate Federal
Credit Union; Southwest Corporate Federal Credit Union; and Constitution
Corporate Federal Credit Union. Together, they reported about $5.7
billion in "unrealized" losses as of the end of May, the filings
indicate. Unrealized losses happen when the market value of a security
falls, even if it hasn't been sold.
Credit unions in general are among the most conservatively run financial
institutions in the U.S. That some are showing strains indicates that
almost no financial sector is immune from the mortgage meltdown that has
caused widespread carnage among commercial banks and on Wall Street.
Financial-services firms have already taken write-downs of more than
$300 billion in connection with the mortgage mess.
"We're not much different from any financial institution," says Michael
Kinne, chief financial officer of Constitution Corporate in Wallingford,
Conn. "Nobody is insulated from this. It seems like every time you turn
around, somebody else is taking a billion-dollar write-down."
Kent Buckham, director of the office of corporate credit unions for the
National Credit Union Administration, the federal regulator, says the
mortgage investments held by corporate credit unions are safer than many
that are causing havoc on Wall Street, and are very likely to rebound in
value. In his view, the paper losses reported by the corporate credit
unions reflect unrealistically low market values for mortgage
investments, in part due to investor nervousness about the sector. He
says he doesn't expect the firms will have to sell those assets at
"fire-sale prices."
There have been predictions for months that the mortgage-market turmoil
was coming to an end, and that mortgage-related assets would bounce back
in value. So far, that hasn't happened.
Negative Equity
The paper losses of the five big corporate credit unions are large
enough to wipe out the net worth of each of them. Added together, their
negative equity totals $2.9 billion -- meaning, in theory, that their
debts exceed the current market value of their assets by that amount.
That would be a troubling situation for a commercial bank. But credit
unions say their balance sheets are a lot stronger than they appear
because current accounting rules don't allow them to show a key source
of capital -- certain funds parked with the corporates by regular credit
unions.
[Mortgage Woes]
To address what it says is a misleading financial picture, the federal
regulator, the NCUA, plans this month to revise an accounting rule to
allow corporate credit unions to more clearly highlight in their federal
filings these funds, called membership capital.
The corporate credit unions showing the biggest losses, U.S. Central and
Western Corporate, reacted to the mortgage-market turmoil with an
unusual accounting change. They reclassified some assets in a way that
allows them to avoid recording any more unrealized losses. Executives at
those firms say the shift, which was reviewed by regulators, frees them
from reporting losses on investments they have no plans to sell.
Critics say the move is accounting window dressing that covers up real
problems. "What all of a sudden changed?" says Lynn Turner, a former
chief accountant at the Securities and Exchange Commission. "The only
reason to do it is to avoid reporting further losses in the financial
statements."
Little Impact
So far, the troubles of the corporate credit unions appear to be having
little impact on regular credit unions. Executives at several of the
regular firms say they are closely monitoring the financial condition of
the corporates, but that they remain confident and haven't reduced their
funds on deposit with the corporates.
There were about 8,400 credit unions holding more than $775 billion in
assets at the end of last year, according to an industry trade group.
Many serve employees of a specific company, members of occupational or
other groups, or a geographical area. Some have expanded greatly in
recent years, adding branches and competing more directly with
commercial banks.
Corporate credit unions were founded to serve regular credit unions,
many of which are too small to engage directly in sophisticated
investing. Regular credit unions park a portion of their funds with one
or more of the corporates, which in turn invest the money. In total, the
28 corporates, which are owned by their member credit unions, have about
$90 billion in assets. (U.S. Central serves as a credit union for
corporates, providing them with similar investment services.)
By regulation, the corporates are supposed to invest only in safe
securities that are highly liquid, meaning easy to sell. In recent
years, some have made investments backed by subprime and so-called Alt-A
loans extended to buyers with poor or spotty credit. Despite the risky
underlying loans, Wall Street had concocted ways to package the loans so
that slices of the investments appeared ultrasafe. Most bought by the
credit unions initially carried top credit ratings of AAA.
The big credit unions, like other investors, generally were caught
unprepared for the meltdown in mortgage markets that began in mid-2007.
Buyers became scarce, and even some high-rated investments dropped
sharply in value.
The result: Some corporate credit unions have been forced to record
large unrealized losses on their assets, even though they continue to
own the securities. For example, Southwest Corporate reported $672
million in such losses as of the end of May. The Plano, Texas-based
company, with $12.2 billion in total assets, says the problems are
centered on about $2.5 billion in securities backed by subprime or Alt-A
mortgages and home-equity loans.
Bruce Fox, Southwest Corporate's chief investment officer, says the
securities it holds generally are safer than the ones causing massive
losses on Wall Street. "These are very high-quality assets, and all of
them are paying principal or interest at the moment," he says. As of the
end of May, 94% of its mortgage-related securities were still rated AAA.
Instead of selling at what it views as distressed prices, Southwest
plans to hold the investments until they recover or until maturity, he says.
Crucial Contention
The contention that the mortgage losses are temporary is a crucial one
for the corporate credit unions. Under accounting and regulatory rules,
temporary losses don't eat into earnings or capital, while permanent
losses do. (Financial institutions are required to have adequate
capital, usually expressed as a percentage of assets.)
In the case of Southwest Corporate, if it counted as permanent $100
million of its $672 million in "unrealized" losses as of the end of May,
it would have fallen below the minimum capital threshold set by the
NCUA. Unlike banks, credit unions can't easily raise new capital, which
they generally get from accumulating earnings over the years.
Mr. Fox says there's "a very low probability" of any significant
permanent write-offs. Southwest's capital, he adds, continues to grow
with strong earnings.
Todd Adams, chief financial officer of Members United -- another of the
five firms -- also says that any unrealized losses are likely to be
temporary. But "if market conditions continue to deteriorate," he says,
"some of [the investments] could see real cash losses." He adds that "it
would take a lot to do that, but there's a lot of bad news in the market
right now."
Reclassified Assets
Starting early this year, the two biggest corporates, Western Corporate
and U.S. Central, reclassified a large portion of the mortgage-related
assets on their balance sheets from "available for sale" to "held to
maturity." The NCUA says no corporate credit union had ever done that.
Under accounting rules, if a firm says it plans to hold an asset until
it matures, it doesn't need to record any temporary swings in the
asset's market value. The move allowed the two firms to avoid taking
further unrealized losses on those holdings, although they would have to
write off any permanent or realized losses.
At the end of May, Western Corporate had moved $9.6 billion to the new
category -- about one-third of its total investments -- including all
its Alt-A mortgage-related assets. Chief Financial Officer Jim Hayes
says the shift "wasn't a matter of jury-rigging the accounting." He says
the securities chosen were ones for which the firm had difficulty
getting accurate pricing. "We never felt like we had to do it before,
because we didn't feel like we had the pricing dislocations before." He
adds that Western intends to hold the securities to maturity, which the
new category more accurately reflects. He says the company consulted
with its outside auditors and the NCUA before making the change.
U.S. Central, which shifted a big batch of assets to the new category in
June, had $10.9 billion of its $35.3 billion of investments in that
grouping at the end of that month, compared with none at year-end 2007.
Chief Financial Officer Kathryn Brick says the decision stemmed partly
from "the negative perception of these unrealized losses, which are
paper losses....We just wanted to cap the unrealized losses." A bigger
factor, she says, is that U.S. Central arranged new sources of
financing, including credit lines with federal agencies, so no longer
needed to consider all of its holdings as available for sale. Ms. Brick
says the shift is allowed under accounting rules.
Other corporate credit unions haven't followed suit. Mr. Adams, the
finance chief at Members United, says the traditional accounting better
shows his firm's members where the problems are in its portfolio. "We
had selected available-for-sale before, and we should stay consistent,
even though we're going through an historic situation in the market," he
says.
The accounting shift has a potential downside for the two big credit
unions. If the market value of the reclassified investments starts to
climb, they won't be able to show that increase on their balance sheets.
As with banks, credit unions are federally insured up to $100,000 per
account and $250,000 per retirement account. So far this year, nine
regular credit unions have failed, including at least two due to
mortgage-related problems. Seven failed in 2007.
In theory, the failure of a corporate credit union could lead to losses
for any regular credit union that has deposited money with the
corporate, and ripple down to individual depositors. The last time a
corporate credit union failed was in 1995. Ultimately, the regular
credit unions that were involved recovered their money.
The NCUA's Mr. Buckham says the possibility that a corporate credit
union might fail now is "so remote" that "I can't even imagine that
happening."
Write to Mark Maremont at mark.maremont@wsj.com1
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