Coronavirus to test credit union capital levels

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The economic fallout from the coronavirus is about to test the industry’s capital strength.

Heading into the current crisis, the industry had a healthy level of net worth, which should help limit the number of credit union failures and management teams that feel like they must find a merger partner for financial reasons.

Still, net worth ratios will take a hit from lower earnings and an influx of deposits, experts said. That could lead to some institutions seeking out secondary capital to either support asset growth or help absorb losses, some experts said.

“There is an increased interest in secondary capital right now,” said Eben Sheaffer, chief financial officer and chief investment officer for Inclusiv. “It is a really good fit for a lot of credit unions, especially right now as a way to increase net worth for a period of time when net worth might be challenged.”

The industry had a net worth of $182 billion and a net worth ratio of about 11% for the first quarter, said Sam Taft, associate vice president of analytics at Callahan & Associates, a consulting and analytics firm. That means credit unions would have to lose roughly $66 billion in capital to bring the entire industry’s net worth ratio below the well-capitalized level of 7%, Taft added.

It’s extremely unlikely the entire industry would see that kind of a hit but credit unions will still experience pressure on capital. The net worth ratio dropped to about 11% in the first quarter from 11.37% in the fourth quarter, according to data from Taft and the National Credit Union Administration. Only one month of the first quarter was truly affected by the pandemic so financials for the rest of the year could be even bleaker.

Decreased earnings will be one issue hurting net worth. Lending opportunities have slowed because many businesses have closed and consumers have decreased their spending. Additionally, credit unions are helping borrowers through the crisis by offering options such as deferred loan payments, but that also hits the bottom line, said Michael Macchiarola, CEO of Olden Lane, which provides secondary capital and other services to credit unions.

“There is more pressure on capital right now than perhaps at any other time in recent memory,” Macchiarola said. “Your ability to make money is becoming more difficult in this environment.”

An influx of deposits from government relief programs and consumers looking for a safe place to park their funds is also lowering net worth ratios, experts said.

Share balances increased by almost 8% in the first quarter from a year earlier, Taft said. That’s the second-highest first quarter gain since March 2009. At the same time, the average loan-to-share ratio dropped by 1.2 percentage points, to 81.1%.

“Based on discussions with our clients and a number of virtual roundtables, it’s not the losses [executives] are concerned about right now,” Taft said. “It’s the pressure via deposit increases as a result of members seeking safe havens for their assets, stimulus funds and just traditional increases in deposits in the first quarter.”

NCUA is taking steps to give institutions flexibility in managing these issues. In May, Chairman Rodney Hood asked the Senate Banking Committee to lower the minimum requirements for credit unions to be considered well- and adequately capitalized by one percentage point each. Currently to be well-capitalized a credit union must have a net worth ratio of 7% and 6% to be adequately capitalized.

And earlier this week the regulator said that it would not require some institutions to meet retained earnings standards and would allow certain credit unions to submit streamlined net worth restoration plans because of the economic challenges caused by the coronavirus.

Park Side Credit Union in Whitefish, Mont., reported its first-quarter net worth ratio dropped to 9.8% from 10.37% a year earlier, according to call report data from NCUA. The decline can be attributed at least partly to a surge in deposits, said Chief Financial Officer Troy Brackey.

Montana hasn’t been as hard hit by the outbreak as other parts of the country, Brackey said. The $269 million-asset institution has seen growth in its mortgages as residents continue to buy homes. Still, Brackey said senior executives and the asset-liability committee have worked hard to manage Park Side’s balance sheet, including finding ways to deploy the new deposits into interest-earning assets.

“We are going to use some of our capital because the balance sheet grew too fast. There is a flight to safety and growth in deposits,” Brackey said. “Our loan growth hasn’t slowed. We are just continuously focusing on protecting the balance sheet, protecting members from fraud and protecting the loan portfolio.”

Still, some institutions are preparing for potential capital issues and that includes considering raising secondary funds. Only institutions with a low-income designation can raise secondary capital. In the fourth quarter, there were about 2,600 credit unions with this classification, or roughly half of the industry.

There was already a growing interest in raising secondary capital given that the number of low-income credit unions has more than doubled in the last decade. The economic fallout from the coronavirus seems to be accelerating that trend, Sheaffer said.

Additionally, interest in secondary capital surged after the last financial crisis, Macchiarola said, adding that this type of funding grew by 201% for the year ending March 2010.

“After financial trauma, people do seek out a solution to raise capital,” Macchiarola said. “It’s happened in the past and we believe it will happen again. It is a much more generally accepted concept.”

Inclusiv provides secondary capital to the industry by using its own funds and also pooling money from other investors. Its typical loans to credit unions are for seven to 10 years at a 4% to 5% interest rate, and currently its largest credit is for $5 million while its smallest is for just $35,000, Sheaffer said.

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Still, a relatively small number of credit unions have taken advantage of secondary capital and that may not change drastically through this cycle. In 2000, just 800 credit unions — out of roughly 10,000 — were designated as low-income. Of those, just 25 had issued secondary capital, according to Peter Duffy, a managing director at Piper Sandler.

Last year, just 68 out of the roughly 2,600 low-income designated institutions issued debt, Duffy said.

There are a few reasons more credit unions don’t take advantage of this option, experts said. Some institutions may not be familiar with the process and are therefore reluctant to go through it. Others may simply not need additional funds to support growth.

Additionally, secondary capital can be expensive, especially if a CU is looking to raise the money when it is struggling.

“There’s a commonly used phrase in the business that it’s better, easier and cheaper to raise capital when you don’t need it,” Duffy said.

Because of that, consolidation could accelerate, at least temporarily, as some credit unions decide to find merger partners. There could also be some institutions taken over by NCUA.

“If you have a well-thought out business plan, you will probably prosper,” Macchiarola said. “If not, then you will be looking like a risk. Consolidation will continue. Weaker credit unions will give way to stronger ones.”

Correction: A previous version of this story incorrectly stated the amount of net worth of the industry. It's $182 billion, not $192 billion.

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Capital Capital requirements NCUA Deposits Coronavirus Failures Consolidations M&A