SAN DIMAS - As much as attention has focused on billion-dollar securities writedowns at the world’s largest financial companies, the fingerprints of fair-value accounting are nowhere more evident than in the arcane and isolated milieu of corporate credit unions.
Because of their mission as liquidity repositories for the more than 8,000 U.S. credit unions, corporate credit unions are stuck with short-funded, highly leveraged, securities-heavy balance sheets that are taking a serious hit from credit market turmoil.
The corporate credit unions and their regulator say that this is merely a temporary problem of perception, and that fair-value accounting’s conflation of market, liquidity, and credit risk is distorting their true financial condition.
As the debate over fair-value accounting continues, the corporate CUs may offer the best forum for debating the meaning of value and price–and how they should be reflected in financial statements.
“Every security we own is performing and cash-flowing, and yet we have a fair-value, temporary writedown of over a billion dollars,” said Jim Hayes, CFO at the $30-billion Western Corporate FCU in San Dimas, Calif. “Just looking at the fair value is just not realistic.”
According to a statement of financial condition filed with NCUA, U.S. Central had $49.4 billion of assets and negative total equity of $689 million at the end of February. That appearance of a deficit has an anti-credit-union cadre in the banking industry smelling blood and raising questions about solvency. Critics also point out that U.S. Central is still waiting for auditors to sign off on its 2007 financial statements.
But solvency is ultimately about meeting payment obligations in a timely manner, and that has not been an issue for U.S. Central.
The statement of financial condition does not include $1.6 billion of capital from its members, who must give three years’ notice before they can withdraw it. And just like bank regulators, the NCUA excludes unrealized securities losses when it calculates regulatory capital. In all, U.S. Central reported close to $2.6 billion of regulatory capital and a capital ratio of 5.62%.
The difference between those two pictures is largely a result of fair-value accounting. U.S. Central had a securities portfolio of $35 billion at the end of April, according to its May 21 financial statements. It invests in securities because that is effectively its mission as a liquidity repository for its members.
The Downside
The downside: virtually its entire balance sheet is subject to mark-to-market accounting. It has few loans, which are excluded from fair-value measurement. Its investment portfolio includes almost $21 billion of nonagency residential mortgage-backed securities, most of which are “level 3” instruments under the fair-value accounting standard–meaning there are few if any discernible market inputs by which to value them. As a result, U.S. Central had a net unrealized loss of $2.4 billion at the end of April.
“It is a reflection of the dislocated market conditions, where the fair values assigned to these highly rated securities are not indicative of their value–it is instead indicative of extreme market dislocation and a lack of liquidity in the market,” said Kathryn Brick, CFO at U.S. Central. “There are no willing buyers and sellers upon which to establish a true fair value” under GAAP.
The situation is similar at WesCorp, which reported a $22-billion securities portfolio in its statement of financial condition for the end of February. It also reported negative total equity of $584 million; adding in member capital and excluding unrealized losses, it had $2 billion of capital and a capital ratio of 6.44%.
“A retail organization has a large portion of its balance sheet in whole loans, and those aren’t required to be marked to market,” Hayes said. “Our securities portfolio and all of the corporate network’s portfolio makes up most of our balance sheet just by virtue of what we do.”
Four other corporate credit unions–Corporate One, Columbus, Ohio; Southwest Corporate, Plano, Texas; Members United Corporate, Warrenville, Ill.; and Constitution Corporate, Wallingford, Conn.–reported negative total equity on their statements of financial condition for the end of February. Including member capital and excluding securities writedowns, all reported capital ratios well above regulatory minimums.
The rating agencies generally take the side of the corporates. Moody’s Investors Service Inc., Standard & Poor’s Corp., and Fitch Inc. rate U.S. Central at one notch beneath triple-A. WesCorp comes in two notches below triple-A, but good enough to qualify as having very strong repayment capacity.
“The bottom line is these are very low-risk entities. Without the marks to market, we wouldn’t even be having this conversation,” said Ken Ritz, an analyst at Fitch. “The portfolio is still made up of very high-quality securities. From a market value standpoint, there has been a significant drop in value, but the credit quality has still been maintained.”
In fact, almost all the corporates’ investment securities have triple-A ratings, as mandated by regulations. Credit spreads and a cratering market for asset-backed securities have hit their fair value, but they generally have reported few, if any, credit impairments on the securities. Regardless of market value, they are considered performing, money-good investments. “It would take a very material erosion in the underlying loans to ever touch principal and interest on the securities they have chosen,” said Blaine Frantz, an analyst who covers corporates at Moody’s. “They have done that specifically because they have a fiduciary responsibility to their members, and their predominant role is a liquidity repository.”
‘Temporarily Impaired’
As an accounting matter, securities can be considered temporarily impaired for only so long before auditors start requiring companies to recognize losses as permanent, but companies need only prove they have the intent and ability to hold the securities until they mature. And the regulator of corporate CUs has little doubt about their ability to do both. “If we believed those securities were other than temporarily impaired, they would be required to write those down, and that would impact capital,” said Kent Buckham, NCUA’s director of corporates. “The investments continue to perform even in this stressed market situation, and they are expected to continue to perform.”
Analysts expect the losses to disappear as spreads narrow and markets stabilize. “If you have the willingness and the ability to hold these assets, over time a lot of these losses will come back into income,” Frantz said. “It will not impair the companies.”
Brick said NCUA has made it clear the corporate will not be forced to sell performing investments at distressed prices, a move that effectively would turn paper losses into real ones. “Because we have many other sources, we would never have to sell securities to come up with liquidity,” she said.
Those sources include member deposits, access to the Federal Home Loan banks, committed credit facilities, and, most recently, the Federal Reserve Board’s discount window.
Whether it will need all those sources is still unclear. Depository institutions depend on public confidence to remain in business, and frequently the perception of financial difficulty is enough to create problems–one reason some executives seem to have almost limitless vitriol for fair-value accounting.
If Brick falls in that category, she’s not saying so, at least for now. “I’m not objective enough to weigh in on fair-value accounting at this time,” she said. “I want to wait until we’ve lived through these market conditions.”
