ALEXANDRIA, Va. — As they work to revive U.S. Central FCU and WesCorp FCU, NCUA officials are struggling with a $23-billion question; what to do with the troubled mortgage-backed securities at the two corporate giants that continue to decline in value?
That is the book value - the amount at purchase - of the MBSs held by the two corporates, which were taken over by the regulator on March 20. Those securities are valued now-marked-to-market under current accounting rules - at a little over 50% of their original value and continue to decline in value, according to NCUA.
Most troubling is the fact that a large portion of those MBSs are comprised of risky subprime, Alt-A and Option ARM mortgage securities, which are falling in value as defaults on the underlying assets, the mortgages themselves, are rising at accelerated paces, according to an analysis of the two corporates' portfolios provided by NCUA.
The analysis, which is based on the review by bond experts PIMCO, shows that securities backed by the risky mortgages, most of them rated AAA at purchase, continued to deteriorate over the past two years, forcing down the ratings on many of them to below investment-grade. The downgrades have forced down the market values of the bonds, rendering many of them unmarketable and causing holders, like U.S. Central, WesCorp and other corporates to mark unrealized losses on their books.
At U.S. Central, where 95% of its $35 billion of holdings were rated AAA at purchase, more than half of those holdings - a staggering $17 billion worth - had slid below AAA, while almost a third, $11 billion worth, were below investment grade at Feb. 23, according to NCUA's analysis.
The vast majority of U.S. Central's projected losses are from securities originated in 2006 and 2007, which are just now starting to be affected by soaring defaults on the loans.
At WesCorp, the figures were even more stark, NCUA said. While 86.5% of the corporate's $23 billion of investments were rated AAA at purchase, by Feb. 23, 64% of the portfolio-$14.6 billion-had eroded below that, with 46.5% of the holdings, or $10.7 billion having fallen below investment grade.
The situation has left NCUA with a Catch-22. They can hold the bonds to maturity - some have as many as 20 years to run - and capture much of the principle and interest. But the accelerating rate of defaults may erode much of the payments stream.
Or they can sell the bonds now at a loss and realize the loss on their books. "In the immediate term, our plans are maintaining liquidity so the bonds don't have to be sold," said NCUA Executive Diretor David Marquis, who cited mark-to-market rules that require an entity to realize losses once a holding is sold. "We can't have that happen."
The accounting requirement could affect NCUA's decision whether to participate in the White House plan to buy distressed assets for sale on the secondary market. NCUA is exploring the plan to see which assets may be eligible for purchase and what kind of pricing will be offered.
Another option: creation of a bridge bank-a so-called bad bank-in which distressed assets like the troubled MBSs at U.S. Central and WesCorp would be segregated from good assets and worked off over time. That is, the bonds would either held to maturity or sold when market conditions improve. However, the mark-to-market rules once again posses problems for this approach, noted Marquis.
From a practical standpoint, there is no market for these bonds, especially the private-label MBSs. Marquis said their current plans are to revive the two corporates, at least until the NCUA Board derives a plan to reform the corporate system, a process expected to take months or longer.
NCUA explained in its analysis of the U.S. Central and WesCorp portfolios, as the yields in other investments started to decline, all corporates began to load up on mortgage-backed securities in 2003, so that by 2007 35% of all corporate investments were in MBSs. The federal regulator became alarmed and issued a directive in mid-2007 for corporates to stop buying private-label MBSs, those not guaranteed by a government agency, like Fannie Mae or Freddie Mac.
"During the time frame in which corporate credit unions were investing more heavily in mortgage related securities, significant changes were taking place in the mortgage industry. The use of sub-prime, Alt-A, and interest only mortgage loan products grew at a very rapid rate. These loan products were packaged into the private label MBSs that were being marketed at an increasing magnitude in 2006 and 2007," wrote NCUA.
While the securities were mostly rated AAA during this period, "no reliable historical data existed relating to the performance of the sub-prime and other types of loans that were originated in a period of rapid home price increases and relaxed underwriting criteria," explained the regulator. "As such, ratings did not prove to be a reliable means of determining the quality of these securities.
"Since late-2007, analysis of these securities has been based on actual performance of the underlying assets and projected future performance. This has led to very significant downgrades in the ratings of many of the securities held by corporate credit unions. The downgrades had the most severe impact on the portfolios of WesCorp and U.S. Central."
Beginning in mid-2007, credit and liquidity issues associated with sub-prime mortgages began to surface and eventually spread beyond sub-prime mortgages to prime mortgages., NCUA explained. Then delinquencies increased, foreclosures rates began to rise, housing prices were declining, and confidence in the markets dropped, leading to an inactive mortgage securities market. Corporates with significant levels of investments in mortgage related securities faced two critical issues as a result of the inactive market: liquidity and market value losses.
