**SUPERVISORY LETTER**

**NATIONAL CREDIT UNION ADMINISTRATION**

**OFFICE OF EXAMINATION AND INSURANCE**

**1775 DUKE STREET, ALEXANDRIA, VA 22314**

**DATE: February 2009 Supervisory Letter No.: 09-01**

**TO: All Field Staff**

**SUBJECT: Supervision Considerations for Natural Person Credit Unions
and the Announced Corporate Stabilization Efforts**

Recent NCUA Board actions to stabilize the corporate credit union system
will impact individual credit union earnings and net worth ratios. We
are fully aware of the potential concerns and outcomes from such
actions. When examining and supervising credit unions, evaluating
financial trends, and assigning CAMEL codes and risk ratings, examiners
must clearly distinguish between the impact of the actions taken by the
NCUA Board and the decisions made by the credit union's management. The
attached letter provides guidance to consider when supervising your
assigned credit unions.

Credit unions participating in the Credit Union System Investment
Program (CU SIP) may experience temporary reduction in their return on
average assets ratio and dilution in their net worth ratio due to the
additional funds on their balance sheet. Examiners should recognize
these institutions are voluntarily participating in an NCUA Board
initiative to assist with our efforts to address the larger market
liquidity needs present in the credit union system.

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If you have any questions on this issue, please direct them to your
immediate supervisor or regional management.

Sincerely,

/s/

John Kutchey,

Acting Director, Office of Examination and Insurance

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**Supervision Considerations for Natural Person Credit Unions and the
Announced Corporate Stabilization Efforts**

**Background**

Actions recently taken by the NCUA Board will have a financial impact on
all natural person credit unions. This Supervisory Letter provides
guidance to staff on the evaluation of earnings, net worth, and overall
CAMEL and risk ratings of credit unions given the special circumstances
of the actions taken. It is imperative staff differentiate between the
impact of the actions taken by the NCUA Board versus actions and
operational results produced by credit union management and the overall
risk of the financial institution.

**[Corporate Stabilization Efforts]{.underline}**

On January 28, 2009, the NCUA Board approved a series of actions
designed to enhance and support the corporate credit union system.[^1]
The corporate credit union system is facing unprecedented strains on
liquidity and capital due to extraordinary market disruptions and the
current economic climate. To counter the effects of these conditions,
the NCUA Board approved the following actions which impair the National
Credit Union Share Insurance Fund (NCUSIF) Deposit and necessitate a
premium to return the NCUSIF's equity ratio to 1.30 percent:

-   Guaranteed uninsured shares at all corporate credit unions through
    February 2009, and established a voluntary guarantee program for
    uninsured shares of all corporate credit unions through December 31,
    2010;

-   Issued a \$1 billion capital note to U.S. Central Corporate Federal
    Credit Union; and

-   Declared a premium assessment to be collected in 2009 to restore the
    NCUSIF equity ratio to 1.30 percent.

The impact of these actions on individual credit union financial
statements will be:

-   An impairment of the NCUSIF deposit requiring a write-down (expense)
    of a portion, presently estimated at 51 percent, of the credit
    union's NCUSIF Deposit, and

-   An assessment of a premium equal to 0.30 percent of insured shares.

The current estimate for the write-down of the NCUSIF deposit and the
premium assessment will, on average, produce a 62 basis point reduction
in the return on assets for 2009 and reduce the net worth by 56 basis
points.[^2] These figures are estimates and may change in either
direction as economic conditions change. Additional guidance will be
issued to credit unions as we determine the actual amounts which will
affect credit union financial statements.

The actions taken by the NCUA Board allow natural person credit unions
to continue safely supporting the corporate system by maintaining their
current deposits and placing any excess liquidity in their corporate
credit union. Success of the credit union system in weathering the
current economic cycle hinges on the cooperative foundation of the
credit union system.

**[The Credit Union System Investment Program (CU SIP)]{.underline}**

On December 9, 2008, the NCUA Board announced a new initiative to
address system-wide liquidity challenges, the CU SIP.[^3] Under this
program, the Central Liquidity Facility (CLF) will lend funds to credit
unions (a CU SIP advance) to invest in fixed-rate, matched-term NCUSIF
guaranteed notes at a corporate credit union, the proceeds of which are
then used to retire the corporate credit union's external system debt.
This program was designed to improve system-wide liquidity positions by
freeing corporate credit union collateral and providing corporate credit
unions with increased contingent borrowing capacity.

A credit union receiving a CU SIP advance must invest the proceeds in CU
SIP Notes, which are NCUSIF guaranteed senior debt of a corporate credit
union. A credit union will earn ¼ of 1 percent on the difference between
the CLF advance and the CU SIP Note. CU SIP advances have a maximum
one-year term, are fully secured by collateral of the borrowing credit
union, and have interest payable semi-annually. Credit unions interested
in participating can request to participate through their corporate
credit union by the last Friday of the month. Funding and required
investment transactions will occur simultaneously on the second Friday
of each month through June 2009, unless the NCUA Board extends the
Temporary Corporate Credit Union Liquidity Guarantee Program.

**Examiner Responsibilities**

**[Assessment of Earnings]{.underline}**

Examiners must consider the above actions when evaluating a credit
union's earnings. Although the return on average assets will decline
over the short-term, most natural person credit unions have the net
worth to absorb the charge and retain sufficient levels of capital.
Examiners are encouraged to fully evaluate the earnings level and not
take exception to the amount of earnings resulting from these NCUA Board
actions. However, other business decisions made by credit union
management and the impact of those decisions on current and future
earnings must be reflected in the CAMEL earnings component code.
Examiners must evaluate each credit union's earnings level relative to
net worth needs, financial and operational risk exposures, the current
economic climate, and the credit union's strategic plans.

Credit unions investing in the CU SIP will receive a net ¼ of 1 percent
return on the asset. The infusion of funds may reduce the overall return
on assets by increasing the amount of assets. Examiners should not take
exception to the planned, reduced return, attributable to CU SIP
participation. However, examiners should address any unsafe and unsound
risks or practices affecting earnings through discussions with
management, documenting concerns in the examination or supervision
contact, and assigning appropriate CAMEL and risk ratings.

**[Assessment of Net Worth]{.underline}**

When evaluating a credit union's net worth level, as in the evaluation
of earnings, examiners must consider the NCUA Board actions. Although
the net worth ratio may decline over the short-term, most natural person
credit unions have adequate net worth levels to withstand the current
economic environment. Examiners are encouraged to fully evaluate the net
worth level and not take exceptions to the reduction due to the actions
taken by the NCUA Board. In addition, the CU SIP program is an NCUA
initiative, and examiners should not take exception to planned capital
dilution directly attributed to the program.

Net worth evaluations must include both immediate as well as strategic
considerations related to risk and future plans. Examiners should
reflect the impact of any action the credit union management takes to
increase risk in the CAMEL capital component and related risk ratings.
Examiners should continue to address any negative capital trends or
increased risk from unsafe and unsound practices.

**[Prompt Corrective Action and Net Worth Restoration
Plans]{.underline}**

Credit unions whose net worth ratio falls below 7 percent are subject to
Prompt Corrective Action requirements per NCUA Regulation Part 702. Net
worth categories are established by statute and cannot be changed or
temporarily adjusted by the NCUA Board.

NCUA [does]{.underline} have flexibility when reviewing a Net Worth
Restoration Plan. NCUA takes into account why the net worth ratio fell
below 6 percent and how long it will take to increase the ratio to the
"adequately capitalized" level. Examiners and regional office analysts
are instructed to be flexible when reviewing credit union plans and to
consider the impact of any action taken by the NCUA Board, specifically
if that action alone triggers mandatory Prompt Corrective Action.
Approval of the plan should consider the credit union's overall
financial condition and the ability to withstand the current economic
environment. The overall net worth ratio and restoration plans must be
evaluated based on the risks present in the current balance sheet, the
credit union's historical performance, and future strategic plans of the
credit union.

**[Due Diligence]{.underline}**

It is essential credit unions continue to support the corporate credit
union system. It has been NCUA's practice for examiners not to take
exception to credit unions which have invested exclusively in the
corporate system, unless warranted. However, examiners should expect
each credit union to continue performing due diligence on any third
party, including their corporate credit union.[^4] When reviewing the
credit union's due diligence process, the examiner should acknowledge
the credit union's commitment to support the credit union system by
participating in the NCUA Board initiatives. In addition, the due
diligence process will be limited if the credit union deposits funds in
a corporate credit union participating in the uninsured share guarantee.

Since CU SIP reduces the potential borrowing capacity for participating
credit unions, CU SIP investments have been limited (maximum exposure of
37.5 percent of borrowings plus CU SIP advance as a percentage of paid
in and unimpaired capital and surplus), leaving a potential liquidity
cushion should the need arise during the term of the investment. A
credit union should manage its risk of exposure for alternative
borrowing capacity to meet its liquidity needs accordingly. Examiners
should expect sound liquidity management strategies and practices on an
ongoing basis.

**[CAMEL Rating System]{.underline}**

Examiners will continue to use the principles of the Risk Focused Exam
program set forth in Letter to Federal Credit Unions 02-FCU-09 when
evaluating the impact of NCUA Board actions. Examiners are reminded the
CAMEL ratings are based on risk and not determined by a matrix.[^5] NCUA
uses the internal rating system to evaluate the safety and soundness of
credit unions based on the degree of risk to the NCUSIF and for
identifying those credit unions that require additional supervision.
Credit unions still using benchmarks based upon the old matrix system
without adequate risk management processes could lead to unsafe and
unsound business decisions.

Examiners must assign the CAMEL ratings based on the examiner's
qualification of the impact material risk(s) has on the credit union's
soundness and established strategic plans. The risk focused
examinations' seven risk indicator ratings are a forward-looking
assessment. Any program approved by the NCUA Board should be a separate
consideration from the actual risk of the credit union and should not be
an automatic adjustment in CAMEL ratings. Each credit union's earnings
and net worth level must be based on the credit union's unique risk
characteristics, as well as taking into consideration the overall
economic trends. Examiners should continue to document CAMEL ratings and
any material adjustments based on risk within the Scope Workbook.

**Conclusion**

The determination of the CAMEL composite and component ratings, as well
as the seven risk ratings is a judgmental process and requires the
examiner to take into account all of the subjective and objective
variables that affect a credit union's financial and operational
condition, as well as their interrelationships.

It continues to be incumbent on credit unions to proactively develop and
document sound strategic plans. A variety of factors, such as the
contemporary decisions affecting the direction of the risk in a credit
union's balance sheet, require examiners to exercise a high degree of
professional judgment when evaluating the adequacy of earnings and net
worth levels.

Participation in CU SIP should not adversely affect examiner
perspective, recognizing the temporary reduction in earnings and diluted
net worth ratio will be just that, temporary

**It is essential credit union management and examiners maintain an open
and ongoing dialogue on the strategic direction of the credit union in
relation to earnings and net worth and not be overly focused on the
financial impact of the actions taken by the NCUA Board.**

If you have any questions on this issue, please direct them to your
immediate supervisor.

**References**

1.  NCUA Letter to Credit Unions 09-CU-02, January 2009, *Corporate
    Credit Union System Strategy*

2.  NCUA Letter to Credit Unions 08-CU-20, August 2008, *Evaluating
    Current Risks to Credit Unions*

3.  NCUA Letter to Credit Unions 08-CU-17, June 2008, *Impact of the
    Current Mortgage Market on Corporate Credit Unions*

4.  NCUA Letter to Credit Unions 07-CU-12, December 2007, *CAMEL Rating
    System*

5.  NCUA Letter to Federal Credit Unions 06-FCU-04, *Evaluation of
    Earnings*

6.  Supervisory Letter 05-01, August 2005, *Evaluating Capital Adequacy*

7.  NCUA Letter to Federal Credit Unions 02-FCU-09, May 2002,
    *Risk-Focused Examination Program*

[^1]: See NCUA Letter to Credit Unions 09-CU-02, January 2009,
    *Corporate Credit Union System Strategy.*

[^2]: Based on information available at the time the actions were taken
    and is subject to change as economic conditions change. The figures
    were an average for all credit unions and could be materially
    different for each credit union.

[^3]: Examiners can find program materials posted on:
    <http://www.ncua.gov/CLF/index.htm>.

[^4]: NCUA Letter to Credit Unions 08-CU-17 states: "each credit union
    board of directors must independently make investment decisions,
    evaluate risk tolerances, and perform due diligence."

[^5]: CAMEL Rating System was modified by the matrix being eliminated in
    2007. NCUA Letter to Credit Unions 07-CU-12, December 2007, *CAMEL
    Rating System.*