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The Crisis That Swallowed the Credit Union Debate

During a period of wide economic uncertainty, credit unions and community banks squared off for another round in their competition to continue making honest loans — perhaps for naught.

At least two sectors of the financial services industry are boasting their ability to weather the current economic ebb.

Credit unions contend, in a series of releases and speeches doled out by the Credit Union National Association’s (CUNA’s) economists in the first quarter, that the subprime mortgage fiasco — which they did not cause but with which they too must deal — might actually benefit them and their customer-members further into 2008 and beyond.

Their reasoning invokes the philosophical mission of credit unions in the U.S., solidified through the Great Depression: to provide credit to those who need it the most and when it is hardest to come by. In return, state and federal governments view them as tax-exempt nonprofits operating mainly for the profit of their members.

Credit unions’ most direct competition, community banks, also stand proud above the current mess. Credit unions and commercial banks got a pass on the mortgage crisis because a minority actually trade in mortgages, a tiny sliver dabble in subprime loans and subprime mortgages are very rare between the two.

In other words, the smallest institutions can’t afford to be so risky. When they do, they often fail.

Their lessons were learned between 1986 and 1995 during the savings and loan (S&L) debacle, when bloated real estate loans, inflation and deregulation brewed a pungent stew of 1,043 insolvent S&Ls.

While credit unions have not experienced a comparable industrywide crisis, historically they are only slightly less likely to bury themselves one by one. For example, the San Francisco Bay Area-based Cal State 9 Credit Union failed in September 2007 after coloring outside of the mortgage and real estate lines. It’s one of the few credit unions or community banks taken over by its respective federal regulator as a direct result of the current subprime mortgage crisis. Still, an assessment of the probable credit union and community bank contribution to the current crisis finds the sum trifling compared to the enormous contribution of mortgage brokers at the center of the saga.

But as large U.S. lenders creak and moan, pending credit union legislation in Congress has these smaller, nimble and seasoned old opponents rising out of their worn leather armchairs to address similar issues: What are the benefits and detriments of financial regulation?

The U.S. House Financial Services Committee held a hearing on March 6 regarding the Credit Union Regulatory Relief Act. The bill has floated around the Hill in various forms for six years and would nearly double a tax-exempt credit union’s Member Business Loan limit, which is based on a percentage of a given credit union’s assets. Among other changes, the Credit Union Regulatory Relief Act would broaden the scope of the credit union “community charter.” As it stands, this allows credit unions to offer membership to anyone “who lives, works, worships, or attends school within a geographical field of membership.” The act would widen the potential “geographic field.”

The Independent Community Bankers of America (ICBA) strongly opposes the bill, calling it a further deviation from the original mission of credit unions to serve the underclasses and tightly designated niche groups. They insist that if credit unions want broad lending authority, they should simply convert to tax-paying banks. The ICBA has also long opposed the loosening of criteria by which credit union membership is defined and is leveraging a recent credit union lending fiasco resulting from a widely cast membership net in its argument.

“This was part of a basic trade-off put in place decades ago: limited activities, providing credit to individuals of modest means, but valuable tax and regulatory benefits,” testified R. Michael Stewart Menzies Sr., CEO of Maryland’s Easton Bank & Trust Company.

“The ICBA has long supported credit unions as nonprofit organizations as long as they don’t act like banks.”

Menzies retold the story of a late 2007 Florida real estate muddle, in which a number of credit unions granted speculative, out-of-state land development loans. By stretching membership rules, out-of-market investors needed to pay only a $5 membership fee to join the credit union. The deal deflated along with the housing market, and three of the credit unions involved failed as a result.

“What original members were served in their home states of Colorado and Michigan when these credit unions made these risky loans on Florida real estate?” Menzies asked Congress, demonstrating that, given enough freedom to stray off-mission, credit unions, too, could make careless decisions.

In his rebuttal, the CUNA’s elected board chair, Tom Doherty, president of the Suncoast Schools Federal Credit Union in Tampa, focused on the lending-limit portion of the bill, stating the cap was too low and stifling for small businesses seeking capital and credit unions ready to offer it.

“Quite frankly, for many credit unions, the current (lending) limit effectively bars entry into the business-lending arena,” he said. And that’s a shame, Doherty continued, given the success of credit union business lending. “Over the years, credit unions’ mission has been to meet the financial services needs of their members. Credit unions throughout the country have a good story to tell on how their member business-lending programs have helped members who have been denied business loans from banks.”

With their cases made, both sides wait. Neither trade group is willing to speculate on the record about the chances of the bill making its way to a vote. Sure bets in Washington are hard to come by when looking down the barrel of a recession in a presidential election year.

But the sides continue to keep the pot stirred. The CUNA re-upped the call in the March 18 edition of its newsletter, News Now. Doug Hampel, its chief economist, said that because of the slump, credit unions will write off more loans and lose income, but he added that the pending recession comes after a prolonged period of credit union prosperity. The industry can absorb the blow.

“This is a good opportunity for credit unions to show what they are,” Hampel wrote, referring to the industry’s traditional mission. “It’s an opportunity to shine.”

The ICBA responded by touting the continued solvency of community banks, their competitive advantages and obligatory community reinvestment.

The total number of banking assets in the U.S. is estimated to be roughly $13 trillion. CUNA and ICBA members represent about 13 percent of this total. This stable slice’s in-fighting is prescient as the U.S. looks for ways to emerge out of tough times caused by poor lending practices. Yet the aforementioned S&L crisis — which, by the numbers, will leave a smaller financial crater in the history books than the current crisis — eventually led to a significant retooling of the regulatory landscape, including the abolishment of two federal regulators and the creation of the Office of the Comptroller of the Currency. And while credit unions and community banks have kept Congress thinking about futzing with regulation during the good years, their scrap on Main Street might get rolled into a much bigger war brewing in Washington.

“It seems doubtful that (the Credit Union Regulatory Relief Act) will be enacted during the current financial crisis, even though credit unions are only marginally involved and its provisions have nothing directly to do with mortgage authority,” Bernard Shull, professor emeritus in the Department of Economics at Hunter College of the City University of New York, told “I would expect that a comprehensive review of current regulation for a wide array of financial institutions, with the prospects of further restriction, is likely to be the first order of business.”

Two days prior to the Credit Union Regulatory Relief Act debate, Sen. Chris Dodd, D-Conn., chairman of the Senate Committee on Banking, Housing, and Urban Affairs, held a hearing with bank regulators. “The question has been asked over the past year as our credit markets have grown increasingly impaired: Where were the regulators? Why didn’t they do more? Were they asleep at the switch? And when the alarm went off, did they merely hit the snooze button?” he asked.

Two weeks after the Credit Union Regulatory Relief Act debate, on March 20, Financial Services Committee Chairman Barney Frank, D-Mass., made a strong call for big changes in financial institution regulation and promised hearings, the first of which is scheduled for April 19.