Sarah Snell Cooke's column, "Parsing the Possible Harm Awaiting NCUSIF" (Aug. 17 issue) presents some unfounded extrapolations about potential losses to the NCUSIF. The column simply took the assets of all CAMEL 4 and 5 credit unions, assumed they would all fail and applied the average loss ratio of 17% to come up with a "potential for $6.8 billion in losses to the insurance fund."
It's easy to use speculative assumptions to quickly concoct a scary number in these admittedly challenging and uncertain times. But, let's get to the real math for the NCUSIF by putting some context on probable losses and reserve needs.
Reserving and loss-projection methodologies are based on historical data applied to assumptions about (1) the probability of default and (2) the loss given default.
First, the probability of default is the flaw in the column's conjecture about potential losses. The column assumed that 100% of CAMEL 4 and 5 credit unions are going to fail–all at a loss to the NCUSIF. That's very improbable.
So, what's a realistic estimate? Based on a two-year look back, which covers the most stressful period for credit unions in recent history, the annual failure rate is 3.7% for CAMEL 4s and 27% for CAMEL 5s. Keep in mind that failure is defined as a credit union that causes a direct loss to the NCUSIF. A higher percentage of CAMEL 4s and 5s do cease operations (e.g., are merged) or are restored to health at no cost to the NCUSIF due to regulators' timely intervention and diligent resolution efforts to protect member deposits.
The NCUA also includes failure probabilities for CAMEL 2s and 3s when calculating loss reserves. By multiplying the assets by CAMEL rating with the corresponding annual failure rate, the probable assets subject to failure is $3.46 billion.
To continue estimating reserve needs, take the $3.46 billion in assets subject to failure and multiply it by the 10-year adjusted average loss of 17.73% to get an initial estimate of $613 million. Apply a 90% confidence interval for an upper bound estimate; the reserve need reaches $1 billion. Finally, adjust for other accounting requirements and you arrive at the $1.2 billion now in the NCUSIF reserves. This amount is based on conservative assumptions (e.g., the 90% confidence interval and an adjusted 10-year average loss that's higher than actual loss history). Yet this conservative reserve need of $1.2 billion is clearly much lower than the $6.8 billion.
Admittedly, the above math is a simplification of the actual process. The NCUA's actual loss reserving methodology is much more complex in using confidence intervals, scenario analyses, and simulations. (For a full description, see footnote 6 of the 2010 NCUSIF audit at www.ncua.gov.)
On the contrary, some think the NCUSIF is over-reserved. The NCUA runs these numbers quarterly and makes adjustments to the reserve balance both up and down. And of course the process and annual year-end figures are audit tested by independent third parties.
On top of reserving for probable losses on credit union failures, the NCUA conducts extensive stress testing on the NCUSIF equity ratio. The latest projections indicate the fund is performing well. Even under a pessimistic scenario, at this time it appears that an NCUSIF premium or a restoration plan will not be statutorily required in 2011.
One caveat. Dramatic changes to world events or an extraordinary failure of a very large credit union could create added stresses. Various economic uncertainties reinforce the importance of sound risk management in credit unions, a balanced prudential regulatory regime, and capable supervision by federal and state regulators.
Nevertheless, the NCUSIF is in fact strong and well-reserved based on a reasonable range of possible scenarios. The real math supports this conclusion.
Larry Fazio
Director of Examination and Insurance
NCUA
Alexandria, Va.
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