National Credit Union Administration: Earlier Actions Are Needed to Better Address Troubled Credit Unions
Published: 2012-01-04T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Corporate credit unions (corporates)financial institutions that provide liquidity and other services to the more than 7,400 federally insured credit unionsexperienced billions in financial losses since the financial crisis began in 2007, contributing to failures throughout the credit union system and losses to the National Credit Union Share Insurance Fund (NCUSIF). Since 1998, Congress has required the National Credit Union Administration (NCUA), the federal regulator of the credit union system, to take prompt corrective action (PCA) to identify and address the financial deterioration of federally insured natural person credit unions (credit unions) and minimize potential losses to the NCUSIF. Legislation enacted in 2011 requires GAO to examine NCUAs supervision of the credit union system and use of PCA. This report examines (1) the failures of corporate and credit unions since 2008, (2) NCUAs response to the failures, and (3) the effectiveness of NCUAs use of PCA. To do this work, GAO analyzed agency and industry financial data and material loss reviews, reviewed regulations, and interviewed agency officials and trade organizations.
section_title: What GAO Found
paragraphs: From January 1, 2008, through June 30, 2011, 5 corporates and 85 credit unions failed. As of January 1, 2008, the 5 failed corporates were some of the largestaccounting for 75 percent of all corporate assetsbut the 85 failed credit unions were relatively smallaccounting for less than 1 percent of total credit union assets. GAO found poor investment and business strategies contributed to the corporate failures. Specifically, the failed corporates over concentrated their investments in private-label, mortgage-backed securities (MBS) and invested substantially more in private-label MBS than corporates that did not fail. GAO also found that poor management was the primary reason the 85 credit unions failed. In addition, NCUAs Office of Inspector General has reported that NCUAs examination and enforcement processes did not result in strong and timely actions to avert the failure of these institutions NCUA took multiple actions to stabilize, resolve, and reform the corporate system. NCUA used existing funding sources, such as the NCUSIF, and new funding sources, including the Temporary Corporate Credit Union Stabilization Fund (Stabilization Fund), to stabilize and provide liquidity to the corporates. NCUA placed the failing corporates into conservatorship and liquidated certain poor performing assets. In order to decrease losses from the corporates failures, NCUA established a securitization program to provide long-term funding for assets formerly held in the portfolios of failed corporates by issuing NCUA guaranteed notes. To address weaknesses highlighted by the crisis, in 2010, NCUA issued regulations to prohibit investment in private-label MBS, established a PCA framework for corporates, and introduced new governance provisions. NCUA considered credit unions ability to repay borrowings from Treasury and included measures to reduce moral hazard, minimize the cost of resolving the corporates, and protect taxpayers. While NCUA has estimated the losses to the Stabilization Fund, it could not provide adequate documentation to allow NCUAs Office of Inspector General or GAO to verify their completeness and reasonableness. Without well-documented cost information, NCUA faces questions about its ability to effectively estimate the total costs of the failures and determine whether the credit unions will be able to pay for these losses. GAOs analysis of PCA and other NCUA enforcement actions highlights opportunities for improvement. For credit unions subject to PCA, GAO found those credit unions that did not fail were more likely subject to earlier PCA actionthat is, before their capital levels deteriorated to the significantly or critically undercapitalized levelsthan failed credit unions. GAO also found that for many of the failed credit unions, other enforcement actions were initiated either too late or not at all. GAO has previously noted that the effectiveness of PCA for banks is limited because of its reliance on capital, which can lag behind other indicators of financial health. GAO examined other potential financial indicators for credit unions, including measures of asset quality and liquidity, and found a number of indicators that could provide early warning of credit union distress. Incorporating such indicators into the PCA framework could improve its effectiveness.
section_title: What GAO Recommends
paragraphs: NCUA should (1) provide its Office Inspector General the necessary documentation to verify loss estimates and (2) consider additional triggers for PCA that would require early and forceful regulatory action and make recommendations to Congress on how to modify PCA, as appropriate. NCUA agreed with both recommendations.

section_title: Letter
paragraphs: The credit union system has undergone a period of financial turmoil since  the financial crisis that began in 2007, resulting in an estimated $5 billion  to $10 billion in losses to the 7,400 credit unions and the institutions that  support them, known as corporate credit unions (corporates). Corporates  are financial institutions whose members are credit unions, not  individuals, and that provide credit unions with payment services,  investment opportunities, and other forms of credit, should credit unions  face liquidity needs. The corporates experienced significant financial  losses during the financial crisis that in turn contributed to losses to the  National Credit Union Share Insurance Fund (NCUSIF). NCUSIF covers  the balance of each member’s account, up to the insurance limit,  including principal and posted dividends through the date of any failure.  The National Credit Union Administration (NCUA) is responsible for  administering NCUSIF, as well as for overseeing federally insured credit  unions, which includes corporates.
To minimize losses to NCUSIF, NCUA is required to take prompt  corrective action (PCA) to identify and address declining capital in credit  unions. Specifically, NCUA is required to classify credit unions into one of  five capital categories, and take mandatory and increasingly severe  supervisory actions, such as restrictions on asset growth, as a credit  union’s capital deteriorates. Prior to the 2007-2009 financial crisis, PCA  for credit unions was largely untested. In particular, after the passage of  the Credit Union Membership Access Act, which established PCA for  credit unions, the growth in the economy meant that the financial  condition of credit unions was generally strong. However, as the financial  crisis unfolded, the financial condition of many credit unions declined,  testing the effectiveness of PCA on a widespread basis.
Legislation enacted in January 2011 requires us to examine NCUA’s  supervision of the credit union system and use of PCA. This report  examines (1) what is known about the causes of any failures among  corporates and credit unions since 2008; (2) the steps that NCUA has  taken to resolve these failures and the extent to which its actions were  designed to protect taxpayers, avoid moral hazard, and minimize the cost  of corporate resolutions; and (3) the effectiveness of NCUA’s use of PCA  and other enforcement actions. This report also contains information on  NCUA’s implementation of its Office of Inspector General (OIG)  recommendations in appendix I.
To determine what is known about the causes of failures among  corporates and credit unions, we obtained and analyzed NCUA  documents, including the OIG’s Material Loss Reviews (MLR), NCUA  postmortem reports, regional examiner reports, and Board Action  Memorandums (BAM). As of November 30, 2011, OIG had issued MLRs  on 5 corporates and 11 credit unions, and NCUA had conducted 15  postmortem reviews on credit unions that failed since 2008. We obtained  and analyzed NCUA data related to conservatorships and resolution  actions from January 2008 to June 30, 2011, to determine the number  and causes of corporate and credit union failures. To corroborate this  information, we assessed the asset size and investment concentrations  for all failed and nonfailed corporates using data from SNL Financial—a  financial institution database. We assessed the reliability of certain data  from this database, which is obtained from credit union financial reports  submitted to the credit union regulators (referred to as call reports), and  found the data to be sufficiently reliable for calculating ratios for our  analysis.lending as a percentage of total loans for the failed credit unions and their  peers that did not fail. We interviewed officials in NCUA’s OIG, Office of  Corporate Credit Unions, Office of Capital Markets, and Office of  Examination and Insurance to gain their perspectives on the causes of  the corporate and credit union failures.
We further calculated ratios of credit union member business  To assess the steps that NCUA has taken to stabilize, resolve, and  reform the credit union system, we analyzed information from BAMs;  MLRs; NCUA’s Corporate System Stabilization and Resolution Plan;  NCUA’s 2008, 2009, and 2010 annual reports; audited financial  statements and other cost estimate information; and NCUA- commissioned reports; in addition to testimonies at relevant  congressional hearings and planning documents. We also analyzed NCUA’s proposed and final rules to determine actions taken to reform the  system. We interviewed officials in NCUA’s OIG, Office of Corporate  Credit Unions, Office of Capital Markets, Office of Examination and  Insurance, and Office of General Counsel to discuss NCUA’s response to  corporate and credit union failures, and efforts to stabilize, resolve, and  reform the system.
To determine the regulatory actions NCUA has taken to address  deteriorating credit unions, we reviewed NCUA’s regulatory information  that included Capital Adequacy, Asset Quality, Management, Earnings  and Liquidity (CAMEL) ratings, enforcement action data, and PCA-related  actions over a 2-year period prior to each credit union failure. To assess  the outcomes of PCA, we analyzed the instances and dates of CAMEL  downgrades, enforcement actions taken, and PCA-related actions to  determine whether and when NCUA examiners took actions for  distressed credit unions subject to PCA from January 1, 2006, through  June 30, 2011. We assessed the data reliability of NCUA’s enforcement  data and found these data to be sufficiently reliable for this analysis. We  reviewed a variety of indicators of credit unions’ financial condition, such  as return on assets, operating expenses, and liquid assets as an early  warning of financial distress. We selected these leading indicators based  on the OIG’s MLRs, NCUA’s postmortem studies, and our previous work  on bank regulation related to PCA. Using these indicators and data from  SNL Financial, we compared the performance of failed credit unions to  peer credit unions that did not fail. We found the data to be sufficiently  reliable for our purposes. We also verified the status of NCUA’s  implementation of OIG recommendations through a documentation  review and interviews with NCUA OIG officials and relevant NCUA  officials. Appendix II contains additional details of our scope and  methodology.
We conducted this performance audit from May 2011 to December 2011  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Credit unions are tax-exempt, cooperative financial institutions run by  member-elected, primarily volunteer boards. To build capital, credit  unions do not issue stock; they are not-for-profit entities that build capital  by retained earnings. Their tax-exempt status and cooperative, not-for- profit structure separate credit unions from other depository institutions.  Like banks and thrifts, credit unions are either federally or state chartered.
subsections: section_title: Credit Union System
paragraphs: Prior to the financial crisis, the credit union system consisted of three  tiers, as shown in figure 1. As of December 31, 2007, there were 8,101  credit unions, 27 corporate credit unions, and 1 wholesale corporate  credit union—U.S. Central Federal Credit Union (U.S. Central). Credit  unions are owned by individual members (natural persons) who make  share deposits and are provided with products and services, such as  lending, investments, and payment processing. Credit unions are subject  to limits on their membership because members must have a “common  bond”—for example, working for the same employer or living in the same  community. Corporates are owned by and serve credit unions.  Corporates provide payment processing services and loans for liquidity  purposes and serve as repositories for credit unions’ excess liquidity,  among other things. In particular, when loan demand is low or deposits  are high, credit unions generally invest excess liquidity in corporates and  then withdraw funds when loan demand is high or deposits are low.  Corporates meet liquidity needs with member deposits and by borrowing  from U.S. Central, capital markets, or the Federal Home Loan Banks.Corporates primarily owned by U.S. Central, which functioned as a  corporate for the corporates, provide the same depository and other  services that corporates provide to credit unions. U.S. Central was the  agent group representative for the Central Liquidity Facility (CLF), which  we discuss later in this section. U.S. Central also acted as an aggregator  of corporate credit union funds, which allowed them better access to the  markets at better rates.
While the corporate system—including both U.S. Central and the  corporates—was designed to meet the needs of credit unions, the  corporates face competition from other corporates and financial  institutions that can provide needed services. For instance, credit unions  may also obtain loans and payment processing from Federal Reserve  Banks. In addition, credit unions can obtain investment products and  services from broker-dealers or investment firms rather than corporates.  Credit union service organizations (CUSO) also compete with corporates  and offer, among other things, investments and payment processing. As  we reported in 2004, corporates seek to provide their members with  higher returns on their deposits and lower costs on products and services  than can be obtained individually elsewhere.
Credit unions and corporates are insured by NCUSIF, which provides  primary deposit insurance for 98 percent of the nation’s credit unions and  corporates. NCUA administers NCUSIF, collects premiums from credit  unions and corporates to fund NCUSIF, and ensures that all credit unions  operate in a safe and sound manner. NCUA is required to maintain  NCUSIF’s equity ratio at a percentage of no less than 1.2 percent and not  more than 1.5 percent of insured shares. In addition, NCUA provides  oversight of the CLF, which lends to credit unions experiencing unusual  loss of liquidity. Credit unions can borrow directly from the CLF or  indirectly through a corporate, which acts as an agent for its members.  U.S. Central was the primary agent for the CLF and was the depository  for CLF funds until August 2009, when NCUA changed its investment  strategy for the liquidity facility.
section_title: NCUA Supervision and Examination of the Corporates and Credit Unions
paragraphs: NCUA supervises and issues regulations on operations and services for  federally chartered credit unions and for both state- and federally  chartered corporates. NCUA has supervisory and regulatory authority  over both state- and federally chartered corporates because they provide  services to federally insured credit unions. In addition, NCUA shares  responsibility for overseeing state-chartered credit unions to help ensure  they pose no risk to the insurance fund.
NCUA categorizes corporate supervision into three categories (Types I, II, and III) based  on asset size, investment authorities, complexity of operations, and influence on the  market or credit union system. For example, a corporate with Type III supervision  generally has billions of dollars in assets, exercises expanded investment authorities,  maintains complex and innovative operations, and has a significant impact in the  marketplace and on the credit union system. NCUA assigns a full-time, on-site examiner  to corporates with Type III supervision. agency examinations, performs off-site monitoring, and conducts joint  examinations of credit unions with state supervisory agencies.
As part of its on-site examinations, NCUA assesses a credit union’s  exposure to risk and assigns risk-weighted ratings under the CAMEL  rating system. The ratings reflect a credit union’s condition in five  components: capital adequacy, asset quality, management, earnings, and  liquidity. Each component is rated on a scale of 1 to 5, with 1 being the  best and 5 the worst. The five component ratings are then used to  develop a single composite rating, also ranging from 1 to 5. Credit unions  with composite ratings of 1 or 2 are considered to be in satisfactory  condition, while credit unions with composite ratings of 3, 4, or 5 exhibit  varying levels of safety and soundness problems. A similar rating system,  known as the Corporate Risk Information System, is used to assess the  corporates.
NCUA has the authority to take an enforcement action against credit  unions and corporates to correct deficiencies identified during an  examination or as a result of off-site monitoring. NCUA can issue letters of  understanding and agreement, which is an agreement between NCUA and  the credit union or corporate on certain steps the credit union or corporate  will take to correct deficiencies. They can also issue preliminary warning  letters, which is an NCUA directive to a credit union or corporate to take  certain actions to correct deficiencies. Further, NCUA can issue a cease- and-desist order, which requires a credit union or corporate to take action  to correct deficiencies. Although not considered an enforcement action,  NCUA examiners also can issue documents of resolution to record NCUA’s  direction that a credit union or corporate take certain action to correct a  deficiency or issue within a specified period.
NCUA also has a number of options for dealing with a credit union or  corporate that has severe deficiencies or is insolvent. It can place the  institution into conservatorship—that is, NCUA takes over the credit  union’s or corporates’ operations. After NCUA assumes control of the  institution’s operations, it determines whether the credit union or  corporate can continue operating as a viable entity. To resolve a credit  union or corporate that is insolvent or no longer viable, NCUA may merge  it with or without assistance, conduct a purchase and assumption, or  liquidate its assets. In an assisted merger, a stronger credit union or  corporate assumes all the assets and liabilities of the failed credit union or  corporate with NCUA providing financial incentives or an asset guarantee.  In a purchase and assumption, another credit union or corporate  purchases specific assets and assumes specific liabilities of the failed  corporate or credit union. In liquidation, NCUA sells the assets of a failed  credit union or corporate.
section_title: PCA Framework
paragraphs: PCA is a comprehensive framework of mandatory and discretionary  supervisory actions for credit unions. PCA is based on five categories  and their associated net worth ratios—that is, capital as a percentage of  assets (see table 1). If a credit union falls below well capitalized (7  percent net worth), the credit union is required to increase retained  earnings. When NCUA determines the credit union is in the  undercapitalized, significantly undercapitalized, or critically  undercapitalized categories, NCUA is required to take additional  mandatory supervisory actions. In addition to these mandatory  supervisory actions, NCUA often enforces discretionary supervisory  actions. Discretionary supervisory actions are applied to credit unions that  fall into the undercapitalized category or below and include requiring  NCUA approval for acquisitions or new lines of business, restricting  dividends paid to members, and dismissing the credit union’s board  members or senior management.
Before 2010, U.S. Central and other corporate credit unions were not  subject to PCA but were instead required to maintain total capital at a  minimum of 4 percent of their moving daily average net assets. Total  capital for U.S. Central and corporate credit unions was calculated using  any combination of retained earnings, paid-in capital, or membership  capital. If total capital fell below this level, NCUA required U.S. Central or  the corporate to submit a capital restoration plan. If the capital restoration  plan was inadequate or the corporate failed to complete the plan, NCUA  could issue a capital directive. A capital directive orders the corporate to  take a variety of actions including reducing dividends, ending or limiting  lending of certain loan categories, ending or limiting the purchase of  investments, and limiting operational expenses in order to achieve  adequate capitalization within a specified time frame.
section_title: Corporate and Credit Union Failures Were Largely the Result of Poor Investment Strategies and Weak Management
paragraphs: From January 1, 2008, to June 30, 2011, 5 corporates and 85 credit  unions failed. The five failed corporates—U.S. Central, Western  Corporate (Wescorp), Members United, Southwest, and Constitution— were some of the largest institutions within the corporate system,  although the credit unions that failed were relatively small. Specifically,  these five failed corporates accounted for 75 percent of all corporate  assets as of December 31, 2007 (see fig. 2). In contrast, the 85 credit  unions that eventually failed represented around 1 percent of all credit  unions and less than 1 percent of total credit union assets, as of  December 31, 2007.
NCUA’s OIG MLRs of the failed corporates and our analysis of historical  financial data for the corporate system show that management of both  U.S. Central and the failed corporate credit unions made poor investment  decisions. Specifically, U.S. Central and the failed corporates  overconcentrated their investments in private-label, mortgage-backed  securities (MBS), investing substantially more in private-label MBS than  corporate credit unions that did not fail (see fig. 3). At the end of 2007,  the five failed corporates had invested 31 to 74 percent of their assets in  private-label MBS. In particular, Wescorp and U.S. Central had invested  74 percent and 49 percent, respectively, of their portfolio in private-label  MBS. In contrast, 10 of the 23 remaining corporates had also invested in  private-label MBS but at lower levels—for example, from 1 to 19  percent. These high concentrations of private-label MBS exposed the  failed corporates to the highs and lows of the real estate market, which  experienced significant losses.
Furthermore, corporates had significant deposits in U.S. Central, which  led to indirect exposure to its high concentration of private-label MBS and  losses when it failed. For example, in 2007, Members United had  invested more than 40 percent of total assets in U.S. Central, and  Southwest and Constitution had each invested approximately 30 percent  of total assets, according to the MLRs.
In addition to poor investment decisions, the business strategies U.S.  Central and the other four failed corporates’ pursued contributed to their  failure. Specifically, their management implemented business strategies  to attract and retain credit union members by offering lower rates on  services and higher returns on investments. According to the MLRs, U.S.  Central shifted towards an aggressive growth strategy to maintain and  increase its market share of corporates. This strategy led its management  to increase its holdings of high-yielding investments, including private- label MBS. From 2006 to 2007, U.S. Central’s assets grew by 22 percent  as members invested their liquid funds in return for competitive rates. The  other failed corporates implemented similar business strategies.
The financial crisis exposed the problems in the corporates’ investment  and business strategies, leading to a severe liquidity crisis within the  credit union system. Specifically, the downturn severely diminished the  value and market for private-label MBS and depositors lost confidence in  the corporate system because of the institutions’ substantial investment in  these securities. The decline in value of these investments resulted in  corporates borrowing significant amounts of short-term funds from outside  of the credit union system to meet liquidity needs as credit unions  reduced their deposits. However, these options became limited when  credit rating agencies and lenders lost confidence in individual corporates  and some lines of credit were suspended. For example, from 2007 to  2009, credit rating agencies downgraded U.S. Central’s long- and short- term credit ratings, and in 2009, the Federal Reserve Bank of Kansas City  downgraded its borrowing ability. Eventually, the deterioration of the  underlying credit quality of the private-label MBS led to the corporates’  insolvencies.
subsections: section_title: Poor Management Was the Primary Reason That 85 Credit Unions Failed
paragraphs: According to our analysis of NCUA’s and its OIG’s data, the 85 credit  union failures were primarily the result of poor management.Management of failed credit unions exposed their institutions to increased  operational, credit, liquidity, and concentration risks, which it then failed to  properly monitor or mitigate. The following describes these risks and  provides examples of how exposure to these risks led to the failure of a  number of credit unions.
Operational risk includes the risk of loss due to inadequate or failed  internal controls, due diligence, and oversight. We found that  management’s failure to control operational risk contributed to 76 of the  85 failures. For example, Norlarco Credit Union’s management had weak  oversight policies and controls for an out of state construction lending  program and failed to perform due diligence before entering into a  relationship with a third party responsible for managing it. Norlarco’s  management allowed the third party to have complete control in making  and overseeing all of the credit union’s residential construction loans,  leading to a decline in borrower credit quality and underreported  delinquencies. Potential losses from its residential construction loan  program led to Norlarco’s insolvency.
Management’s failure to control operational risk can also create the  potential for fraud. We analyzed NCUA’s and its OIG’s data and found  that fraud or alleged fraud at credit unions contributed to 29 of 85 of credit  union failures. According to NCUA, credit unions with inadequate internal  controls are susceptible to fraud. In addition, NCUA’s internal  assessments of fraud showed that their examiners often had cited  inactive boards or Supervisory Committees, limited number of staff, and  poor record keeping before the fraud was discovered at the failed credit  unions. For example, the OIG reported that Certified Federal Credit  Union’s internal controls were severely lacking, enabling the chief  executive officer to report erroneous financial results to the credit union’s  board and in quarterly call reports. According to the MLR, before the fraud  was identified, the credit union’s board was weak and unresponsive to  repeated reports of inaccurate accounting records and weak internal  controls from NCUA examiners and external auditors. The credit union  was involuntarily liquidated in 2010. NCUA OIG officials told us that some  other indicators of potential fraud are high ratios of investments to assets  and a low number of loan delinquencies.
Credit risk is the possibility that a borrower will not repay a loan or will  default. We found that management’s failure to control for credit risk  contributed to 58 of the 85 credit union failures. For example, Clearstar  Financial Credit Union management originated and funded a significant  number of loans that were poorly underwritten—that is, they were made  to borrowers with poor credit histories. Management then compounded  these mistakes by extending delinquent loans and poor collection  practices, contributing to the credit union’s eventual failure.
Moreover, management at some failed credit unions did not consistently  monitor the credit risk associated with member business loans (MBL).  With some limitations, credit unions can lend to their members for  business purposes. However, these loans can be risky for credit unions.  For example, NCUA reported in recent congressional testimony that due  to the lack of credit union expertise and challenging macroeconomic  conditions, over half of the losses sustained by the NCUSIF were related  to MBLs for a two year period in the late 1980s. Our analysis of NCUA’s  and its OIG’s data indicated that MBLs contributed to 13 of the 85 credit  union failures. According to our analysis of historical financial data, failed  credit unions had more MBLs as a percentage of assets than peer credit  unions that did not fail or the credit union industry (see fig. 4). In  addition, more than 40 percent of failed credit unions participated in  member business lending. Comparatively, NCUA had testified that only  30 percent of all credit unions participated in member business lending,  as of March 31, 2011.
Liquidity risk is the risk that the credit union may not be able to meet  expenses or cover member withdrawals because of illiquid assets. We  found that liquidity risk contributed to 31 of the 85 credit union failures.  For example, the management of Ensign Federal Credit Union relied on a  $12 million deposit to fund credit union operations. However, when the  deposit was withdrawn in 2009, the credit union lacked other funding  sources to meet normal member demands and operational expenses,  contributing to the credit union’s failure.
Concentration risk is excessive exposure to certain markets, industries, or  groups. While some level of concentration may not be avoidable, it is the  responsibility of management to put in place appropriate controls,  policies, and systems to monitor the associated risks. We found that  concentration risk contributed to 27 of the 85 credit union failures. For  example, High Desert Federal Credit Union’s management began  expanding its real estate construction lending in 2003, and by 2006, its  loan portfolio had more than doubled from $73 million to $154 million. In  2006, construction lending accounted for more than 60 percent of the  credit union’s loan portfolio. When the housing market collapsed, its  concentration in the real estate construction loans led to its insolvency.
section_title: OIG Identified Weaknesses in NCUA’s Examination Processes for Corporates and Credit Unions
paragraphs: In addition to the management weaknesses in corporates and credit  unions, NCUA’s examination and enforcement processes did not result in  strong and timely actions to avert the failure of these institutions. The OIG  found that stronger and timelier action on the part of NCUA could have  reduced losses from the failures from U.S. Central and the four other  failed corporates. NCUA examiners had observed the substantial  concentration of private-label MBS for U.S Central and three of the four  other corporates that failed prior to 2008, but did not take timely action to  address these concentrations. For example, NCUA examiners observed  Wescorp’s growing concentration in private-label MBS beginning in 2003;  but they did not limit or take action to address this issue until 2008.  Similarly, the OIG’s material loss review of Southwest Corporate cites that  NCUA’s March 2008 exam concluded, “current and allowable MBS  exposures are significant given the unprecedented market dislocation…  Southwest’s exposure is clearly excessive.” However, the MLR did not  indicate that NCUA issued a document of resolution or enforcement  action to address Southwest’s high concentration. In the case of  Constitution Corporate, the MLR noted that NCUA took enforcement  action to address concentration limits prior to failure.
Similar to its findings for corporate failures, the OIG found weaknesses in  NCUA’s examination and enforcement processes for 10 of the 11 failed  credit unions for which it conducted MLRs. In particular, the OIG stated  that “if examiners acted more aggressively in their supervision actions,  the looming safety and soundness concerns that were present early-on in  nearly every failed institution, could have been identified sooner and the  eventual losses to the NCUSIF could have been stopped or mitigated.”
The OIG made a number of recommendations to address the problems  that the financial crisis exposed. For example, to better ensure that  corporate credit unions set prudent concentration limits, the OIG  recommended that NCUA provide corporate credit unions with more  definitive guidance on limiting investment portfolio concentrations. Based  on the credit union failures, the OIG recommended that NCUA take steps  to strengthen their examinations process by, among other things,  improving the review of call reports and third-party relationships, as well  as following up credit union actions in response to documents of  resolution and the quality control review process for examinations.  Appendix I contains more information on the status of NCUA’s  implementation of OIG’s recommendations.
section_title: NCUA Has Taken Various Actions to Stabilize and Reform the Corporate System
paragraphs: NCUA took actions to stabilize, resolve, and reform the corporate system  and to minimize the costs of its intervention. NCUA based these actions  on four guiding principles:  to avoid any interruption of services provided by corporate credit  unions to credit unions;  to prevent a run on corporate shares by maintaining confidence in the  overall credit union system;  to facilitate a corporate resolution process in line with sound public  policy that is at the least possible cost to the credit unions over the  long term, while avoiding moral hazard; and  to reform the credit union system through new corporate rules with a  revised corporate and regulatory structure.
NCUA established a number of measures to ensure that corporates had  access to liquidity. To resolve the failed corporates, NCUA placed five  corporates—U.S. Central, Wescorp, Members United, Southwest, and  Constitution—into conservatorship and isolated their nonperforming  assets. To reform the system, NCUA enacted new rules to address the  causes of the failures, assessed credit unions for corporate losses,  forecasted the impact of future assessments through scenario tests, and  took measures to reduce moral hazard. Through these actions, NCUA  attempted to resolve the corporates’ losses at the least possible cost.  However, we could not verify all NCUA’s estimated losses of the  corporates’ and credit union failures.
subsections: section_title: NCUA Used Existing and Temporary Funding Sources to Stabilize the Corporate System
paragraphs: To provide liquidity, NCUA used two existing funds—NCUSIF and CLF— and based on legislative changes, created a temporary fund—the  Temporary Corporate Credit Union Stabilization Fund (Stabilization  Fund). NCUA also created four new programs—the Credit Union System  Investment Program (CU-SIP), the Credit Union Homeowners’  Affordability Relief Program (CU-HARP), the Temporary Corporate Credit  Union Liquidity Guarantee Program (Liquidity Guarantee Program), and  the Temporary Corporate Credit Union Share Guarantee Program (Share  Guarantee Program). See appendix III for more information about these  programs.
NCUA used NCUSIF to provide liquidity to the corporate system. As  stated earlier, U.S. Central had experienced substantial losses, impairing  its ability to provide liquidity to the credit union system. In December  2008, NCUA provided for a NCUSIF loan to U.S. Central to cover an end- of-year liquidity shortfall. The loan was outstanding for 3 days and then  fully repaid. In January 2009, NCUA placed a $1 billion capital note in  U.S. Central. NCUSIF subsequently wrote off this note when it  determined the credit losses on the private label MBS (held by U.S.  Central) impaired the full value of the note.
To avoid compromising its borrowing authority with Treasury, NCUA changed the CLF’s  investment strategy in mid-2009. Specifically, before 2009, the CLF’s funds from  subscribed capital stock and retained earnings placed in a deposit account with U.S.  Central, the CLF agent. However, given U.S. Central’s insolvency, NCUA moved its funds  out of U.S. Central and invested them with Treasury in 2009, to avoid an adverse  accounting treatment for the fund—thereby reducing the fund’s member equity and  ultimately limiting its borrowing authority with Treasury. restricted from lending directly to corporates, NCUA then used funds from  NCUSIF to lend $5 billion to U.S. Central and $5 billion to Wescorp. By  October 2010, U.S. Central and Wescorp had repaid their loans to  NCUSIF using funds raised primarily from the sale of more than $10  billion in unencumbered marketable securities that sold near their par  value in August and September 2010.$10 billion CLF loan with proceeds from asset sales.
In addition, NCUA used a temporary fund created by Congress in 2009 to  help increase liquidity in the system. In May 2009, Congress passed the  Helping Families Save Their Homes Act, which, among other things,  created a temporary fund to absorb losses from corporates. the act created the Stabilization Fund, which replaced NCUSIF as the  primary source to absorb the corporates’ losses. The act also amended the  Federal Credit Union Act to give NCUA the authority to levy assessments  over the life of the Stabilization Fund to repay the corporates’ losses  instead of repaying them in a lump sum. In addition, it increased NCUA’s  borrowing authority with Treasury up to $6 billion through a revolving loan  fund to be shared between the Stabilization Fund and NCUSIF.
Amending the Federal Credit Union Act, 12 U.S.C. §§ 1751-1795k. funds to pay down their external debt, freeing up assets that had been  posted as collateral against the debt. In exchange for participating in  the programs, the corporates were required to pay CLF borrowing  costs to credit unions and an additional fee to the credit unions as an  incentive for them to participate in the programs. CLF lending to credit  unions totaled approximately $8.2 billion under CU-SIP and about  $164 million under CU-HARP. All borrowings for both programs were  repaid in 2010.
Liquidity Guarantee Program and Share Guarantee Program. NCUA  created these two temporary guarantee programs in late 2008 and  early 2009 to help stabilize confidence and dissuade withdrawals by  credit unions, in an attempt to avoid a run on the corporates. These  programs provided temporary guarantees on certain new unsecured  debt obligations issued by eligible corporates and credit union shares  held in corporates in excess of $250,000. Initially, NCUA provided the  coverage to all the corporates for a limited time but later provided  extensions to continue guaranteeing coverage to corporates that did  not opt out of the program. Based on NCUA’s 2009 financial  statements, no guarantee payments were required for either program.  However, as of December 19, 2011, the audited financial statements  for calendar year 2010 of the Stabilization Fund were not completed  and available.
section_title: NCUA Took Steps to Resolve Corporate Failures and Maintain Ongoing Payment System Functions
paragraphs: NCUA took a variety of steps to resolve the failed corporates and  maintain corporate payment processing services for credit unions. First, in  April 2009, NCUA enacted a temporary waiver to allow corporates not  meeting their minimum capital requirements to continue to provide  services to credit unions. In particular, the waiver allowed corporates to  use their capital levels of record on their November 2008 call reports in  order to continue providing the necessary core operational services to  credit unions. In addition, it granted the Office of Corporate Credit Unions  discretionary authority to modify or restrict the use of this capital waiver  for certain corporates based on safety and soundness considerations.  Without the waiver, corporates that failed to meet the minimum capital  requirements would have had to cease or significantly curtail operations,  including payment system services and lending and borrowing activities.  As a result, the credit union system would have faced substantial  interruptions in its daily operations, potentially leading to a loss of  confidence in other parts of the financial system.
Second, NCUA ultimately placed the five failing corporates into  conservatorship. According to NCUA, it placed the corporates into  conservatorships to reduce systemic exposure, exert greater direct  control, improve the transparency of financial information, minimize cost,  maintain confidence, and continue payment system processing. When  placing the five corporates into conservatorship, NCUA replaced the  corporates’ existing boards, the chief executive officers, and in some  cases, the management teams and took over operations to resolve the  corporates in an orderly manner. As a part of the conservatorships,  NCUA set up bridge institutions for the wholesale corporate—U.S.  Central—and the three other corporates. Through these bridge  institutions, NCUA managed the corporates’ illiquid assets and  maintained payment services to the member credit unions. The member  credit unions must provide sufficient capital to acquire the operations of  these bridge institutions from NCUA.
Third, NCUA established a securitization program to provide long-term  funding for the legacy assets formerly held in the securities portfolios of  certain corporate credit unions by issuing NCUA-guaranteed notes.  NCUA’s analysis showed that MBS were trading at market prices  considerably below the intrinsic value that would eventually be received  by long-term investors. NCUA used a method similar to the “good bank-bad bank” model that the Federal Deposit Insurance Corporation has  sometimes adopted with insolvent banks to remove illiquid or “bad” assets  from the failed corporates. In particular, NCUA transferred the corporates’  assets into Asset Management Estates, also known as liquidation  estates. Using these estates, NCUA held and isolated the corporates’  illiquid assets (i.e., MBS) from the bridge institutions and issued the  NCUA-guaranteed notes.
NCUA issued $28 billion (at the point of securitization) in these NCUA- guaranteed notes, while the face value of the original MBS assets was  approximately $50 billion. notes so that its value would approximate the value of the principal and  interest cash flows on the underlying legacy assets. NCUA officials said  that by structuring the notes in this manner, NCUA minimized its  exposure in the event that the underlying cash flow was less than the  notes’ value. According to NCUA’s term sheet, cash flows from the  underlying securities will be used to make principal and interest payments  to holders of the notes, and NCUA guarantees timely payments. NCUA  issued 13 separate notes, with the final sales occurring in June 2011 and  maturing between 2017 and 2021. Any necessary guarantee payments  are to be made from the Stabilization Fund, which also expires in 2021.
NCUA structured each of the guaranteed  Finally, as of November 2011, NCUA has initiated lawsuits against parties  it believes are liable for the corporates’ MBS-related losses. These  lawsuits allege violations of federal and state securities laws and  misrepresentations in the sale of hundreds of securities, according to  NCUA.
NCUA relied on external consultants—in addition to its own analysis—to estimate its  losses from the failed corporate credit unions.
section_title: NCUA Enacted Rules to Address the Causes of Corporate Failures
paragraphs: NCUA issued a new rule for corporates to address the key causes of the  failures. Among other things, the rule (1) eliminates the definition and  separate treatment of the wholesale corporate or third tier of the credit  union system, (2) prohibits corporates from investing in certain securities  and set sector concentration limits, (3) creates a new system of capital  standards and PCA for corporates, and (4) introduces new corporate  governance requirements. Some parts of the new rule addresses the  recommendations of NCUA’s OIG. NCUA issued the rule on October 20,  2010, and it will be implemented over a number of years. For additional  information on the rule, see appendix IV.
Essentially eliminate the wholesale corporate or third tier of the credit  union system. The new corporate rule that NCUA issued on October  20, 2010, eliminated both the definition of and the requirements  applicable to a wholesale corporate or the third tier of the credit union  system. NCUA essentially eliminated the wholesale corporate, in  part, to mitigate inefficiency and systemic risk in the credit union  system. The failure of U.S. Central, the credit union system’s only  wholesale corporate, highlights some of the risks. Specifically, its  failure contributed to the failure of three corporates, instability in the  other corporates, and substantial losses to the Stabilization Fund.
Prohibit corporates from certain investments and set sector  concentration limits. NCUA amended the corporate rule to prohibit  certain investments, such as private-label MBS, and set certain sector   In addition to prohibiting private-label MBS, the concentration limits. rule prohibits corporate investments in collateralized-debt obligations,  net interest-margin securities, and subordinated securities. Previously,  corporates were allowed to set their own sector concentration limits,  which enabled them to continually increase their limits or set  excessive limits. The new rule sets maximum sector concentration  limits for corporate investments and addresses OIG recommendations  that NCUA provide corporates with more definitive guidance on  limiting investment portfolio concentrations. Corporates are limited to  investing less than 1,000 percent of capital or 50 percent of total  assets in specific investments, including agency MBS, corporate debt  obligations, municipal securities, and government-guaranteed student  loan asset-backed securities. Furthermore, corporates are restricted  from investing more than 500 percent of capital or 25 percent of total  assets in other asset-backed security sectors, including auto loans  and leases, private-label student loans, credit card loans, or any  sector not explicitly noted in the rules. NCUA has taken additional  steps to mitigate the associated risk by limiting the weighted-average  life of the portfolio to approximately 2 years. NCUA also tightened the  limits on securities purchased from a single obligor from 50 percent of  capital to 25 percent.
Create a new system of capital standards and PCA for corporates.
NCUA’s new corporate rule also established a revised set of capital  standards for corporates and PCA framework. The new capital  standards replace the existing 4 percent mandatory minimum capital  requirement with three minimum capital ratios, including two risk-  The risk- based capital ratios and a leverage ratio (see table 2). based capital and interim leverage ratios became enforceable on  October 20, 2011, and all corporates were required to meet these  capital standards. Starting in October 2011, corporates are also  subject to PCA if their capital falls below the adequately capitalized  level for any of the three capital ratios. As discussed earlier, a  corporate becomes subject to more severe supervisory actions and  restrictions on its activities if its capital continues to fall.
Introduce new corporate governance requirements. NCUA has  instituted a new corporate governance rule. To ensure that corporate  board members have adequate knowledge and experience to oversee  sophisticated corporate investment and operation strategies, they  must hold an executive management position, such as chief executive  offer, chief financial officer, or chief operating officer of a credit  union. Corporate board members are also prohibited from serving  on more than one corporate credit union board. According to NCUA,  this restriction will help ensure that board members’ loyalty is  undivided and that they are not distracted by competing demands  from another corporate. Effective October 21, 2013, the majority of a  corporate’s board members must be representatives from member  credit unions. The purpose of this rule is to limit another corporate  from serving other corporates rather than serving their member credit  unions. In addition, the governance rules require disclosure of  executive compensation and prohibit “golden parachutes”—lucrative  benefits given to executives who are departing their jobs.
section_title: NCUA’s Total Loss Estimates Related to Credit Union Failures Were Unavailable
paragraphs: NCUA’s audited financial statements for NCUSIF reported an allowance  for loss of $777.6 million at December 31, 2010. This allowance for loss  represents the difference between funds expended to close failed retail  credit unions and the amounts NCUA estimates it will recover from the  disposition of the failed retail credit unions’ assets. Also, these financial  statements reported additional estimated losses of about $1.23 billion as  of December 31, 2010, associated with troubled credit unions considered  likely to fail.
With respect to the Stabilization Fund, the 2010 audited financial  statements were not yet final, as of December 19, 2011. NCUA officials  cited ongoing challenges in resolving and valuing failed corporate assets  as contributing to the delays in finalizing the Stabilization Fund financial  statements. We requested documentation adequate to support NCUA’s  estimates of losses from corporate failures, but NCUA was not able to  provide the documentation we required. The NCUA OIG was provided  with the same information that we obtained and told us that they were  unable to verify NCUA’s loss estimates. Absent this documentation, it is  not possible to determine the full extent of losses resulting from corporate  credit union failures. Moreover, without well-documented cost information,  NCUA faces questions about its ability to effectively estimate the total  costs of the failures and determine whether the credit unions will be able  to pay for these losses.
section_title: Credit Unions Are Responsible for Repaying Loans, but Risks Remain
paragraphs: Credit unions are responsible for repaying NCUSIF and the Stabilization  Fund, and NCUA has begun to assess credit unions for those losses.  NCUA borrowed taxpayer funds from Treasury to fund NCUSIF and the  Stabilization Fund to provide liquidity to the corporate system and it plans  to repay the debt to Treasury with interest by 2021. Since 2009, NCUA  has assessed credit unions a total of about $5 billion (about $1.7 billion  for NCUSIF and $3.3 billion for the Stabilization Fund).
NCUA officials told us that they had analyzed the credit unions’ ability to  repay by determining the impact that varying assessment levels would  have on the net worth ratios of both individual credit unions and the credit  union system. NCUA considers factors such as the number of credit  unions that would fall below 2 percent capital or be subject to PCA’s net  worth restoration plan. In 2011, NCUA levied a $2 billion assessment for  the Stabilization Fund. According to NCUA officials, NCUA determined  that the credit union system had enough surplus capital to pay the  assessment because of its strong return on assets of 0.86 percent for first  three quarters of the year. NCUA determined that the assessment would  result in around 811 credit unions having a negative return on assets.  NCUA officials also noted that in a typical year about 10 to 20 percent of  credit unions have had a negative return on assets. According to NCUA  officials, the primary driver for the $2 billion Stabilization Fund  assessment in 2011 was interest and principal on maturing medium-term  notes that the corporates issued and that were to be repaid by the  Stabilization Fund. NCUA officials told us that if they had found that the  credit unions could not afford the Stabilization Fund assessment, they  would have considered other options, such as issuing additional NCUA- guaranteed notes or unsecured debt.
Although NCUA officials have stated that the credit union system will bear  the ultimate costs of corporate and credit union failures, risks to the  taxpayers remain. However, many of the reforms are ongoing and NCUA  continues to resolve the failure of U.S. Central and Wescorp, as will be  discussed. Moreover, the ultimate effectiveness of NCUA’s actions and  associated costs remain unknown. As a result, whether the credit union  system will be able to bear the full costs of the losses or how quickly  NCUA will repay Treasury is unknown. Should the credit union system be  unable to repay Treasury through NCUA assessments, taxpayers would  have to absorb the losses.
section_title: NCUA Took Measures to Reduce Moral Hazard in Designing the Assistance and Reforms
paragraphs: Moral hazard occurs when a party insulated from risk may behave  differently than it would behave if it were fully exposed to the risk. In the  context of NCUA’s actions to stabilize the credit union system, moral  hazard occurs when market participants expect similar emergency  actions in future crises, thereby weakening their incentives to manage  risks properly. Furthermore, certain emergency assistance can also  create the perception that some institutions are too big to fail. In general,  mitigating moral hazard requires taking steps to ensure that any  government assistance includes terms that make such assistance an  undesirable last resort, except in the direst circumstances, and specifying  when the government assistance will end. For example, we previously  reported that during the 2007-2009 financial crisis, the federal  government attached terms to the financial assistance it provided to  financial institutions such as (1) limiting executive compensation,   (2) requiring dividends be paid to providers of assistance, and   (3) acquiring an ownership interest—all of which were designed to  mitigate moral hazard to the extent possible.
NCUA designed actions to mitigate moral hazard at various stages of its  effort to resolve and reform the corporate credit union system, but the  effectiveness of these actions remains to be seen. Examples of the  actions designed to mitigate moral hazard include terminating the  corporates’ management teams and eliminating their boards, issuing  letters of understanding and agreement as a condition to entering the  Share Guarantee Program, requiring a guarantee fee under the Liquidity  Guarantee Program, requiring credit unions to repay the losses to  NCUSIF and the Stabilization Fund, filing lawsuits against responsible  parties, and requiring credit unions to disclose executive compensation.  In addition, NCUA enhanced market discipline by requiring corporates to  obtain capital from their member credit unions to remain in operation.  That is, member credit unions decided whether to capitalize new  corporates. As of October 30, 2011, the two of the four bridge  corporates—Wescorp Bridge and U.S. Central Bridge—had either not  succeeded in obtaining sufficient member capital (Wescorp) or had not  attempted to do so because of a lack of anticipated demand (U.S.  Central). They are both being wound down by NCUA.
section_title: NCUA’s Use of PCA and Other Enforcement Actions Illustrate the Need to Improve Their Effectiveness
paragraphs: Credit unions that triggered PCA had mixed results. Our analysis of credit  unions that underwent PCA indicates corrective measures that were  triggered earlier were generally associated with more favorable  outcomes. We observed successful outcomes associated with PCA, but  also noted inconsistencies in the presence and timeliness of PCA and  other enforcement actions. Furthermore, in most cases, other  discretionary enforcement actions to address deteriorating conditions  either were not taken or taken only in the final days prior to failure. Other  financial indicators could serve to provide an early warning of  deteriorating conditions at credit unions.
subsections: section_title: Use of PCA and Other Enforcement Actions Highlight the Need to Address Deteriorating Credit Unions Earlier
paragraphs: The number of credit unions in PCA significantly increased as the  financial crisis unfolded (see fig. 5).June 30, 2011, 560 credit unions triggered PCA. Specifically, of the 560  credit unions that entered PCA from January 1, 2006, through June 30,  2011, the vast majority (452) triggered PCA from January 2008 through  June 2011.
section_title: Conclusions
paragraphs: NCUA has taken steps to stabilize, resolve, and reform the corporate  system. Many of the reforms are ongoing and NCUA continues to resolve  the failures of U.S. Central and Wescorp. As a result, the ultimate  effectiveness of NCUA’s actions and associated costs remain unknown.  Moreover, while the 2010 financial statements for NCUSIF are final—and  record a loss—the 2010 financial statements for the Stabilization Fund  were only recently released at the end of December 2011. Prior to the  release of these statements, NCUA had estimated losses for the  Stabilization Fund, but NCUA did not provide adequate documentation to  allow us to verify the reasonableness and completeness of these  estimates. Without well documented cost information, NCUA faces  questions about its ability to effectively estimate the total costs of the  failures and determine whether the credit unions will be able to pay for  these losses.
Before the recent financial crisis, PCA was largely untested because the  financial condition of the credit unions had been generally strong since  PCA was enacted. With the failure of the 85 credit unions, the PCA  framework showed some weaknesses when addressing deteriorating  credit unions. The main weakness of the PCA framework, as currently  constructed in statute, stems primarily from tying mandatory corrective  actions to only capital-based indicators. As previously reported, capital- based indicators have weaknesses, notably that they can lag behind  other indicators of financial distress. Other alternative financial indicators  exist or could be developed to help identify early warning signs of  distress, which our analysis shows is a key to successful outcomes. Tying  regulatory actions to additional financial indicators could mitigate these  weaknesses and increase the consistency with which distressed credit  unions would be treated. By considering which additional financial  indicators would most reliably serve as an early warning sign of credit  union distress—including any potential tradeoffs—and proposing the  appropriate changes to Congress, NCUA could take the first steps in  improving the effectiveness of PCA.
section_title: Recommendations for Executive Action
paragraphs: Given that the 2010 financial statements for the Stabilization Fund were  not available for our review and NCUA was unable to provide us  adequate documentation for their estimates as well as the identified  shortcomings of current PCA framework, we recommend that NCUA take  the following two actions.  1.  To better ensure that NCUA determines accurate losses incurred from  January 1, 2008, to June 30, 2011, we recommend that the Chairman  of NCUA provide its OIG the necessary supporting documentation to  enable the OIG to verify the total losses incurred as soon as  practicable.  2.  To improve the effectiveness of the PCA framework, we recommend  that the Chairman of NCUA consider additional triggers that would  require early and forceful regulatory actions, including the indicators  identified in this report. In considering these actions, the Chairman  should make recommendations to Congress on how to modify PCA  for credit unions, and if appropriate, for corporates.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to NCUA and its OIG for their review  and comment. NCUA provided written comments that are reprinted in  appendix V and technical comments that we have incorporated as  appropriate.
In its written comments, NCUA agreed with our two recommendations.  Notably, NCUA stated that it had taken action to implement one of the  recommendations by providing OIG with documentation of loss estimates  for the Stabilization Fund as of December 31, 2010. It expects to provide  additional documentation of loss estimates as of June 30, 2011, in  January 2012. In its letter, NCUA also stated that the December 31, 2010,  audited financial statements for the Stabilization Fund would be issued in  the near future and described reasons for the delay in finalizing this audit.  These reasons included the scope and magnitude of the corporate  failures and the actions that NCUA had undertaken to resolve the  corporate failures and strengthen its financial reporting systems. While  NCUA acknowledged that some of the loss estimates were not finalized  at the time of our audit, including the 2010 financial statements, it noted  that the results from the valuation experts were complete and available.  Our report recognizes the challenges that NCUA has faced in finalizing its  financial statements and describes the actions that it has taken to  stabilize, resolve, and reform the credit union system. However, as we  reported, NCUA was unable to provide us with the documentation that we  required to verify the reasonableness and completeness of the loss  estimates for the Stabilization Fund. Subsequently, the NCUA 2010  Financial Statement Audit for Temporary Corporate Credit Union  Stabilization Fund was released on December 27, 2011. Although NCUA  has said that its analysis shows that the credit union system has the  capacity to pay for the loss estimates, we continue to believe that without  well-documented cost information, NCUA faces questions about its ability  to effectively estimate the total costs of the failures and determine  whether the credit unions will be able to pay for these losses. Taking the  steps to address our recommendation will help NCUA address these  questions.
In its written comments, NCUA also described its commitment to  continued research and analysis to improve the effectiveness of PCA. In  particular, NCUA cited its membership on the Federal Financial  Institutions Examination Council and the Financial Stability Oversight  Council. NCUA also noted that it was following developments related to  the federal banking agencies’ consideration of enhancements to PCA  triggers, a step that we recommended in our report Banking Regulation:  Modified Prompt Corrective Action Framework Would Improve  Effectiveness. NCUA agreed with the recommendation to consider other  triggers for PCA but noted that some of the potential financial indicators  that we identified could have drawbacks. We also acknowledged in the  report that multiple indicators of financial health could be used as early  warning indicators and that the extent to which the financial indicators we  identified could serve as strong early warning indicators might vary.  Furthermore, using some of these indicators as early warning signs of  distress could present different advantages and disadvantages—all of  which would need to be considered. Nevertheless, we continue to believe  that considering a range of potential indicators, including those identified  in the report, is a necessary and important step in improving the  effectiveness of PCA.
NCUA’s letter also noted a potential “misconception” in the report and  said that it recognized the need for timelier use of formal enforcement  action, as evidenced in its response to OIG findings and  recommendations. However, NCUA stated that nearly all failed credit  unions received an enforceable regulatory action prior to failure, either  through PCA or non-PCA authorities. In some cases, the failures  occurred so abruptly that NCUA did not have a long lead time to take  action. NCUA also stated that it had a strong record of employing PCA  actions when credit unions tripped PCA triggers, as PCA actions are  often more expedient forms of enforceable regulatory action. As  discussed in the report, successful outcomes were associated with PCA  in some cases. However, we also found inconsistencies in the presence  and timeliness of PCA and other enforcement actions. Furthermore, we  also found that other discretionary enforcement actions to address  deteriorating conditions either were not taken or were taken only in the  final days before the failure. Finally, the letter concluded that credit  unions performed well during the recent financial crisis and that NCUA  had successfully mitigated the failures that did occur. Our report  describes the scope and magnitude of failures among corporates and  credit unions and also notes that the 85 credit unions represented less  than 1 percent of credit union assets as of 2008. Finally, we also  described actions NCUA had taken to stabilize the credit union system,  but we note that NCUA’s examination and enforcement processes did  not result in strong and timely actions to avert the failure of these  institutions.
We are sending copies of this report to NCUA, the Treasury, and the  Financial Stability Oversight Council, and other interested parties. The  report is also available at no charge on the GAO website at  http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  A. Nicole Clowers at (202) 512-8678 or clowersa@gao.gov. Contact  points for our Office of Congressional Relations and Public Affairs may be  found on the last page of this report. GAO staff that made major  contributions to this report are listed in appendix V.
section_title: Appendix I: Status of OIG Recommendations to NCUA, as of October 30, 2011
paragraphs: During the period of November 2008 to October 2011, the National Credit  Union Administration’s (NCUA) Office of Inspector General (OIG) made  25 recommendations to NCUA to improve both corporate and credit union  supervision, operations and financial reporting. Six of the 25  recommendations were for corporates and 19 were for credit unions.  NCUA has fully implemented 6 of the 25 recommendations relating to  improving the corporate structure, corporate governance, examination  processes, and call report data, as well as providing guidance on  concentration risk. In addition, they have partially implemented another 10  recommendations—2 of these relate to corporate risk management and  corporate examiner training. The other 8 partially implemented  recommendations are related to improving the credit union examination  process and financial monitoring of credit unions on areas such as fast  growing and new business programs, third-party relationships,  concentration risk, and ensuring credit union’s take appropriate action to  respond to documents of resolution (DOR). Finally, NCUA has not yet  implemented another 9 recommendations—6 of these recommendations  are related to improving examination processes for credit unions with  more than $100 million in assets, internal controls and documenting call  report analysis. The remaining 3 recommendations that were not  implemented relate to improving follow-up procedures for DORs.  Furthermore, OIG officials have told us that 13 of the 19 partially or not  implemented recommendations will likely be fulfilled with the issuance of  the revised National Supervision Policy Manual (NSPM) in 2012. OIG  officials have reviewed the draft revised NSPM and determined that it  addresses their recommendations. Table 3 provides a summary of these  recommendations and their status based on our evaluation of the  information that NCUA and its OIG provided.
section_title: Appendix II: Objectives, Scope, and Methodology
paragraphs: Legislation enacted in January 2011 requires us to examine NCUA’s  supervision of the credit union system and the use of PCA. This report  examines (1) what is known about the causes of failures among  corporates and credit unions since 2008; (2) the steps that NCUA has  taken to resolve these failures and the extent to which its actions were  designed to protect taxpayers, avoid moral hazard, and minimize the cost  of corporate resolutions; and (3) NCUA’s use of PCA and other  enforcement actions. In addition, we reviewed NCUA’s implementation of  its OIG recommendations. (See app. I.)
subsections: section_title: Analysis of Causes of Failures among Corporates and Credit Unions
paragraphs: To identify the causes of failures among corporates and credit unions, we  obtained and analyzed NCUA documents, including Material Loss  Reviews (MLR), postmortem reports, Board Action Memorandums (BAM),  and other relevant documents. To corroborate this information, we also  assessed the asset size and investment concentrations for all failed and  nonfailed corporates by conducting analyses of data from SNL  Financial—a financial institution database—on corporates’ investment  portfolios from January 2003 to September 2010. We obtained and  analyzed NCUA data related to conservatorships and resolution actions  taken from January 2008 to June 2011 to determine the number and  causes of corporates’ and credit union failures. We further assessed  credit union member business loan participation as a percentage of total  loans for both failed and their peer credit unions that did not fail from  December 2005 to January 2011. To identify credit union failures related  to fraud, we reviewed data, analyzed reports and documents by NCUA  and its OIG on each of the failed credit unions from January 2008 to June  2011. To determine loss data from the corporates’ and credit union  failures, we reviewed NCUA’s 2008, 2009, and 2010 annual reports;  MLRs; BAMs; and NCUA data on losses to National Credit Union Share  Insurance Fund (NCUSIF) and the Temporary Corporate Credit Union  Stabilization Fund (Stabilization Fund). We interviewed NCUA’s OIG,  Office of Corporate Credit Unions, Office of Capital Markets, Chief  Financial Officer, and Office of Examination and Insurance to obtain their  perspectives on the causes of the corporates’ and credit union failures.  We further met with credit union industry associations to obtain their  views on NCUA’s efforts to reform the corporate credit union system. We  assessed the reliability of the SNL and NCUA data used for this analysis  and determined that these data were sufficiently reliable for our purposes.
section_title: Analysis of Actions Taken by NCUA to Stabilize the Credit Union System
paragraphs: To assess the steps that NCUA has taken to stabilize, resolve, and  reform the corporate and credit union system, we reviewed NCUA  documents and data including BAMs; MLRs; NCUA annual reports from  2008, 2009, and 2010; audited financial statements; NCUA’s Corporate  Stabilization and Resolution Plan; and NCUA-commissioned reports; in  addition to testimonies at relevant congressional hearings and planning  documents.  To determine actions taken to reform the corporate system,  we reviewed NCUA’s proposed and final rules and interviewed NCUA’s  General Counsel to discuss the potential impact of these rules and their  effective dates. To determine NCUA’s assessments for credit unions’ and  their ability to repay, we reviewed BAMs, NCUA’s scenario analyses for  its credit union assessments and loss estimates, and interviewed NCUA  officials. We requested detailed information on NCUA’s loss estimates for  NCUSIF and Stabilization Fund; NCUA provided some information but it  was not sufficient for us to determine the reasonableness and  completeness of these estimates. To determine the steps that NCUA took  to reduce moral hazard, we compared the actions taken to stabilize,  resolve and reform the credit union system to principles cited in our past  work on providing federal financial assistance.
section_title: Analysis of PCA Outcomes, Ratings Downgrades, Enforcement Actions and Other Indicators
paragraphs: To assess the outcomes of PCA, we reviewed the outcomes of credit  unions as a whole that were subject to PCA from January 1, 2006,  through June 30, 2011. Additionally, we tracked a group of credit unions  that were subject to PCA from January 1, 2008, through June 30, 2009,  during the 2007-2009 financial crisis to identify those credit unions that (1)  failed, (2) survived and remained in PCA, and (3) survived and exited  PCA. To determine the actions that NCUA took to address deteriorating  credit unions, we reviewed regulatory information that included CAMEL  ratings, enforcement action data, and PCA-related activities over a 2 year  period prior to each credit union failure from January 1, 2008, through  June 30, 2011. Specifically, we analyzed the instances and dates of  CAMEL downgrades, enforcement actions taken, and PCA-related  actions to determine whether and when actions were taken.
To assess the utility of various financial indicators in detecting credit unions’  distress, we reviewed the OIG’s MLRs, NCUA’s postmortem studies, and  our previous work on PCA. credit unions that did not fail to assess their performance on numerous  financial indicators, such as return on assets, operating expenses and  liquid assets as an early warning of financial distress. We also compared  the failed credit unions and their peers to credit union industry averages  across the same period. In considering other indicators for detecting early  distress in credit unions, we reviewed data from regulatory filings from the  fourth quarter of 2005 through the first quarter of 2011 for three groups: (1)  the 85 credit unions that failed from January 2008 to June 2011; (2) a  group of 340 peer credit unions—the four closest credit unions in terms of  total assets within the state as each failed credit union; and (3) all credit  unions that reported their financial condition in a regulatory filing for each  quarter within the period. To compare the performance of these three  groups, we chose a range of indicators from the CAMEL rating that  demonstrates asset quality (A), management (M), earnings (E), and  liquidity (L). For assessing asset quality, we also looked at credit unions’  risk exposure and credit performance.data from SNL Financial.
GAO-11-612.
We assessed the reliability of the SNL Financial database and NCUA’s  enforcement data used in our analyses, and found these data to be  sufficiently reliable for our purposes.
section_title: Analysis of NCUA’s Actions to Address OIG Recommendations
paragraphs: To determine the status of NCUA’s implementation of OIG  recommendations, we reviewed the OIG’s corporate and credit union  MLRs and their recommendation tracking documents and interviewed  NCUA and NCUA’s OIG officials.
We conducted this performance audit from May 2011 to December 2011  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix III: NCUA Temporary Stabilization and Guarantee Programs
paragraphs: To help stabilize the credit union system, NCUA created four new  programs to provide liquidity to corporates. NCUA initiated two of these  new programs, the Credit Union System Investment Program (CU-SIP)  and the Credit Union Homeowners’ Affordability Relief Program (CU- HARP) in early 2009. Due to the restriction preventing the Central  Liquidity Facility (CLF) from lending directly to the corporate credit unions,  NCUA designed both programs, CU-SIP and CU-HARP, so that the CLF  would lend to the credit unions, which agreed that they in turn would  invest in NCUA-guaranteed notes issued by corporates. Starting in  January 2009, corporates were required to use the invested funds to pay  down their external secured debt. Money from the corporates’ debt  issuances were used to free up collateral and to pay back loans made by  the credit unions. In exchange for participating in the programs, the  corporates were required to pay CLF borrowing costs to credit unions and  an additional fee to the credit unions as an incentive for them to  participate in the programs. CLF lending to credit unions totaled  approximately $8.2 billion under CU-SIP and about $164 million under  CU-HARP. All borrowings for both programs were repaid in 2010.
CU-SIP. Credit unions received a 25-basis-point spread over the cost  of borrowing from the CLF for investing in 1-year CU-SIP note issued  by participating corporate credit unions. Lending from the CLF for the  CU-SIP started in January 2009 and ended in March 2009, totaling  approximately $8.2 billion. All borrowings were repaid by the credit  unions to the CLF by the respective months in 2010 (see fig. 12).
CU-HARP. This 2-year program was designed to assist struggling  homeowners by temporarily facilitating modifications to their monthly  mortgage payments. Credit unions invested in CU-HARP Notes from  participating corporates. These notes had 1-year maturities and the  option to extend the date of maturity for an additional year. The  extension of the program’s 1-year maturity depended on the credit  union’s continued good standing and available CLF funding. The CLF  lent approximately $164 million to credit unions under the CU-HARP.
All remaining notes under the program matured in December 2010  and the credit unions repaid all borrowings. The corporates paid a  bonus to the credit unions, which was tied to a 50 percent reduction  relief in mortgage payments to homeowners. According to NCUA,CU- HARP was not very successful as the program’s design for credit  unions to earn the bonus was complex and the time frame in which to  apply was limited (see fig. 13).
NCUA created two temporary guarantee programs in late 2008 and early  2009 called the Temporary Corporate Credit Union Liquidity Guarantee  Program (Liquidity Guarantee Program) and Temporary Corporate Credit  Union Share Guarantee Program (Share Guarantee Program) to help  stabilize confidence and dissuade withdrawals by credit unions, in an  attempt to avoid a run on the corporates by member credit unions. These  programs provided temporary guarantees on unsecured offerings by  corporates and shares of credit unions held by corporates in excess of  $250,000. NCUA originally included all corporates under both guarantee  programs for a limited time after signing a letter of understanding and  agreement limiting activities and compensation. It later extended the  programs to corporates chose not to opt out of the programs.
Liquidity Guarantee Program. NCUA guaranteed the timely payment of   The program’s principal and interest of all corporates’ unsecured debt. debt issuance deadline was September 2011, with debt maturing no  later than June 2017. However, the program was later revised so that  any unsecured debt issued after June 2010 would mature no later than  September 2012. NCUA stated that this revision was necessary to  focus on short-term liquidity needs and bring the program’s deadline in  line with its other stabilization efforts (see fig. 14).
Share Guarantee Program. This program largely mirrors the Liquidity  Guarantee Program. That is, NCUA guaranteed credit union shares in  excess of $250,000 through February 2009, with the option of  continuing participation in the program through December 2010. NCUA  revised the program in May 2009 to extend the program’s deadline to  December 2012 and shortened the length of the program’s coverage to  shares with maturities of 2 years or less (see fig. 15).
In mid-2009, NCUA transferred obligations from both the Liquidity  Guarantee and Share Guarantee programs to the Stabilization Fund to  limit NCUSIF’s losses stemming from any future corporate losses.  According to NCUA officials, NCUSIF was obligated to provide for any  guarantee payments that might arise from either the Liquidity Guarantee  Program or the Share Guarantee Program. Based on NCUA’s 2009  financial statements, no guarantee payments were required for either  program; however, as of December 19, 2011, audited 2010 financial  statements for the Stabilization Fund were not available.
section_title: Appendix IV: Summary of NCUA’s 2010 Corporate Rule
paragraphs: On September 24, 2010, the NCUA Board adopted comprehensive new  rules to govern corporates. Following its initial publication the final rule,  the corporate rules underwent several technical corrections and five  additions to the corporate rule were published on April 29, 2011. The  corporate rule affect several parts of title 12 of the Code of Federal  Regulations but is codified primarily in 12 C.F.R. Part 704.
This table provides an overview of the corporate rule as initially published  in October 2010 and later amended in April 2011. It summarizes the  major provisions at a general level and gives references to where more  detailed explanations can be found in the preambles of the October 2010  and April 2011 final rulemakings. The preambles describe in considerable  detail the rationales for the provisions, section-by-section analyses of  each provision, what NCUA initially proposed, the comments it received  and its response to them, and how the final provisions differ from those  originally proposed.
section_title: Appendix V: Comments from the National Credit Union Administration
section_title: Appendix VI: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contacts named above, Debra R. Johnson, Assistant  Director; Emily R. Chalmers; Gary P. Chupka; Nima Patel Edwards;  Debra Hoffman; Barry A. Kirby; Colleen A. Moffatt; Timothy C. Mooney;  Robert A. Rieke; and Gregory J. Ziombra made significant contributions  to this report. Other contributors included Pamela R. Davidson, Michael  E. Hoffman, Grant M. Mallie, Jessica M. Sandler, and Henry Wray.