Credit Union Journal Monday, August 22, 2011

A recent op-ed in American Banker came to shocking conclusions about the future of the credit union industry.
(&CU Conversions Are Looking Inevitable," Aug. 11, 2011.)

In the article, Sandler O'Neill & Partners' Peter Duffy described an analysis suggesting that to pay assessments, make up for the potential loss of interchange income and maintain adequate capitalization, the largest credit unions will need to grow pre-assessment, noninterchange earnings at 30% per year for the next five years.

Duffy concludes from this analysis that meeting these growth targets without additional capital is difficult, if not impossible; therefore, he contends, widespread credit union conversions are "inevitable."

This topic clearly deserves more attention. So, I took the time to replicate Duffy's analysis in hopes of better understanding the dynamics at work. What I found was that — as in most analyses — assumptions matter. When I replace Duffy's extreme assumptions with more realistic estimates, it becomes clear that even average earnings growth over the next several years will be sufficient to maintain a well-capitalized credit union industry.

Duffy's analysis focuses on 380 CUs with greater than $500 million in assets. As of the first quarter of this year, they held combined assets of more than $590 billion, had an aggregate net worth in excess of 9.5% of assets and earned a healthy return on assets of nearly 90 basis points. Contrary to Duffy's assertion, losses are not widespread. Only 9% of these credit unions posted losses in 2010; and less than 5% had negative net earnings in the first quarter.

So what is the problem? As Duffy describes, it is the prospective loss of interchange income, corporate stabilization assessments and "possible new minimum capital requirements." So how bad do these prospective hurdles need to be to result in the need for 30% annual net earnings?

My analysis suggests that to hit Duffy's 30% target, the assumed conditions would have to be far outside the realm of possibility. In an effort to replicate Duffy's 30% target, for each credit union I projected the required annual net income growth before assessments and reduction due to interchange that results in a net-worth ratio after assessments and reduction in income due to interchange above the assumed regulatory requirement and that is greater than or equal to the credit union's 2010 net worth ratio.

Here are the assumptions necessary to duplicate Duffy's net income growth target, followed by the results more realistic assumptions produce:

## No Reason To Assume 10% Capital

In the article, Sandler O'Neill & Partners' Peter Duffy described an analysis suggesting that to pay assessments, make up for the potential loss of interchange income and maintain adequate capitalization, the largest credit unions will need to grow pre-assessment, noninterchange earnings at 30% per year for the next five years.

Duffy concludes from this analysis that meeting these growth targets without additional capital is difficult, if not impossible; therefore, he contends, widespread credit union conversions are "inevitable."

This topic clearly deserves more attention. So, I took the time to replicate Duffy's analysis in hopes of better understanding the dynamics at work. What I found was that — as in most analyses — assumptions matter. When I replace Duffy's extreme assumptions with more realistic estimates, it becomes clear that even average earnings growth over the next several years will be sufficient to maintain a well-capitalized credit union industry.

Duffy's analysis focuses on 380 CUs with greater than $500 million in assets. As of the first quarter of this year, they held combined assets of more than $590 billion, had an aggregate net worth in excess of 9.5% of assets and earned a healthy return on assets of nearly 90 basis points. Contrary to Duffy's assertion, losses are not widespread. Only 9% of these credit unions posted losses in 2010; and less than 5% had negative net earnings in the first quarter.

So what is the problem? As Duffy describes, it is the prospective loss of interchange income, corporate stabilization assessments and "possible new minimum capital requirements." So how bad do these prospective hurdles need to be to result in the need for 30% annual net earnings?

My analysis suggests that to hit Duffy's 30% target, the assumed conditions would have to be far outside the realm of possibility. In an effort to replicate Duffy's 30% target, for each credit union I projected the required annual net income growth before assessments and reduction due to interchange that results in a net-worth ratio after assessments and reduction in income due to interchange above the assumed regulatory requirement and that is greater than or equal to the credit union's 2010 net worth ratio.

Here are the assumptions necessary to duplicate Duffy's net income growth target, followed by the results more realistic assumptions produce:

- Weak earnings. Using unusually weak 2010 earnings creates a low earnings base, thus requiring large percentage changes. By contrast, starting with more recent earnings averages from first-quarter 2011 reduces the annual growth needed from more than 30% to less than 22%.
- Overestimated assessments. To reach Duffy's 30%, I had to assume corporate stabilization assessments of 25 basis points of assets in 2011 and 20 basis points of assets each year through 2015. To put this assumption in perspective, such overestimated assessments would raise about 45% more dollars in five years than NCUA currently projects as needed over the entire remaining corporate stabilization initiative.

- Extreme net worth requirements. Most importantly, to reach Duffy's 30% target, I had to assume minimum net worth requirements rise from 7% today to 10% in 2015. While we cannot rule out increases in capital requirements, especially for institutions holding large concentrations of risky or complex assets, there is no reason to believe the leverage ratio of 7% capital to total assets required in Prompt Corrective Action for credit unions needs to be raised; and it is safe to assume that any changes to the risk-based requirement would be targeted and phased in over reasonable periods. Dropping Duffy's extreme assumption to 7.5% reduces required net income growth to about 12%.
- Overstated asset growth. Finally, when I replaced the assumed 10% asset growth with a rate more consistent with historical norms-i.e., 8%-required annual net income growth fell to just over 6% per year. Importantly, the credit union industry as a whole had similar net earnings growth rates in the five-year period after the last recession

John Worth is chief economist at NCUA. The opinions expressed are his own and do not necessarily reflect the views of NCUA or its board. He can be reached at 703-518-6308 or jworth@ncua.gov

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