The competitive implications of prohibiting credit unions from raising supplemental capital are now too serious to ignore and warrant broad discussion. The discussion should include the type of capital a CU can rely on and what tradeoffs may be involved.
Banks Access Capital To Enable Growth
On March 14, three mutual thrifts filed to sell a total of $350 million in stock as part of a planned conversion into the stock form of organization. Their stated use of the capital is for acquisitions, among other things, according to company press releases.
Separately, Rep. Keith Rothfus (R-Pa.) introduced H.R. 4252, proposing to allow mutual capital certificates (MCC) with a five-year term to satisfy regulatory capital requirements for mutual depositories. The bill would also establish the Mutual National Bank (MNB) charter, which would allow a mutual savings bank to avoid the qualified thrift lender test and allow commercial lending in excess of the cap (20% of assets). Additionally, the bill provides for CU charter conversion directly to the MNB.
Banks obtain capital to accommodate their growth strategies, including M&A, and to pay for the technology and staff to meet new operational requirements and regulations. If the long awaited thaw in M&A activity is materializing, larger credit unions may soon see their competitiveness negatively impacted as banks add scale, market presence and efficiencies through M&A.
CUs fund operational improvements solely through retained earnings and without access to capital, credit union mergers will be limited to small combinations due to the dilution of capital that occurs. Over the last four years, the average asset size of an acquired bank ranged from $160 million to $339 million, while the average asset size of the merged credit union ranged from $15 million to $27 million. This disparity will likely widen as M&A thaws. In the two years before the credit bubble popped, the acquired bank asset range was $400 million to $600 million while the CU range was $14 million to $19 million (based on Sandler O'Neill research using FDIC and NCUA call report data).
No Progress For CUs; Wrong Capital Sought
The credit union movement is divided on the legislative priority of supplemental capital. Most don't care while many larger and faster growing credit unions consider it the top priority; (some are willing to trade it for removal of the federal tax exemption). Congress has never considered equity capital for credit unions.
The MCC as proposed in H.R. 4252 are very similar to the Voluntary Patronage Capital Certificates (VPC) in the NCUA White Paper on supplemental capital (released April, 2010) and neither would qualify for tier 1 under Basel III based on these characteristics:
- 20-year maturity and membership of at least 1 year
- minimum $10,000 investment and maximum 15% of shares on deposit
- no voting rights
- proposed as equity classification
- non-cumulative
- no early redemption and no secondary market
- subject to losses as incurred by the CU or as a result of losses in the system which the CU is responsible for (such as assessments for CCU legacy assets)
The term nature of the VPC and MCC would seem to make congressional approval for equity treatment a high hurdle. True equity capital is stock, not debt, and has no term, meaning there is no maturity. The investor accepts the non-maturity nature of stock for the possibility of higher returns over time and the "exit ramp" of a secondary market to sell to for whatever reason.
In the past two years, investors received a 6% to 6.375% coupon for investing in the debt of non-rated banks with a five year maturity and received 4.10% to 7.25% for the debt of rated banks in the 10-15 year maturity range (Sandler O'Neill research). CUs are non-rated institutions with gross income to average assets in the 4.75% to 5.25% range and therefore unlikely to consider debt affordable.
Why CUs Should Be Wary
Even if debt-like instruments were both affordable and treated as equity, CUs should be wary based on history. Instruments such as trust preferred securities and pooled trust preferred securities once qualified for tier 1 treatment but in most instances no longer do. Also, as we learned from the resolution of the savings and loan crisis, supervisory goodwill was provided to healthy thrifts as tier 1 capital treatment to encourage acquisition of troubled thrifts. The acquiring thrift was told they could "write down" the goodwill over 40 years, only to have the congress decide that balances be written down in about five years. The action caused thrifts to record billions in losses.
Another important consideration is member/owner "rights" in the context of supplemental capital.
Is now the time?
Leveraging off debt has not proven to be a reliable foundation for long term growth. The clear trend is that only stock and retained earnings qualify for tier 1 capital. In light of the proposed capital rule, growth minded credit unions should broaden the participants in the discussion for access to capital in order to increase clarity. Waiting could prove troublesome to competitiveness.
Peter Duffy is a managing director at Sandler O’Neill, New York.
