cuhrt_Re-Imagine Your Balance Sheet

Re-Imagine Your Balance Sheet

The Credit Union Housing RoundTableNovember 2008

Joe Barron, WescorpChip Filson, Callahan & Associates

Nizar Hashlamon, Prime Alliance Solutions, Inc.Sam Inman, Community First CU

Jay Johnson, Callahan and AssociatesDenise Ouellette, Oakmont Advisors, LLC

Jill Peterson, CUMAnetBill Walker, CMG Mortgage Insurance Company

Dan Green, Prime Alliance Solutions, Inc.

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©2008 BECU, Callahan Associates and Prime Alliance Solutions, Inc. All Rights Reserved.

AcknowledgementsThe CU Housing RoundTable is indebted to the authors of this paper, without whom this work would not be possible. Their donation of time, talent and expertise for the purpose of advancing credit union housing finance is greatly appreciated.

The White Paper series is truly a collaborative effort. The RoundTable would also like to acknowledge the following individuals who attended the Third Annual Meeting. Their contributions throughout the meeting shaped the final version of this paper, especially the proposed Member Mortgage Relief Initiative.

Carlos Griego Sandia Laboratory FCU

Douglas Grout SELCO Community CU

Gary Hails Silver State Schools CU

Nizar Hashlamon Prime Alliance Solutions, Inc

Betsy Henkel Pentagon FCU

Francois Henriquez U.S. Central FCU

Mercy Jimnez

Dale Kerslake Cascade FCU

Joe Kleeman Patelco CU

Lorraine LachapelleCU Members Mortgage

Marcia Lightfoot Woodstone CU

Robert Lund Beth Page FCU

Rick Marshall MidWest Loans

Steve Mase DEXMA

Dawn McCarn Unitus Community CU

David Miller PA Loan Servicing, Powered By Cenlar

Beth Millstein Fannie Mae

Tim Mislansky Wright-Patt Credit Unions

Richard Mullen Coastal FCU

Gary Oakland BECU

Penny Adair Charlie Mac

Maxine Allen ORNL FCU

Tracy Ashfield Prime Alliance Solutions, Inc

Joe Barron WesCorp

Fred Becker NAFCU

Brian Best Grow Financial FCU

Tanya Boggs Space Coast CU

Joseph Brancucci BECU

Bruns, Greg Verity CU

Shelly Calhoun IBM Southeast Employees’ FCU

Robert Chavez Sandia Laboratory FCU

Linda Clampitt C U Members Mortgage

Janita Clausell ORNL FCU

Kevin Collins Star One CU

Bob Dorsa ACUMA

Paul Emanuels Valley First CU

Chip Filson Callahan & Associates

Aurora Geis San Antonio FCU

Jamie GrayFirst Tech CU

Daniel Green Prime Alliance Solutions, Inc

Norman Okimoto Hawaiian Tel FCU

Kerry Oldenburg Prime Alliance Solutions, Inc

Denise Ouellette Oakmont Advisors, LLC

Lori PintoPA Loan Servicing, Powered By Cenlar

Jerry Reed Alaska USA FCU

John ReedCUSO Mortgage Corp

Scott Richter Eli Lilly FCU

Carlyn RoyOSU FCU

Carol Safberg Star One CU

Marla Shapiro Travis CU

Hank Sigmon First Tech CU

Scott Strand BECU

Bill Strunk SACU

Robert Tort CU National Mortgage

Pete Valerioti Tropical FCU

Jim Wagy Tropical Financial CU

EC Williams Grow Financial FCU

Larry Wilson Coastal FCU

Robert Zearfoss Randolph-Brooks FCU

© 2006 – 2008 CU Housing RoundTable. All Rights Reserved. Page 3 of 40

THECUHOUSINGROUNDTABLE.......................................................................................................4 TheHousingRoundTable’sPositioningStatement ...............................................................................................................4 Big,Hairy,AudaciousGoals .............................................................................................................................................................4

EXECUTIVESUMMARY..........................................................................................................................5 REIMAGINEYOURBALANCESHEET ...............................................................................................6 SECTIONI:CREDITUNIONMORTGAGELENDINGOVERVIEW.................................................7

Category1:NonParticipants ........................................................................................................................... 8 Category2:PortfolioonlyLenders................................................................................................................. 8 AccountingTreatment......................................................................................................................................... 9 Risks ............................................................................................................................................................................. 9 LiquidityRisk .........................................................................................................................................................................................9 InterestRateRisk.............................................................................................................................................................................. 10 CreditRisk ............................................................................................................................................................................................ 10 ConcentrationRisk ........................................................................................................................................................................... 10

Category3:ActiveSecondaryMarketParticipants ..............................................................................11 SellingLoansServicingReleased ..................................................................................................................12 SellingLoansServicingRetained ..................................................................................................................12 ServicingFees ..................................................................................................................................................................................... 12 MemberRetentionandCrossSellOpportunities................................................................................................................ 13 OtherServicingRetainedRevenueOpportunities.............................................................................................................. 13

SECTIONIIBALANCESHEETREALITIES ...................................................................................... 15 SECTIONIII:LIQUIDITYANDCAPITALACCESS ......................................................................... 17

CreditUnionMortgageAssetQuality..........................................................................................................17 That’sourStory,andwe’restickingtoit ................................................................................................................................ 17

AccesstotheSecondaryMarkets–1978toPresent.............................................................................19 Vehicles.....................................................................................................................................................................19 LoanParticipations .......................................................................................................................................................................... 19 WholeLoanSales .............................................................................................................................................................................. 20 CoveredBonds.................................................................................................................................................................................... 22 CUMortgage‐backedSecurities .................................................................................................................................................. 26

MakingVehiclesWork:StandardizationandConsistency ................................................................30 SECTIONIV:NEXTSTEPS .................................................................................................................. 34

TheNeedisReal....................................................................................................................................................34 ACooperativeGSE‐likeEntity ..................................................................................................................................................... 34 AModeltoEmulate? ........................................................................................................................................................................ 35 TheCentralLiquidityFacility ...................................................................................................................................................... 37

ClosingThoughts..................................................................................................................................................38 INDEXOFTABLESANDGRAPHS .................................................................................................... 40


The CU Housing RoundTable The CU Housing RoundTable® was founded by BECU, Callahan and Associates and Prime Alliance Solutions, Inc., as a forum for credit unions to create and exchange strategies that make housing more attainable for more credit union members. The RoundTable is a volunteer group open to all credit unions and credit union organizations. To learn more about the CU Housing RoundTable, visit the web site at www.cuhousingroundtable.com. The Housing RoundTableʼs Positioning Statement The CU Housing RoundTable (CUHRT) exists for the purpose of raising public awareness of the credit union system as a premier source of member friendly mortgage loans. The RoundTable will foster cooperation and collaboration among credit union system entities to ensure a heightened sense of public awareness and to ensure credit unions have access to timely, accurate information about housing finance policy, strategy and operations. It will identify issues and address solutions that facilitate the system's success in all aspects of housing finance. The networking capabilities of the internet plus periodic meetings will be used to create a virtual organization that is open to all credit unions and credit union organizations who wish to participate either on a long-term or ad hoc basis. The result of these efforts will be increased credit union market share, enhanced industry capability, expertise in housing finance and, recognition of the unique ability credit unions have to address the country's housing needs today and in the future due to their local presence and member focus. Big, Hairy, Audacious Goals The term ‘Big, Hairy, Audacious Goal’ or BHAG was coined by James Collins and Jerry Porras in their 1996 article entitled Building Your Company's Vision. The idea, of course, is that every organization ought to establish a goal that is, perhaps, ever so outlandishly out of reach. Thinking that good advice, the CU Housing RoundTable, during its first annual meeting in 2006, determined that a BHAG for the credit union system was in order. The Goal: Achieve 10% share of the annual U.S. Housing market by 2016. From 1996 to 2006 the industry managed to achieve just 2% each year, without much fluctuation plus or minus. Our fortunes brightened in 2007. Credit unions closed 2007 at 2.6% for the year; fourth quarter share reached 3.6%. While we’re benefitting from the crisis in the mortgage markets, the time to seize the long-term opportunity is now. What follows is another in a series of CU Housing RoundTable White Papers that strategically help credit unions do just that. This paper, ‘Re-Imagine Your Balance Sheet’ recognizes the balance sheet reality of ‘Two to Ten’. Our industry’s capacity is simply not large enough to hold 10% of all U.S. mortgages originated annually. Given that fact, and this summer’s changes to the financial markets, this question is one of the most important facing credit union lenders in the near-term.


Executive Summary 'Re-imagine your Balance Sheet' addresses one of the most important issues facing credit union mortgage lenders today: affordable access to capital. Credit unions are in the housing finance business as never before. As an industry we'll loan over $80 billion this year, a feat we’ve accomplished just one other time in the height of a refinance boom. We're gaining market share, too. By the end of 2008 it is conceivable our industry will have made 4% of all mortgages in the country. Our previous, rather static record, had been 2%. The CU Housing RoundTable is asking you to make two investments of your valuable time. First, please read the paper. In three parts, it:

1) provides an overview of the credit union demographics of mortgage lending and their lending practices. The vast majority of credit unions, over 5,700 out of the 8,200 total, do not make mortgage loans. The remainder do, though, through a variety of models, and in growing quantities. This section contains valuable insight into how the most successful manage their housing finance strategies while managing their risks;

2) illustrates the balance sheet issue of ever-increasing mortgage lending market share. Credit unions, through the use of their balance sheets and secondary market practices, can manage 4% annual market share without much strain. As this section shows, however, at 10% share, the Housing RoundTable's Big, Hairy Audacious Goal, the picture is very different; and

3) discusses the issue of 'what do we do with 10% market share' in the broader context of the recent upheaval in the capital markets. Freddie Mac and Fannie Mae, both stalwart providers of housing finance liquidity to the credit union industry, were placed into conservatorship in September 2008. Wall Street has changed, too, with the acquisitions of Merrill Lynch and Bear Stearns by major financial institutions. What the future holds for capital markets is at best unclear. Consequently, credit unions need a clear understanding of their alternatives and how to use them.

The second investment we'd like you to make is to get involved in this effort. Credit unions have made tremendous strides as mortgage lenders over the past decade. Always seen as reliable, affordable and sustainable, our industry is now also seen as some of the highest quality providers as well. Controlling our own destiny as it relates to capital markets / liquidity access is the next logical step in our progression as our members' housing finance provider of choice. For this to happen you must become involved in the dialogue. Please, treat this with a sense of urgency. While our first attentions must always be focused on our individual credit unions, this is a rare, historic opportunity to think and act holistically and cooperatively. Credit unions are best when credit unions work together. Our industry has tackled many adversities over the past 80 years, overcoming them with remarkable success. Ongoing access to affordable liquidity that we manage is this Century's first opportunity to demonstrate, that, while a lot has changed in 80 years, our collaborative spirit remains stronger than ever.


Re-Imagine Your Balance Sheet This paper is presented in four parts:

I. Credit Union Mortgage Lending Overview II. Balance Sheet Realities

III. Liquidity and Capital Access IV. Next Steps

Section I reviews the credit union industry today: the credit unions that participate in housing finance and how they approach the business, dividing credit unions into three distinct categories:

1) Credit unions that do not participate in the mortgage market 2) Credit unions that are portfolio only lenders 3) Credit unions that are active in the secondary market

In terms of numbers of credit unions, most aren’t mortgage lenders. In terms of assets, however, the view is quite different: credit unions are actively involved in housing finance. Section II discusses Balance Sheet realities. This portion of the paper is excerpted and adapted from the Housing RoundTable’s 2007 ‘Two to Ten’ White Paper. Section III discusses liquidity and capital access in two different ways. First, it explores several ‘vehicles’ for both moving and creating liquidity using credit union mortgage loans. Second, it suggests organizations with which credit unions might work to ensure a consistent source of affordable capital for the industry’s housing finance activities. ‘Re-Imagine Your Balance Sheet’ attempts to spark dialogue on this critical subject. Furthermore, it suggests action be taken quickly. It does not, however, recommend a specific action or direction. That’s the purpose of the dialogue and the subject of the CU Housing RoundTable’s next project.


Section I: Credit Union Mortgage Lending Overview Over the past ten years credit unions have steadily increased their reliance on mortgage lending as an important balance sheet and member relationship strategy. Graph I uses two snapshots to tell the story. The first picture was taken in 1997 and shows the traditional reliance on consumer lending. The second snap was taken this June. The picture has changed remarkably:

Graph I CU Balance Sheet Structure – A Ten Year History

Source: Callahan and Associates

Real estate lending now accounts for 53% of all total loans, up from approximately 35% ten years ago. Taking share from all other types of lending, housing finance has gained in importance due to member demand, the relationships these loans build and their profitability. And why not? As several surveys have shown, more than 50% of member households own homes.1 For some credit unions the rate is much higher. After ten years of trying, credit unions finally broke through their 2% U.S. market share barrier, achieving 2.6% in 2007, and a remarkable 3.6% during the fourth quarter of the same year. It’s conceivable that market share could reach 4% in 2008. The change in balance sheet structures depicted in Graph I is the beginning of a larger change to come. 1 CUNA’s National Member Survey


How have credit unions grown into housing finance over the past ten years? One of three ways:

1) Credit unions that do not participate in the mortgage market 2) Credit unions that are portfolio only lenders 3) Credit unions that are active in the secondary market

Now taking each in turn:

Category 1: Non Participants In terms of numbers of credit unions, 5,754 out of 8,2082 total credit unions do not offer a mortgage lending program to their members. These are small credit unions, with an average asset size of $22.5 million and a smaller, average membership base of 3,555. This group, fully 70% of all credit unions, stay away from this important member service for many reasons, including:

1) Lack of resources 2) Perceived mortgage lending complexity 3) Lack of commitment

As an alternative, some of these credit unions refer members to mortgage brokers and local lenders. The downside of this strategy is the loss of relationships. Auto loans, credit cards, deposit and checking accounts often follow the mortgage loan. The data seems to bear this out: average share growth for this group of credit unions has declined .65% over the past ten years.

Category 2: Portfolio only Lenders Portfolio lenders are the largest group, numbering 1,399. These credit unions use their balance sheets, as opposed to the secondary markets, to fund their mortgage lending activities. Ranging in asset size from $1.7 million to $4.3 billion, they have seen a steady rise in the growth of the mortgage lending portfolios, as Table I shows:

Table I Five and Ten Year Growth in Portfolio Lender Holdings

June 08 June 03 June 98

1st Mortg. as % of Total Loans (outstanding) 36.45% 30.44% 24.28%

1st Fixed Mortg. as % of Total Loans (outstanding) 25.94% 24.86% 18.45%

1st Fixed Mortg. as % of Total Loans (originations) 25.60% 24.70% 16.50% Portfolio lending has its advantages. Unconstrained by the strictures of secondary market guidelines and pricing, these credit unions create niche products that meet specific member and community demand. Affordability products are one example,

2 CUNA & Affiliate U.S. Credit Union Profile, March, 2008


and an excellent representation of this type of lending is CUNA’s HLPR Loan.3 Another timely example is credit union sub-prime rescue loans. This is discussed at some length in the Housing RoundTable’s companion White Paper entitled “Forever Changed: Housing Finance in the Post-Sub-Prime Environment.” The advantages of portfolio lending are also its major disadvantages, namely, lack of standardization in loan terms and pricing. Balance sheet lending depends on liquidity, liquidity that comes in the form of a growing deposit base and amortizing loans. When loan demand outstrips these sources, however, balance sheet lending becomes difficult if not impossible. Consequently, credit unions in this group, while they do not sell on a flow basis, do sell loans out of portfolio from time to time. Commonly referred to as bulk sales, groups of like loans are offered to investors for cash or may be securitized, though cash is the more usual form of the transaction.

Accounting Treatment Different accounting treatments apply to loans held-to-maturity than to loans held-for-sale, a designation that must be made at the time a loan is originated. A loan classified as held-to-maturity means the credit union has the intent and ability to hold the loan until it is paid off. The impact of temporary fluctuations in fair value of the assets is not reflected in the credit union’s financial statements. Loans that are classified as held-for-sale are those that are originated for the purpose of selling them within a short time. These assets are considered short-term in nature and are revalued at each balance sheet date to their current fair market value. Any gains or losses due to changes in fair market value during the period are reported as gains or losses on the income statement.

Risks Lending is inherently risky. Portfolio lenders have exposure to four types of risk: Liquidity Risk Liquidity risk, previously alluded to as a disadvantage of portfolio lending, is the risk that the credit union will be unable to fund member loan demand and share withdrawals without adversely affecting profitability or capital. Prevailing interest rate environments attenuate this risk. One of the best historical examples is the aftermath of the Depository Institution Deregulation and Monetary Control Act of 1980. With high inflation and even higher interest rates, Savings and Loans, although now legally able to pay competitive deposit rates, could not match short-term rates offered elsewhere. Their long-term, low rate mortgages were matched against short-term deposits, deposits that were being withdrawn rapidly. This in turn impacted both their capital and their profitability, some to the point that they ceased operations. 3 For more information, visit http://www.cuna.org/initiatives/hlpr/


We’ve learned a great deal about liquidity risk since the 1980s. Our assets and liabilities are better matched for duration. Our mortgage loans, though held in portfolio, do typically adhere to secondary market standards and pricing.4 The current interest rate environment requires the credit union to be able to better manage such risk. As rates increase, fewer members will have the market incentive to prepay their loans and refinance. Accordingly, the credit union likely will be amortizing their fixed rate mortgage loans longer than expected. This likely scenario will reduce the cash available to loan or reinvest at the higher rates and potentially negatively impact the credit union’s ability to meet members’ financial needs. Interest Rate Risk Interest rate risk is the risk that the cost of deposits could exceed the yield on loans. 1980 was the classic example of interest rate risk, when, taken to its extreme, forced many savings and loans into a liquidity risk situation as mentioned above. Changes in interest rates will potentially have a significant effect on the fair value of credit unions’ balance sheet. In a rapidly rising interest rate environment, a credit union’s cost of shares generally will increase faster than the return received on loans. This can ultimately diminish the credit union’s profitability. In addition, as higher yielding loans become readily available, the fair market value of the credit union’s existing loans declines. This diminution in value could reduce the credit union’s capital. Credit Risk Credit risk is the risk that a borrower will default or not repay the principal loan balance. This has been a significant issue in the past year. While historically credit unions have not been exposed to significant default risk and maintain quality portfolios, they are not immune. The current economic conditions and rise in mortgage loan delinquencies has proved that credit unions are subject to increased credit losses as well as reduced net interest margins. Concentration Risk A fourth risk to portfolio lenders is asset concentration risk. Concentration risk comes in two principle forms. First is product. An example of this might be an over-reliance on long-term fixed rate mortgages. Since fixed rate mortgages are just that, as interest rates rise, there is no ability to reprice these assets. A mix of long-term and shorter-term fixed rate loans combined with adjustable and balloon notes is one way to avoid product concentration risk. The second form of concentration risk is geographic, which is very real for credit unions, since, for the most part, this is an industry of community lenders. If all a credit union’s mortgages are made in the same community, county or state, should those areas suffer natural disasters or economic downturn, large numbers of loans have the potential to become delinquent and or default.

4 NCUA, in the early 1990s began requiring credit unions to originate mortgage loans according to secondary market standards, even those loans that were destined for the portfolio, as a way to address liquidity risk.


Category 3: Active Secondary Market Participants Successful real estate lending requires many things, strong secondary marketing5 strategy and execution being one of them. Effectively using the secondary market affords credit unions ways to manage the risks inherent in mortgage lending as discussed above. It also provides credit unions access to a broader array of products as well as consistent, affordable access to capital. Using the markets is one sure way credit unions can create and sustain a healthy housing finance program. On a head count basis, the smallest number of credit unions play here. This group is comprised of 746 credit unions and they are the most successful of all mortgage lenders, as Table II illustrates:

Table II Ten Year Growth Rates: Mortgage v. Non-Mortgage Lending Credit

Unions Category I

Non Lenders

Category II

Portfolio Lenders

Category III Secondary

Market Servicing Released Lenders

Category III Secondary

Market Servicing Retained Lenders

Number of CUs6 5,746 1,399 Assets 5.09% 7.00% 8.57% 10.64% Loans 4.10% 6.96% 8.61% 11.97% 1st Mortgage Loans .40% 1.68% 2.74% 4.64% Members -.65% 0.19% 1.54% 3.61% Employees -11.69% -1.84% -1.05% 4.14% ROA While all mortgage lending credit unions outperform non-lending credit unions by these measures, those that actively involve the secondary market and retain servicing have turned in the best performance over the past ten years. As Table II points out, there are two ways to lend when using the secondary markets, service

5 Secondary market, as used here, includes Fannie Mae and Freddie Mac (the Government Sponsored Entities or GSEs, the Federal Home Loan Bank, conduits such as Countrywide and other investors). 6 The numbers were run using Callahan’s Peer to Peer software and three account codes from the 5300 Call Report (scrubbed NCUA data):

1. 720 – Amount of Mortgage Originations YTD 2. 736 – Total Amount of All first Mortgage Loans which have been sold in the secondary

market year-to-date. 3. 779a – Amount of real estate loans sold but serviced by the credit union

To define the groups (originally 4), the following account codes were used, and define the search fields as follows –

1. CUs Not originating mortgages 720<0, 736<0, 779a<0 2. CUs originating but not selling 720>1, 736<0, 779a<0 3. CUs originating, selling, not servicing sold loans 720>1, 736>1, 779a<0 4. CUs originating, selling, and servicing 720>1, 736>1, 779a>1

Adding the ‘numbers of credit unions’ results in 355 fewer credit unions than the total of 8,201 taken from CUNA & Affiliates U.S. Credit Union Profile. These 355 credit unions didn’t fall into one of these four groups due to the way the data was supplied to NCUA by these credit unions (i.e., a credit union that has originated and sold mortgages in the past may have neglected to do so this year, or a credit union who still services one of these mortgages and did not originate any this year would also be excluded).


released and service retained.7 Of course jumping into the discussion of servicing released versus servicing retained begs the question of just who or what and how credit unions will be selling loans to in the future. Section III of this paper presents several ideas on this subject and proposes a number of possible next steps.

Selling Loans Servicing Released Two assets are created when a loan closes: the loan and the servicing right. They often part company shortly after the member signs their loan documents. That’s the case for credit unions that sell loans on a servicing released basis. The incentive to do so is the Service Released Premium (SRP). SRPs provide immediate cash at the time of sale, but no additional cash flow over the life of the loan. Credit unions that employ this strategy may use SRPs to either improve the pricing for the member or to increase the credit union’s current earnings. Other reasons that may motivate a credit union to sell the servicing rights are the elimination of the cost of servicing the loan, or to mitigate liquidity, interest rate, credit and concentration risks.8 The disadvantage of servicing released sales, however, is the potential loss of member relationships. With the servicing, so goes the opportunity to maintain regular contact with mortgage borrowing members for the purposes of enriching the relationships. Those that retain servicing rights often do so for exactly this reason. Look again at Table II. Credit unions that have sold mortgages on a servicing released basis for the last ten years experienced member growth of 1.54%; those that retained the servicing relationship saw growth over the same period of 3.61%.

Selling Loans Servicing Retained Retaining ownership of servicing rights has tremendous value for credit unions of all sizes and strategies. To fully understand the true value of the servicing asset, it helps to look at the four main components of value:

1) Servicing fee 2) Member retention and Cross-Sell Opportunities 3) The Value of the P&I Float, Escrow Earnings 4) Late Fees and other ancillary income

Servicing Fees Investors typically pay a servicer9 25 basis points for servicing fixed rate loans on their behalf. Servicing unusual loans or adjustable rate mortgages may result in higher fees. One of the most overlooked benefits of servicing is it provides income

7 It is important to note that these classifications are not mutually exclusive. That is to say, credit unions may use a strategy that calls for some loans to be sold servicing released while selling other loans servicing retained. For a full discussion of options, see the CU Housing RoundTable’s companion paper entitled ‘Appoint a Housing Czar’. 8 This assumes these credit unions sell the loan and the servicing right concurrently, which most that use the secondary market in this way do. That does not have to be the case, however. Lenders may retain the loan in their portfolios but sell the servicing right. This is a viable strategy, though it is not widely used within the credit union industry. 9 In this context, the servicer is the credit union.


stability to the servicer in the form of steady revenue, an annuity. This is especially important in a rising rate environment when origination volume typically slows. As rates increase, so does the value of mortgage servicing rights. Member Retention and Cross Sell Opportunities Mortgage loans are becoming an increasingly more significant anchor product and leading business line for building member relationships. Members who have their mortgage loan with the credit union tend to use more of the credit union’s products and services. Retaining ownership of the servicing rights helps the credit union reinforce this relationship. This can occur whether or not credit unions service the loans internally or utilize a subservicer.10 Regardless, the important point is that credit unions should utilize the servicing function to maximize the value of the overall relationship. Servicing mortgage loans enables the credit union to provide targeted marketing for other products. As traditional checking accounts evolve into electronic bill payment / home banking usage and the prevalence of debit card transactions increases, there are fewer opportunities to interact personally with the member, moments that have traditionally been used to cross-sell additional services. When the mortgage loan servicing is retained though, a credit union has more opportunity to increase its “wallet share” by recapturing interaction and service usage. Moreover, it’s been proven that borrowers who are satisfied with the behavior of their loan servicer are more inclined to return to that original lender to obtain future home financing. Compare this with service-released sales, which put credit union members in the hands of competing organizations. Furthermore, with service-released sales it is impossible to limit the number or frequency of servicing transfers, a very common complaint among mortgage borrowers. As an additional benefit, retaining the ownership of the servicing rights also allows the credit union to offer streamlined refinancing options or modification programs during times of low rates. Other Servicing Retained Revenue Opportunities Retaining servicing provides the credit union with additional revenue opportunities. The first area to earn additional income is the float on principal and interest payments (P&I). Mortgage payments are traditionally due on the first of the month and are typically received during the first week, yet they are not due to the investor until later in the month, typically around the 15th. This means, in most cases, funds do not need to be delivered to the investor for several days, if not weeks, later. This represents potential significant income for the credit union. Escrow funds also provide a low cost source of funds to the credit union. The industry generally values loans with an escrow account at about 12.5 to 25 basis points higher because of the additional liquidity escrow funds represent. Furthermore, during the life of the loan, the credit union has the opportunity to earn late fees as well as ancillary income from sales of products such as mortgage life and credit life insurance. In terms of dollars, think back to the basic service fee of 25 basis points. MBAA Cost Studies on loan servicing have historically put the value of these components at 3 to

10 For a full explanation of servicing in-house vs. outsourcing to a sub-servicer, see the CUHRT’s companion White Paper, ‘Appoint a Housing Czar’.


as much as 10 basis points. Servicing, if performed efficiently, can produce additional revenue.


Section II Balance Sheet Realities11 The member implications of Two to Ten are significant. Holding the 2007 projected market constant, our industry would grant an estimated 1.1 million mortgage loans assuming 10% market share, or an increase of 348% over the 245,000 homes credit unions are projected to finance this year. What would credit unions do with $256 billion in mortgage financing in a single year? Graph II illustrates this point. Assuming credit union assets grow at a consistent, historically-based pace over the next 10 years, mortgage originations, as a percent of assets would top 20%. In comparison, mortgage assets equal just under 8% of credit union assets today.

Graph II What Does 10% Mean?

Source: Wescorp This becomes more poignant when considering the current nature of credit union balance sheets. According to CUNA & Affiliates March 2007 U.S. Credit Union Profile, long-term assets to total assets stands at 26%. For credit unions in excess of $100 million in assets, the statistic is 28%. Add to this the fact that, according to the Profile, liquidity is tight among all credit unions, especially those larger than $100 million. At these credit unions, the loan-to-share ratio stands at 81%.

11 Excerpted and adapted from CUHRT ‘Two to Ten’ White Paper, 2007.


While there is some additional room for mortgage loans on credit union balance sheets in the near-term, the message is clear: growing market share much beyond today’s 3.6% requires a new approach.


Section III: Liquidity and Capital Access Section III is a survey of sorts, presented in three parts. The first part provides background on credit union asset quality, historic access to the secondary markets, and thoughts on standardization. The second part presents various vehicles credit unions might employ to create liquidity using mortgage assets. Part two discusses organizations with which credit unions might work to ensure a consistent source of affordable capital for their housing finance activities. Neither the vehicles nor the organizations are mutually exclusive. All could and should work in concert. Nor are these exhaustive lists. Starting a dialogue and sparking ideas are what this Paper is intended to do.

Credit Union Mortgage Asset Quality Creating a secondary market for credit union mortgages has been on the minds of industry leaders for 30 years, since the day it became legal for credit unions to make long-term fixed rate loans. Thirty years later the industry continues to use the same vehicles: predominantly Fannie Mae and Freddie Mac, with a smattering of Ginnie Mae and the Federal Home Loan Bank (the “GSEs”) for good measure. The GSEs have been good partners, even through the tumultuous market conditions of the past 12 months. That said, the future structure of these organizations is uncertain, as are their capabilities. After three decades of effort, credit unions must now act to ensure the consistent availability of affordable credit union funds for members’ home financing. Thatʼs our Story, and weʼre sticking to it The story goes like this: credit union mortgage loans outperform the mortgage loans of all other lenders. Delinquency, on an historical basis, is less than half of the industry. Foreclosures are fewer in number, almost non-existent. This continues to prove true through June of this year, as Graph III illustrates:


Graph III Credit Union Asset Quality12

Sources: Callahan’s Peer to Peer Software, FDIC Various credit union entities have pitched this story to the capital markets, to private investors, and to Wall Street with the idea that the superior credit quality of these loans would warrant better pricing, perhaps as good as the pricing available in the old days direct from the GSEs. No dice. “Historical performance is no indication that the trend will continue into the future…” or something like that, was the consistent answer. The pricing from the GSEs was the best credit unions could do as an industry. While superior historical performance is borne out by the data, the fact remains it will not accurately predict the same will hold true in the future. As credit unions become more community-based and members diversify their use of financial service providers, performance may, in fact, regress to the industry mean. What credit unions can provide prospectively, though, is a level of transparency that has been absent in the mortgage-backed securities of the recent past. It appears, in fact, that a major obstacle to working through the current crisis at the lender and borrower levels is reconstructing their original financing through the various securitization schemes that took place post-closing. While not unique in all the world, the U.S. system does make it difficult to track back when in fact doing so may offer the best route to relief for the borrower and their lender. The Next Steps Section presents several thoughts for a credit union secondary market, the intent of which is to provide a consistent source of affordable liquidity for the industry’s financing needs.

12 On its face, Graph III tells a good story. The real story, however, is actually better. Credit union loan performance is reported on a 60-day past due basis. Banks report their performance on 90-day past due basis.


Access to the Secondary Markets – 1978 to Present Historically credit unions have relied on the Government Sponsored Enterprises (GSEs) - - Fannie Mae, Freddie Mac and the Federal Home Loan Bank - - and a variety of familiar conduits such as Countrywide, PHH, GMAC, Homeside, WAMU and others for their access to the secondary markets. While it worked, it worked fairly well, especially relationships with the GSEs and the Federal Home Loan Bank. Even several conduit relationships, such as the long-standing program offered by PHH, helped credit unions grow into mortgage lending. This paper resulted from a discussion of the implications the Two to Ten Strategy would have on credit union balance sheets, a discussion that began in 2006. If the industry achieves 10% annual market share, credit union balance sheets are simply not large enough to hold the additional volume. That was a complex enough problem to consider on its own. The recent upheaval in the capital markets, at the GSEs and several of the conduits credit unions once used, adds another layer of complexity as well as an increased sense of urgency to create more than alternative forms of secondary market access. Today’s need, given the market’s dynamism, is for a total reformation of the way credit unions acquire consistent, affordable liquidity for the preservation and growth of their housing finance programs. What will the secondary markets look like in the post-sub-prime, post-bailout environment? No one knows. Credit unions have been here before, however, with numerous other financial products and services. The historic answer? The credit union system has been able to develop its own system solutions for most areas of financial institution commerce in the last 10-15 years, except for secondary market access for real estate loan sales. We have the track record, the capacity, the systems in place and the market need is now. If ever there was a moment for credit unions to develop their own cooperative GSE-like model, it’s now. Cooperation and collaboration among all parties will be necessary to determine how the model might function. The ‘Vehicles’ Section of this paper discusses this concept further. Accomplishing such a feat puts the final keystone in the credit union financial arch.

Vehicles This section of the paper discusses various ‘vehicles’ the credit union industry might use to move liquidity between credit unions, or, in the case of covered bonds or securitization, use credit union mortgage loans to attract liquidity from other sources. Loan Participations Loan Participations is a long-standing method for CUs to gain liquidity, capital relief and lending capacity by selling participation interests in loans made to members, and CU buyers of loan participations benefit from loan growth that is not available to them organically in their local market. Some CUs self-manage their participation


sales program, generally with a very limited group of local buyers, while others utilize the expertise and staff of Corporate CUs such as WesCorp that makes a market in participations with a broad group of loan participation buyers and handles all buyer reporting and disbursements. Credit union volume in loan participations outstanding reached $10.8 billion in June 2008, and the year-over-year growth rate of 11.1% is roughly double the growth rate of 5.6% in the prior year, as shown in Table III. Historically dominated by auto loans and home equity loans, loan participation programs have not been as significant in residential first mortgage loans. Unfortunately, the industry loan participation volume data is not detailed by loan type, and so a deeper understanding of volume as to residential first mortgage loans is not available.

Table III Credit Union Loan Participation Volume – June 2008

Jun-08 Jun-07 Jun-06 Units 443,276 425,183 442,255 Dollars $10,861,297,679 $9,774,219,509 $9,255,949,171 YOY Growth ($) 11.1% 5.6% Source: NCUA 5300 call reports

Considering loan participations (hereafter “LP”) as a future vehicle to support the ‘Two to Ten’ vision for CU residential mortgage loans gives rise to two distinct lines of thought…where loan participations can’t help at all, and where loan participations can help given the right environment and way of doing business. What loan participations can’t help with is the mismatch between short-term balance sheet funding and long-term balance sheet assets. The traditional loan participation model relies on CU to CU transfer of assets. But CU’ can’t hold a large volume of fixed rate mortgages since it creates an asset-funding mismatch, and loan participations would only transfer this asset-funding mismatch from one CU to another CU. As such, LP is not an option for fixed rate mortgages that will help CUs achieve ‘Two to Ten’. What’s needed is a non-traditional LP model with a transferee, a buyer, that can hold a large volume of fixed rate mortgages. CUs will have to look outside the CU system for loan participation investors such as insurers and pension funds, relatively few and large organizations that seek ongoing sources of large dollar volume acquisitions. Given the large number of CUs and the few large investors, this many-to-few market model gives rise to issues of Scale, Consistency, and Standardization. Whole Loan Sales Secondary mortgage markets are of two general types. “Whole loan” markets involve the sale of mortgages themselves, on a loan-by-loan or block basis. Such markets primarily involve a one-time sale of newly originated loans. Mortgage-backed securities are the other market type. In this scenario loans are segregated in pools, and securities, known as mortgage-backed securities (MBS), are issued against the pools. While MBS are actively traded after the initial issuance, whole loan sales are usually final.


The U.S. housing market’s recent turmoil has rattled investor confidence in the various structures of mortgage assets, especially those created in the past decade. The obvious disconnect is the risk / reward structure inherent in the creation of MBS and the derivations thereof. The mortgage industry specialized in transference of the credit risk, in such way that, the originating loan officers were no longer held accountable for poor decisions. This is discussed in greater depth in the ‘Credit Union Mortgage-backed Securities’ section. One effective way to address the issue of shaken investor confidence is to remove the complexities of securitization, putting in their place transparent, whole loan sales. By directly connecting investors with credit union lenders and providing detailed loan level information rather than the average pool information used in typical MBS scenarios, investors get access to high-quality credit union loans. Credit unions get increased liquidity. Credit unions could, to make whole loan sales even more attractive, provide investors with credit enhancements that might include recourse13 in the event of default. This guarantee should enhance investors’ confidence and increase the price they are willing to pay. Whole Loan Execution & successful game plan for accessing the private markets Whole loan sales are the most fundamental and transparent of secondary market transactions. They are the most fundamental basis of transporting mortgage capital and the simplest and one of the oldest deal structures in use. Sales can range from one loan to whatever amount an investor has need for. Several minor variations on the theme have emerged addressing, for instance, who services the loans, which party(ies) bear collateral risk and in what proportions, and how defaults are cured. Whole Loan Execution for Credit Unions

• Investors are looking for high quality assets with clear transparency. • The credit union origination and servicing model, which has never been

broken and continues to work well even with the markets under duress, may help restore investor confidence.

• Investors want to reduce fees between themselves and lenders. It follows, at least theoretically, that arrangements that have credit unions dealing directly with investors should reduce the cost of the transaction.

• Credit unions maintain lower credit risk profiles relative to other financial service participants. This performance cannot be rewarded when credit union loans are pooled with all others. This is an historic opportunity to leverage the industry’s superior asset quality.

• Investors are remaining on the sidelines, yet may be willing to buy given the right product. Possible investors include life insurance companies, pension funds, and, perhaps, even banks that have been hoarding cash for the past several months. These investors might also have a motivation to invest in their community. For example, a teachers’ retirement fund might be willing to invest in a pool of loans made by a teachers’ credit union.

• Credit unions will need to be willing to cover the risk of default, whether through a recourse transaction or some kind of guarantee structure.

13 Recourse arrangement may have regulatory implications that will have to be explored further should whole loan sales become a desired option to pursue.


• Credit union mortgage servicing rights should remain with the credit union in any whole loan structure. This is now a perceived weakness with banks that bought and sold servicing rights.

Covered Bonds Covered Bonds, not a new invention by any means, have been popular in Europe for some time and have proven to be an economic source of funding and are now a part of the general banking activities. Covered Bonds provide investors with high-quality investments and attractive yields. The U.S. Treasury defines Covered Bonds in its Best Practices Guidelines on Covered Bonds as:

“A Covered Bond is a debt instrument secured by a perfected security interest in a specific pool of collateral (“Cover Pool”). A Covered Bond provides funding to a depository institution (“Issuer”) that retains a Cover Pool of residential mortgage assets and related credit risk on its balance sheet. Interest on the Covered Bond is paid to investors from the Issuer’s general cash flows, while the Cover Pool serves as secured collateral.”

The European covered bond market has grown tremendously over the past few years and recently an increasing number of articles and industry experts are calling for broader use of these vehicles for U.S. financial institutions. Since Covered Bonds are an on-balance sheet form of secured debt instrument or collateralized borrowing, they are different than the traditional off-balance sheet securitization involved with mortgage-backed securities (MBS). The bonds are obligations of the Issuer and the Issuer retains control of the loan assets, the Cover Pool. Loans in the Cover Pool can be changed by the Issuer to affect credit quality and other factors related to the security required for the Covered Bond. Covered Bonds are similar to a secured bond issuance as there is no transfer of the assets, the Cover Pool, to a special purpose entity. The assets are identified and are placed as a security for the bondholders. In the event of bankruptcy of the Issuer, a general secured lending law or a special law relating to the Covered Bonds grants the bondholders recourse against the pool of mortgages over which security interest had been created. Because the bond is secured, typically with high quality assets, and issued by a strong counterparty, most Covered Bonds receive double or triple-A credit ratings. Maturities can range from two to ten years based on the expected life of the underlying pool of assets. Furthermore, in the event of defaults on the mortgages that make up the Cover Pool, investors still have recourse against the bond issuer. In other words, investors in the covered bond have recourse against the bond issuer as well against the collateral in the Cover Pool. Table IV describes the general characteristics of Covered Bonds, comparing them with Mortgage-Backed Securities.


Table IV Covered Bond Characteristics compared with Mortgage-Backed

Securities Covered Bonds Securitization Purpose Essentially, to raise

liquidity Liquidity, off balance sheet, risk management

Risk transfer The originator continues to absorb default risk as well as prepayment risk of the pool

The originator does not absorb default risk above the credit support agreed; prepayment risk is usually transferred entirely to investors.

Legal structure A direct and unconditional obligation of the issuer, backed by creation of security interest.

True sale of assets to a distinct entity; bankruptcy remoteness is achieved by isolation of assets

Type of pool of assets Mostly dynamic. Originator is allowed to manage the pool as long as the required “covers” are ensured.

Mostly static. Except in case of master trusts, the investors make investment in an identifiable pool of assets.

Payment of interest and principal to investors

Interest and principal are paid from the general cashflows of the issuer

Interest and principal are paid from the asset pool

Prepayment risk Prepayment of loans does not affect investors

Prepayment of underlying loans is passed on to investors; hence investors take prepayment risk

Off balance sheet treatment

Not off the balance sheet Usually off the balance sheet

Covered bonds structure under U.S. Treasury Guidelines The U.S. Treasury developed best practice guidelines on Covered Bonds. The guidance note proposes two alternative structures: issuance of bonds by a Special Purpose Vehicle (SPV) and issuance of bonds by the originator directly.

Direct issuance by the originator: Under this structure, the issuer is the entity holding the pool of mortgages, the Cover Pool. The issuer contains a mortgage interest on the pool of cover assets and issues bonds. Issuance through Special Purpose Vehicle (SPV): In case of the SPV structure, the SPV acquires a mortgage bond issued by the originator. The SPV in turn issues the securities, backed by the mortgage bond it holds. The maintenance of the mortgage cover would be the responsibility of the originator. The conceivable advantage of using the SPV structure is that there


might exist legal and structural enhancements at SPV level such as liquidity facility, independent trustees, etc. Pricing and risk assessment of Covered Bonds: Theoretically, the spreads on Covered Bonds should be lower than those for off balance sheet securitization and higher than those for unsecured bonds The quality is solely dependent on the strength of the issuer. The spreads being higher than unsecured bonds is easy to understand, as Covered Bond are backed by effective collateral and are mostly AAA rated. The reason for the spreads being lower than securitization is because in the case of securitization, investors do not have recourse against the originator, and importantly, investors face prepayment risk. The asset-liability mismatch inherent in the pay-back profile of the loans is taken entirely by investors. In the case of Covered Bonds, investors are not affected by the prepayment risk, and the payment term is defined in the Covered Bond Offering Circular. From the investor viewpoint, the key point in analysis of a Covered Bond is the quality of the underlying mortgage loans. The attractiveness of the Covered Bonds to investors is the relatively high credit quality of mortgage assets used in the Cover Pool. Typically loans must be less than 80% loan-to-value and require full documentation of borrower eligibility such as income. Furthermore, pools of loans are geographically diverse avoiding the dangers of concentration of loans from any specific area. And, as the pool is not static, the crucial issue is the underwriting standards and the selection criteria for introducing new loans into the Cover Pool. Covered Bonds have been used in Europe as highly liquid instruments, which are typically sold to rate-product investors, those who focus primarily on yield, rather than credit-product investors, those who focus on return. They also have been subject to extensive statutory and supervisory regulation designed to protect the interests of Covered Bond investors from the risks of insolvency of the issuing institution. In the U.S. they remain a relatively new innovation with only two issuers: Bank of America, N.A., and Washington Mutual.

Graph IV Simplified Structural Overview of Covered Bonds Issued by WAMU

and BOA

Source: Dresdner Kleinwort Debt research

The Case for Credit Union’s Use of Covered Bonds Section II establishes the fact that credit union balance sheets cannot hold an annual 10% of U.S. mortgage origination, even with the accelerated asset growth credit unions are likely to experience as a result of the large number of financial institution failures and consolidations of the past several months. Deposit growth adds to liquidity in the short term, but there’s no assurance it will continue. Covered Bonds


create liquidity. That’s their purpose. Let us look at what using Covered Bonds might look like from a credit union perspective:

Graph V Simplified CU Covered Bond Overview

Covered Bonds: Issues and Requirements

Regulatory requirements: More definitive rules and regulations may need to be clarified for credit unions’ ability to engage in Covered Bond activity. While the European market has well-established legal and regulatory framework in place under which the Covered Bond market operates, credit unions face a different regulatory framework than banks in the U.S. Does the regulatory framework (NCUA) and charter credit unions operate under make it feasible for credit unions to ‘issue’ Covered Bonds themselves? Rating: Do credit unions, as not–for-profit cooperatives, have to be ‘publicly rated’ for counterparty risk? If credit unions cannot participate directly, can corporate credit unions take on the role of Covered Bond Issuer? How then do the loan assets get transferred to the corporate credit union for an on-balance sheet transaction? Can they play a counterparty guarantor role for individual credit unions to participate or invest in the Covered Bonds? Scale: Research has shown that the average issue for Covered Bonds is $1 billion. At present one credit union has the capacity to place more than $1 billion in flow business into a Covered Pool. Consistently issuing $1 billion Covers would require cooperation, collaboration and coordination. Servicing: The world is truly flat today. Just as the GSEs provide a shared loan-decisioning infrastructure for underwriting purposes, an aggregate servicing platform or master servicer would be needed too so that mortgages could be


pooled, transmitted to the investor and serviced in an efficient and cost effective manner. Investors: Credit unions could achieve diversity and purchase Covered Bonds from each other or do the same with outside investors that may be willing to pay premiums for credit union loan quality.

In conclusion, the current disruption in the mortgage markets is an opportunity for credit unions to leverage their collective strength: create a new collaborative opportunity that leverages and rewards our members’ intense loyalty and sound underwriting practices. CU Mortgage-backed Securities Securitization is the process through which loans are removed from the balance sheet of lenders and transformed into collateralized repayment obligations or securities that are then purchased by investors. Securitization transforms raw assets into tradable instruments. Structuring of the transactions may rearrange the cash flows and risks of the real financial assets in order to meet diverse investor needs. The U.S. mortgage-backed securities market is the largest and most developed securitization market in the world. Residential mortgages are the most widely used form of collateral due to the sheer number of loans and the well-established legal structure for transferring ownership of mortgages and ensuring enforceability of the lien on the property. The primary economic motivation for securitization is to allow the issuer to sell loans in an efficient manner and receive the maximum value for the loan assets. The issuer can then use the proceeds of the sale to make additional loans. Securitization helps alleviate the balance sheet risk of building large portfolio of loans, and therefore, Mortgage-Backed Securities (MBS) provide a source of liquidity to fund loan production. Securitization allows the segmentation of the origination and investment activities. Securitization may also provide a more attractive or economic source of financing compared to issuing debt or equity depending on the all-in cost of issuing the securities. Additionally, securitization may allow the issuer to increase their leverage or free up capital for other investments, depending on their overall balance sheet objectives. In the mortgage market, securitization converts mortgages made to individual borrowers into mortgage-backed securities. An MBS is a bond whose payments are based on the principal and interest payments of a collection of individual mortgages. The initial sales of the bonds are put together either by the GSEs, Wall Street dealers, or by private financial institutions such as mortgage bankers. In the course of securitization, issuers may work with lawyers, accountants, and rating agencies. Each party receives compensation for its services. The MBS origination process typically begins when the issuer purchases a collection of mortgages from the originators. As payments are made on the mortgages, the servicers of the mortgages pass through to the appropriate trustee for the bondholders. A guarantor may be called upon to cover any losses in the event of a default. Generally, the servicer, guarantor, and trustee will all receive a piece of the interest payment as compensation for their services.


Several types of issuing structures are commonly used in securitization with the simplest type of trust being a grantor trust, or "pass-through", where MBS certificate holders receive the monthly principal and interest payment from each of the underlying mortgage loans as it is "passed through" to investors of the securities. The interest rate of the security is lower than the interest rate of the underlying loan to allow for the payment of servicing and guaranty fees. Participants in securitization In addition to private firms, the participants in the mortgage securitization process are the government agency, Ginnie Mae, and the GSEs (Fannie Mae and Freddie Mac). Ginnie Mae facilitates the securitization of home mortgages backed by federally insured or guaranteed loans, such as those issued by the Federal Housing Administration (FHA) or the U.S. Department of Veterans Affairs (VA). Ginnie Mae guarantees the timely payment of mortgages’ principal and interest, thereby reducing the risks for MBS investors. The GSEs use conforming loans to back the MBSs they issue, adding guarantees that principal and interest on the mortgages will be paid. Private sector financial institutions package private issues MBSs. Most of these MBSs include securities backed by high quality (prime) loans or sub-prime loans. Given the goal of securitization to transform individual borrower loans (and promises to pay) into easily transferable securities that are appealing to investors, three general features will determine the securities investment characteristics:

1) The timing of the principal repayment. Often driven by underlying collateral cash-flows; therefore, principal payment schedule of the securities may vary.

2) The amount and form of interest paid on the outstanding principal balance. Interest payments are generally fixed or floating.

3) The credit quality of the security. The credit quality of the security reflects the likelihood that principal and interest payments will be paid in full and on schedule and therefore reflects the credit quality of the underlying collateral and the degree and form of any credit enhancement.

Investors in these securities will analyze these characteristics to determine their measure of value and risk. There are many ways to view value and risk depending on the type of instrument being assessed, structure of the security, and objectives of the investor. Common measures include yield or rate of return on the investment and relative spread to other instruments for a given risk rating. Another risk measure is duration or the relative sensitivity of the price of the security to changes in interest rates. Convexity is related to duration and represents the change in duration as interest rates change and is a measure of the embedded option features of the security. There are three major risks to MBS investors:

1) The first risk is interest rate risk (common to all bondholders): If interest rates change, the value of a bond changes in the opposite direction.

2) The second risk is prepayment risk: Most mortgages can be prepaid without

penalty. Prepayments introduce timing risk, since investors do not know when their bonds will be repaid (thereby eliminating future interest payments).


This is especially important when combined with a lower interest rate environment. When the interest rates on new mortgages fall, investors like the fact that they continue to receive the old, higher interest rates on existing MBSs, but this is precisely when borrowers are most likely to prepay loans by refinancing their mortgages.

3) The third risk faced by MBS investors is default risk (i.e., the risk that

homeowners will default on the mortgages that back the MBS). While Ginnie Mae, Fannie Mae, and Freddie Mac offer guarantees against default risk, private sector MBS issuers may obtain direct insurance against default but often they structure their MBSs to allocate default risk toward parties willing to bear it.

Re-securitization Mortgage-backed securities are not the end of the line for individual mortgage loans. Pools of MBSs are sometimes collected and securitized. Bonds that are themselves backed by pools of bonds are referred to as Collateralized Debt Obligations (CDO) or Collateralized Mortgage Obligations (CMOs) when mortgage loans are used. In the CMO structure, a mortgage-backed security is created from separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. The repayments from the pool of pass-through securities are used to retire the bonds in the order specified by the bonds' prospectus. The issuers of CDOs were the major buyers of the low-rated classes of sub-prime MBSs. Structured Investment Vehicles (SIV) are similar to CDOs. The difference between SIVs and CDOs is essentially in the type of debt they issue. The SIVs are structures backed by pools of assets, such as MBSs and CDO bonds. The SIVs issue short- and medium-term debt rather than the longer-term debt of most CDOs. The short-term debt is referred to as asset-backed commercial paper. It is these complex instruments that have gained controversy for being the basis of the sub-prime crisis. Conversely, the agency pass-through market for conforming conventional mortgage loans is the simplest form of securitization, with the agency providing the guarantee or payment to the investor. For loans that do not meet conforming market (i.e., the nonconforming or non-agency or private label market), the securities must carry some form of credit enhancement against credit losses to receive investment grade ratings. MBSs allow originating banks to offload their exposures to homeowners to the bond market, recycling their capital so they can originate more mortgages. Investors count on the investment banks and, crucially, the rating agencies to rate and then monitor the credit quality of the resulting MBS. While highly visible and distressing, sub-prime MBSs and CDOs are only a fraction of the securitization market; many MBSs are still considered high-grade either because of the high credit quality of the mortgage pools that back them or because of the guarantee of the federal government. Securitization remains an essential part of the capital markets because of its ability to move loan assets and associated risk onto


the balance sheets of investors and creditors who are better able to bear that risk than the originating institutions, or at least that was the basis historically. Historically, through securitization, the conforming mortgage market protected most investors from the risk of default on the underlying mortgage loans. The credit risk is borne mostly by the private mortgage insurance companies, the government agencies, Fannie Mae, Freddie Mac, Ginnie Mae (FHA and VA), and by the holders of the lower rated and unrated, subordinated classes of private label pass-throughs. In many cases, the issuer of the private label security retained the riskiest, first loss position subordinated class and, to add to the misery, provided representations and warranties to the buyers of the securities thus retaining even more credit risk. With the relative newness and emergence of the private label securities market, analysis of the credit risk was not as well developed as the analysis of the interest rate risk and prepayment risk, and the developing poor performance of the underlying loan types that collateralized sub-MBSs have become painfully visible to investors. The Look of Credit Union Mortgage-backed Securities What would a credit union specific MBS execution look like? Three issues will determine their viability:

1) Scale and volume 2) Servicing 3) Credit guarantees or enhancement

While scale and servicing were discussed in the Covered Bond Section, ‘guarantees’ are unique to MBS execution and are used to protect against credit losses. Offering guarantees could be achieved using existing channels offered by the GSEs through Fannie’s Major Pools or Freddie’s Multi Swap arrangements. Either instrument provides credit unions the opportunity to pool their loans together to achieve a size that’s attractive to the investor market. While this provides a better execution than flow sales, it keeps credit unions constrained by GSE parameters. Freddie and Fannie may, however, consider ‘credit union’ only multi-pools to test the volume flow and pricing and execution components. This option utilizes an existing guarantor entity with access to the capital markets and with the existing ability to manage the risks of aggregating mortgage loans for portfolio or securitization. Credit unions do not, today, have such a proprietary vehicle in place. Another alternative is to use a third-party intermediary such as a Special Purpose Entity (SPE). The SPE would ensure that the loan volumes are aggregated from different credit unions while being hedged against interest rate movements. It also provides the needed credit enhancement for each MBS pool, although the SPE would have to demonstrate sufficient counterparty strength for this to be an option investors would take seriously. Establishing and maintaining counterparty strength is critical. Graph VI provides one look at a potential deal flow through a Special Purpose Entity.


Graph VI

CU MBS Deal Flow through an SPE

Making Vehicles Work: Standardization and Consistency Sub-prime lending aside, the fundamental mechanisms of conventional, conforming mortgage lending are sound and based on a system of standards established decades ago. All conventional mortgage lenders use the same forms, follow the same processing rituals, underwrite in the same fashion, close according to custom and service according to standards. Again, sub-prime loans aside, one 30 year fixed rate loan is like another, all else equal. The result, for years, was a highly liquid mortgage market that was reliable. It also assured steady availability of affordable capital for housing finance. As the previous section mentions, no one knows exactly what the capital markets will look like in the future. That they will be different is a certainty. Regardless of the outcome, maintaining standards is of paramount importance, whether we’re


considering a credit union specific secondary market or maintaining and/or restoring the global market we’ve come to rely upon. The following summarizes thoughts on standardization, the ‘gotta haves’ if the credit union industry is to make its own Cooperative GSE-like entity function:

UnderRight. Consistent underwriting guidelines and the right documentation are necessary to efficiently process a large volume of loans. Achieving significant volume necessitates sampling for secondary buyer (or intermediary) due diligence and loan file review, but underwriting inconsistency raises the prospect of rejecting entire pools or, alternatively, of time consuming and expensive complete reviews of all loan files in a loan pool. The seller will ultimately pay for inconsistencies, either in the form of a diminishing buyer pool or in the form of increased spreads to compensate buyers for their labor and risk. Moreover, buyers are picky, and in particular, credit union buyers save the exception loans for building and sustaining member relationships. As such, underwriting and documentation exceptions should be identifiable, reportable, documented, and nevertheless kept to an absolute minimum. Homogeneity. Ever been carpet shopping? In that industry the entire value chain does everything it can to make their products seem heterogeneous (or differentiated) to insulate themselves from buyer shopping and price based negotiations, even when it may be the exact same super-crypto-surelastforever stuff in some color similar to but not really beige. Buyers won’t go carpet shopping. It must be easy for a buyer to make the buy decision. For our purposes, easy means homogeneity in pools…homogeneity of product features, borrowers, housing collateral, pricing, and underwriting (as noted previously). By way of extreme example, imagine how relatively easy it is to buy a pool of all 30 year 5/1 ARMs on owner-occupied, single-family residences with a narrow range of LTVs, credit scores, and debt-income ratios. Now imagine, add to that pool a small group of manufactured homes, throw in a handful of investor four-plexes, a dash of stated income second homes at the local vacation spot, and a pinch of condominium loans in the new complex out west of town that were originated through the builder program at the credit union. Well, now you’ve just woven a beige carpet. When it’s homogeneous, the buyer has an easier time understanding what they’re buying, investment in the buying decision is reduced, and buyer spread requirements are reduced. Supply. Buyers will want assurances of consistent supply with sufficient volume to get them interested and keep them interested. The investment of the buyer’s management attention to get comfortable with a credit union capital access program and seller syndicate must have a payoff. To get such a program embedded in a buyer’s business strategy takes still greater assurances of future supply. The payoff requirement is the promise of future supply. This suggests that on-again off-again lending will not support supply demands and points to the necessity of an originate-to-sell business model. More on that later. Market Pricing. CUs must be diligent in pricing to secondary market investor expectations. Buyers don’t make a “member relationship” pricing decision like the originating CU may feel compelled to do. Be assured that under-pricing a large balance loan is a sure way to keep it on the CU books for a long time. No Dumping. CUs, like any other secondary market seller, can’t “dump the dogs” into a secondary market loan pool or other vehicles although it can be


acceptable to lay-off risk with full disclosure, transparency, and, perhaps, a risk-share arrangement with the buyer. No seller can expect to clean-up its portfolio and then expect that there will be repeat buyers in the long run. Nor can a CU originate a loan that it would not otherwise hold in its portfolio with the intent to sell the loan. NCUA regulations part 701.22(c)(4), related to loan participations, requires that CUs “…use the same underwriting standards for participation loans used for loans that are not being sold in a participation…unless there is a participation agreement in place prior to the disbursement of the loan.” The wisdom here is clear…nobody wants to swim after someone has peed in the pool, except perhaps the dog. Servicing Systems. Whether loans are sold servicing released or retained, loan servicing systems and CU back-office operations must be designed to meet the specific requirements of a secondary market program. In general, capabilities must include tracking of buyer interests in the loan, price and fee pass-through, accounting system interfaces, and automated data extracts for periodic buyer reporting and asset-liability modeling. Seller Modification Rights. One current challenge in today’s housing situation is that most residential mortgage-backed securities deals did not allow seller-servicers to modify troubled loans. Working through the myriad of issues and investor interests, which could vary with each deal, will continue while salvageable loans continue the march toward foreclosure and short-sales. A well-designed program for first mortgages will anticipate potential borrower troubles and specify a set of measures the seller-servicer can take, established by contract and done without prior approval of loan buyers. The FDIC recently announced a plan for workouts of troubled IndyMac Bank loans, a program that includes possible interest rate reductions, deferments, and forbearance to achieve a target borrower debt-income ratio. Industry watchers suggest this approach may serve as a model for modifications going forward. Risk-Based Seller Retention. Under NCUA regulations, Loan Participation sellers are required to maintain a 10% stake in the loans sold. The foundation of this rule is the principle that if the originator-seller has a stake in loan performance and servicing quality, this will help ensure they don’t pass bad loans to other credit union Loan Participation buyers. This is good, but a one-size-fits-all approach no longer addresses the needs of a complex product market and may inhibit the ‘Two to Ten’ vision. Instead, we suggest a new risk-based seller retention guideline that considers significant risk components such as property type, borrower credit profile, loan product features (those that impact price and default risk), loan-to-value ratio, and loan seasoning. We recommend a CU system workgroup to develop and advocate a risk-based seller retention guideline. Geographic Diversity. Buyers must manage geographic diversity of their loan portfolio and their loan participation pools. Geographic diversity in participation pools is especially critical since buyers generally can’t “know” a distant market like they know their local market. And since buyers must avoid geographic risk concentration in purchased pools, buyers will need a ready supply of geographically diverse pools in order to balance the economic and collateral risk of any one pool. The only practical way to achieve this is through sufficient scale with many sellers and many buyers, and an intermediary with a key role of aggregating individual CU pools to create geographic diversity.


Secondary Markets. Most loan participations are a one-way one-time secondary market transaction where the buyer holds their interest in a pool until the pool matures or a clean-up call provision is executed. This becomes more challenging as the underlying loan term extends to 30 or 40 years because CU buyer liquidity and lending capacity can change. Buyers whose balance sheet needs change will need a ready secondary market to sell participation interests, and this need gives rise to the opportunity for a market-maker in this space. Originate to Participate. CUs are familiar with the originate-to-sell business model as described elsewhere in this paper. An originate-to-participate business model would entail integration of buyer guidelines into CU underwriting platforms and advance purchase commitments by a buyer or market maker with sufficient working capital to build pools from multiple sellers on an ongoing basis.


Section IV: Next Steps

The Need is Real It’s clear from Sections I and II that credit unions, as their share of the U.S. mortgage market grows, will have a need for additional liquidity. Market changes of the past 12 months make it clear that the traditional sources of liquidity, namely the GSEs and Wall Street, may not be the reliable options they once were. That said, the Housing RoundTable strongly believes in the need for and the continued existence of Freddie Mac and Fannie Mae. Without these entities the cost of capital could become much greater and the access to it much more difficult. Either circumstance will make the cost of homeownership, which is already out of reach for so many credit union members, even higher. So, what do we do? It’s clear from the Section III there are a number of existing vehicles credit unions can use right now to move liquidity around the industry. Loan participations and whole loan sales are the simplest and most immediate means. Both have been used informally for years. Loan securitization would seem the logical next step as the vehicle creates liquidity, has the potential to reduce concentration risk, and helps both issuers and investors achieve their asset liability management objectives. Covered Bonds are an interesting alternative as well, yet it is unclear at this writing what authority or ability credit unions might have to use this vehicle. A Cooperative GSE-like Entity Credit unions need something akin to a Cooperative GSE-like (CGSE) entity to focus on liquidity for their housing finance activities. A case in point: loan participations using mortgage loans have taken place informally for years. They occur when two credit unions have an immediate need. The deal is struck, it’s completed, and then it’s over. Each credit union with a need for liquidity has to search for a credit union that has liquidity every time that need arises. That alone is time-consuming. Once two credit unions find one another, the terms of the deal and the process it will follow have to be created, again. What would the CGSE do? For starters, let’s revisit the ‘Making Vehicles Work: Standardization and Consistency’ section. The factors described there are reasons the capital markets worked so well and, absent the problems created by sub-prime lending, will work again. The first thing the CGSE would do is work with credit unions to establish standards:

1) Products 2) Vehicles 3) Underwriting 4) Pricing

A fledgling undertaking such as this would have to start simply. There would have to be violent agreement14 at least these three factors. For instance, CGSE CUs might agree that the automated underwriting systems provided by Fannie Mae and Freddie 14 According to the Urban Dictionary, violent agreement occurs when people, who all want the same goal, have totally different ideas how to get there, reach agreement on achieving the goal.


Mac become the underwriting standard by which loan decisions are made and that loan participations are the vehicle with which to begin. Agreement might also be had on the initial loan products that qualify for participation. Thirty and/or 15 year fixed rate loans, for instance. Elemental to success of such an endeavor is commitment, commitment in the form of regular, predictable loan volume. Fannie Mae and Freddie Mac provide a good example. Lenders that sell to them ‘take down a commitment’ in the form of a master agreement. The agreement describes the terms and conditions under which the GSEs will buy loans and, for a given contract price, the dollar amount of loans by product the lender will deliver in a set time frame. Not only does this provide capacity planning for Fannie and Freddie, it permits them to make upstream commitments to their investors and to the capital markets. A Cooperative GSE-like entity doesn’t have to be a ‘from scratch’ creation. In 1974 the credit union system created the corporate credit union network as a liquidity facility for the industry. Credit unions with liquidity, the theory went, would deposit their excess funds in state-level corporates that would then lend to credit unions in their states that needed liquidity. State-level corporates would deposit their excess liquidity with the U.S. Central Credit Union (USC). USC would then move liquidity around the state-level corporates as needed. (The state-level corporates and USC comprise the Corporate Credit Union Network.) It was a good plan though it didn’t work out exactly as planned. Credit unions haven’t needed a liquidity facility, for the most part, over the past 35 years. Liquidity, while not abundant, has been adequate for lending needs and operations to the point that the Corporate Credit Union Network has grown to a substantial size and expanded its offerings to include investment and payment services among others. The point is, though, the credit union industry may have the facility it needs to deliver a Cooperative GSE-like entity close at hand. Needed would be housing finance expertise and intense focus on this need. A Model to Emulate? The Subprime Mortgage Crisis of 2007 / 2008 shines a bright light on many of the problems with the United States' current housing finance system. Three come to mind easily, and, in fact, were enumerated by George Soros in a Wall Street Journal Editorial15:

1) The U.S. Mortgage Securitization System is full of inherent conflicts. Many that originate, securitize and service are often not the same entities that invest in the mortgage securities. In these instances, there is little incentive to originate quality loans, since all risk is passed to the investor. Case in point: finding themselves in trouble many borrowers who financed through a broker using a sub-prime loan had little luck locating that same broker when they needed help.

2) Mortgage Securitization is too complex. This isn't a new problem. Collateralized Mortgage Obligations (CMOs) debuted in 1983. Collateralized Debt Obligations (CDOs) appeared roughly four years later. The eighties were the jumping-off point, though securitization creativity reached a fever pitch as ever-more exotic mortgage securities blossomed as world-wide investor

15 George Soros Wall Street Journal Editorial dated October 10, 2008


appetites reached gluttonous proportions. The result: it is often difficult, if not impossible, to put a borrower's loan back together for any reason, work-out included.

3) The U.S. Market is Asymmetric. When rates fall, housing prices rise, spawning periods of refinance activity, equity withdrawals and housing bubbles. Conversely, when rates rise, housing prices fall, yet mortgage loans can only be refinanced at face value, even though the price of the underlying security has decreased.

A model that addresses these flaws has been working and performing well in Denmark since 1795. The Danish, needing to recover from the devastating Copenhagen fire of the same year, created a symmetric, balanced system that's managed to appropriately distribute risks and rewards among everyone: lender, borrower, and investor. Not incidentally, the securitization resulting from a closed loan is simple and transparent. Two things to note. First, Denmark's mortgage system and ours have many similarities. The differences, though, as described briefly below, are striking. Second, the Danish market continues to perform well through the Sub-Prime Crisis, though housing prices in the country have declined from their peaks.16 The mechanism is simple. Based on the balance principle,17 each time a loan is granted, a bond in exactly the same amount is issued and often immediately sold, then placed in a pool of like bonds. If this sounds familiar, it should. The Danish example employs the covered bond technique described earlier in this paper. Bond issuers, the Danish mortgage lender, retain default risk, thus providing the incentive to originate quality loans. Bond investors are made whole in the event of default, though by regulation pre-payment risk transfers to them as the lender / bond issuer is not permitted to retain it.18 This system becomes more interesting at the borrower level. Borrowers may retire their mortgage loan by either paying the loan off as is done in the U.S. or by purchasing bonds in the same amount as the bond that backs their mortgage. Since every mortgage granted is instantly converted into a bond of the same amount, mortgages and bonds remain interchangeable at all times. In Denmark the value of homes and the value of the underlying bonds tend to move in the same direction. Homeowners should not end up in a negative equity situation. Think of it this way: as home prices decline, the amount of bonds required to retire the mortgage decreases as well. Symmetry and balance. Disadvantages? There appear to be several:

1) Stringent lending regulation. 2) Loan-to-Value Limits. Based on information available thus far, it appears

Loan-to-Values are limited to 80% or less. 3) Lending is Concentrated. Most single-family mortgage lending in Denmark is

handled by four institutions, a sharp contrast to the thousands that originate in the United States.

16 'Danish Covered Bonds' Nykredit, April 2008, page 41. 17 'Danish Covered Bonds' Nykredit, April 2008, page 4. 18 Reforming Housing Finance: ‘Perspectives from Denmark', Mikkel Svenstrup and Søren Willemann, page 2.


The advantages, however, appear to outweigh the disadvantages, at least so far. Mortgage loans outstanding in Denmark, as a percent of Gross Domestic Product (GDP), were 101% in 2003. The U.S. market, by the same measure, was 81%.19 Whether the Danish model is one to emulate in whole or in part is an open question. The CU Housing RoundTable’s work group, ‘Challenging Financial Markets’, recognizes the urgency and intends to address this question and others by no later than January 31, 2009. The Central Liquidity Facility There is yet another entity that exists to provide liquidity to the credit union industry though not a credit union entity. The Central Liquidity Facility (CLF) was established by law as Title III of the Federal Credit Union Act in 1977. The CLF is completely funded by credit unions but administered by NCUA. NCUA works with the Corporate Network both to accept members as well as to extend credit when requested. The CLF has made no significant loan advances this decade. By statute, one of the purposes of the CLF is "to improve general financial stability by meeting the liquidity needs of credit unions and thereby encourage . . . mortgage lending and provide basic financial services to all segments of the economy." The CLF is authorized to extend protracted adjustment credit available in the event of an unusual or emergency circumstance of a longer term nature resulting from national, regional or local difficulties. This is certainly the situation today. As of July 31, the CLF had $1.7 billion in assets, all of it in short-term investments. No loans were outstanding. Total capital stock is $1.7 billion from regular and agent members. The CLF on Friday, September 26, had its borrowing limit with the Federal Financing Bank increased from the annual appropriated amount of $1.5 billion to over $40 billion, the statutory limit. In carrying out its duties, the CLF might be able to assist in the creation of a cooperative secondary market solution in one of two ways:

1) Under section 1795f (B)(6) purchase assets from a member with the member's endorsement. This authority could be used to buy loans for resale into the secondary market.

2) Under section 1795(B)(5) guarantee performance of the terms of any financial obligation of a member . . .

How the CLF might utilize this authority would depend on the aggregation and servicing organization that would source the loans for sale. CLF's broad role could be twofold:

1) Establish minimum levels of underwriting standards so there is a widely understood conforming requirement to participate.

2) Provide a credit enhancement to the securities resold to ensure the highest possible credit rating on the pools of loans.

19 Reforming Housing Finance : Perspectives from Denmark', Mikkel Svenstrup and Søren Willemann, page 2.


The effect of CLF's involvement would be to create cooperatively owned GSE-like security pools for sale within the credit union system or for resale in the secondary market. Hopefully this participation would provide funding-pricing that would be very competitive with other secondary market alternatives. Should any legislative clarifications be needed in this effort, we would anticipate these could be included in the regulatory reform efforts that will be passed in Congress to deal with the current crisis.

Closing Thoughts Everything old is new again. Look to the late 1970s for proof. In the days and years before the Depository Deregulation and Monetary Control Act (DIDMCA) of 1980, mortgage bankers were niche players, handling FHA, VA and prime loans the Savings and Loan industry was not interested in. The conventional residential market was dominated by those same S&Ls, which, at the time, were subject to an overabundance of regulations. Yet the housing finance market was theirs, and they had their own liquidity facility in the Federal Home Loan Bank System (FHLB). Moreover, Regulation Q provided Savings and Loans with a rate advantage. The 1980s brought deregulation to many industries including financial services. S&Ls lost their regulated advantage; mortgage brokers, funded by large banks and Wall Street took their place.20 The regulatory changes of the 1980s were positive for mortgage bankers and mostly positive for borrowers, until the private-label mortgage-backed security market began its rise in 1999. This led to the sub-prime meltdown of 2007 and the resulting market and fallout we are faced with today. We can’t know precisely what lies in store for the capital markets, mortgage lending, the GSEs or credit unions. We can surmise that a return to more stringent regulation is not just a mere possibility, it’s a very likely reality. What we can do is exercise some measure of control over the future of credit union mortgage lending, assuming we act now. An underlying theme of this paper and its two 2008 companions is one of unprecedented opportunity for credit unions to take their place as a dominant mortgage lender for decades to come. Members and potential members alike have ‘re-discovered’ credit unions as a trusted, reliable source of affordable mortgage loans in the past 12 months. So have Realtors®, mortgage brokers, builders and others that are seeking steady lenders. Congress and Treasury Secretary Paulson even acknowledged the positive role credit unions have been playing over the past year as the Emergency Economic Stabilization Act of 2008 was being debated. Credit unions have all of these advantages plus one more: our industry had very little clean-up work to do as a result of the sub-prime crisis. That’s an automatic leap forward over other lenders, our competition. The following suggested next steps are not intended to be all-inclusive or complete. They’re presented here as a place to begin the dialogue on how credit unions can capitalize on the opportunity at

20 Although it became legal for credit unions to make long-term fixed rate loans in 1978, our industry never managed to gain more than 2% market share in any year until 2007.


hand, to help develop a more detailed and results oriented action plan, and to answer the industry’s need to shape its own housing finance destiny:

1) Understand the implications for credit unions of the Emergency Economic Stabilization Act of 2008 and the Treasury Asset Repurchase Program (TARP).

2) Identify the liquidity access options that hold the most immediate promise for credit unions. The Corporate Credit Union Network, the Central Liquidity Facility, Special Purpose Vehicles and/or Special Purpose Entities need to be examined for their viability and potential. Emphasis must be placed on what can be accomplished quickly, as this opportunity, like all others, is fleeting.

3) Identify the vehicles that hold the most immediate potential for credit unions to use to move liquidity through the industry as well as to add liquidity to the industry. Loan participations, whole loan sales, securitization, Covered Bonds and others not yet considered need to be examined for their potential and with an eye towards what can be accomplished quickly.

4) Identify the legislative and regulatory implications of the liquidity access options and vehicles that appear most rapidly viable.

5) Outline a CU Housing RoundTable Feasibility Study (Study) and form a steering committee to immediately begin work on the Study for completion before the end of the year. It is expected that the Study will contain details sufficient to launch a business plan and project for an initiative that addresses the liquidity and capital access issues.


Index of Tables and Graphs

Graph I CU Balance Sheet Structure – A Ten Year History.....................................7 Table I Five and Ten Year Growth in Portfolio Lender Holdings...............................8 Table II Ten Year Growth Rates: Mortgage v. Non-Mortgage Lending Credit Unions 11 Graph II What Does 10% Mean? ..................................................................... 15 Graph III Credit Union Asset Quality ................................................................ 18 Table III Credit Union Loan Participation Volume – June 2008 ............................. 20 Table IV Covered Bond Characteristics compared with Mortgage-Backed Securities 23 Graph IV Simplified Structural Overview of Covered Bonds Issued by WAMU and BOA.................................................................................................................. 24 Graph V Simplified CU Covered Bond Overview ................................................. 25 Graph VI CU MBS Deal Flow through an SPE ..................................................... 30

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