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N.Y. fed report stirs corporate CU failures.

Regulatory capture, a phenomenon where the regulated dominate the regulators and unduly influence their actions, did not play a role in the corporate financial crisis that eventually cost credit unions billions of dollars, according to the NCUA.

Instead, the agency said that when it rewrote corporate credit union regulations in 2002, it neglected to address risk concentration adequately and allowed corporate credit unions too much authority in developing investment strategies, given how complex and little understood many of the investments were at the time.

"When NCUA wrote new corporate regulations in 2002, Chairman Matz, then a Board Member, voted against the proposal, believing the crucial issue of risk concentration was inadequately addressed, and that the investment authority being granted was overly permissive," NCUA Public Affairs Specialist John Fairbanks wrote in an email to CU Times.

The corporate credit union had too much authority in setting investment strategy, "particularly given the complexity of the financial instruments being made available to the corporate credit unions. After the 2002 corporate rule passed via 2-1 vote, examiners had little authority to take enforcement actions against corporates that built excessive concentrations of potentially risky investments," according to the NCUA.

The question arose after a confidential report, now made public, addressed how the Federal Reserve Bank of New York supervised and failed to supervise New York banks. The report reinvigorated speculation about how the former corporate credit unions were swept into the financial crisis and whether the NCUA could have done anything to have stopped or slowed the meltdown.

The report, named for its principal investigator and finance professor David Beim, came about after Federal Reserve Bank of New York Chairman William Dudley asked him and a small team in 2009 to investigate how the financial meltdown came about, according to a report from ProPublica and the NPR program "This American Life."

Among other things, Beim and his team blamed the Fed's culture of lax supervision as a significant factor leading up to the 2008 collapse.

Despite the New York Fed having offices inside the major banks --or sometimes because they had them--Fed staff often lacked initiative to take actions on things they saw and the agency's culture did not encourage such action, the report read.

"Examiners note how important it is to receive support from senior management when the banks complain about supervisory intrusion, and how demoralizing it can be when they perceive insufficient support," the report's authors wrote. "Many have been reluctant to press changes on the supervised banks. Some interviewees attribute the excessive deference to a lack of seniority, training, experience and confidence on the part of the relationship managers themselves."

A footnote quoted one of the supervisors the report's authors interviewed: "Within three weeks on the job, I saw the [regulatory] capture set in."

The Fed's report entered the public square in the course of litigation between a former Federal Reserve employee, Carmen Segarra and the Federal Reserve, ProPublica reported.

Segarra charged the Fed had fired her because she had been following the recommendations in the Beim report even though the agency had not been, according to ProPublica.

Segarra also secretly recorded meetings she attended while working for the Fed, which had offices in investment bank Goldman Sachs. Her recordings, the ProPublica and NPR stories argued, back up the suggestion that the New York Federal Reserve had still not made changes to its culture. The New York Federal Reserve has strongly denied this claim.

Meanwhile, the NCUA also pointed out that its inspector general delivered material loss reviews about the major corporate credit unions that failed and that those reports pointed to several structural deficiencies in the agency's supervision of the corporates --not regulatory capture.

For example, when discussing the failure of WesCorp, the inspector general's material loss review noted that the NCUA's staff had not objected or stopped the corporate from taking aggressive positions in mortgage-backed securities backed by riskier mortgages.

The NCUA's staff had also not objected to the purchase of mortgage-backed securities backed largely by mortgages made in only California, or by one lender, Countrywide, because they lacked regulatory backing to do so, the inspector general found.

"As a result, OCCU examiners did not have the regulatory leverage to limit or stop the growth of WesCorp's purchase of privately-issued RMBS, which would have likely mitigated WesCorp's severely distressed financial condition and expected loss as a result of the extended credit market dislocation, and thus averted NCUA's ultimate conservatorship of WesCorp" the NCUA's inspector general wrote.

Similar conclusions about failures at other corporates were also reached, the inspector general said. However, a source very familiar with the failure of one corporate credit union argued that the inspector general had only revealed a part of what the source had seen at his institution and that, in his view at least, NCUA staff onsite at the credit union had been captured by the corporate's culture and strategy.

Speaking to CU Times on background, the source described an atmosphere where corporate executives, and sometimes NCUA staff, considered NCUA examiners and supervisors as not being a match for the corporate leadership team; not as experienced, not as sophisticated, not as trained and not as comfortable with the investment world.

"There's no question that NCUA's people were in awe of some of those guys," the source said, pointing out that the NCUA staff merely adopted an attitude prevalent among many of the corporate credit union's more junior executives who were also overawed by their leaders.

A big part of that awe was until the financial crisis, the executives who drew up the corporate's investment strategy had years of success behind them.

"Quarter after quarter after quarter came in without a loss," the source recalled. "And that kind of record is a powerful thing. How do you argue with success?"

He also pointed out that the securities the corporate bought were highly rated and that the all the purchases were legal, further limiting the NCUA staff's ability to question them even if they had seen a reason to do so.

"So the [inspector general] is right that it probably would have helped if the examiners had a specific regulation to point to that limited the ability to buy as many of these securities," the source said. "But there was no guarantee they would have used it."

However, the source was also adamant that NCUA staff onsite should not be the only officials characterized as captured.

"It would be so easy and so wrong to look at the NCUA people onsite and say 'oh they just missed the boat' or 'oh, they fell asleep at the switch,' when the reality is the whole agency was captured, from the lowest examiner up to the seventh floor. The whole agency was enthralled with this model," the source said.

Ironically, the source pointed to the 2002 corporate credit union rule, which the NCUA pointed to as a primary reason its staff did not stop the corporate system's expansion into more mortgage-backed securities, as evidence for his contention.

"Every time the NCUA had made some noises about wanting to put some brakes on or limit what corporates could do, the corporates would scream about how their authorities were appropriate for the levels of risk the [mortgage backed securities] represented," the source said.

"The fact that the NCUA bought the corporates' line of argument and wound up giving them the sort of regulation they wanted just proves how much not only examiners, but NCUA executives as well, had accepted their view of their activity" the source added.

The Rundown

* New York Fed report blames lax bank supervision for financial crisis.

* Report sparks questions about NCUA supervision at former corporates.

* NCUA denies regulatory capture played a role in corporate failures

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Title Annotation:CORPORATES
Author:Morrison, David
Publication:Credit Union Times
Date:Oct 15, 2014
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