    Corporate Credit Unions: Competitive Environment May Stress
    Financial Condition, Posing Challenges for NCUA Oversight
    (10-SEP-04, GAO-04-977).

    Thousands of credit unions have placed about $55 billion of their
    excess funds in corporate credit unions (corporates). In a
    three-tiered system, corporates provide lending, investment, and
    processing services for their member credit unions. Problems with
    investments in the past prompted regulatory changes that required
    higher capitalization and stricter risk management, but allowed
    for expanded investment authorities. GAO assessed (1) the changes
    in financial condition of the corporate network and (2) the
    oversight of corporates by the National Credit Union
    Administration (NCUA), the federal regulator of credit unions.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-04-977
        ACCNO:   A12414
      TITLE:     Corporate Credit Unions: Competitive Environment May
    Stress Financial Condition, Posing Challenges for NCUA Oversight
         DATE:   09/10/2004
      SUBJECT:   Credit unions
    	     Financial institutions
    	     Financial management
    	     Internal controls
    	     Investments
    	     Regulatory agencies
    	     Risk management

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    GAO-04-977

    Report to the Ranking Minority Member, Committee on Banking, Housing, and
    Urban Affairs, U.S. Senate

    September 2004

    CORPORATE CREDIT UNIONS

    Competitive Environment May Stress Financial Condition, Posing Challenges
    for NCUA Oversight

    Contents

    Tables

    Figures

    Abbreviations

    September 10, 2004Letter

    The Honorable Paul S. Sarbanes Ranking Minority Member Committee on
    Banking, Housing, and Urban Affairs United States Senate

    Dear Senator Sarbanes:

    Thousands of credit unions have placed about $55 billion of their excess
    funds in corporate credit unions for investment purposes. Under a
    three-tiered system, corporate credit unions (corporates) are member-owned
    financial cooperatives whose members are credit unions, not individuals.
    As the "credit union for credit unions," corporates provide deposit,
    liquidity, investment, and processing services for their members. In turn,
    the member credit unions have about 82 million members, to whom they
    provide deposit, loan, and some investment services. U.S. Central Credit
    Union (U.S. Central), a nonprofit cooperative, is owned by corporates
    (serves as the "corporate for the corporates") and it serves its members
    much like corporates serve their credit union members-which the federal
    regulator for credit unions, National Credit Union Administration (NCUA),
    and the corporate network refer to as natural person credit unions.1

    We last conducted a comprehensive review of corporates and their oversight
    by NCUA in 1991.2 In addition, we conducted more targeted reviews of
    corporates in 1994 and 1995 in response to the failure of a large
    corporate in the mid-1990s.3 Since that time, assets placed in corporates
    have grown, corporate credit union business strategies have changed, and
    NCUA has significantly changed its approach to oversight. In light of the
    evolution of corporate credit union operations and the change in NCUA's
    supervisory approach, and as part of our overall review of the credit
    union industry, you asked us to review a number of issues involving
    corporates and NCUA.4 Based on discussions with your staff, we assessed
    (1) the changes in financial condition of corporate credit unions since
    1992 and (2) NCUA's supervision and oversight of corporates, particularly
    with regard to how it identifies and addresses safety and soundness
    issues.

    To assess the changes in the financial condition of corporates, we
    analyzed corporate credit union call report data from December 1992 to
    December 2003, and reviewed internal corporate credit union analyses and
    independent studies of the industry from rating agencies.5 We also
    conducted a legislative and regulatory review to determine the key
    legislative and regulatory changes affecting corporates since 1992. To
    depict the business environment that can affect the financial condition of
    corporates, we administered a questionnaire to all 31 currently operating
    corporates, and interviewed NCUA and credit union trade organization
    officials. To assess how NCUA's supervision of corporates identified and
    addressed safety and soundness issues, we reviewed NCUA documentation on
    its risk-focused examination program and reviewed examinations and NCUA
    management reports for all corporates from 2001 through 2003. We also
    conducted a detailed review of NCUA workpapers for 10 corporates and
    interviewed the examiners who were responsible for supervising these
    corporates. In addition, we conducted site visits to seven corporates,
    selected based on their size, geographic location, and whether they were
    state or federally chartered, or were granted expanded investment
    authorities.6 Appendix I provides additional details on our scope and
    methodology. Appendix II provides a list of all 31 corporates that were
    active as of December 31, 2003, and appendix III contains a copy of the
    structured questionnaire. We conducted our work in Alexandria, Virginia,
    Washington, D.C., and other U.S. cities from December 2003 to September
    2004 in accordance with generally accepted government auditing standards.

    Background

    Corporate credit unions occupy a unique niche among financial
    institutions.7 They are nonprofit financial cooperatives that are owned by
    natural person credit unions (that is, credit unions whose members are
    individuals), and provide lending, investment, and other financial
    services to these credit unions. For example, corporates offer loans to
    member credit unions, which in turn use these loans to meet the loan
    demands of their individual members. However, corporates are not the only
    financial institutions that provide products and services to credit
    unions. For example, some credit unions may also obtain loans from Federal
    Reserve Banks or Federal Home Loan Banks.8 Additionally, corporates offer
    credit unions investment products and investment advice, but credit unions
    can also obtain these services from broker-dealers or investment firms.
    Finally, corporates also offer automated settlement, securities
    safekeeping, data processing, accounting, and electronic payment services,
    which are similar to the correspondent services that large commercial
    banks have traditionally provided to smaller banks. With an emphasis on
    safety and liquidity, corporates seek to provide their members with higher
    returns on their deposits and lower costs on products and services than
    can be obtained individually elsewhere. However, corporates' limited
    ability to generate profits-as nonprofit institutions, owned and
    controlled by their primary customers-constrains their ability to build a
    financial cushion against adverse financial conditions or unexpected
    losses.

    Since 2000, corporates have experienced deposit inflows from natural
    person credit unions that increased corporates' assets and shares.
    Corporates act as a "liquidity sponge" for the underlying natural person
    credit union system, and the cyclical rise and fall of corporates' assets
    and shares (deposits) are rooted in the deposit flows of the natural
    person credit unions. Thus, these inflows and outflows of deposits, which
    are beyond corporates' control, affect their measures of financial
    strength-such as profitability and capital ratios. As we discuss later in
    the report, this has exacerbated the stress on their financial condition.

    Since 1992, the number of corporates in the corporate network has
    decreased, with assets more concentrated in larger institutions. (See fig.
    1 for an illustration of the network's geographic distribution.) Mainly as
    a result of mergers, corporates have decreased in number from 44, at the
    end of 1992, to 30 as of December 31, 2003, excluding U.S. Central. On
    average, corporates also have become larger, with the median asset size
    (excluding U.S. Central) increasing from $450.6 million in 1992 to $1.2
    billion at the end of 2003. However, the corporate network still
    encompasses small and large institutions, ranging in size from $7.3
    million in assets to $25 billion, as of December 31, 2003. In addition,
    asset concentration in the network has become more pronounced since 1992.
    Excluding U.S. Central, at the end of 1992 the three largest corporates
    accounted for approximately 42 percent of the corporates' total assets. By
    the end of 2003, these corporates accounted for roughly half of
    corporates' total assets and the largest corporate accounted for about
    one-third.

    Figure 1: Location of Corporate Credit Unions, as of December 2003

    As shown in figure 2, the credit union industry is organized into three
    closely connected groupings. At the "top" or retail level, as of December
    31, 2003, there were the 9,488 credit unions that served roughly 82
    million individual customers. In the middle are the 30 corporates, which
    serve credit unions by investing the cash they have not lent out and by
    providing loans and other financial services to the credit unions.
    Finally, on the "bottom" or wholesale level is U.S. Central, which
    provides corporates a range of products and services, similar to those
    that corporates provide to credit unions.

    Figure 2: Services Provided to Natural Person Credit Unions by Corporate
    Credit Unions and U.S. Central Credit Union, as of December 31, 2003

    aIncludes cash management products and services, risk management,
    settlement, and funds transfer.

    bTwenty-nine corporates are members of U.S. Central Credit Union. LICU
    Corporate Federal Credit Union is not a member of U.S. Central. LICU
    Corporate was originally established as a corporate credit union to
    facilitate payment and payroll processing for a league of IBM credit
    unions. While LICU Corporate and U.S. Central have discussed the
    possibility of LICU Corporate joining U.S. Central, LICU has not applied
    for membership.

    Since their inception, corporates' primary functions have been to accept
    deposits and make loans to their members. In addition, today, they also
    provide investments and other financial services to credit unions, and
    corporates over time have broadened the types of products and services
    they offer. Most corporates offer

    o investment services;

    o electronic services, such as the Automated Clearing House (ACH) and wire
    transfers;

    o correspondent services, such as settlements with the Federal Reserve and
    other financial institutions;

    o check services, including collection and settlement of money orders and
    traveler's checks;

    o credit card settlement; and

    o education and training.

    However, corporates now offer or plan to introduce new products and
    services such as online training, electronic bill payment, Internet
    banking, asset/liability management (ALM), and brokerage services.9 For
    more detailed information on the products and services corporates offered
    or planned to offer, see appendix IV.

    While the first credit union in the United States started in 1909, the
    first corporate did not start operations until 1968.10 Many corporates
    grew out of the various state credit union leagues and initially served
    only single states or regions. Over time, corporates were granted national
    fields of membership that allowed them to expand the number of credit
    unions they served. While corporate credit union membership can be
    national, corporates can have either a state or federal charter. As of
    December 31, 2003, 18 of the 31 corporates, including U.S. Central, were
    state-chartered. In terms of oversight, NCUA has authority for supervision
    and examination of federally chartered corporates. Under the
    dual-chartering system, the supervisory authorities for those states that
    have state-chartered corporates are primarily responsible for supervision
    of these institutions. However, since all corporates provide deposit,
    liquidity, and correspondent services to federally insured credit unions,
    NCUA also has regulatory authority over state-chartered corporates and
    assesses the risks federally insured, state-chartered corporates and
    noninsured, state-chartered corporates present to the National Credit
    Union Share Insurance Fund (NCUSIF).11 This assessment, which is
    essentially an examination of the corporates' operations, is performed
    jointly with state supervisory authorities during their examinations of
    state-chartered corporates.

    Part 704 of NCUA's regulations, together with the relevant provisions of
    the Federal Credit Union Act of 1934, constitutes the primary federal
    regulatory framework for both state- and federally chartered corporates.12
    NCUA first issued Part 704 in 1982. Since our previous report on
    corporates in 1991, NCUA made significant revisions to Part 704 in 1998
    and 2002 relating to risks, capital, investments, and other areas covered
    by this report.

    Results in Brief

    Corporates face an increasingly challenging business environment that has
    created potential stresses on their financial condition. Like other
    financial institutions, corporates operate in an environment characterized
    by increasing competition, changing product and service offerings, and the
    continuous introduction of new technology-thus increasing the complexity
    of their operations, which in turn can impact their financial condition.
    The corporates' financial condition, as measured by profitability (the
    ratio of net income to average assets) and capital ratios, remained close
    to a range that has prevailed since the mid-1990s. However, since 2000, a
    large influx of deposits coupled with low returns on traditional corporate
    investments has caused a downward trend in corporates' overall
    profitability because deposits/assets have grown more quickly than income.
    More recently, the relatively slower growth in retained earnings (a
    component of income) has also put pressure on capital ratios, which raises
    some concern since capital ratios are an important indicator of financial
    strength. To generate earnings, corporates increasingly have targeted more
    sophisticated and potentially riskier investments. However, corporates
    appear to be managing risk by shifting toward more variable-rate and
    shorter-term investments, providing a potentially better match for the
    relatively short-term nature of their members' deposits and managing its
    other risks. Further, NCUA recently permitted the three largest corporates
    to invest in lower-rated securities, potentially increasing their credit
    risk (that is, there is a higher risk of nonpayment on assets held by the
    corporate), but their use of this expanded authority has been negligible
    to date.  The corporates' changing business environment and their use of
    more sophisticated and potentially riskier investments increases the
    importance of NCUA regularly assessing its oversight processes to ensure
    that corporates are properly managing these risks.

    NCUA has strengthened its oversight of corporates, which has allowed it to
    better address safety and soundness issues; however, NCUA faces challenges
    in identifying networkwide problems on a consistent basis, using
    specialists effectively, providing relevant guidance on mergers, and
    assuring the quality of corporates' internal controls. Since 1991, NCUA
    has created an office dedicated to the oversight of corporates-the Office
    of Corporate Credit Unions (OCCU)-significantly revised regulations
    specific to corporates, implemented risk-focused supervision and
    examinations, and hired specialists in areas such as capital markets and
    information systems. Based on our review of NCUA examinations for 2001
    through 2003, NCUA examiners generally have identified safety and
    soundness issues and mandated corrective actions to address them. However,
    NCUA has not tracked or systematically evaluated trends in examination
    findings and their resolution to help its examiners anticipate emerging
    issues within the corporate network. Further, NCUA has not systematically
    considered certain operational risks, such as weak information system
    controls, when assigning specialists to examinations. This may have led to
    NCUA overlooking certain problems or not ensuring that problems were
    corrected in a timely manner. In addition, although it has
    responsibilities to approve proposed mergers, we found that NCUA had not
    developed specific guidance for corporates submitting merger proposals or
    ensured that the guidance examiners used to assess these proposals was
    comprehensive and clearly applicable to corporates. For example, NCUA has
    referred corporates to guidance issued for natural person credit unions
    that provides step-by-step instructions for completing the merger process,
    but the capital ratios were not relevant for evaluating corporates'
    proposals. During our review of five recent mergers, we found that NCUA
    did not conduct their reviews in a consistent manner; additionally, we
    could not always determine why NCUA reached certain decisions concerning
    these mergers. In an increasingly competitive environment in which
    corporates are considering mergers to remain competitive, nonspecific
    guidance and inconsistent reviews of merger proposals might lead to
    mergers that would not be in the best interest of members and would
    present undue risks to the network's safety and soundness. Finally, as
    corporates introduce new technologies and offer their members more
    sophisticated products and services, NCUA's oversight of corporates'
    internal controls has become more important. However, corporates are not
    subject to the internal control reporting requirements imposed on other
    financial institutions of similar size that help to ensure safety and
    soundness, as defined under the Federal Deposit Insurance Corporation
    Improvement Act of 1991 (FDICIA). This raises a question about whether
    NCUA has the necessary information to assess corporates' internal
    controls.

    This report contains recommendations to NCUA that, if implemented, would
    provide a more systematic and consistent approach to NCUA's oversight of
    corporates to help achieve its goal of promoting a network of financially
    healthy, well-managed federally insured corporates.

    We requested comments on a draft of this report from the Chairman of the
    National Credit Union Administration. We received written comments from
    NCUA that are reprinted in appendix VIII. NCUA concurred with most of our
    assessments and conclusions and agreed to take action to implement all but
    part of one of our report's recommendations. NCUA's comments and our
    response are discussed at the end of this report.

    Corporate Network Faces an Increasingly Challenging Business Environment,
    Creating Potential Stress on Its Financial Condition

    Like other financial institutions, corporates face a challenging business
    environment that affects their financial condition and is characterized by
    increasing competition, changing product and service offerings, and rapid
    technological advances.13 Moreover, recent pressure from a
    low-interest-rate environment and rapid growth in assets has put
    additional stress on the corporate network's profitability and capital
    ratios.14 While net income levels have grown since 2000, corporates'
    profitability was lower in 2003 than in 1993. As rapid asset growth
    negatively impacts profitability, it affects corporates' ability to
    generate sufficient retained

    earnings-the primary component of their capital.15 As overall capital
    levels have been rising, corporates have been relying more on less
    permanent (relatively weaker) forms of capital. Additionally, rapid asset
    growth and the relatively slower growth in retained earnings has put
    pressure on corporates' capital ratios, which could be a cause for concern
    since capital ratios are an important indicator of financial strength.
    Growth and changes in corporate investments, such as recent shifts of more
    of the corporates' investment portfolios into potentially higher yielding
    and more volatile securities, may increase interest-rate risk if the
    investments are not managed properly. In particular, the percentage of
    corporate investments in obligations of U.S. Central has declined while
    the percentages of corporates' investments in privately issued
    mortgage-related and asset-backed securities have increased.16 Corporates
    appear to be managing risk by shifting toward more variable-rate and
    shorter-term securities, providing a potentially better match for the
    relatively short-term nature of their members' deposits. However, a
    regulatory change effective in 2003 allowed certain corporates to purchase
    securities with lower credit quality (more credit risk), raising
    implications for NCUA oversight since this activity may lead to increased
    risk if it is not managed properly.

    The Challenging Business Environment in Which Corporates Operate May
    Impact Their Financial Condition

    Corporate credit unions are operating in a challenging business
    environment characterized by increased competition, pressure to increase
    returns on their investments in a low-interest-rate environment, and the
    need to invest in technology and personnel to meet the demands of their
    credit union members for new and more sophisticated products and services.
    To obtain the corporates' views on their business environment, we
    distributed a questionnaire to the entire network and achieved a 100
    percent response rate. The corporates reported that they faced competition
    from outside the corporate network from entities such as banks,
    broker-dealers, the Federal Reserve System, and Federal Home Loan Banks.
    About 87 percent of the corporates reported that they also faced
    competition from other corporates despite the cooperative nature of the
    network. In addition, in recent years (since 2000), corporates have
    received a large inflow of deposits from their natural person credit union
    members, which had increasing amounts of unloaned funds because of the
    "flight to safety" that occurred in the wake of the stock market
    downturn.17 These inflows increased corporates' assets, pressuring them to
    ensure that they received sufficient returns when investing these funds to
    maintain adequate capital levels and fund operations. However, over the
    last several years, low interest rates have reduced the returns that
    corporates could obtain on their investments, which has put stress on
    their overall profitability. Finally, the corporates stated that they
    faced a rapidly changing marketplace, particularly related to the
    increased demands from credit unions for more sophisticated products and
    services such as electronic banking.

    The strategies corporates have employed to respond to their challenging
    business environment can have positive or negative impacts on their
    overall financial condition. For example, over time, corporates have
    increasingly invested in securities such as privately issued
    mortgage-related and asset-backed securities and less so in obligations of
    U.S.Central, suggesting that they are seeking to enhance the yields on
    their investments. As corporates shift their investments into potentially
    higher-yielding securities, the network could face increased risks if
    individual corporates do not have adequate infrastructure in place to
    manage risks associated with their investments.18

    Increasing competitive pressures may have encouraged consolidation,
    through mergers within the network, as corporates sought to achieve
    economies of scale. Consolidation is likely to continue as 7 of the 30
    corporates responding to our questionnaire stated that they were likely or
    would consider merging in the next 2 years. Industry observers have noted
    that mergers are an effective strategy to attain economies of scale
    necessary to afford investments in technology and skilled personnel;
    however, if poorly implemented, mergers have the potential to impact
    operating performance. The recent and expected consolidation activities
    within the network could impact the financial condition of the acquiring
    corporate, as well as the corporate network.

    Finally, based on the responses to our questionnaire, corporates reported
    that they have been forming strategic alliances with other corporates to
    provide member credit unions with sophisticated products and services such
    as online banking and business lending services. Industry observers have
    viewed these alliances as an effective approach to meet the demands of
    members while distributing the costs among several corporates. However, as
    corporates move into new areas to meet the demands of their members,
    corporates need to maintain sufficient retained earnings and capital
    levels.

    Despite General Growth in Net Income, Corporate Profitability Has Trended
    Lower Recently

    Despite generally rising net income levels since 1995, the profitability
    of corporates has declined recently due to the low-interest-rate
    environment and large inflows of deposits from natural person credit
    unions.19 More specifically, as shown in figure 3, while net income of
    corporates generally fluctuated since 1992, it grew overall since 1995.
    While profitability generally remained within ranges prevalent in the
    industry since the mid-1990s, it was lower at the end of 2003 than at the
    end of 1993.  20

    Figure 3: Net Income Has Generally Risen, but Profitability Has Declined
    Recently

    Note: In this figure, profitability in a given year is measured by the
    ratio of that year's net income to the average of that year's total assets
    and the prior year's total assets. This figure excludes data on U.S.
    Central.

    Also, as shown in figure 3, profitability-the net income corporates
    realize on their assets-was relatively stable in the mid-1990s, but has
    been trending downward since 2001. Effectively, the recent
    lower-interest-rate environment has narrowed the difference between what
    corporates were earning on their investments and what they were paying to
    their members. (Appendix V provides more details on corporates' income and
    operating expenses.) Profitability is an important indicator of financial
    condition, as it is a key determinant of the sufficiency of a corporate's
    retained earnings. Retained earnings are the primary component of a
    corporate's capital, representing that corporate's financial strength and
    its ability to withstand adverse financial events. The recent trend
    downward in corporates' profitability has slowed growth in their retained
    earnings and capital compared with their assets.

    Despite Increases in Overall Capital Levels, Corporates' Capital Ratios
    Have Trended Lower Recently

    The overall level of capital at corporates has steadily increased since
    1998, in part due to regulatory changes that allowed corporates to use
    other, less permanent (or relatively weaker) forms of capital in addition
    to retained earnings.21 Corporates have been increasingly relying on these
    relatively weaker forms of capital. However, since 2000 capital ratios
    have declined as growth in assets outpaced growth in capital.22 The
    increasing reliance on less permanent forms of capital and corporates'
    generally constrained ability to build capital in periods of stress raises
    a potential concern about the financial strength of the corporate network.

    Capital Levels Have Generally Risen, but Corporates Increasingly Have
    Relied on Less Permanent Forms of Capital

    As shown in figure 4, the overall level of capital at corporates has
    steadily increased since 1998. This is due in part to regulatory changes
    that allowed corporates to use other, less permanent (or relatively
    weaker) forms of capital in addition to retained earnings.

    Figure 4: Capital Levels Have Risen, but Corporates Have Increasingly
    Relied on Less Permanent Forms of Capital

    Note: Retained earnings represent the most permanent form of capital,
    while membership capital represents the least permanent. This figure
    excludes data on U.S. Central.

    Beginning in 1998, Part 704 of NCUA regulations expanded the definition of
    regulatory capital by defining capital as the sum of reserves and
    undivided earnings (that is, retained earnings) and permitted corporates
    to include two other, less permanent forms-paid-in capital and membership
    capital. More specifically, reserves and undivided earnings include all
    forms of retained earnings, including regular or statutory reserves and
    any other appropriations designated by management or regulatory
    authorities. NCUA currently defines "core capital" for corporates in Part
    704 as retained earnings plus paid-in capital. Retained earnings, which
    are internally generated, are the most permanent form and the primary
    component of corporates' capital. Both paid-in capital and membership
    capital, which are from external sources, are less permanent forms of
    capital, suggesting they provide a relatively weaker cushion against
    adverse financial events. Prior to July 1, 2003, paid-in capital was
    defined as a member deposit account with an initial maturity of at least
    20 years. However, NCUA now requires paid-in capital to be a more
    permanent form of capital (a perpetual dividend account), available to
    cover losses that exceed reserves and undivided earnings. NCUA had noted
    that, due to its high cost, paid-in capital would be used by corporates as
    a bridge during short periods of stress, such as rapid growth, and should
    not be used for long periods. While NCUA's redefinition of paid-in capital
    has increased the relative permanence of this form of capital, membership
    capital represents funds contributed by members that have either an
    adjustable balance with a required notice of withdrawal of at least 3
    years or are term certificates with a minimum term of 3 years.23 As such,
    membership capital is probably best thought of as a form of subordinated
    debt, which can protect the insurance fund in the event of a corporate
    failure.

    As shown in figure 4, corporate capital rose from $2.9 billion in 1998 to
    $5 billion at the end of 2003. Retained earnings accounted for 41 percent
    of total capital in 1998 but declined to around 36 percent of total
    capital at the end of 2003. Paid-in capital increased from around 6
    percent of total capital in 1998 to around 10 percent in 2003. Membership
    capital shares have consistently represented the largest percentage of
    capital, typically around 50 percent, and have been steadily accounting
    for a greater percentage of capital since 2000. Thus, while the capital of
    corporates continues to rise, corporates have increasingly relied on less
    permanent (that is, relatively weaker) forms of capital. While this is a
    method corporates can use to increase capital during periods of rapid
    growth in assets, it does lead to concerns about the ability of the
    network to withstand financial shocks, especially in light of the
    increasingly challenging business environment they face.

    Capital Ratios Have Declined Recently but Remain above Current Regulatory
    Requirements

    While the total capital of corporates has steadily increased since the
    late-1990s, since 2000 capital ratios have declined as growth in assets
    outpaced growth in capital. NCUA currently specifies three capital ratios:
    the capital ratio, which includes all forms of capital relative to moving
    daily average net assets (DANA); the core capital ratio, which includes
    core capital (retained earnings plus paid-in capital) relative to moving
    DANA; and the retained earnings ratio, which includes reserves plus
    undivided

    earnings relative to moving DANA.24 As depicted in figure 5, these capital
    ratios were lower in 2003 than in 1998 despite generally rising capital
    levels.

    Figure 5: Capital Ratios Have Declined Recently (1998-2003)

    Note: In this figure, capital ratios are calculated by dividing capital by
    the moving daily average of net assets (DANA), which is a measure of
    average assets as set forth in Part 704 in 1998. This figure excludes data
    on U.S. Central.

    As assets have increased, corporates have been unable to generate
    sufficient capital to maintain capital ratios. In particular, after
    peaking in 2000, capital ratios declined, as the corporates' asset
    base-which inversely affects the capital ratio-increased by over 80
    percent over the same period. Despite recent declines, at the end of 2003
    the capital and retained earnings ratios remained in excess of their
    current respective regulatory requirements of 4 percent and 2 percent.25
    Due to corporates' role in serving their members, their generally low
    earnings continue to present a challenge and a potential weakness-as
    corporates generally rely on building permanent capital from retained
    earnings-and could put a strain on the profitability of the corporate
    network in the future. As a result, corporates' capital ratios, although
    above current regulatory requirements for safety and soundness purposes,
    are vulnerable to erosion from factors such as rapid inflows of deposits
    that corporates may not be able to control.

    Growth and Changes in Corporates' Investments May Increase Risks If Not
    Monitored or Managed Properly

    Although assets have grown through the recent influx of deposits,
    corporates have continued to allocate them almost exclusively to
    investments (rather than other assets that include cash, loans, or fixed
    assets). With this growth, the percentage of corporates' investments in
    obligations of U.S. Central has declined somewhat, particularly for the
    largest corporates. In response to the low-interest-rate environment,
    corporates have moved relatively more of their investments into
    potentially higher yielding-and more volatile-securities. The largest
    corporates also appear to be managing interest-rate risk by shifting
    toward more variable-rate and shorter-term securities, providing a
    potentially better match for the relatively short-term nature of their
    members' deposits. However, a regulatory change effective in 2003 allowed
    certain corporates to purchase securities with lower credit quality, but
    few have used this investment authority. It is not clear, however, to what
    extent corporates might use this investment flexibility in the future,
    raising implications for NCUA oversight since this activity may lead to
    increased credit risk if it is not managed properly.

    While Corporate Investment Portfolios Have Grown, Larger Corporates
    Invested Less in U.S. Central

    Corporates' investments have grown with the recent inflows of deposits
    from natural person credit unions. Investments, which include asset-backed
    securities, commercial debt obligations, mortgage-related issues, and U.S.
    government obligations, represent the vast majority of corporates'
    assets-usually 90 percent or more (see fig. 6). At the end of 1992, total
    investments of corporates stood at $41.1 billion; at the end of 2003, they
    were reported at $65.3 billion. Since 2000, total investments of
    corporates have grown by 84 percent.

    Figure 6: Corporates' Investments Have Grown and Consistently Represent
    Most of Corporates' Assets

    Note: Other assets include cash, loans, and fixed assets. This figure
    excludes data on U.S. Central.

    Since 1992, corporates' investments in U.S. Central obligations have
    typically accounted for approximately one-half of their total investments,
    the largest single investment category. The generally high proportion of
    investments in U.S. Central obligations reflects the "pass-through" nature
    of many corporates. Historically, U.S. Central has functioned as a conduit
    between corporates and the capital markets. Despite growth in the overall
    amount of corporates' investments in U.S. Central obligations, they
    declined as a percentage of corporates' total investments from 1997 to
    2003. For example, they went from $15.6 billion (53 percent) at the end of
    1997 to $29.2 billion (45 percent) at the end of 2003. This decline
    indicates that the largest corporates are investing their funds directly,
    rather than through U.S. Central. As shown in figure 7, in general, the
    largest corporates have held smaller percentages of their investments in
    U.S. Central obligations than smaller corporates.

    Figure 7: Largest Corporates Have Invested Relatively Less in U.S. Central
    Obligations Than Smaller Corporates

    Notes: In this figure, which separates corporates into three categories
    according to their year-end assets, corporates' investments in U.S.
    Central obligations are shown relative to corporates' total investments.
    Prior to 1997, NCUA call reports did not disaggregate investments in U.S.
    Central obligations from investments in corporate credit unions, and thus
    a proxy measure-investments in corporates relative to corporates' total
    investments-is depicted for 1992-1996. To the extent that corporates
    invested in other corporates during 1992-1996, the call report data
    reflect an upper bound on investments in U.S. Central obligations. This
    figure does not follow the same institutions each year; rather, it
    reflects the investments of those corporates in a given size category in a
    given year. This figure excludes data on U.S. Central.

    As investment management has increased in complexity, smaller corporates
    may not have had the resources necessary to develop and maintain
    investment capabilities internally, and U.S. Central thus was able to
    provide smaller corporates with these services by leveraging the
    efficiencies gained through its economies of scale. Despite the recent
    decline in the percentage of corporates' investments in U.S. Central
    obligations, U.S. Central still provides substantial investment
    services-suggesting that the health of U.S. Central remains critically
    important for its members and their associated natural person credit
    unions.

    Investments Have Shifted Toward Potentially Higher Yielding and More
    Volatile Securities, but Largest Corporates Appear to Be Managing
    Interest-Rate Risk

    In response to the low-interest-rate environment, corporates have moved
    relatively more of their investments into potentially higher yielding-and
    more volatile-securities. In particular, corporates have increased their
    relative holdings of privately issued mortgage-related and asset-backed
    securities, which may offer higher yields for corporates relative to other
    investments such as government-guaranteed obligations. As illustrated in
    table 1, the percentage of investments in privately issued
    mortgage-related securities increased from 0.9 percent of total
    investments in 1997 to 14.1 percent in 2003. Asset-backed securities also
    increased relative to total investments (from 19.5 percent in 1997 to 24.7
    percent in 2003).26 With the potentially higher yields, the corporates are
    also potentially increasing risk-notably interest-rate risk. This shift
    highlights the importance of risk monitoring and management by the
    corporates and NCUA.

    Table 1: Corporates' Investments Shifted toward Potentially Higher
    Yielding and More Volatile Securities

    Investments
    relative to total     1997    1998    1999    2000    2001    2002    2003
    investments
    (percent)
    U.S. Central
    obligations held       53%     56%     57%     53%     45%     42%     45%
    by corporates
    Asset-backed            19      18      24      23      23      23      25
    securities
    Privately issued
    mortgage-related         1       2       3       4       6       9      14
    securities
    Government and
    agency                  13       9       9       8       8       7       6
    mortgage-related
    securities
    Other                   14      14       7      11      18      18      11
    Total investments  $29,727 $41,645 $35,642 $35,553 $55,449 $63,859 $65,280
    (in millions)

    Source: Call report data.

    Notes: Totals may not add due to rounding. "Other" includes U.S.
    government obligations, U.S. government-guaranteed obligations,
    obligations of U.S. government-sponsored enterprises, and commercial debt
    obligations. This table excludes data on U.S. Central.

    However, corporates also have shifted the composition of their investment
    portfolios toward more variable-rate and shorter-term securities, a
    strategy that tends to reduce adverse exposure to changing interest rates
    and thus reduces interest-rate risk. While 41.7 percent of corporates'
    asset-backed securities were classified as fixed-rate at the end of 1997,
    18 percent were so classified at the end of 2003. Since corporates' call
    reports do not include weighted-average life data-the expected time that
    the principal portion of a security will remain outstanding-we reviewed
    materials from the three largest corporate credit unions that showed these
    institutions tended to hold securities with relatively short
    weighted-average lives, with most being less than 3 years.27 As a result,
    while corporates have moved to securities that may entail additional
    investment risk, the largest corporates in the network appear to be
    managing interest-rate risk by shifting toward more variable-rate and
    shorter-term securities, providing a potentially better match for the
    relatively short-term nature of their members' deposits.28

    Expanded Authority to Invest in BBB Rated Securities May Lead to Increased
    Credit Risk If Not Managed Properly

    Due to the revision of Part 704, some corporates have been allowed to
    invest in lower-rated securities (down to BBB rated), which might lead to
    increased credit risk if these investments were not managed properly.29
    Investments with lower credit quality tend to provide higher yields but
    can also expose investors to the increased likelihood that promised cash
    flows will not be paid. While "moving down the credit curve" (that is,
    investing in lower credit quality securities) potentially exposes a
    corporate to increased credit risk, such a strategy might not increase the
    overall risk for a corporate making such investments provided the
    additional risk was managed appropriately. According to NCUA, this
    regulatory change gave corporates added flexibility with which to
    diversify their portfolios and

    reduce investment concentration.30 In particular, these securities could
    be used in an attempt to limit credit risk by lowering concentrations in
    certain industries or geographical areas and creating a more diversified
    portfolio. Also, lower-rated securities could be purchased because they
    carried a particularly attractive return for their credit rating or
    provided a good mix of credit risk and interest-rate risk given the other
    holdings of a corporate.31 According to NCUA and corporate officials, the
    ability to hold such lower-rated securities in their portfolios (as
    opposed to having to sell a security immediately if it were downgraded)
    might provide these institutions more flexibility in disposing of an
    investment that suffered a rating downgrade. Corporates would be able to
    hold the investment in an effort to limit realized losses rather than
    being forced to promptly liquidate it. Based on our review of information
    provided by the three corporates that have the authority to invest in
    these securities, as well as discussions with their officials and risk
    management staff, corporates either have made few such investments or
    none. Further, officials at the three institutions indicated that they did
    not plan to use their authority to purchase BBB rated securities.

    However, it is not clear to what extent corporates will take advantage of
    this investment flexibility in the future, which has implications for NCUA
    oversight that we discuss later in this report. If corporates were to hold
    or invest in BBB rated securities to a greater extent, these investments
    might create additional risks to the corporate network if not managed
    properly. In general, like other financial institutions, a corporate's
    vulnerability to risk depends on its overall portfolio and the amount of
    capital that is backing it. Some have suggested that corporates tend to be
    relatively thinly capitalized compared with other financial institutions,
    which may raise concerns over potential additional exposure to risk. For
    example, the Department of the Treasury has raised concerns that allowing
    corporates to invest in BBB rated securities could weaken the safety and
    soundness of the corporate network because the amount of capital held in
    the corporatesmight not be commensurate with the risks associated with
    these lower credit quality investments.32

    NCUA Strengthened Its Oversight of Corporates, but Could Do More to
    Anticipate and Address Emerging Network Issues

    NCUA has made numerous changes over the last several years to strengthen
    its oversight of corporates but faces challenges in such areas as
    networkwide assessments, obtaining and utilizing technical staff
    resources, developing merger guidance for corporates, and assuring the
    quality of corporates' internal control structures. Specifically, NCUA
    established a separate office dedicated to the oversight of corporates,
    and revised its corporate regulation (Part 704) to improve corporates'
    management of credit, interest-rate, and liquidity risks. NCUA also
    adopted a risk-focused supervision and examination approach, and trained
    or hired a limited number of specialists to help oversee increasingly
    complex operations at corporates. However, NCUA has not put in place a
    system to track the resolution of deficiencies or evaluate trends in
    examination data and therefore may not be able to anticipate emerging
    issues within the network. Further, NCUA has not systematically considered
    certain operational risks, such as weak information system controls, when
    assigning specialists to examinations, which may have led to NCUA
    overlooking certain problems or not ensuring that problems were corrected
    in a timely manner. While continued consolidation of the corporate network
    appears likely, NCUA has not developed merger guidance specific to
    corporates, and its examiner guidance has not ensured that merger
    proposals were assessed consistently. Thus, NCUA's inadequate guidance has
    increased the risk that resulting decisions may not be in the best
    interests of corporates or their members, or may negatively affect the
    safety and soundness of corporates. Also, as corporates have invested in
    more complex technologies and added more sophisticated products and
    services, the importance of NCUA's oversight of corporates' internal
    controls has increased. However, corporates are not subject to the
    internal control reporting requirements imposed on other financial
    institutions of similar size that help to ensure safety and soundness, as
    defined under the Federal Deposit Insurance Corporation Improvement Act of
    1991 (FDICIA). This raises a question about whether NCUA has the necessary
    information to assess corporates' internal controls.

    NCUA Made Several Major Improvements in Oversight Since 1991

    Since 1991, NCUA has strengthened its oversight of corporates by
    reorganizing staff, revising regulations, and changing examination and
    supervisory focus. NCUA established the Office of Corporate Credit Unions
    (OCCU) in 1994, partly in response to problems with selected investments
    at U.S. Central.33 Within this new office, NCUA centralized its
    supervision of corporates and increased the number of examiners dedicated
    to supervision and examination of corporates. According to NCUA officials,
    prior to this change, NCUA examiners lacked adequate training and
    expertise to examine activities undertaken by corporates, since they spent
    most of their time examining natural person credit unions, whose
    operations generally are less complex than those of corporates. Further,
    in 1992, NCUA had 12 examiners dedicated to the oversight of 44 corporates
    and U.S. Central. As of June 2004, NCUA had 22 examiners plus three
    information systems specialists and one payments system specialist hired
    to help oversee the 30 corporates and U.S. Central.

    NCUA also revised its corporate regulation (Part 704) in 1998 to increase
    measurement and monitoring of interest-rate, liquidity, and credit risk
    within the corporate network.34 The revisions to Part 704 were in response
    to the failure of Capital Corporate Federal Credit Union in January 1995
    and GAO and other recommendations for NCUA to improve its oversight of
    corporates.35 The 1998 revisions required corporates to measure and report
    on the impact of interest-rate and liquidity changes on their net economic
    value.36 Corporates also were required to change the methods used to
    calculate their investment concentration limits-moving from a calculation
    that used an asset base to one that consisted of core capital (reserves
    and undivided earnings and paid-in-capital). Corporates could use this
    method to improve their management of credit risk by matching the risks
    associated with investment concentrations with capital, which protects
    corporates if investment risks lead to losses.

    NCUA also implemented a risk-focused supervision and examination approach
    in 1999 to concentrate its resources on the high-risk areas within
    corporate operations. Similar to the examination approach taken by other
    financial institution regulators, the risk-focused approach is intended,
    in part, to better employ examiner resources and improve examination
    results by emphasizing the areas of greatest risk. Under this approach,
    examiners have greater discretion to identify areas that require their
    attention and allocate their time accordingly. Further, examiners can
    determine when and where to employ the assistance of specialists with
    skills tailored to the activities of the institution, as its operations
    become more complex. According to NCUA officials, OCCU also began to
    promote examiners who had experience in investments and asset/liability
    management to the position of capital market specialist. As of August
    2004, OCCU had five capital market specialists. Additionally, NCUA's
    Office of Strategic Program Support and Planning (OSPSP) had three
    investment specialists with private-sector financial market experience
    that could assist OCCU's capital markets specialists.37 For example, OSPSP
    investment specialists participate in selected examinations of corporates
    that have expanded investment authorities.

    NCUA Identified Deficiencies but Did Not Systematically Track Their
    Resolution or Evaluate Trends in Examination Data

    NCUA's risk-focused approach has helped it identify weaknesses in
    corporates' operations and require corrective actions at corporates;
    however, we found that NCUA did not methodically aggregate and track the
    resolution of deficiencies or systematically conduct trend analyses to
    identify recurrent or networkwide issues. We have reported that sound
    risk-focused examination practices rely on the regulator's ability to
    maintain an awareness of industrywide risk.38 Other depository institution
    regulators, such as the Office of the Comptroller of the Currency, the
    Board of Governors of the Federal Reserve System, and the Office of Thrift
    Supervision reported that they have mechanisms in place to conduct some
    degree of industrywide assessments of their depository institutions.
    Further, the Federal Deposit Insurance Corporation (FDIC) tracks and
    analyzes trends in examination findings and their resolution in several
    ways. For example, after each examination, FDIC reviews, analyzes, and
    enters findings and their resolution into various databases. In addition,
    FDIC gathers information on its institutions' internal controls to report
    on local, regional, and national trends in bank performance and identify
    activities, products, and risks that affect banks and the banking
    industry.

    Based on our review of about 100 risk-focused examinations for all
    corporates and U.S. Central from January 2001 through December 2003, NCUA
    examiners had identified deficiencies-most frequently in the areas of
    asset/liability management, investments, management, funds transfer, and
    information systems-but we could not always determine if corporates had
    resolved these deficiencies. NCUA also had established time frames for
    correcting deficiencies and procedures for corporates to take actions to
    address the deficiencies. According to NCUA, corporates must prepare plans
    that specify the action needed and identify the corporate official
    responsible for implementing the plan. Further, NCUA reported that
    examiners typically verify the resolution of deficiencies during an
    examination or on-site supervision, actions that examiners were expected
    to document in the examination workpapers. Examiners assigned to
    subsequent examinations also were to review the deficiencies from the last
    examination report to see what corrective action had been implemented.
    NCUA reported that based on the severity of the deficiency, as a matter of
    practice, resolutions might be noted in the examination report or in the
    workpapers.

    However, after reviewing these examination reports and other NCUA
    oversight documents, we were unable to consistently determine whether the
    deficiencies NCUA had identified for individual corporates had been
    resolved. The executive summaries included in some examination reports
    noted that deficiencies from the previous year had been addressed, but
    this practice was not standard for all of the exam reports we reviewed.
    For example, 14 of 38 examination reports we reviewed had discussed the
    status of deficiencies and whether they were resolved. Moreover, the
    corporate examiners' guide did not stipulate that examiners should
    document the resolution of prior deficiencies when preparing the final
    examination report. NCUA officials told us that the examiner-in-charge
    tracked the status of deficiencies at individual institutions and reported
    this information in monthly examiner reports. While these reports
    documented the status of deficiencies, information on the status was not
    included or consolidated in monthly reports prepared for the OCCU Director
    or in quarterly reports to NCUA's Board. As a result, NCUA management may
    have been unaware of issues related to the resolution of examination
    deficiencies, as can be seen in the following examples:

    o In the review of one corporate's examinations, we noted that its
    information system disaster recovery site did not meet NCUA requirements
    (for site location and a separate power system) for at least 3 years. The
    examination documentation we reviewed did not issue a deficiency finding
    detailing the weaknesses of the recovery site. After further review, we
    found that the disaster recovery site was located at the chief executive
    officer's home for at least 6 years before the examination report detailed
    the need to replace the disaster recovery site.

    o At another corporate, NCUA acknowledged in the examination that the
    institution had not addressed information systems deficiencies related to
    information security for 3 years. However, in the prior year's
    examination, NCUA had no mention of recurring problems with information
    systems at this corporate.

    o NCUA issued a deficiency finding in the area of accounting and financial
    reporting for a corporate after it had submitted 13 months of data
    inaccuracies in its 5310 call reports, exposing the corporate to financial
    and reputation risk.

    NCUA management believed that its existing examination processes and
    available information (such as call reports, examiner reports on
    corporates, internal monthly management and quarterly reports, and staff's
    institutional knowledge) provided it with sufficient information to assess
    the adequacy and timeliness of corporates' corrective actions. For
    example, NCUA officials stated that OCCU management reviews all
    examination reports prior to issuance, including any noted deficiencies.
    In the regulator's view, this practice provides an additional layer of
    oversight and evaluation. Additionally, OCCU emphasized that its monthly
    management reports serve as a key supervision tool to assess issues,
    trends, and corrective action at individual corporates. Despite OCCU's
    practices for coordinating and overseeing individual examinations, these
    practices were informal (that is, we did not identify guidance or formal
    operating procedures) and appeared to operate independently of one
    another. Additionally, these processes and practices did not constitute a
    system that would aggregate the number and type of deficiencies occurring
    at all corporates.

    According to NCUA officials, their current practices kept them abreast of
    potential overall issues affecting the network without the need for a
    separate system to catalogue the deficiencies. For example, OCCU has
    trained three corporate program specialists to support field examiners,
    who track issues and trends in their assigned corporates and meet
    periodically with OCCU management to discuss issues and trends across the
    corporate system. They also noted that the examination review process had
    identified a number of issues or trends such as the need to address Bank
    Secrecy Act-related issues. However, NCUA officials also said that at the
    request of their corporate program specialists, they were developing a
    database to track deficiencies identified in examinations to better track
    their resolution. They did not specify the planned completion date for
    this database.

    NCUA's current system has relied on interaction between the different
    offices, examiners, and specialists involved in oversight of corporates. A
    tracking system may have helped NCUA to identify, anticipate, or otherwise
    address some of the information system weaknesses we noted above. More
    specifically, without such a system for tracking examination findings and
    their resolution, NCUA's ability to identify the extent and duration of a
    problem at an individual corporate is limited, which may prevent the
    timely resolution of deficiencies. Similarly, the lack of a tracking
    system that aggregates deficiencies diminishes NCUA's ability to identify
    networkwide problems readily, assist examiners-in-charge in developing
    examination plans, and devise strategies to address issues before they
    become a significant safety and soundness concern.

    NCUA Did Not Systematically Consider Certain Risks When Allocating
    Resources or Scheduling Specialists for Examinations

    NCUA has not systematically considered corporates' risk management (both
    quality and capacity) when allocating resources and scheduling specialists
    for examinations.39 Federal depository institution regulators, under the
    auspices of the Federal Financial Institution Examination Council
    (FFIEC)-of which NCUA is a member-had issued guidance on how to
    systematically determine when to assign specialists to an examination.40
    In addition, FDIC and Office of the Comptroller of the Currency (OCC) have
    issued specific guidance on the frequency with which specialty
    examinations should be conducted. For example, OCC's guidance requires
    that information systems examinations be consistently conducted at least
    every 12 to 18 months for community banks with assets of less than $1
    billion, with a minimum objective of assessing the quantity of transaction
    risk and the quality of risk management, including staff capacity and
    skills. By contrast, NCUA has not established a minimum level of
    involvement of specialists in examinations.

    Since we noted that NCUA had identified a number of problems in
    information systems at the corporates and were concerned that they had
    relatively few specialists in this area, we reviewed FFIEC's Information
    Systems Examination Handbook, which also provides a process by which
    regulators can determine when and where to employ information systems
    specialists. We used this handbook to assess how NCUA deployed examiners,
    relative to best practices and guidance as exemplified in the handbook.
    According to this handbook, information systems examiners must judge risk
    posed by the quantity of transactions and quality of the

    institution's risk management.41 Assessing aggregate risk allows examiners
    to weigh the relative importance of both the quantity of transactions and
    the quality of risk management for a given institution and direct the
    activities and resources for the regulators' supervisory strategies. Under
    this approach, a smaller corporate with a low volume of transactions and
    weak risk management could pose a risk to the network equal to that of a
    large corporate with a high volume of transactions and a strong risk
    management program.

    We reviewed examination-planning documents for all 31 corporates to
    determine how NCUA evaluated these risks when determining the frequency at
    which specialists would be assigned to examinations. We found that NCUA
    documented its assessment of operations risk in these planning documents,
    but did not explicitly discuss the quality of risk management for various
    functions and operations when determining if specialists should be
    assigned to examinations.42 For example, in some cases, we found that the
    examination-planning documents only provided a single line stating that an
    information systems specialist was not needed on the next examination and
    did not document the reason for this assessment. While the planning
    documents were not clear about NCUA's decision process for assigning
    specialists to examinations, it also was not clear to us whether NCUA
    routinely or consistently considered various operational weaknesses at
    these corporates when assigning specialists.

    An external review of OCCU in 2002 concluded that NCUA's complement of two
    information systems specialists and one payment system specialist did not
    appear to be sufficient to adequately oversee the corporate network and
    that OCCU should consider hiring additional specialists in these areas.
    NCUA believes it has sufficient specialists to examine the 31 corporates;
    however, it has made this determination without fully assessing the
    corporates' business environment and networkwide challenges. NCUA tended
    to assign specialists on the examinations of larger corporates or those
    implementing newer systems and less so on examinations of smaller
    corporates or examinations of established systems at large corporates.
    According to NCUA, specialists had limited or no involvement in
    examinations at the 12 smallest corporates (with assets of less than $1
    billion) from 2001 to 2003. During the same period, specialists were
    annually involved in the examination of the eight corporates with assets
    above $2.6 billion. While this approach appears reasonable, the limited
    involvement of specialists under such circumstances may have contributed
    to important information system weaknesses at corporates that were either
    not identified by NCUA or not promptly corrected. For example, U.S.
    Central's automated clearing house (ACH) software had deficiencies that
    led to a system failure that delayed payments to customers of 2,200
    natural person credit unions for nearly 2 days. According to NCUA,
    information systems specialists had reviewed the system's performance in
    prior examinations. However, because the Automated Clearing House (ACH)
    software was mature and U.S. Central staff was monitoring its performance,
    NCUA did not consider it a high-risk component of U.S. Central's
    operations and had not reviewed it recently. As a result, weaknesses in
    their backup procedures and routine maintenance, insufficient capacity
    (noted in prior examinations but not satisfactorily resolved), and other
    deficiencies that resulted in the outage were not corrected. NCUA has
    stated that it is reviewing its procedures to determine if such systems
    should receive a minimum level of review. NCUA has also acknowledged that
    the ACH delay resulted in financial loss and increased reputation risk to
    the corporate network.

    NCUA also faces other obstacles to conducting more systematic evaluations
    of risk-both in assuring that corporates have the capacity for managing
    risks and ensuring that, as a regulator, it has the staff to assess the
    quality and operations in corporates' risk management functions. As noted
    previously, corporates have been operating in a challenging investment
    environment, with additional authorities to make lower-rated investments.
    Consequently, the quality of risk management at corporates has grown in
    importance. While the results of our review of the risk management
    function at the three largest corporates suggested that these corporates
    were taking appropriate steps to assess and mitigate their risks, these
    corporates had a relatively small number of staff in their risk management
    functions. More specifically, the largest corporates and U.S. Central were
    using sophisticated financial models to assess and manage

    interest-rate, credit, and liquidity risks.43 But a rating agency and
    external auditor have expressed concerns about small staff sizes and how
    they affect these corporates' continued ability to evaluate and manage
    risks and undertake succession planning should key staff leave. The loss
    of any such staff at a corporate could hamper its ability to undertake the
    sophisticated analyses needed to evaluate risks. The thinness of
    corporates' risk management staffs indicates that NCUA should routinely
    assess corporates' investment risk. However, as we noted earlier, NCUA
    also has a limited number of specialists to conduct comprehensive
    evaluations of risk management at corporates. Given that the risk-focused
    approach allows judgment in assigning resources to areas of greatest
    concern, the thinness of corporates' risk management staff, in combination
    with the limited number of specialists at NCUA, suggests that continued
    attention to corporates' investment strategies may help to ensure that
    corporates are adequately undertaking their risk management functions.
    Therefore, this may require NCUA to reassess its staffing levels and
    consider the costs and benefits of adding additional examiners or
    specialists to adequately monitor and oversee the growing complexity of
    corporates' operations.

    As Corporate Network Consolidates, Merger Approval Process Could Be
    Improved with Better Guidance

    As part of its regulatory authority to ensure the safety and soundness of
    corporates, NCUA reviews and approves corporate merger applications. Some
    corporates, NCUA, and trade-organization officials indicated that
    consolidation in the network-as a result of mergers-would likely continue
    over the next several years. However, with more mergers likely, NCUA has
    not developed specific guidance for corporates preparing merger proposal
    packages. In contrast, NCUA has issued guidance for natural person credit
    unions that provides step-by-step instructions for completing the merger
    process, and NCUA refers corporates to this guidance. However, NCUA has
    recognized that this guidance may be insufficient for corporates. In its
    guidance to examiners, who are responsible for evaluating merger proposal
    packages, NCUA has suggested that capital ratios unique to corporates,
    defined in Part 704 of NCUA's Rules and Regulations, were more appropriate
    than the probable asset share ratio

    applicable to natural person credit unions.44 However, in the guidance on
    mergers available to corporates on its Web site, NCUA has not indicated
    that corporates needed to include this information. In our review of five
    merger packages recently approved by NCUA, we found that three merger
    packages were initially submitted without the corporate capital ratios
    defined in Part 704. These merger packages required revision or additional
    analysis by the corporate and NCUA before the package could be approved,
    encumbering the approval process.

    Other regulators such as OCC have provided detailed guidance to banks
    applying for mergers that listed specific data needed for evaluation and
    described the regulators' merger review process. OCC has stated that their
    approach is intended to avoid misunderstandings and unnecessary delays in
    the approval. NCUA officials told us they considered several factors when
    approving corporate mergers such as consolidated budgets and conversion
    and consolidation plans for information systems that it has not discussed
    in the natural person credit union guidance. However, only one of the five
    merger proposals we analyzed was submitted with this additional
    information. Other corporate's proposals required revisions or were
    approved without additional information being provided. One corporate
    stated they believed the merger process could be improved and made less
    cumbersome if NCUA provided clearer or more specific guidance for
    corporates. Finally, NCUA's guidance did not explicitly discuss how the
    effects of competition should be considered when approving corporate
    mergers, which may become more of an issue as the network continues to
    consolidate and corporates increasingly compete with each other or with
    other financial institutions.

    Corporates Not Subject to Internal Control Reporting Requirements of
    FDICIA

    As corporates react to a competitive environment by investing in
    technology and offering more products and services, NCUA's oversight of
    internal controls at corporates becomes even more critical. However,
    corporates with assets over $500 million were not required to report on
    the effectiveness of their internal controls for financial reporting.45
    Under the Federal Deposit Insurance Corporation Improvement Act of 1991
    (FDICIA) and its implementing regulations, banks and thrifts with assets
    over $500 million are required to prepare an annual management report that
    contains:

    o a statement of management's responsibility for preparing the
    institution's annual financial statements, for establishing and
    maintaining an adequate internal control structure and procedures for
    financial reporting, and for complying with designated laws and
    regulations relating to safety and soundness; and

    o management's assessment of the effectiveness of the institution's
    internal control structure and procedures for financial reporting as of
    the end of the fiscal year and the institution's compliance with the
    designated safety and soundness laws and regulations during the fiscal
    year.46

    Additionally, the institution's independent accountants are required to
    attest to management's assertions concerning the effectiveness of the
    institution's internal control structure and procedures for financial
    reporting. The institution's management report and the accountant's
    attestation report must be filed with the institution's primary federal
    regulator and any appropriate state depository institution supervisor, and
    must be available for public inspection. These reports allow depository
    institution regulators to gain increased assurance about the reliability
    of financial reporting.

    The reporting requirement for banks and thrifts under FDICIA is similar to
    the reporting requirement included in the Sarbanes-Oxley Act of 2002.47
    Under Sarbanes-Oxley, public companies are required to establish and
    maintain adequate internal control structures and procedures for financial
    reporting. In addition, a company's auditor is required to attest to, and
    report on, the assessment made by company management on the effectiveness
    of internal controls. As a result of FDICIA and Sarbanes-Oxley, reports on
    management's assessment of the effectiveness of internal controls over
    financial reporting and the independent auditor's attestation on
    management's assessment have become a normal business practice for
    financial institutions and many companies.

    While NCUA has issued a letter to corporates indicating that selected
    provisions of the Sarbanes-Oxley Act of 2002, including the provision on
    internal control reporting standards, may be appropriate to consider, NCUA
    has not mandated that corporates adopt this standard.48 Given that other
    depository institutions of similar size are required by FDICIA to adhere
    to the internal control reporting requirements to ensure safety and
    soundness, NCUA's lack of such a requirement for corporates raises the
    question of whether NCUA has the necessary information to adequately
    assess corporates' internal controls. This assessment has become more
    important as corporates' operations have grown in complexity due to their
    changing investment strategies, investments in technology, and
    introduction of new products and services.

    Conclusions

    Increased competition both inside and outside of the credit union system
    has challenged corporates to explore new technologies and introduce more
    products and services to retain their members. Increased competition,
    large fluctuations in inflows and outflows of deposits, in combination
    with low interest rates, have created potential stress on the financial
    condition of corporates and U.S. Central. While corporates' assets have
    increased rapidly, their ability to increase earnings remained
    constrained. As a result, corporates have increased their investments in
    privately issued, mortgage-related and asset-backed securities, which can
    increase returns but require more sophisticated analysis and monitoring.
    The change in corporates' investment profile is another indication of the
    growing complexity in their operations. Since some corporates have been
    allowed to invest in lower-rated securities (although few have), this
    could introduce increased risks in the system if not managed properly.
    With the changing operating and investment environments, this increases
    corporates' potential vulnerability to different financial stresses-and
    requires that corporates and their regulator, NCUA, place continued
    attention on their risk-assessment and monitoring strategies.

    NCUA has made strides in strengthening its oversight of corporates,
    particularly with the adoption of a risk-focused approach, certain
    regulatory changes, and the hiring or training of specialists in
    information

    o Establish a process and structure to ensure more systematic involvement
    of specialists in identifying and addressing problems and developing and
    consistently applying policies, and reassess whether there are sufficient
    specialists to oversee corporates;

    o Track and analyze examination deficiencies on a networkwide basis to
    identify and track recurring and pervasive issues throughout the network
    and to ensure that corporates take required corrective actions;

    o Pay increased attention to oversight of corporates' risk management
    functions to ensure corporates have sufficient capacity and skills to
    monitor and manage their risks;

    o Provide specific guidance to corporates for merger proposal packages to
    ensure they are providing sufficient and relevant information, and improve
    guidance to examiners to ensure that merger proposals are reviewed
    consistently and meet the goals of serving members while not placing
    NCUSIF at undue risk; and

    o Require corporates with assets of $500 million or more to be subject to
    the internal control reporting requirements of the Federal Deposit
    Insurance Corporate Improvement Act of 1991 to ensure that corporates are
    held to the same standards as other financial institutions that face
    similar risks.

    Agency Comments and Our Evaluation

    We requested comments on a draft of this report from the Chairman of the
    National Credit Union Administration. We received written comments from
    NCUA that are summarized below and reprinted in appendix VIII. In
    addition, we received technical comments from NCUA that we incorporated
    into the report, as appropriate.

    NCUA stated that it concurred with most of our assessments and conclusions
    contained in the report and plans to take actions to implement all but
    part of one of our recommendations.

    Specifically, NCUA concurred with the report's assessment that corporates
    are operating in an increasingly challenging and competitive environment.
    In its comments on a draft of this report, NCUA stated that its changes to
    the corporate rule, made in response to the dynamic financial marketplace,
    functioned as intended, thus permitting the corporates' balance sheets to
    expand and contract, sometimes rapidly, depending on liquidity levels in
    credit unions, while not compromising safety and soundness. NCUA agreed
    that the influx of deposits, combined with decreasing interest rates had
    strained profitability and resulted in lower capital ratios. However, NCUA
    did not agree with the report's assessment that paid-in capital and
    membership capital are "weaker forms of capital." NCUA restated its
    requirements for these two forms of capital and, as stated in the report,
    believed that both paid-in capital and membership shares are available to
    cover losses that exceed retained earnings, and are not insured by either
    NCUSIF and cannot be pledged against borrowings. While we agree with
    NCUA's statements, as further discussed in the report, we remain concerned
    that both forms of capital are from external sources and are less
    permanent than retained earnings, therefore, providing a relatively weaker
    cushion against adverse financial events.

    In commenting on corporates' investments, NCUA believed that the slight
    potential increase in credit risk exposure due to the 2002 rule change
    permitting corporates to purchase securities with lower credit quality is
    more than offset by the rule's decrease in exposure to credit
    concentration risk. Additionally, NCUA is of the opinion that the rule's
    "modest expansion" of permissible investment graded securities, combined
    with its reduction in credit concentration limits, results in a stronger
    corporate network-that corporate management is better positioned to
    compete, within prudent safety and soundness thresholds, than under the
    previous rule. NCUA also pointed out in its comments that as of June 30,
    2004, 97 percent of the network's rated long-term securities are rated
    AAA. Based on the high quality and diversification of the network's
    investments, NCUA believes credit risk is minimal. NCUA stated that it has
    addressed controlling interest-rate risk in the corporate rule and its
    assessment of the network's investment portfolio interest-rate risk is
    minimal. We acknowledged in our report that corporates either have made
    few or no investments in BBB rated securities, and they indicated that
    they did not plan to use their authority to purchase such investments.
    However, it is not clear to what extent corporates will take advantage of
    this investment flexibility in the future, which has implications for
    NCUA's oversight, especially given the thinness of risk-management staff
    at corporates. Further, we share Treasury's concerns that allowing
    corporates to invest in BBB rated securities could weaken the safety and
    soundness of the corporate network because the amount of capital held in
    the corporates might not be commensurate with the risks associated with
    these lower credit quality investments.

    While NCUA concurred with the report's recommendation for the need to
    provide corporates with specific merger guidance to facilitate the
    regulatory review process, NCUA did not concur with the report's
    conclusion that improved guidance to examiners is needed to ensure mergers
    meet the goals of serving members while not placing NCUSIF at undue risk.
    NCUA stated in its comments that it has adequate procedures in place, and
    that every corporate merger package prepared by OCCU is reviewed by NCUA's
    Office of General Counsel prior to being presented to the NCUA Board for
    action. As stated in the report, NCUA officials told us that they
    considered several factors when approving corporate mergers such as
    consolidated budgets and conversion plans for information systems that
    NCUA has not discussed in the natural person credit union guidance.
    However, we found that only one of the five merger proposals we analyzed
    was submitted with this additional information and, therefore, we do not
    believe that NCUA's guidance to examiners was sufficient to ensure that
    examiners consistently evaluate corporate mergers. As stated in the
    report's conclusions, without sufficient guidance, NCUA lacks assurances
    that decisions on corporate mergers are consistently made using
    appropriate criteria and information or that these decisions are made in
    the best interests of their members and NCUSIF. While clear criteria and
    consistency in review are important, improving examiner guidance for
    mergers is also necessary to help protect against forbearance on the part
    of NCUA.

    As agreed with your office, unless you publicly announce the contents of
    this report earlier, we plan no further distribution until 30 days from
    its issuance. At that time, we will send copies of the report to the
    Chairman of the Senate Committee on Banking, Housing, and Urban Affairs;
    the Chairman and Ranking Minority Member of the House Committee on
    Financial Services; and interested congressional committees. We also will
    send copies to the National Credit Union Administration and make copies
    available to others upon request. In addition, this report will be
    available at no charge on the GAO Web site at http://www.gao.gov.

    contact me at (202) 512-8678 or hillmanr@gao.gov or Debra R. Johnson at
    (202) 512-9603 or johnsond@gao.gov. Key contributors are acknowledged in
    appendix IX.

    Sincerely yours,

    Richard J. Hillman Director, Financial Markets and Community Investment

    Objectives, Scope, and MethodologyAppendix I

    Our report objectives were to (1) assess the changes in financial
    condition of corporate credit unions (corporates) since 1992 and (2)
    assess the National Credit Union Administration's (NCUA) supervision and
    oversight of corporates, particularly with regard to how it identifies and
    addresses safety and soundness issues in the industry.

    Financial Condition of Corporate Credit Unions Since 1992

    To assess the changes in the financial condition of corporates since 1992,
    we analyzed corporate credit union call report data, which include balance
    sheet and income statement data for corporates. Our analysis, based on
    Forms 5300 and 5310 data supplied by NCUA, included calculating
    descriptive statistics and key financial ratios and describing trends in
    financial performance and the structure of the industry.1 The information
    included Form 5300 data from the end of 1992 through the end of 1996 and
    monthly Form 5310 data from January 1997 through December 2003. Our
    analysis relied upon selected balance sheet and income statement data such
    as assets, shares, investments, capital, net economic value (NEV), and
    various income measures and ratios that are commonly used to assess the
    financial condition of financial institutions. The transition in 1997 from
    Form 5300 (still used by natural person credit unions) to Form 5310, which
    is specifically designed for corporates, entailed numerous changes in
    reporting. Furthermore, significant regulatory changes, effective in 1998,
    also resulted in numerous changes to the information reported on Form 5310
    for 1998. Overall, these changes resulted in the deletion of some items
    from the financial reports and the addition of others. Subsequently, in
    some cases the data were not comparable across time. For example, NEV,
    which is a measure of interest-rate risk, was added to Form 5310 in 1998;
    thus, we were only able to conduct analysis on this measure from 1998 to
    2003. In our prior report on natural person credit unions, we reviewed
    NCUA's procedures for verifying the accuracy of the Form 5300 database and
    found that the data were verified on an annual basis, either during the
    corporate credit union's examination, or through off-site supervision. We
    determined that the data were sufficiently reliable for the purposes of
    this report. We also performed a data reliability assessment on data from
    January 1997 through December 2003 for Form 5310, which involved
    electronic testing of the data and obtaining information from NCUA on its
    data verification procedures. We found that the data were verified for
    accuracy on a monthly basis and determined that the data were sufficiently
    reliable for the purposes of this report.

    To augment our analysis and obtain a more comprehensive assessment of
    corporates' financial condition and risks, we reviewed internal corporate
    credit union financial analysis reports from selected corporates,
    independent evaluations of corporate risk controls and models, and
    external studies of the industry from major rating agencies, such as
    Fitch, Moody's, and Standard and Poor's. We also met with selected NCUA
    examiners and risk management staff at corporates to better assess how
    corporates were managing their risks. In addition, we reviewed internal
    documents and analyses dealing with risk monitoring and control from
    several corporates in order to assess how well these corporates could
    assess and manage risk.

    NCUA's Supervision of Corporates

    To assess how NCUA's supervision of corporates identifies and addresses
    safety and soundness issues, we conducted a review of key legislative and
    regulatory changes affecting corporates since 1992. We reviewed NCUA
    documentation on its risk-focused program, including NCUA examination
    reports, their corresponding three-year plans, and the Office of Corporate
    Credit Union (OCCU) management reports for all 31 corporates for
    2001-2003.2 We conducted interviews with OCCU management and with OCCU
    examiners-in-charge for 10 corporates.3 In addition, we visited seven
    corporates. We developed a structured questionnaire for all 31 corporates
    to solicit their views on what challenges individual institutions and the
    collective corporate network faced. We reviewed past GAO and U.S.
    Department of the Treasury reports on corporates and NCUA, internal
    reviews of OCCU, and an external review of OCCU performed by an outside
    auditing firm. We also contacted officials from the Federal Deposit
    Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS), the
    Office of the Comptroller of Currency (OCC), and the Board of Governors of
    the Federal Reserve System. Lastly, we interviewed trade association
    officials.

    As part of our legislative review, we reviewed the Federal Credit Union
    Act to determine the legislative authority for corporates and NCUA's Part
    704, which is the primary regulation governing corporates. Specifically,
    we reviewed the Federal Register for all changes made to Part 704 since
    1992 to understand the rationale behind these changes. We also obtained
    summaries from NCUA, which provided their rationale for the changes and
    brief descriptions of the changes to specific sections of Part 704.

    To assess NCUA's documentation for its risk-focused program, we reviewed
    NCUA's Corporate Examiner's Guide, which describes the policies and
    procedures under which examiners are to implement the risk-focused
    program. The guide describes procedures for off-site monitoring, on-site
    examinations, information required in an examination report, and
    coordination with state supervisory authorities for corporates that have a
    state charter.

    Also, as part of our assessment of NCUA's risk-focused examination
    program, we reviewed about 100 examinations for the 31 currently operating
    corporates, corresponding 3-year plans, and OCCU monthly management and
    quarterly reports for the period January 2001 through December 2003. For
    the review of examinations, we developed a data collection instrument
    (DCI) to collect 3 years' worth of information for each of the 31
    corporates. The DCI enabled us to aggregate examination areas appearing in
    a large number of corporates over the time period reviewed that could be
    potential networkwide issues due to their prevalence or persistence.
    Examples of findings identified by NCUA in the various examination areas
    included errors or problems associated with 5310 reporting, accounting
    procedures, asset/liability management, Bank Secrecy Act compliance,
    contingency planning, corporate governance, credit analysis, funds
    transfer, information systems, interest-rate risk, investment, lending,
    and management.

    The 3-year plans included information on the last examination and
    financial profiles-for example, daily average net assets (DANA), capital
    ratios, and net economic value (NEV). These plans also contained the
    supervision type of the corporate, supervision plans, Corporate Risk
    Information System (CRIS) ratings, and in some cases, requests for
    information system,

    payment system, or capital market specialists for the next examination or
    supervision contact.4

    The OCCU monthly management reports covered areas such as OCCU's
    administration news, trends in corporates, significant problem case
    corporates, other significant program issues, miscellaneous corporate
    information, information on internal or external affairs, board action
    items, and the next month's calendar. The quarterly reports provided a
    brief update of events since the previous report, a summary of corporate
    network trends, the current status of e-commerce in corporates, specific
    discussions on 20 percent to 50 percent of individual corporates, and the
    future outlook for corporates and OCCU during the next quarter and beyond.

    We met with OCCU management to follow up on questions generated from our
    review of the examinations, 3-year plans, and OCCU monthly management and
    quarterly reports. We also selected a judgmental sample of 10 corporates
    from which to gather additional information about NCUA oversight. These
    corporates were selected based on asset size, geographic location, charter
    type, level of expanded investment authority, and significant findings in
    the examinations. We obtained NCUA's most recent examiner workpapers for
    these 10 corporates to review how NCUA supported its findings. We also met
    with the examiner-in-charge and, when possible, capital market specialists
    for the 10 corporates to better comprehend their approach to examining the
    corporate credit union and to understand the support and rationale for
    some examination findings. In addition, we visited 7 of the 10 corporates
    to observe and discuss their operations, risk management practices, and
    interactions with NCUA. We selected these 7 based on their asset size,
    geographic location, type of charter (state or federal), and whether they
    had expanded investment authorities. We interviewed senior management and
    some board and supervisory committee members. We asked structured
    questions of officials from various departments within the corporates. The
    departments included investments, risk management, accounting, internal
    audit, external audit, information systems, and product support. We
    obtained policies and procedures for various areas within the corporates,
    including investments, lending, and risk management. We also obtained
    documentation packages, which were submitted to the asset/liability
    committees of corporates for some of the institutions we visited, to
    review investments and their impact on the risk within the corporates. We
    also observed corporates' physical environment to determine the types of
    safeguards that were in place, particularly for information technology.

    We developed a structured questionnaire to collect information from the
    corporate network that focused on their perspectives about various
    components of the industry. We pretested the questionnaire with one of the
    largest corporates and received numerous meaningful observations about our
    original version and made refinements. We administered the structured
    questionnaire to the entire population of active corporates (as of
    December 31, 2003) as shown in appendix II.

    Appendix III includes a copy of our structured questionnaire, and appendix
    IV includes responses to the majority of questions in the questionnaire.
    The Association of Corporate Credit Unions (ACCU) oversaw the distribution
    of our structured questionnaire to its 30 corporate members. We
    administered the questionnaire to the one non-ACCU corporate member. The
    questionnaires were sent by e-mail at the end of March 2004. We received
    all responses to our questionnaire by mid-May 2004 and achieved a 100
    percent response rate. We conducted follow-up telephone interviews with
    numerous corporates to obtain clarification on some of their responses.
    Our questionnaire covered the following areas:

    o products and services that corporates offer to their natural person
    credit unions,

    o Credit Union Service Organizations (CUSO),

    o competition,

    o investment authorities,

    o corporate investments with U.S. Central,

    o regulatory changes and impacts on corporates' operations,

    o the effects of the risk-focused approach on corporates,

    o corporates' fields of membership,

    o challenges corporates face and their responses to these challenges, and

    o corporates' immediate and future merger plans.

    We analyzed the results by summarizing responses or providing simple
    statistics (for example, range, median, and average) to most of the
    quantitative questions. Specifically, we conducted quantitative analysis
    on questions 1, 3, 4, 5, 7, 7a, 11, 12, 13, 14, 17, and 21. We performed
    content analysis on most of the responses to the qualitative questions.
    Specifically, we conducted content analysis on questions 8, 9, 10, 16, 19,
    20, 21a, and 22. The results of our analysis for most of the questions are
    presented in appendix IV.

    To gain a better understanding on the challenges and problems NCUA has
    faced in overseeing corporates, we reviewed past GAO and U.S. Department
    of the Treasury reports on corporates and NCUA. These reports also
    provided recommendations for NCUA to improve its oversight. Additionally,
    we reviewed internal NCUA reviews on OCCU. These reviews are conducted
    about every 3 years by OCCU's Director and staff from outside OCCU, who
    review OCCU's operations and suggest improvements. Similarly, NCUA has
    contracted for an outside party to review OCCU's operations, and this
    party also has provided recommendations on improvements in OCCU management
    and oversight. OCCU's last external review was completed in 2002. We
    interviewed officials from the Department of the Treasury and academia who
    had studied corporates.

    To obtain information on the experiences of other depository institution
    regulators with the risk-focused examination and supervision approach, we
    obtained written responses from officials at FDIC, OTS, OCC, and the Board
    of Governors of the Federal Reserve System.

    Finally, to obtain perspectives on the business environment confronting
    the corporate network and their responses to a changing environment, we
    interviewed trade association officials from ACCU, the National
    Association of Federal Credit Unions, including its board of directors,
    and the National Association of State Credit Union Supervisors.

    We conducted our work from December 2003 to September 2004 in Alexandria,
    Virginia, Washington, D.C., and other U.S. cities in accordance with
    generally accepted government auditing standards.

    Corporate Credit Unions Active as of December 31, 2003Appendix II

    Source: NCUA.

    Structured Questionnaire to Corporate Credit Unions on Their Current
    Makeup and Challenges Facing the Network Appendix III

    We distributed the following questionnaire to the entire network of
    corporates in the United States, including both federally and
    state-chartered institutions, and achieved a 100 percent response rate.
    (Appendix II lists the 31 corporates active as of December 31, 2003, and
    whether they are federally or state-chartered.) The questionnaire has
    three sections: products and services, regulatory changes, and challenges
    facing corporates. The first section addresses the types of products and
    services offered by corporates to their members, the issues they faced
    regarding competition, the type of investment authorities corporates had
    or sought, and the extent of their investments with U.S. Central Corporate
    Credit Union. The second section addresses various regulatory issues such
    as what regulatory changes affected their institution, a description of
    the corporate's field of membership (for example, whether they had a
    national field of membership), and their perception of NCUA's risk-focused
    supervisory approach. Finally, the questionnaire solicits the opinions of
    corporate managers on what future issues the corporate credit union
    industry faces. Appendix IV contains selected responses to the
    questionnaire.

    Selected Responses to Structured Questionnaire Distributed to Corporate
    Credit Unions Appendix IV

    As noted in appendix III, we distributed a questionnaire to the entire
    network of corporates. This appendix provides responses to the majority of
    questions posed in the questionnaire (see questions 1, 3-5, 7-14, 16-17,
    and 19-22). This information was analyzed in the aggregate to prevent
    specific responses from being associated with an individual institution.

    Financial Condition of Corporates, 1992-2003Appendix V

    The corporate credit union network has consolidated since 1992, with asset
    concentration rising moderately. As corporates' investments have grown,
    their composition has changed, with relatively more emphasis on privately
    issued mortgage-related and asset-backed securities and a shift toward
    more variable-rate investments. Concurrent with net income ratios,
    interest-related income and expense ratios have declined recently. In
    recent years, natural person credit unions have invested less in
    corporates.

    Corporate Credit Union Network Has Consolidated and Asset Concentration
    Has Risen Moderately

    Since 1992, the corporate system has consolidated, a change primarily
    driven by mergers. This consolidation trend has resulted in a moderate
    increase in asset concentration. For more detailed, year-by-year
    information, see the table and figures below.

    Table 2: Number of Institutions and Total Assets in the Corporate and
    Natural Person Credit Union Systems, 1992-2003

                         Total assets of   Total shares
               Number of     corporates, of corporates, Number of Total assets of
             corporates,       excluding      excluding   natural  natural person
    Year    excluding                                   person   credit unions
                            U.S. Central   U.S. Central    credit (in millions of
            U.S. Central (in millions of   (in millions    unions        dollars)
                                dollars)    of dollars)
    1992           44         $43,447        $37,186    12,595        $258,365
    1993           44          40,982         33,922    12,317         277,130
    1994           44          35,993         29,217    11,991         289,453
    1995           41          33,807         29,199    11,687         306,642
    1996           40          30,154         24,196    11,392         326,887
    1997           38          33,097         27,222    11,238         351,165
    1998           37          43,555         38,743    10,995         388,700
    1999           36          39,206         32,768    10,630         411,418
    2000           35          39,627         32,248    10,316         438,219
    2001           34          59,154         51,997     9,984         501,540
    2002           32          68,968         60,421     9,688         557,075
    2003           30          73,835         58,808     9,369         610,156

    Source: NCUA call reports.

    Note: This table includes only federally insured natural person credit
    unions.

    Figure 8: Size Distribution of Corporates, by Number, 1992-2003

    Note: This figure excludes data on U.S. Central.

    Figure 9: Asset Concentration Levels of Corporates, 1992-2003

    Note: While one corporate was the largest in each year from 1992 through
    2003, this figure depicts the asset concentration in a given year for the
    largest corporates in that year, and the largest four corporates were not
    necessarily the same in all years. This figure excludes data on U.S.
    Central.

    Investments of Corporates Have Grown since 1992, and Composition Has
    Changed

    As noted earlier, investments, which are the vast majority of corporates'
    assets, have grown since 1992, but recently the percentage of corporates'
    investments in U.S. Central has declined somewhat and corporates have
    moved relatively more of their investments into privately issued
    mortgage-related and asset-backed securities. We made this determination
    using call reports and other data (for more information on our methodology
    see app. I). Since there were significant changes to NCUA's call reports
    in 1997, in the transition from Form 5300 to Form 5310, some account codes
    were not available previously and thus could not be disaggregated.

    In general, corporates' investments in mortgage-backed securities
    (including mortgage pass-throughs, collateralized mortgage obligations,
    and real estate mortgage investment conduits) as a percentage of total
    investments declined from the mid-1990s through 1998 in the wake of the
    Cap Corp failure, which was largely driven by ineffective interest-rate
    risk management for collateralized mortgage obligations. However, since
    1998, corporates steadily have been increasing their investments in
    mortgage-backed securities. In addition, corporates have been shifting
    more of their investments in mortgage-related and asset-backed securities
    to variable-rate securities, a move that tends to lessen interest-rate
    risk. In particular, while 41.7 percent of corporates' asset-backed
    securities were classified as fixed-rate at the end of 1997, by the end of
    2003 this proportion stood at 18.0 percent. The trend in collateralized
    mortgage obligations and real estate mortgage investment conduits (REMIC)
    has been similar, with a relatively greater proportion now classified as
    variable rate.1 Table 3 offers additional details of corporates'
    investments in U.S. Central, privately issued mortgage-related securities,
    and asset-backed securities, from 1997 through 2003.

    Table 3: Composition of Selected Investments of Corporates, 1997-2003

    U.S. Central
    obligations held
    by corporates
    U.S. Central
    obligations           1997    1998    1999    2000    2001    2002    2003
    relative to total
    investments
    Daily shares        20.16%  24.17%  25.44%  21.03%  13.77%   9.37%   8.68%
    Time certificates    18.38   20.11   18.53   17.41   15.44   18.08   17.42
    Investments
    resulting from        0.00    0.00    0.14    0.15    0.19    0.20    0.11
    repurchase
    transactions
    Amortizing            1.42    0.40    0.18    0.30    0.11    0.52    0.88
    certificates
    Smart floaters        0.00    0.00    0.12    0.00    0.00    0.00    0.00
    Step up               1.57    0.86    1.88    2.14    1.23    1.64    2.36
    certificates
    FRAPs                 5.43    6.84    4.45    6.58   10.64    8.68    9.21
    Membership capital    2.25    1.93    2.61    2.10    1.47    1.58    1.74
    shares
    Central Liquidity
    Facility share        2.29    1.59    2.32    2.37    1.63    1.57    1.77
    deposit
    Paid-in capital       0.00    0.00    0.00    0.00    0.00    0.00    0.46
    U.S. Central
    obligations           1997    1998    1999    2000    2001    2002    2003
    relative to total
    investments
    Other                1.09a    0.48    0.87    1.04    0.54    0.70    2.12
    Total U.S. Central
    obligations         52.59%  56.38%  56.56%  53.12%  45.03%  42.35%  44.76%
    relative to total
    investments
    Total U.S. Central
    obligations (in    $15,634 $23,480 $20,159 $18,887 $24,966 $27,041 $29,220
    millions)
    Privately Issued
    Mortgage-Related
    Issues, 1997-2003
    Privately issued
    mortgage-related
    issues relative to
    total investments
    Fixed-rate           0.33%   1.68%   2.17%   3.04%   2.13%   2.44%   3.11%
    CMOs/REMICs
    Variable-rate         0.32    0.54    0.83    1.20    1.08    3.19    5.69
    CMOs/REMICs
    Mortgage-backed       0.25    0.09    0.08    0.09    0.10    0.22    0.21
    pass-throughs
    Other                 0.00    0.00    0.00    0.00    2.69    3.00    5.08
    Total privately
    issued
    mortgage-related     0.90%   2.31%   3.08%   4.33%   6.01%   8.85%  14.09%
    issues relative to
    total investments
    Total privately
    issued
    mortgage-related      $267    $961  $1,098  $1,540  $3,333  $5,652  $9,199
    issues

    (in millions)
    Asset-backed
    securities,
    1997-2003
    Asset-backed
    securities
    relative to total
    investments
    CUGRs               0.00%a   0.47%   0.64%   0.00%   0.00%   0.00%   0.00%
    Fixed-rate credit     2.44    1.24    1.58    1.75    1.96    1.42    0.68
    cards
    Variable-rate         4.37    4.67    5.77    5.95    5.46    4.38    4.16
    credit cards
    Fixed-rate autos      4.14    2.94    4.08    3.48    3.47    3.30    2.23
    Variable-rate         1.67    1.12    0.99    1.06    2.29    2.34    2.03
    autos
    Fixed-rate home       1.35    1.91    1.87    1.53    1.39    1.73    1.33
    equity
    Variable-rate home    3.89    4.18    5.64    5.86    5.80    8.20   12.09
    equity
    Fixed-rate other      0.21    0.31    0.67    0.67    0.33    0.33    0.20
    Variable-rate         1.43    1.38    2.80    3.07    1.92    1.54    1.94
    other
    Total asset-backed
    securities          19.48%  18.23%  24.03%  23.37%  22.62%  23.24%  24.66%
    relative to total
    investments
    Total asset-backed
    securities (in      $5,792  $7,590  $8,563  $8,309 $12,541 $14,841 $16,100
    millions)

    Source: NCUA call reports.

    Notes: CUGR stands for U.S. Central Grantor Trusts, FRAP stands for
    Floating Rate Asset Program, CMO stands for collateralized mortgage
    obligation, and REMIC stands for real estate mortgage investment conduit.
    Totals may not add due to rounding. This table excludes data on U.S.
    Central.

    aIn the 1997 data in this table, the "Other" category of U.S Central
    obligations held by corporates includes CUGRs-which accounted for 0.81
    percent of total investments-as NCUA specified CUGRs with U.S. Central
    obligations in Form 5310. Beginning in 1998, CUGRs were specified with
    asset-backed securities in Form 5310.

    Concurrent with Net Income Ratios, Interest-Related Income and Expense
    Ratios Have Declined Recently

    Concurrent with the recent low-interest rate environment, corporates'
    interest-related income and expenses, relative to average assets, have
    declined, as illustrated in figure 10. Net interest income, total
    noninterest income, and operating expense ratios cycled from 1993 through
    2003, generally expanding from 1995 through 2000 and then contracting
    through 2003. Recently, net interest income and operating expense ratios
    were lower and total noninterest income ratios were higher, suggesting
    that fee income has become more important for corporates.

    Figure 10: Income and Expense Ratios of Corporates, 1993-2003

    Note: In this figure, net income components in a given year are measured
    relative to the average of that year's total assets and the prior year's
    total assets. The operating expense ratio is shown as a negative number
    for illustrative purposes. This figure excludes data on U.S. Central.

    Net interest income as a percentage of average assets is often referred to
    as net interest margin.2 A corporate can maximize its net interest margin
    by effectively allocating resources among earning and nonearning assets,
    maintaining low levels of nonperforming assets, providing adequate funding
    through the lowest cost mix of funds, and maintaining a strong capital
    position. In a volatile interest-rate environment, large changes in a
    corporate's net interest margin are associated with high-interest-rate
    risk exposures and weak risk management.

    Net interest income, which is interest income minus interest expense, is
    normally the primary source of income for a corporate and a key indicator
    of earnings performance and stability. Interest income consists of
    interest earned on loans and investments. The major contributor to
    interest income within a corporate is normally the investment portfolio.
    Interest expense consists of the corporate's cost of funding operations,
    or simply its "cost of funds." Interest expense in a corporate is realized
    through dividends on shares, share certificates, member capital accounts,
    and interest on borrowings (for example, loans and commercial paper). As
    illustrated in figure 11, interest income and expense have narrowed
    significantly since 2000.

    Figure 11: Interest Income and Expense Ratios, 1993-2003

    Note: In this figure, interest income (yields on investments and loans)
    and expense (cost of funds) ratios in a given year are measured relative
    to the average of that year's total assets and the prior year's total
    assets. The cost of funds is shown as a negative number for illustrative
    purposes. This figure excludes U.S. Central.

    In Recent Years, Natural Person Credit Unions Have Invested Less in
    Corporates

    Natural person credit unions' investments in corporates, which include
    membership capital, paid-in capital, and other investments, actually were
    lower at the end of 2003 than at the end of 1998-both in amount ($37.8
    billion versus $29.1 billion) and as a percentage of investments (30.4
    percent versus 18.1 percent). The smallest natural person credit unions
    (those with assets of less than $100 million) consistently invested more
    in corporates, as a percentage of their total investments, from 1998
    through 2003. It is important to note that this measure does not include
    cash on deposit in corporates, since these data were not disaggregated
    from deposits in other financial institutions in the Form 5310 report
    until 2003. At the end of 2003, natural person credit unions reported
    $26.2 billion in cash on deposit at corporates, which represented over
    three-quarters of natural person credit unions' total cash on deposit.
    Corporates held $55.3 billion, or 26.9 percent, of the total amount of
    natural person credit unions' cash on hand, cash on deposit, and
    investments at the end of 2003, with the smallest natural person credit
    unions (those with assets of less than $100 million) holding around 34
    percent and the largest (those with assets in excess of $1 billion)
    holding around 23 percent of their total in corporates. While it cannot be
    confirmed given the available data, the growth in natural person credit
    unions' loans, coupled with the possibility that natural person credit
    unions have become more willing to invest their funds directly rather than
    through corporates, may have resulted in relatively less funds flowing
    from natural person credit unions into corporates.

    Financial Condition of U.S. Central Generally Mirrors Other
    CorporatesAppendix VI

    U.S. Central Credit Union (U.S. Central) is a nonprofit cooperative that
    is owned by corporates, and it serves these member-owners much like
    corporates serve their natural person credit union members. Trends in U.S.
    Central's balance sheet and income statement suggest that its financial
    condition has been similar to other corporates, with greater profitability
    and slightly higher capital ratios.

    The balance sheet of U.S. Central grew overall from 1992 through 2003.
    However, as with the corporates, the dynamics of its asset and share
    growth have varied as the use of U.S. Central by its member-owners has
    varied. Investments, the vast majority of U.S. Central's assets, have
    mirrored the general growth pattern of its assets, declining through the
    early to mid-1990s and rising thereafter. Recently, U.S. Central has moved
    relatively more of its investments into privately issued mortgage-related
    securities.

    Overall, total assets and shares of U.S. Central have grown since 1992;
    after generally declining in the early to mid-1990s, by the end of 2003
    they were reported at $35 billion and $30.7 billion, respectively (see
    fig. 12).

    Figure 12: Balance Sheet of U.S. Central, 1992-2003

    U.S. Central's balance sheet is primarily influenced by the balance sheet
    dynamics of its underlying corporate member-owners, which have varied
    since 1992. As noted earlier, corporates saw their assets and shares
    decline in the early to mid-1990s but then rebound; corporates' assets and
    shares both grew by over 80 percent from 2000 through 2003. While
    displaying a similar cyclical trend from 1992 through 2003, U.S. Central
    did not experience the same degree of growth from 2000, as assets grew by
    around 54 percent and shares grew by around 57 percent. As with
    corporates, in general investments represent over 90 percent of U.S.
    Central's assets, as illustrated in figure 13.

    Figure 13: U.S. Central's Investments Relative to Total Assets, 1992-2003

    Note: Other assets include cash, loans, and fixed assets.

    Investments in accounts at U.S. Central, including overnight accounts,
    term certificates, structured products, and membership shares, are
    important to many corporates, especially the smaller ones. As of the end
    of 2003, 17, or 57 percent of all corporates, had at least 70 percent of
    their total investments in accounts at U.S. Central and 4 had over 60
    percent. With the recent investment environment characterized by historic
    low interest rates, U.S. Central's members may have increased their
    utilization of U.S. Central's economies of scale to help increase the
    spreads between the rates they offered their customers and the rates they
    earned on their investments. In general, it seems sensible for
    corporates-especially the smaller ones-to be able to rely on the services
    of U.S. Central given its economies of scale. This reliance, however, adds
    more weight to the need for U.S. Central to be a safe and sound
    investment.

    As U.S. Central's total investments have grown, the composition of these
    investments has changed, particularly with increases in investments in
    mortgage-related securities since 1997 (see table 4). U.S. Central's
    investments in privately issued mortgage-related securities increased from
    3.4 percent of its total investments in 1997 to 24.7 percent of its total
    investments in 2003. Overall, U.S. Central's mortgage-related investments,
    including government and agency mortgage-related issues, rose from 10.5
    percent of its total investments to 32.7 percent of its total investments
    over this period. As with corporates, asset-backed securities have
    consistently been an important investment type for U.S. Central.

    Table 4: Composition of Total Investments of U.S. Central, 1997-2003

    Dollars in millions
    Investments relative     1997    1998    1999    2000    2001    2002    2003
    to total investments
    U.S. government and
    government-guaranteed   5.17%   2.34%   1.23%   0.41%   0.55%   1.36%   1.35%
    obligations
    Obligations of U.S.
    government-sponsored     0.10    1.19    0.43    0.30    0.10    0.50    0.00
    enterprises
    Central Liquidity
    Facility stock           4.06    2.96    3.39    4.16    2.96    3.36    3.58
    (direct)
    U.S. banks              12.27   23.34   26.77   10.50    4.27    2.40    6.34
    Foreign banks            0.00    2.02    0.00   15.41    6.80    0.83    1.84
    Repurchase activity     14.73    9.89   17.65    4.51   10.41    5.38    0.94
    Government and agency
    mortgage-related         7.10    3.80    2.61    3.01    2.74    4.55    8.05
    issues
    Privately issued
    mortgage-related         3.35    0.69    1.04    2.94   13.17   19.24   24.66
    issues
    Asset-backed            52.12   50.23   44.20   52.68   44.10   49.00   48.24
    securities
    Mutual funds             0.00    0.00    0.00    0.00    7.12    1.49    0.00
    Commercial debt          1.10    3.55    2.68    6.09    7.77   11.90    4.99
    obligations
    Other                    0.00    0.00    0.00    0.00    0.24    0.34    0.18
    Total investments     $17,364 $24,773 $24,668 $20,444 $30,952 $30,342 $32,656

    Source: NCUA call reports.

    Note: Totals may not add due to rounding.

    Holding variable-rate investments and securities with shorter weighted
    average lives tends to result in relatively lower interest-rate risk. U.S.
    Central, like the corporates, tends to have significant holdings of
    mortgage-related issues and asset-backed securities-80 percent of its
    portfolio was in such investments at the end of 2003-but holds most of
    these in the form of variable-rate and shorter weighted average life
    issues. Holdings of variable-rate asset-backed and privately issued
    mortgage-related securities accounted for 67 percent of all investments at
    the end of 2003. According to its 2003 annual report, at the end of the
    year, mortgage-related and asset-backed securities in U.S. Central's
    portfolio had weighted average lives of approximately 2.8 years and 3
    years, respectively, and approximately 83 percent of interest-earning
    assets were set to reprice or mature within 1 year. Table 5 details
    selected investments of U.S. Central from 1997 through 2003.

    Table 5: Composition of Selected Investments of U.S. Central, 1997-2003

    Privately issued
    mortgage-related
    issues, 1997-2003
    Privately issued
    mortgage-related      1997    1998    1999    2000    2001    2002    2003
    issues relative to
    total investments
    Fixed-rate           1.15%   0.00%   0.00%   0.00%   0.00%   0.00%   0.00%
    CMOs/REMICs
    Variable-rate         2.20    0.00    0.07    1.13   12.57   18.76   23.70
    CMOs/REMICs
    Mortgage-backed       0.00    0.69    0.97    1.81    0.60    0.48    0.97
    pass throughs
    Other                 0.00    0.00    0.00    0.00    0.00    0.00    0.00
    Total privately
    issued
    mortgage-related     3.35%   0.69%   1.04%   2.94%  13.17%  19.24%  24.66%
    issues relative to
    total investments
    Total privately
    issued
    mortgage-related      $582    $170    $256    $600  $4,066  $5,817  $8,040
    issues

    (in millions)
    Asset-backed
    securities,
    1997-2003
    Asset-backed
    securities relative   1997    1998    1999    2000    2001    2002    2003
    to total
    investments
    Fixed-rate credit    0.60%   1.07%   1.02%   0.98%   1.53%   1.69%   2.67%
    cards
    Variable-rate        20.57   17.45   22.12   18.84   17.14   20.76   20.87
    credit cards
    Fixed-rate autos      0.14    0.61    1.40    1.59    1.12    0.80    0.59
    Variable-rate autos   0.34    2.82    6.24    5.21    7.85    4.76    5.17
    Fixed-rate home       0.00    0.08    0.31    0.13    0.33    0.78    1.28
    equity
    Variable-rate home    6.08    5.38    6.50   19.10   12.90   16.26   16.05
    equity
    Fixed-rate other      0.27    1.40    0.09    0.04    0.06    0.06    0.35
    Variable-rate other  24.13   21.41    6.52    6.78    3.16    3.89    1.26
    Total asset-backed
    securities relative 52.12%  50.23%  44.20%  52.68%  44.10%  49.00%  48.24%
    to total
    investments
    Total asset-backed
    securities (in      $9,051 $12,442 $10,904 $10,770 $13,617 $14,818 $15,727
    millions)

    Source: NCUA call reports.

    Note: CMO stands for collateralized mortgage obligation, and REMIC stands
    for real estate mortgage investment conduit. Totals may not add due to
    rounding.

    U.S. Central's Capital Levels Generally Increased Since 1998 and, Despite
    Recent Asset Growth, Capital Ratios Were Higher in 2003 Than in 1998

    Since 1998, U.S. Central's capital has generally been rising. Total
    capital, as defined in Part 704, rose from $1.2 billion in 1998 to $2
    billion at the end of 2003. Figure 14 illustrates the growth in U.S.
    Central's total capital. Retained earnings and membership capital have
    grown overall, but paid-in capital has remained constant since 1999.

    Figure 14: Total Capital of U.S. Central, 1998-2003

    Since 1998, undivided earnings (a component of retained earnings) have
    provided the fastest growth, increasing 61 percent, while membership
    capital, the largest component, has grown 37 percent. At the end of 2003,
    membership capital accounted for 58 percent, or $1.1 billion, of U.S.
    Central's total capital.

    Despite recent asset growth, U.S. Central's capital ratios have remained
    relatively stable, as shown in figure 15. After peaking in 2000, capital
    ratios declined in 2001 but have since leveled off. They remain above the
    current regulatory requirements.

    Figure 15: Capital Ratios of U.S Central, 1998-2003

    Note: In this figure, capital ratios are calculated by dividing capital by
    the moving daily average of net assets (DANA), which is a measure of
    average assets as set forth in Part 704 in 1998. NCUA currently specifies
    three capital ratios: the capital ratio, which includes all forms of
    capital relative to moving DANA; the core capital ratio, which includes
    core capital (that is, retained earnings plus paid-in capital) relative to
    moving DANA; and the retained earnings ratio, which includes reserves plus
    undivided earnings relative to moving DANA.

    U.S. Central's Net Income and Profitability Have Grown Since 1992

    U.S. Central's net income has grown since 1992 and was at its highest
    level at the end of 2003. As depicted in figure 16, after declining to
    $10.7 million at the end of 1994, U.S. Central's net income rebounded,
    generally rising through 1998. After peaking in 1998 at $38.4 million, net
    income declined to $22.8 million at the end of 2000. However, by the end
    of 2003, net income had tripled to $67.9 million. U.S. Central's
    profitability-that is, net income divided by average assets-followed the
    general pattern exhibited by net income since 1992, and it was at its
    highest at the end of 2003.

    Figure 16: Net Income and Profitability of U.S. Central, 1992-2003

    Note: In this figure, profitability in a given year is measured by the
    ratio of that year's net income to the average of that year's total assets
    and the prior year's total assets.

    As with the corporates, U.S. Central witnessed a narrowing of its yields
    on investments recently. However, while profitability suffered at the
    corporates since 2001, U.S. Central managed to increase its profitability,
    in part through increased noninterest income.

    Expanded Authorities Available to CorporatesAppendix VII

    In 1998 NCUA revised Part 704. Among other things, the new regulations
    provided qualified corporates with expanded authorities that allowed
    corporates having a strong financial position, management, and
    infrastructure to exercise greater flexibility in managing their risks
    subject to NCUA approval.1 For example, corporates with certain levels of
    expanded authorities were allowed to invest in foreign securities or A-
    rated securities, compared with the higher-rated AAA securities in which
    other corporates were allowed to invest. In 2002, NCUA again revised Part
    704 to allow for further flexibilities in expanded investment
    authorities.2 For example, qualified corporates were allowed to invest in
    BBB rated securities, subject to NCUA approval.3 Table 6 provides more
    detail on the types of investments allowed under the various levels of
    expanded authorities, and the number of corporates that currently have
    these authorities.

    Table 6: Expanded Authorities and Number of Corporates Authorized to
    Engage in Investments under These Authorities, as of December 31, 2003

    Expanded authority Number of corporates Investments allowed under expanded
    level                                   authorities
                                               o Purchase investments with
                                               long-term ratings no lower than A-
                                               (or equivalent)

                                               o Purchase investments with
                                               short-term ratings no lower than
                                               A-2 (or equivalent), provided that
                                               the issuer has a long-term rating
                                               no lower than A- (or equivalent)
                                               or the investment is a
                                               domestically issued asset-backed
    Part Ia            2                    security

                                               o Engage in short sales of
                                               permissible investments to reduce
                                               interest-rate risk

                                               o Purchase principal-only stripped
                                               mortgage-backed securities to
                                               reduce interest rate risk

                                               o Enter into a "dollar roll"
                                               transaction
                                               o Purchase investments with
                                               long-term ratings no lower than
                                               BBB (flat) (or equivalent); the
                                               aggregate of all investments rated
                                               BBB+ (or equivalent) or lower in
                                               any single obligor is not to
                                               exceed 25 percent of capital

                                               o Purchase investments with
                                               short-term ratings no lower than
                                               A-2 (or equivalent), provided that
                                               the issuer has a long-term rating
                                               no lower that BBB (flat) (or
    Part IIb           3                    equivalent) or the investment is a
                                               domestically issued asset-backed
                                               security

                                               o Engage in short sales of
                                               permissible investments to reduce
                                               interest-rate risk

                                               o Purchase principal-only stripped
                                               mortgage-backed securities to
                                               reduce interest-rate risk

                                               o Enter into a "dollar roll"
                                               transaction
                                               o Invest in debt obligations of a
                                               foreign country

                                               o Invest in deposits and debt
                                               obligations of foreign banks or
                                               obligations guaranteed by these
                                               banks

    Part IIIc          3                    o Invest in marketable debt
                                               obligations of foreign
                                               corporations; this authority does
                                               not apply to debt obligations that
                                               are convertible into stock of the
                                               corporation

                                               o Invest in foreign-issued,
                                               asset-backed securities
                                               o Enter into derivative
                                               transactions specifically approved
    Part IVd           3                    by NCUA to create structured
                                               products, manage its own balance
                                               sheet, and hedge the balance
                                               sheets of its members
                                               o Participate in loans with member
    Part Ve            1                    natural person credit unions as
                                               approved by the Office of
                                               Corporate Credit Union Director

    Source: Part 704 of NCUA Rules and Regulations.

    Notes: Corporates can be granted more than one expanded authority level.

    aThe investments under Part I authority are subject to certain conditions,
    including the requirement that aggregated investments in repurchase and
    securities lending agreements with any one counterparty are limited to 300
    percent of capital.

    bThe investments under Part II authority are subject to certain
    conditions, including the requirement that aggregated investments in
    repurchase and securities lending agreements with any one counterparty are
    limited to 400 percent of capital.

    cTo engage in Part III expanded authorities, the corporate must have met
    the requirements of Part I or Part II, and additional requirements for
    Part III. Foreign investments are subject to the following requirements:
    The investments must be rated no lower than the minimum permissible
    domestic rating under the corporate's Part I or Part II authority. The
    sovereign issuer, or the country in which an obligor is organized, must
    have a long-term foreign currency (nonlocal currency) debt rating no lower
    than AA- (or equivalent). For each approved foreign bank line, the
    corporate credit union must identify the specific banking centers and
    branches to which it will lend funds. Obligations of any single foreign
    obligor may not exceed 50 percent of capital. Finally, obligations in any
    single foreign country may not exceed 250 percent of capital.

    dThe derivative transactions under Part IV are subject to the following
    requirements: If the counterparty is domestic, the counterparty rating
    must be no lower than the minimum permissible rating for comparable term
    permissible investments. If the counterparty is foreign, the corporate
    must have Part III expanded authority and the counterparty rating must be
    no lower than the minimum permissible rating for a comparable term
    investment under Part III authority.

    eThe ability to engage in Part V authorities is subject to the maximum
    aggregate amount of participation loans with any one member credit union,
    which must not exceed 25 percent of capital. In addition, the maximum
    aggregate amount of participation loans with all member credit unions must
    be determined on a case-by-case basis by the Office of Corporate Credit
    Union Director.

    Comments from the National Credit Union AdministrationAppendix VIII

    GAO Contacts and Staff AcknowledgmentsAppendix IX

    GAO Contacts

    Richard J. Hillman, (202) 512-8678 Debra R. Johnson, (202) 512-9603

    Staff Acknowledgments

    In addition to those named in the body of this report, the following
    individuals made key contributions: William Chatlos, May Lee, John Lord,
    Alexandra Martin-Arseneau, Kimberley Mcgatlin, Jose R. Pena, Julie
    Phillips, Mitch Rachlis, Barbara Roesmann, Paul Thompson, and Richard
    Vagnoni.

    (250165)
    *** End of document. ***