MIAMI – A new report issued by NCUA on last year’s failure of Eastern Financial Florida CU found that the one-time high-flying credit union, as big as $2.4 billion in assets as recently as 2007, was caused by the credit union’s investments in risky financial derivatives known as collateralized mortgage obligations, or CDOs.
“Eastern Financial suffered substantial losses in the CDO investments during 2007 and 2008 that, coupled with increasing loan losses and other contributing operating factors, quickly eroded the credit union’s net worth and led to its insolvency,” said the report, conducted by NCUA’s Office of Inspector General.
Eastern Financial, the largest credit union failure ever, was the only natural person credit union to invest in CDOs, according to NCUA. The credit union was chartered in 1937 to serve employees of Eastern Airlines and joined the ranks of the failed airline last year when it was acquired in a supervisory merger by Space Coast CU. NCUA projects the losses to the National CU Share Insurance Fund on Eastern Financial will be $41 million.
The NCUA report says as the credit union’s profitability lagged its asset growth, management and the board approved a leverage strategy to allow it to invest in risky investments, specifically CDOs, which are bonds constructed of assets-backed bonds. While NCUA rules bar a federally chartered credit union from investing in CDOs, a handful of states, including Florida, permit it for state charters.
At least one other failed credit union, WesCorp FCU, has also reported large losses due to investments in CDOs. Because there were few credit unions investing in CDOs, Eastern Financial relied heavily on a modeling program produced by WesCorp, according to the IG. WesCorp has recorded losses of more than 95% of its $620 million CDO investments.
According to the Inspector General’s report, Eastern Financial acquired $94.8 million of CDOs in March and June of 2007, bringing its CDO portfolio to $149.2 million. “Most of those CDOs deteriorated rapidly in value once purchased.” By 2009, the credit union had “essentially charged off 18 CDO investments resulting in losses of $149.2 million,” a staggering 99% of those investments.
The CDOs were bought in private placements and were not registered with the Securities and Exchange Commission, according to the Inspector General. The bank reform bill being debated in the Senate this week would require these kinds of investments to be traded on a market.
Eastern Financial’s losses, which amounted to $68.9 million in 2007 and $113.5 million in 2008, eventually erased all of its capital and spelled the end of the one-time airline credit union, which had survived the 1991 demise of its chief sponsor to thrive for almost two decades serving more than 1,000 select groups.
The Inspector General found that Eastern Financial began buying the CDOs, which were backed by bonds comprised of subprime home equity and auto loans and corporate debt, as far back as 2005. Management, said the report, did little due diligence and relied solely on ratings assigned to the bonds. Almost $100 million of the CDOs were backed by home equity loan asset-backed securities.
The credit union, said the report, also had a big exposure to member business loans through its CUSO, known as CU Business Capital, and lost millions on several large MBLs.
The CDO investments, said NCUA, were expressly approved by the Florida CU Division, the credit union’s primary regulator. In a September 2005 letter responding to a legal opinion request by Eastern Financial, the state regulator wrote, “since CDOs have characteristics similar to corporate bonds, which are permitted under [state law], it appears the investments in CDOs would be permissible.”
When the mortgage market began to crater in June 2007, the market value of the CDOs and other mortgage-backed securities plummeted. By September 2007, the market value of Eastern Financial’s $149 million of CDOs had plunged by $63.4 million, or 42% of book value.
The Inspector General found that both NCUA and state examiners missed several chances to properly review Eastern Financial’s CDOs early on. “We also believe NCUA and [state] examiners would have benefitted from performing further analysis on the unusual and very complex investment activity for natural person credit unions that were beyond the expertise of EFFCU management,” stated the IG.
During a September 2007 examination, NCUA and Florida examiners issued a supervisory letter to the credit union management directing them to establish comprehensive policies on reasonable limits on CDOs and limits on underlying collateral in the CDOs (or appropriate documentation to substantiate the legality, credit, and investment risks of CDOs). “Unfortunately,” wrote the Inspector General, “by Sept. 30, 2007, EFFCU had already purchased close to $150 million in CDOs that were rapidly deteriorating in value with limited opportunities for divestiture.”
