NAFCU Compliance Blog

NCUA's Derivatives Proposal; Can't Help Myself

Written By JiJi Bahhur, Regulatory Compliance Counsel

Today, the NCUA Board issued a proposed rule to provide qualified credit unions limited authority to engage in derivatives activities for purposes of mitigating against interest rate risk (IRR). But, the proposal establishes a “pay-to-play” regulatory scheme for credit unions that are permitted to engage in derivatives activities. I’ll get into that in a moment. 

First, I should probably give some background on what derivatives are and what NCUA is proposing. NCUA has created a Q&A document addressing this, among other things.  From the Q&A document:

“Q.1: What are derivatives? What kinds of derivatives is NCUA proposing to allow for credit unions?

The Commodities Futures Trading Commission (CFTC) broadly defines a derivative as: “A financial instrument, traded on or off an exchange, the price of which is directly dependent upon (i.e., “derived from”) the value of one or more underlying securities, equity indices, debt instruments, commodities, other derivative instruments, or any agreed upon pricing index or arrangement (e.g., the movement over time of the Consumer Price Index or freight rates). They can be used to hedge risk or to exchange a floating rate of return for fixed rate of return. Derivatives include futures, options, and swaps.”

While the term “derivatives” covers a broad spectrum of financial instruments in today’s market, NCUA is only recommending authorizing the use of plain-vanilla, US Dollar-denominated (USD) interest rate swaps and purchased-only interest rate caps. These instruments are widely transacted in today’s capital markets, have deep and transparent pricing and afford end users with strong liquidity and execution. The Bank for International Settlements reports that interest rate swaps are the largest component of the global over-the-counter (OTC) derivatives market.

With regard to interest rate swaps, the NCUA Board is proposing to authorize only standard “pay-fixed/receive-floating” and “pay-floating/receive-fixed” interest rate swaps. It is currently anticipated that most interest rate swaps users would enter into “pay-fixed/receive-floating” transactions to hedge against rising interest rates. This “plain vanilla” interest rate swap affords some protection against the most common interest rate exposure experienced by credit unions with material interest-rate risk (IRR) sensitivity—namely, a balance sheet with an asset portfolio that does not reset to external rate changes as quickly as its liabilities. Most credit unions use non-maturity and other short-term shares to fund longer duration assets, creating an inherent re-pricing mismatch for which pay-fixed/receive-floating interest rate swaps can provide some effective mitigation.”

Eligible credit unions seeking derivatives authority must submit an application for one of two levels of authority.  Level I authority contains more stringent limits, including limits to the notional value of interest rate swaps, aggregate book value of interest rate caps, combined limit of interest rate swaps and caps, and the maximum weighted average life of all derivatives transactions cannot exceed 5 years.  Level II authority has fewer limits, but credit unions that seek Level II authority must show why the Level I limits are not adequate to meet their IRR mitigation needs.

So what’s the catch? You have to “pay-to-play.”  The proposed rule calls for application fees and pretty hefty ones at that.  Level I application processing costs would range from $25,000 to $50,000 and Level II applications would range from $75,000 to $125,000.  If that’s not bad enough, there is an associated fee for every year after that. 

NAFCU has long advocated for expanded investment authorities for credit unions, but the "pay-to-play" proposal raises concerns as this would be the first time “pay-to-play” will be required in the credit union industry. 

The proposal can be accessed here.  NCUA’s Q&A document – which provides an understanding of the rule’s intent and the main contents – can be accessed here.  Also, NAFCU’s Regulatory Affairs team is in the process of drafting a Regulatory Alert (NAFCU Member Log-In required) on this proposal so keep your eyes peeled for that. 

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I just had to share these pictures with you all.  Have a great weekend.

Bozo's Grand Prize Game & Share Insurance; NAFCU's March Compliance Monitor

Written by Steve Van Beek

NAFCU's Compliance School is only a couple of weeks away and we are busy putting together the final details - including our presentations.  One of the sessions is on NCUA's Share Insurance and I wanted to share my favorite slide:

To me, Bozo's Grand Prize Game contains lessons for understanding share insurance coverage.  An account can only fit in one "bucket" at a time.  Understanding this helps explain share insurance coverage and how members can structure their accounts to maximize share insurance.  

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NAFCU's March Compliance Monitor.  The March issue of NAFCU's Compliance Monitor is now available for NAFCU members.  The March issue highlights NAFCU's Scope & Applicability Charts and includes two main articles:

• Understanding the Small Servicer Exemptions

• NCUA's Final Credit Ratings Rule Impacts Credit Union Investments

There are also numerous Q&As on the CFPB's new mortgage requirements - including ones submitted during our webcast on the CFPB's Final Mortgage Regulations (available for on-demand purchase).

NAFCU Members:  If you click on the article links above you'll notice a new feature - we are publishing our articles in HTML format (in addition to the PDF).  This means the articles are fully-searchable on NAFCU's website.  And, we have more enhancements in the works as well - so stay tuned!

Have a great weekend!

NCUA Board Meeting; Boardmember Hyland; Cordray Testimony; Video Contest

Written by Steve Van Beek

We'll try to keep it short and sweet for Friday.  

NCUA Board Meeting.  NCUA held a busy Board Meeting yesterday.  A good resource for an overview of NCUA's actions is their Board Action Bulletin.  The NAFCU Today also has additional details: Small CU; Payday Alternative Loans and Treasury Inflation Protected Securities (TIPS) and rural district definition.

Boardmember Hyland.  After the Board Meeting, Boardmember Hyland announced it would be her last as a NCUA Boardmember.  She will officially leave the NCUA Board on October 5th.  Hyland's official term ended in August 2011 but she remained on the Board to ensure NCUA had a three-person Board to lead the agency.  More in the NAFCU Today.

Director Cordray.  Yesterday, Director Cordray testified before the House Financial Services Committee.  This is after testifying before the Senate Banking Committee last week.   

Additionally, the CFPB announced the first meeting of their Consumer Advisory Board:  September 27th in St. Louis.  Attendance is open to the public but RSVPs are required.  

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NAFCU Member Video.  Back in July we blogged on our NAFCU Member Video Contest.  Check out the winning video here.  After a long week, it is a real good laugh.  Well done Baylands FCU!!

Agenda for NCUA's September Board Meeting; Mortgage Servicing Proposals in Federal Register

Written by Steve Van Beek

The agenda for NCUA's September 20th Board meeting is now available.  The agenda includes:

1. Proposed Rule – Part 703 of NCUA’s Rules and Regulations, Permissible Investments – Treasury Inflation Protected Securities.
2. Proposed Rule – Parts 702 and 741 of NCUA’s Rules and Regulations and Interpretive Ruling and Policy Statement 12-2, Regulatory Relief for Small Credit Unions.
3. Proposed Rule – Section 701.1 of NCUA’s Rules and Regulations, Expanded Definition of “Rural District” for Field of Membership.
4. Advanced Notice of Proposed Rulemaking – Section 701.21 of NCUA’s Rules and Regulations, Payday-Alternative Loans.

NCUA will also be meeting in closed session for a few additional agenda items.  

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Mortgage Servicing.  Back in our September 7th blog post, we linked to the CFPB's mortgage proposals as they were published in the Federal Register.  At that time, the Reg Z and Reg X mortgage servicing proposals had not yet been published.

Today, those mortgage servicing proposals have been published in the Federal Register.  The links are below.

• Regulation Z (TILA) Mortgage Servicing Proposal
• Regulation X (RESPA) Mortgage Servicing Proposal

Note:  Even though the proposals were published in today's Federal Register (September 17th), the CFPB is sticking with their October 9th deadline for comments.  

Remember, the CFPB is required by Dodd-Frank to finalize the mortgage servicing rules by January 21, 2013.  In order to meet that deadline, the CFPB is providing very limited timeframes for comments - especially on a proposal that would require 20 new notices.  

When It Rains, It Pours............Regulations

Written by Steve Van Beek

The DC area has had some unseasonably warm weather the past couple of weeks - but the flood of regulations coming from the regulators make it seem like we need to have our galoshes with us at all times.  The past couple of weeks have been a good example of regulatory onslaught from multiple angles - making the lives of compliance officers everywhere very difficult.

Given the fast-paced nature of the recent proposals and finalized regulations, I thought a quick blog post highlighting where to find the new rules was a good start up this mountain I like to call "regulatory change."  As an aside, I'm very interested to see Chairman Matz discuss NCUA's efforts to ease the regulatory burden on credit unions during NCUA's February 8th webinar (which also features CFPB Director Richard Cordray).

Interest Rate Risk Policy - Final Rule.  Recently NCUA issued a final rule on interest rate risk policies.  That rule will be published in the Federal Register this morning.  This final rule becomes effective September 30, 2012.    

Loan Workouts, Nonaccrual Policy & TDRs - Proposed Rule.  At its January Board meeting, NCUA also proposed a new rule that would require all federally-insured credit unions to have a written loan workout/modification policy.  The proposal also contains an Interpretive Ruling & Policy Statement discussing nonaccrual status and troubled debt restructuring reporting.  This proposal was published in the Federal Register yesterday and includes a short, 30-day comment period.

Derivatives - Advanced Notice of Proposed Rulemaking (ANPR).  NCUA also issued a ANPR on derivatives that would provide opportunities for credit unions to use derivatives to manage interest rate risk.  This proposal has not been published yet, but it will have a 60-day comment period (from the date it is published in the Federal Register).

Regulation E (Remittances) - Final Rule.  We discussed this final rule yesterday and I'm fairly certain we'll all become good friends with this rule over the next year.  The final rule will become effective February 7, 2013.

Regulation E (Remittances) - Proposed Rule.  Quite possibly a new record - proposing a rule to amend a final rule that was published on the same day.  Bravo!  The CFPB issue a proposed rule that would tweak the recent final rule.  Rest assured (warning - you may need to adjust your snark meter), the CFPB has indicated they will finalize this proposed rule before the finalized rule that it amends becomes effective.

Junior Lien Loan Loss Allowances - Guidance.  On Tuesday, NCUA along with the other regulators who make up the Federal Financial Institutions Examination Council (FFIEC) announced new guidance for junior lien loan loss allowances.  The Interagency Guidance is here and NCUA also issued Accounting Bulletin 12-1.

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On a happier note, all this talk about raining, pouring and galoshes got me thinking about a wonderful trip with my (now) wife in Seattle.  Good times!  

Letter to Credit Unions on Debt Downgrade; Still Learning

Written by Steve Van Beek

NCUA issued a Letter to Credit Unions yesterday on how the debt downgrade could impact NCUA, credit unions and members.  The Letter can be found here.

The LCU discusses the follow issues:

• Credit Union Investments;
• NCUA Guaranteed Notes;
• Corporate Credit Union Liquidity Guarantee Program;
• Money Market Funds;
• Consumer Confidence; and
• Communications with Members.

The full Letter to Credit Unions is here.  The previous guidance from last Friday is here.  Additional details can also be found in the NAFCU Today.

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I had a wonderful compliance officer quiz me on the number of days until the wedding.  Failed again.  Luckily, I have a trip to Ohio (Wooster) this weekend.  I have a feeling by the end of the trip I will have a much better internal countdown clock.  Currently:  72 days and counting.   

Derivatives

Written by Carrie Hunt

NCUA has announced its agenda for Friday's NCUA Board meeting and front and center is an ANPR on derivatives.  Derivatives are one of those topics of cocktail hour conversations that no one wants to admit that they have no idea what one is.  "So Bob, how about those derivatives traders?  Can you believe they made those swaps?"  "No, I can’t, Carol.  Those deals were crazy."

Hedging.  Counterparties.  Third party transactions.  The fun never stops.

So what does Derivative mean?  Investopedia tells us that it is a "security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage."


Currently, NCUA has a pilot program relative to derivatives and almost all of the derivative action that credit unions participate in is relative to interest rate swaps.  NCUA discussed derivatives in a February 2011 NCUA Report:

"What are swaps and caps, and why use them? Depository institutions rely on both instruments to hedge interest-rate risk - the risk a change in rates will materially impair earnings. In a "vanilla" swap - the type credit unions use - one party makes a fixed payment (equal to an unchanging rate times notional value) and receives a floating payment (equal to a varying short-term rate times notional value). Suppose, for example, the floating rate is one-month LIBOR - currently 30 basis points (or bps, three-tenths of a percentage point) - and the fixed rate is 20 bps.  Further, suppose notional value is $10,000,000; payments are annual; and settlement is due. A credit union committed to receive floating/pay fixed will collect the net amount - $10,000 (the difference in rates, 0.001, x $10,000,000) - from the counterparty. In an interest-rate cap, the buyer pays an upfront premium to receive compensation when a floating short-term rate exceeds a fixed rate (say, a payment if one-month LIBOR exceeds 20 basis points on a certain date, equal to notional value times the spread). Note in both cases receipts rise with LIBOR."

With NCUA reconsidering their entire investment rule, derivatives may be an issue that credit unions will not be able to ignore.  As always, NAFCU will prepare a Regulatory Alert on NCUA’s ANPR, so stay tuned on this issue.

A Busy Year

Posted by Anthony Demangone

Not too long ago, I shared my general outlook for 2011.   That post dealt more with general trends.  But we do expect some specific things.  Regarding NCUA, look out for the following in 2011.

• Regulations on interest rate and concentration risks.  If you've been keeping up with the Material Loss Reviews issued by NCUA's Office of Inspector General, you already know that concentration risk has played a huge role in credit union failures.  And that risk affects more than just credit unions.  I was at a meeting recently where an OTS and OCC official both agreed that concentration risks played a role in every major bank failure as well.
• Member business lending. Rather than a major overhaul, look for NCUA to incorporate guidance documents into the regulation.
• CUSOs.  NCUA will ramp up its focus on CUSOs, and they may seek examination authority.
• Examinations.  NCUA will overhaul its examiner's manual.  This is one process to track closely.  In my view, the examiner's manual is a massive guidance document that can affect your operations and NCUA examinations.  For that reason, it is very important to see how they change it. 
• This and That.  NCUA may also overhaul its investment rule (Part 703) and it may direct examiners to review new credit union products/services at each exam. 

Keep in mind that we can't say for certain that NCUA will act on any one of these issues.  But based on our conversations with NCUA officials, these are some of the areas of interest.  Stay tuned!

Permissible Investments for Federal Credit Unions

Posted by Steve Van Beek

Last Thursday, NCUA issued Letter to Federal Credit Unions 09-FCU-01 which details federal credit unions (FCUs) ability to invest in unsecured debt obligations guaranteed under the Temporary Corporate Credit Union Liquidity Guarantee Program (TCCULGP) and senior unsecured debt guaranteed under the FDIC Temporary Liquidity Guarantee Program (TLGP).  The letter indicates FCUs are allowed to invest if certain conditions are met.

The letter provides a brief overview and background of the programs and when FCUs can invest in those programs.  The letter emphasizes that FCUs should confirm the obligations are guaranteed through maturity in order for them to be permissible purposes.

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In case you were wondering, this Letter only applies to federal credit unions.  NCUA, as it did in this case, sometimes analyzes issues solely from the FCU perspective as they are the primary regulator of FCUs.  Whether these investments are permissible for state-chartered credit unions will depend on other factors determined by its state laws and primary regulator. 

A Little of This, A Little of That; Foot-in-Mouth Disease

Here are a few compliance odds and ends:

• FinCEN reminds us again that users of magnetic filing must transition to E-filing by the end of the year.
• Banks continue to get flood-related civil money penalties.  This Bankers Online page details all the fines.
• NCUA issued Legal Opinion Letter 08-0917 regarding the safekeeping of investments. The letter indicates that a wholly-owned subsidiary of a registered bank holding company is eligiblee to act as an investment safekeeper for a federal credit union (FCU).  You may want to pass this along to whomever is in charge of your investments.

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I put my foot in my mouth more than an NFL wide receiver.  Case in point...

The other day, I wandered over to our caffeine station for a late afternoon cup of coffee.  These are always hazardous treks, since more often than not, the coffee available at such an hour is stale and cool to the touch.  Imagine my joy as I see a coworker brewing a fresh pot of coffee.

Imagine my horror as the following words tumble out of my mouth in a volume far too loud for the circumstances:

Compliance Guy: "Thanks for the fresh pot!"