Capital Planning: A Top Priority With a Resource Hidden in Plain Sight

Cue the drumroll … historic deposit growth across all asset size groups since 2019 has rolled forward into 2022. The NCUA’s Quarterly Data Summary reported that total industry deposits at March 31 reached $1.85 trillion, up 9.3% year over year – and by a startling 40.3% since 2019. These funds have been deployed largely into loan portfolios just as net interest margins return to a more normal range. Member satisfaction metrics are off the charts.

So, what’s not to like? Well, the biggest challenge is that net worth positions are getting crushed. Earnings are good but not good enough to offset the capital impact of a deposit tsunami. The industry Net Worth/Assets position dropped to 10.22% at March 31, a decline of 115 basis points in 27 months. Since it is merely an industry average, we know that many credit unions have dropped to an even lower level. Depending on how your credit union allocates funds into loan types, concentration levels and the resulting risk-based capital tolerances could be pushed toward your policy limits.

Financial aspects of declining capital levels are one concern. Credibility is implicated because strong capital and financial safety are historical industry bragging rights with both Congress and the public.

The Urgency of Comprehensive Capital Planning

It’s not surprising then that capital planning has become a singularly hot button issue. Boards of directors and regulators are both looking for answers. Zach Zoia, managing director at Darling Consulting Group, a nationally prominent asset/liability consulting firm, said his firm is being peppered with requests for support. “Capital planning and stress testing are critically important elements of managing risk for every credit union.  With net worth ratios falling and balance sheets inflating from the recent flood of deposits, capital restoration is both a challenge and a necessity. Lower net worth levels weaken a credit union’s ability to buffer future credit loss, the specter of which is rising as the Fed tightens monetary policy. Some economic analysis suggests not only continuing inflation but also a real risk of extended stagflation,” Zoia said.

Zoia continued, “The best capital plans we produce with our clients focus not only on credit, liquidity, interest rate and idiosyncratic risks, but also on the remediation strategies that mitigate those risks. It requires three key resources: Professional expertise, the analytical firepower of customizable planning software and a toolbox of the right capital enhancement options.”

Capital Enhancement Tools and Opportunities

So, what creative strategies should be in your capital-building toolbox? One may be subordinated debt, a traditional if limited tool that has been supercharged by the U.S. Treasury’s ECIP program, moving upwards of $10 billion of 30-year, 2% or so soft debt into the secondary capital of more than 100 credit unions and banks with footprints in low-income areas. But the ECIP program seems fully subscribed, and other private sources of subordinated debt can’t match U.S. Treasury’s concessionary borrowing terms.

Then there are the more familiar strategies of shifting funds from investments into loans, shifting the mix of loans into higher risk/higher yielding credits, shrinking the balance sheet by repaying borrowings and/or targeting highly capitalized merger partners. But, as we’ve explained before, there is one powerful capital enhancement tool hiding in plain sight, one that requires none of the above strategies but would conveniently fit with all of them – the sale and leaseback of owned facilities.

Although less prevalent in the credit union world than in community banks, sale leasebacks are finally beginning to take hold in the credit union space, as several such transactions have been announced this year, including at Wescom Credit Union ($5.8 billion, Pasadena, Calif.) and a Las Vegas location of Credit Union 1 ($1.4 billion, Anchorage, Alaska). Beyond closed deals, industry awareness is growing and deal pipelines are starting to fill. So, it’s a good time to revisit the basics of a sale-leaseback, and how well it fits with the unique characteristics of our industry.

The basic value proposition is simple and time-tested across various industries. Many credit unions have operating facilities on their books at steadily depreciating carrying values. In reality, those facilities enjoy increasing market values. Thanks to recent changes in accounting rules, by selling one or more operating facilities, your credit union could recognize an immediate tax-free gain, generate fresh non-deposit liquidity to invest in CUSOs or member-facing technologies, as well as in loans to build interest income, all while boosting capital. By leasing back the facility, the credit union maintains uninterrupted operations and control for a lease term negotiated to suit your long-term occupancy preferences, typically 20 or more years, often with tenant extension options.

Here’s an example. A $1.8 billion credit union with 10% capital has a main office building acquired 12 years ago with a depreciated book value of $18 million. The building is sold to generate $34 million in net proceeds that is available to be deployed to loans or investments. The sale generates a $16 million tax-free gain on sales, which translates into an 80bp boost to capital.

Steve Eimert is an attorney who has represented credit unions nationwide in a variety of matters, including compliance, CUSOs and executive compensation, and is a co-founder and general counsel of CURES.