Mid-States Corporate Federal Credit Union
Economic Forum
Indianapolis, Indiana

October 17, 2003

“Managing Risk through Diversity”

Thank you for your kind introduction, and thanks to the Mid-States Board for inviting me here today.

It is truly an honor to follow a former Vice President of the United States.

I was happy to see that finally, last month, Dan Quayle was honored with a marble statue in the U.S. Senate along with statues of our nation’s other Vice Presidents.

Cynics noted it took more than a decade to place the statue. They pointed to it as an example of how long it takes to get things done in Washington. After all, Washington is where parties are still debating plans to build a memorial for World War II!

I must admit: As a native New Yorker, I am accustomed to a faster pace. On Wall Street, fortunes can change hands in a second. The economy can change directions in a minute. One piece of good news or bad news can send interest rates soaring or spiraling down.

As a regulator, my most important role is to ensure that throughout the ups and downs, credit unions remain safe and sound.

Whether it’s advising credit unions about the liability of using unregistered CD brokers – or the danger of holding too many fixed-rate mortgages -- NCUA must keep pace with the marketplace.
In today’s economy, it is tempting to take risks. NCUA’s job is not to prevent credit unions from taking risks, but to help credit unions manage risks.

This is particularly important as credit unions today attempt to maximize their yields in a low-interest rate environment.

Many credit unions are turning to CD brokers in an effort to realize higher yields on their investments. Others are holding on to long-term fixed-rate mortgages.

Credit unions working with CD brokers must be aware that each new business partner brings new risk.

A few years ago, 98 credit unions entered contracts with Bentley Financial Services, a Pennsylvania-based broker-dealer that is no longer in business. Mr. Bentley was charged with securities fraud for misrepresenting their CDs as insured.
He ultimately consented to a prohibition order that bans him from any future participation in the securities industry.

It is amazing to me that not one of these 98 credit unions performed due diligence to make sure they were dealing with a reputable firm. Had they checked, they would have discovered that Bentley was not a registered broker.

What’s more, Bentley was using a safekeeper that was in violation of NCUA’s investment regulation. Our regulation requires safekeepers to be supervised by the SEC or a depository institution regulator.

As a result of their failure to perform due diligence, these credit unions lost hard-earned funds that their members had
entrusted to them. Several of those credit unions’ net worth wound up falling below 6%. By law they became subject to PCA and had to submit net worth restoration plans.

All of this damage could have been avoided with proper due diligence.

Let me be clear. NCUA shares this responsibility. I was equally amazed that each of these 98 credit unions had been examined, and not one examiner had discovered this breach of oversight.

It is incumbent on credit unions to verify the legitimacy of their brokers. And it is incumbent on NCUA to verify that due diligence has been performed.

We cannot let unscrupulous third parties tarnish the good reputation that credit unions have worked so hard to build with their members.

This is why NCUA is working to prevent this problem from re-occurring. When I learned about the Bentley situation, I met with the staff to see what we can do differently. As a result: NCUA examiners are now required to verify that credit unions have checked the legitimacy of their CD brokers. Our examiners are being provided with updated guidelines in this area.

• In addition our Offices of General Counsel and Strategic Planning are investigating questionable practices by CD brokers. That will be ongoing.

• Finally, a Letter to Federal Credit Unions is being prepared to warn about custodial CD transactions with unregistered brokers. This letter will reemphasize the need to perform due diligence.

We do not want to impose additional regulatory burdens on credit unions since sufficient investment regulations are already in place. But we must give examiners the guidance and training they need to enforce the existing regulations at the same time we give credit unions the information and assistance they need to manage the risks.

Fixed-rate mortgages pose the same challenge to credit unions.

The current interest rate cycle creates a potentially dangerous incentive. As you know, mortgages earning over 5% afford much higher returns than most shorter-term assets today.

But, will that be true two years from now? Your guess is as good as mine.

One thing seems certain: Interest rates are going to rise. How far and how fast rates rise could determine the fate of many credit unions.

And, of course, this issue is larger than credit unions. It will impact the entire economy.

When I met with Fannie Mae Chairman Frank Raines a few weeks ago, he told me that in the current economy, long-term fixed-rate mortgages are the number one safety and soundness concern facing America’s financial institutions.

Mr. Raines pointed out how dangerous it is that banks currently hold 35% of their portfolios in mortgages.

Yet at credit unions, the average mortgage portfolio is even higher: 44%. That’s a 30% increase over the past seven years.

More than 70% of the mortgages on credit union books have long-term fixed rates. Many credit unions have even higher concentrations of long-term fixed-rates.

Still more than half have not sold any loans on the secondary market, and have no plans to do so.

If rates rise slowly and steadily, credit unions will be able to adjust their portfolios.

But, for example, if rates rise 200 basis points over the next year-and-a-half -- which is not unrealistic -- some credit unions could be squeezed out of the market. There would be so many institutions looking to sell mortgages, there may not be enough buyers. The law of supply and demand would work against those who waited to sell.
And for credit unions that have not sold any mortgages, it would take six-to-eight weeks to set up the first sale.

I am taking every opportunity to make credit unions aware of the possible dangers of holding too many long-term fixed-rate mortgages. The higher earnings flowing in today could evaporate quickly as rates rise, and credit unions could lose liquidity if they cannot meet members’ demand for higher dividends.

In this scenario, many credit unions would have no choice but to merge.
But this scenario can be prevented. At the end of September, NCUA issued a Letter to Credit Unions with guidance on what credit unions should be looking for – and what examiners will be looking for – to safely position mortgage portfolios for the upcoming rate hikes.

Our letter advises officials of credit unions with high concentrations of fixed-rate mortgages to ask:

• Does our balance sheet risk negative net worth under a realistic interest rate shock?

• If so, what actions should I take now to lower our risk to a prudent level?

Each credit union will have its own risk profile. NCUA will not set a one-size-fits-all threshold of fixed-rate mortgages to be held in every portfolio.

But credit unions with high mortgage concentrations are advised to establish a reasonable risk tolerance amount and abide by their threshold.

In addition, credit unions need to demonstrate a risk management process that will enable them to take timely action to reduce excessive risk positions.

Examiners will be evaluating the risk management processes that credit unions with higher mortgage concentrations are using to measure and forecast their balance sheet risk.

Now I am not suggesting that credit unions stop making mortgages. In fact, I always urge credit unions to offer affordable home loans.

But in today’s economy, I urge credit unions to diversify their assets. And just as important to credit unions’ future, I urge credit unions to diversify their memberships.

Diversity – both in assets and in membership – is the best way for credit unions to spread out their risk.

The mortgage market is a perfect example.

During the recent cycle of record-low interest rates, credit unions’ real estate portfolios were boosted by refinancing.

However, as interest rates rise, the demand for refinancing falls.

The future of the mortgage market is in purchase mortgages. Purchase mortgages are first mortgages used to fund actual home purchases, rather than refinancing existing homes.
Unfortunately, credit unions are lagging the market in purchase mortgages.

The purchase mortgage market is very competitive because it’s based on volume. Many real estate agents establish referral relationships with lenders that can generate the most volume for them. Traditionally, these high-volume lenders have been banks or thrifts.

But credit unions have opportunities to build high volume in many new areas. The most promising is offering homeownership to minority populations.

While three-fourths of white Americans own their homes, less than half of minorities do. With the strong growth projections for minorities, new markets of potential homeowners are about to boom.

You may be surprised to learn, as I was, that while the white population is projected to grow 9% through year 2020:

• The African-American population is projected to grow 28%;

• The Latino-American population is projected to grow 75%;

• And the Asian-American population is projected to grow 80%.

Many of these individuals will not have an established relationship with a traditional mortgage lender. Making inroads into these constituencies today is a golden opportunity for credit unions to recruit the members of tomorrow.

Even if credit unions choose to sell their new mortgages, they can retain the servicing. And they can build relationships with new members who will use additional credit union services. This will diversify membership as well as assets.

I strongly believe that forward-looking regulatory policies, designed to help credit unions build more diverse membership and more diverse assets, will make credit unions more safe and sound by spreading out their risk.

This is why in the past year, I have supported three major regulatory changes to help credit unions diversify their membership, diversify their assets, or both.

These regulations are intended to help credit unions manage risk through diversity.

1) Field of Membership

In March, I voted to update NCUA’s field of membership regulation. This regulation should help credit unions diversify their membership.

Under our new rule, any single county or city -- regardless of size -- is presumed to be a local community for chartering purposes. But before any community charter can be approved, the credit union must show an ability and a commitment to serve all types of people in the field of membership.

At the NCUA Board meeting last month, we approved two very large community charters: Bethpage, with 2.6 million potential members in New York, and ABNB, with 1 million potential members in Virginia.

Both credit unions showed the ability and the commitment to serve all types of people in their field of membership – including military, senior citizens, and immigrants with low-to-moderate incomes.

Think of all the people who do not have an affiliation with other insured financial institutions who are now eligible to join a credit union.

Critics may say there’s something wrong with credit unions that are growing beyond their “traditional” common bond. They fear that perhaps the deposits are no longer as safe as they ought to be.

In fact, my experience has shown that often there’s something wrong with credit unions that are not growing. These are typically the credit unions that are unable to fulfill their mission and meet all of their members’ needs.

As their members go elsewhere for new services, credit unions that are not growing can become safety and soundness concerns.

2) Investments

We recently updated our investment regulation to give credit unions flexibility to invest in several products that could generate higher returns for their members.

Credit unions must show an ability to assess how much risk they are willing to take in their investment portfolios -- and to ensure that they can manage this risk.

Our investment regulation also recognizes that the marketplace may move faster than we can. If credit unions want to invest in a product that is not prohibited by law but not authorized by regulation, they may apply to launch a pilot program.

If approved, the pilot program would allow certain credit unions to prove through experience that this new investment can be managed effectively.

Here’s a practical example: With the prospect of higher interest rates, some credit unions are considering using derivatives to hedge potential interest rate risk. Credit unions interested in hedging can now apply for a pilot program to use derivatives on a controlled basis.

The goal is to help credit unions find new ways to safely diversify their assets.

3) Member Business Lending

Last month, the NCUA Board voted to update NCUA’s member business lending regulation. Working to improve this regulation was one of my first major initiatives at NCUA last year.

Business loans can diversify both membership and assets. They help credit unions reach more people in their field of membership with new services that most simply cannot get elsewhere.
Events of the past 12 months underscore how critical this is. The three products that account for most credit union assets – auto loans, credit cards, and mortgages -- are facing unprecedented competition.

• New auto loans are falling for the first time. Even as car prices are go up, credit unions’ new auto loan balances are down.

Some credit unions are turning to indirect lending to try to drive up volume. But be careful. Due to losses from indirect lending, a Florida credit union recently went from a CAMEL 1 to liquidation in six months. They didn’t do their due diligence!

Like working with broker-dealers on CDs, working with auto dealers on indirect lending requires due diligence. Every third indirect loan should be reviewed. That’s the standard.

• Like auto loans, credit cards have traditionally generated a significant portion of credit union assets. But today, credit card portfolio growth is almost flat.

Most credit unions simply do not have the economies of scale to offer corporate partnerships and rewards like airline miles -- nor the affinity programs that can brand cards with your favorite charity, college, or NFL team.

For members who carry credit card balances, credit unions still offer lower interest rates. However, some credit unions have made the business decision to cash out and sell their card portfolios.

• We’ve already talked about the competition for mortgages, and the need to sell mortgages that exceed the credit union’s risk threshold.

Now given the competition for auto loans, credit cards, and mortgages, member business loans are a relatively untapped market.

The proportion of loans to small businesses has been cut in half since 1999. According to the Small Business Administration, small businesses must now rely more on owner capital and less on external debt. This lack of credit makes it difficult for many small businesses to grow.

Now, I’m not talking about loans for golf courses or high-rise buildings. I’m talking about loans that credit union members need to start a home cleaning business or an ethnic market, or to buy a dump truck or next month’s inventory.

Banks generally won’t make these loans – not because they are too risky, but because they are too small.

In fact, more than 70% of banks’ business loans are now over $1 million. In contrast, credit unions’ average business loan is just $118,000.

And interestingly, nearly half of credit unions’ business loans reach members with low-to-moderate incomes.

More than 25% of credit union business loans go to members with household incomes under $30,000. Another 20% go to members with household incomes from $30,000 to $50,000.

Business loans help members at different times in their lives:

• Young members aspire to be entrepreneurs.

• Middle-age members whose firms have downsized start small businesses to support their families.

• And many retirees want to fulfill lifelong dreams of owning their own business.

Of course, our proposed rule emphasizes that business lending is not for every credit union.

Business lending can be risky. We know that. That is why our rule requires credit unions to hire or contract people who have business lending expertise. Due diligence is as important as ever.

When a credit union is authorized to make business loans, we expect each credit union to do it carefully. And each credit union can expect NCUA to examine it carefully.

At the same time, we recognize that business lending can be another important tool to help credit unions meet the unmet needs of many different types of members.

Reaching all the people in your field of membership with low-cost, quality service is the credit union mission.

That’s why I instituted an initiative that I call PALS. It stands for Partnering and Leadership Successes.

PALS is my contribution to NCUA Chairman Dennis Dollar’s Access Across America initiative. Access Across America has been successful in making more Americans eligible for credit union membership. Now I hope PALS will give credit unions the tools to turn potential members into real members.

PALS encourages credit unions to share their best practices for improving member service and reaching all the people in their field of membership.

Many credit union CEOs tell me that they have spent money and resources to reach new members -- yet their results have not met their expectations.

So PALS is a means for credit unions to learn from one another. Those who have taken successful initiatives are sharing them with others.

PALS involves free workshops on different issues in different parts of the country. While the topics of each workshop may be different, all have the same bottom line: to help credit unions attract new members and expand their services.

In the first PALS workshop, a panel of credit unions described how they grew on both sides of the balance sheet by partnering with the Neighborhood Reinvestment Corporation.

We also released a publication featuring eight case studies of successful credit union partnerships with these community-based organizations. And it includes a list of potential partners in your area.

This publication is available free of charge. Just call my office or download it from the PALS website: www.ncua.gov, and click PALS.

Our second PALS workshop focused on connecting with Latinos – America’s largest and fastest-growing minority.

The presentations from this workshop are packaged in a CD – also available by calling my office or by downloading from our website.
My son was so excited when I told him I had made my own CD! Don’t be disappointed, though: When you plug in this CD, you won’t hear me singing salsa songs! But you will see ideas from credit unions on how to market to Latinos, how to get involved in their communities, and how to open accounts for recent immigrants.

The third PALS workshop just took place yesterday. NCUA Vice Chair JoAnn Johnson and I hosted a workshop on member business loans. Over 200 credit union officials attended this meeting in Washington.

NCUA staff explained what our new rule means to credit unions, and credit union leaders shared ideas on how to put together successful business loan programs. They also heard from experts on how to manage risk.

In the next several weeks, we plan to produce a Member Business Lending CD similar to the Latino Connection CD. The workshop was so popular we will probably hold another one on the west coast in the spring.
The next PALS workshop will be held on January 26 in Dallas, Texas on another way to reach new members: Providing rlternatives to Predatory Financial Practices. I hope many of you attend.

At this workshop, credit union speakers will describe innovative loan programs, savings programs, and special services that offer consumers a lifeline to avoid the lure of predatory financial institutions.

In providing these services, credit unions diversify their memberships even further.

One final point: Reaching new members with new services is not only the right thing to do. It’s good business.

Whether it’s opening young people’s first accounts… refinancing predators’ high-cost loans… or helping members realize the dream of owning their own business… Many of these members will stay loyal to your credit union for life.

And with all the new members whose lives you touch, you are helping your credit union manage risk through diversity.

I congratulate you for all the wonderful work you are doing. And I look forward to helping you reach more members in the future. Thank you.