The Senate is preparing to consider legislation that would allow credit unions to engage in more commercial lending, a proposal that the industry has long championed. This proposal is a really bad idea, but because of the political constituency behind credit unions it may actually be passed into law. In the event, the National Credit Union Association and the U.S. taxpayer may be facing significant losses in the future.
Several years ago when I appeared before the Senate Banking Committee, Senator Charles Schumer (D-NY) asked me if it would be a good idea for credit unions to be giving expanded powers to make business loans. He related how a small heating oil business in New York was unable to get accounts receivable financing because commercial banks were no longer willing to finance this type of asset.
My response was immediate and unequivocal: No. While Schumer is correct that banks have largely withdrawn from small business lending (at least without a guarantee from the Small Business Administration), this does not mean that credit unions should now fill this very real need. Instead we need to regrow the nonbank financing sector, which was largely subsumed by commercial banks over the past twenty years. Names like Household Finance in the consumer space and numerous nonbank mortgage and commercial lenders must be recreated from scratch.
The first thing that needs to be said is that most commercial banks are not really equipped to make business loans, whether for general commercial purposes or real estate. While there are some institutions which specialize in business lending and do an excellent job, generally speaking most regional and community banks have limited human, financial and operational resources necessary to make business loans in a safe and sound manner.
When we then move on to considering the capacity of credit unions to make business loans, the situation becomes even more problematic. Most credit unions outside of the top ten largest institutions do not have the internal systems and personnel to even begin to effectively underwrite and manage commercial loans, large or small.
Keep in mind that when we talk about loans for small business, you are referring to very high risk assets where there is often a single point of failure – a sole proprietor. Indeed, this is why we have an SBA program for government guarantees for small business loans.
Think about what the credit rating from Moody's or S&P would be for the typical small business – maybe a "B" or "CCC" equivalent. Neither large nor small banks, nor credit unions are prepared to take first loss exposure on such credits.
A "B" rating from Moody’s, for example, is equivalent to 1,100 basis points of default probability, implying that a lender would need to charge something north of 15-20% per annum to cover the risk on such a portfolio – at least without a government guarantee. This type of "subprime" lending is done by banks such as Capital One (COF), Citigroup (C) and GE Capital, a unit of General Electric (GE). Does Senate Majority Leader Harry Reid (D-NV) really want to take responsibility for putting small, relatively undercapitalized credit unions into the subprime lending business? Most credit unions in the U.S. are like most small businesses, namely fairly low-tech, mom and pop operations that lack the capital, internal systems and controls and profitability to engage in such lending.
Going back to my conversation with Senator Schumer, the nonbank lenders who once banked account receivable finance generally had capital levels over 20%. If you look at the leverage ratios of the subprime units of CapOne, Citi and GE, all are in the high teens to low 20 percent range. Credit unions simply do not have the capital to play in the subprime world – unless you are going to dump all of the risk on the SBA and the U.S. taxpayer. I suspect that this is precisely the agenda of the NCUA and its supporters in the Congress.
Speaking of increased risk to the U.S. taxpayer, the Senate should not act on the credit union proposal unless and until the industry repays all of the money currently guaranteed by the U.S. Treasury to bail out several large wholesale credit unions in 2010. These corporate credit unions wandered into the subprime swamp and are now insolvent.
The Wall Street Journal noted in September 2010: "Under federal rules, wholesale credit unions were supposed to invest only in safe, liquid assets. But some chased higher returns by loading up on securities backed by subprime mortgages or other risky loans. Their portfolios were decimated by the mortgage meltdown."
The NCUA maintains that these borrowings to support corporate credit unions will not be paid by taxpayers, but the fact is that the credit unions as an industry do not have sufficient profits to even begin to repay these debts. Why should the Senate allow credit unions to take even more risk when the industry has already proven that it is incapable of managing complex securities much less risky small business loans?
Christopher Whalen is senior managing director of Tangent Capital Partners in New York. He is co-founder and vice chairman of Institutional Risk Analytics, the Los Angeles based provider of bank ratings, risk management tools and consulting services.