MADISON, Wis. – It's a complaint heard often in the industry – the only method credit unions have of growing capital is retained earnings. CUNA Mutual believes it has a tool to bring an alternative form of capital to credit unions that will be agreeable to both lawmakers and regulators. With NCUA Chairman Dennis Dollar beating the drum for a form of risk-based Prompt Corrective Action to help growing credit unions avoid being hit with PCA and with credit unions looking at converting to thrifts because of capital concerns, the issue of alternative capital issue is hot. Add to that the growing number of community charters (now over 900), which can be hurt the most by capital restrictions as they try to take in new members, alternative capital becomes even more vital. Larry Blanchard, CUNA Mutual's SVP of Corporate and Legislative Affairs, said CUNA Mutual was approached by NASCUS to try and assist in finding a capital tool that was credit union friendly and member friendly. Recurring concerns that arise from lawmakers and others when alterative capital is raised for CUs is that it not dilute credit union members' ownership in the credit union and that credit union members aren't unknowingly purchasing uninsured instruments. Any concerns about members somehow having their federal insurance protections diluted often raise eyebrows. Blanchard said CUNA Mutual's new program, known as Capital Notes, addresses those concerns. "It's an instrument with a long maturity that contractually protects the credit union's membership's ownership right and denies us those rights of ownership. It's an institution-type of investment that will not be sold to consumers," said Blanchard. CUNA Mutual is currently piloting its program with NCUA-designated low-income credit unions, which are allowed to issue subordinated debt for purposes of raising alternative capital. The hope, said Blanchard, is that the pilot program will prove to Congress and regulators that alternative capital can be used safely by credit unions without affecting members in any way. Blanchard said the NCUA seems to be more willing to consider alternative capital these days. "There's been a subtle but important shift with NCUA's stance. They are open to looking at this. It used to be a closed discussion," said Blanchard. That fact coupled with the potential of Congress passing legislation permitting CUs to utilize alternative capital, could help Capital Notes take off on a grand scale. Blanchard noted that CUNA has been working for some time on language that could be inserted into legislation permitting some form of alternative capital, so the mechanisms are in place. He said a legislative attempt could be made as soon as 2005. Although as of press time there have been no transactions through Capital Notes, here's how the program will eventually work. CUNA Mutual will set up a trust solely for the alternative capital program. Credit unions will issue unrated, unsecured notes that the trust will purchase. The trust would then go through a ratings process with S&P and issue its own notes that institutional investors, such as corporate credit unions or other insurance companies could buy. The risk will be broken down into risk levels, and depending on what level an investor takes determines the return, but in the end CUNA Mutual will always be responsible for the money most at risk. So for example a $100,000 note could be broken down into 20% with high risk, 40% with moderate risk, and 40% with no risk. Only CUNA Mutual could assume the 20% high-risk portion, while other investors could assume the remaining 80%. "Here we are borrowing a model that has worked in other financials, banks, S&Ls, and insurance companies where they issue unrated, unsecured notes into a trust and then the trust works with rating agencies to issue its own notes," said Tom Merfeld, head of CUNA Mutual Group's CU Financial Solutions Group and a leader in MEMBERS Capital Advisors. "Credit unions pay coupon and principal to the trust. The trust divides it out first to the highest rated notes. Anything left goes to the unrated piece. The unrated piece would receive residual cash flows," said Merfeld. Merfeld said credit unions benefit from being able to issue an unrated, unsecured note to the trust. They don't have to spend the time or money to go out and get the note rated by a rating agency. Blanchard stressed that CUNA Mutual doesn't want this to be a high-risk operation. "This is not a program intended to bail out credit unions. It's a program designed for well-managed credit unions with thoughtful plans," said Blanchard. Keeping it in the credit union family, corporate credit unions are one viable player for buying the trust's notes, he said. "Corporates are limited to what types of instruments they can invest in. Anything we would give to them would be rated Triple AAA or Double AA just to make sure any losses don't make their way up to the corporate. Losses get hung up on the lower rated pieces, the riskier pieces," said Merfeld. Merfeld noted that initially CUNA Mutual, not the trust, will buy the credit union notes. As volume increases, a trust will be used. The bottomline, said Merfeld, is either the trust or CUNA Mutual is buying the notes, they are not going out to the capital markets. [email protected]