Shaky Credit

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Justine Zenkin and Carl Honegger have a tough job. As directors of the Neighborhood Trust Federal Credit Union, they are under pressure to improve the financial health of their five-year-old institution, which serves 4,100 members in Washington Heights and West Harlem.

After a few years of steady growth, Neighborhood Trust, located in the George Washington Bridge bus terminal, has hit a rough patch lately. “We struggle to have enough income,” says Honegger. “We struggle to offer better products and services so we can reach more people.”

The economics of low-income credit unions like Neighborhood Trust are inherently precarious. Their mission is to offer low-cost services to communities that lack financial resources. At the same time, they’re under the constant watch of federal regulators, who scrutinize every credit union’s books to make sure they stay healthy.

Credit unions earn much of their income from loan interest. But members in places like Washington Heights typically seek small loans, like $500 to fix up a car, or $1,000 to buy new furniture, that just aren’t very profitable. In fact, small loans often lose credit unions money. On a $500 loan, their profit is a mere $39. Factor in the staff time required to help a member who has no credit report fill out paperwork, plus the cost of computer systems, and it’s clear that small loans just aren’t worth it.

But low-income credit unions are not banks; every day, they make decisions based on factors that go beyond dollars and cents. Nonetheless, at the end of each quarter, the long lines of figures have to add up–or else. “There’s a real tension between our bottom line and our social mission,” says Zenkin. That tension is more explicit these days, as Neighborhood Trust straddles a line that could cause regulators to impose harsh sanctions. Over the past year, the ratio of the income it keeps from loans, investments and grants to its total assets has been hovering between 6 and 7 percent. If it falls below 6 percent, federal regulators from the National Credit Union Administration (NCUA) step in and enforce strict rules limiting the institution’s investments and loans.

It’s not just Neighborhood Trust that’s facing tough choices. The twin threats of the strict federal capital mandates and a depressed local economy are forcing all local low income credit unions to take a deep breath before they invest resources and expand their services. That’s because the sources of money they count on to increase their income–and keep it above the 6 percent minimum mandated by the regulators–are shriveling. With interest rates at historic lows, investment income is way down–in just the past few years, money market interest rates have dropped by about two-thirds, from 6 or 7 percent to 2 or 3 percent. Meanwhile, loan delinquencies are rising as the economy sinks.

But these credit unions can’t just sit around and wait for the economy to improve, or for regulators and funders to recognize their plight. Their members, both current and potential, demand that they add new services, like debit cards and ATMs, business loans and credit cards. But those services, which ultimately would spur credit union growth and income, are costly in the short term. It’s a classic Catch-22. Low-income credit unions have to grow or die. Yet if they grow too rashly, they might die anyway.

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New York City has 30 low-income credit unions, with 40,000 members and $40 million in assets. These credit unions are a tiny segment of a much larger industry. Of the more than 10,000 credit unions nationwide–with more than 80 million members–only 887 are classified as explicitly serving poor people.

Despite their relatively limited scale, these credit unions fill a critical niche. In many neighborhoods, they are the only alternative to check cashers, payday lenders and outright loan-sharking. Bushwick, home to the Bushwick Cooperative Federal Credit Union, has only two bank branches for 104,358 people, according to the Neighborhood Economic Development Advocacy Project. “With the expansion we’ve seen in the last 10 years of predatory banking services,” says Sarah Ludwig, the group’s executive director, “we have every policy reason to bolster these credit unions to counter those forces.”

The late 1990s were a period of substantial growth for many credit unions, thanks in part to “community charters.” Previously, credit unions could only serve members associated with a particular employer, union or church. But over the last few years, the NCUA has allowed credit unions to add members in any geographic area that is underserved by other financial institutions. The result is that credit unions across the country are growing at a dizzying clip. Since 2001 the NCUA has approved expansions into areas with more than 30 million potential new members.

But when Congress formalized the right to add new members in 1998, it also approved the strict capital limits that Neighborhood Trust and other small credit unions are struggling with. Federal standards, and specifically their requirement that the institutions hold 6 percent of their assets in what is in effect a reserve fund, mandate that a credit union with low capital reserves might not be able to cover losses if members don’t pay back loans. Then the NCUA would have to bail the credit union out.

Low-income credit unions support the wisdom of conservative financial planning, but they argue that too-tough standards can be a cure worse than the disease. Small credit unions that want to get bigger can’t simply keep taking new deposits, because that won’t do anything to increase their income quickly enough to satisfy regulators. Some that are unable to generate sufficient income have actually had to refuse new members, like one in West Virginia that suspended advertising in August in order to ward off new deposits. That’s evidence, say the credit unions, that the NCUA standards are effectively serving to put a stranglehold on the very growth that would allow them to build up enough income to ward off tough times.

These issues aren’t academic. According to a recent report from the Woodstock Institute, an economic research group in Chicago, one in five low-income credit unions has capital ratios below 6 percent, which means they are subject to the NCUA’s strict mandates. Every small credit union has to worry about it. “The least little thing can send you below 6 percent,” says Lillian Bent, manager of the Union Settlement Credit Union, which currently is at 8.5 percent. “It’s terrifying.”

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By 1994, the Lower East Side People’s Federal Credit Union had reached a period of stagnation. It had grown since its founding in 1986 to about 3,000 members and $1 million in assets. But with the city mired in a recession, the credit union’s manager and board found that without additional outside capital, they couldn’t add services like ATMs or offer big loans that would attract new members.

So Lower East Side turned to outside grants to spur growth. It aggressively sought what’s called secondary capital, in which an outside institution, like a major bank, will deposit $100,000 in a credit union for three years. The bank earns just 1 percent interest from the credit union, which then turns around and loans that money out, hoping to earn a higher interest.

That’s exactly what Lower East Side did. Beginning in 1994, its assets grew steadily, from $2 million to $10 million today. In recent years, its biggest backer has been the Community Development Financial Institutions Fund, which President Clinton created to expand economic activity in poor neighborhoods. Unlike secondary capital, which functions like a series of low-interest loans, CDFI money is literally free.

The Lower East Side credit union has received more than $1 million from the CDFI Fund since 1995. That money “changed how the neighborhood sees us,” says manager Pablo DeFilippi, pointing to the four ATMs and improved signage that attracted new members–and loans–to the Lower East Side’s fold. The CDFI money also has significant leverage with other funders. Adds DeFilippi, “It allows us to go to the private sector and ask for the rest of the money we need.”

The city’s other low-income credit unions have similar histories with the federal fund. Says Cliff Rosenthal, the executive director of the National Federation of Community Development Credit Unions, “CDFI money is responsible for much of the quantum leap in growth we saw in the late 1990s.”

The Bushwick credit union, founded less than two years ago, is using secondary capital and CDFI money to carry out a unique growth strategy: It is trying to build up substantial reserves before expanding membership or adding expensive services like checking accounts or an ATM. As a result, its capital ratio is way above what the NCUA requires, at nearly 15 percent. “Grants give us lots of room to grow,” says Bushwick’s manager, Jack Lawson.

In today’s tough times, credit unions are looking to the CDFI money just to help them maintain fiscal health. But they might not be able to count on it for much longer. In his first budget, President Bush cut the CDFI Fund from $118 million to $68 million. One CDFI insider, who asked not to be named, says it could have been worse. “When the new administration took over, there was real concern that we would no longer be in existence,” the source says. Congress did restore 2002 funding to $80 million, and the 2003 funding, though not yet complete, is currently budgeted at $68 million.

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Union Settlement Federal Credit Union knows what it means to recover from the brink of collapse. In 1992, New York City’s struggling economy had left the credit union with bad loans and only $60,000 in capital on hand. Regulators told Union Settlement it had three to five years to build up those reserves, or else.

After a series of difficult decisions, Union Settlement returned to financial health, says Bent, who has worked at the 4,100-member institution since 1991. Through cutting staff, charging small fees for certain transactions, limiting dividends and giving out only the safest loans, Union Settlement built up enough capital to please regulators; today, it has $660,000. Those actions didn’t make members happy. “We weren’t giving out money as freely as before,” Bent recalls. “Members were angry with us for a period of time.”

At least one local credit union has seen the price of making risky loans with inadequate reserves. In August, the Central Brooklyn Federal Credit Union was dissolved after its loan delinquency rate reached an astronomical 27 percent. With almost no reserves, and plagued by management difficulties, Central Brooklyn was forced to shut its doors.

That’s an extreme example, but not every credit union that’s on shaky footing today will be able to sidestep such troubles. Union Settlement got better during the late 1990s economy. Such growth, and the demand for income-generating loans that comes with it, can’t be counted on anytime soon by those credit unions having trouble today.

The mission of serving members with little formal financial experience is inherently expensive, and the profitable payoffs are few, especially during a recession. Something has to give, either the stringent regulations that constrain growth, or Washington’s decimation of the CDFI Fund. “We all strive for self-sufficiency,” says Lawson, “while also accepting that the work we do can’t survive without some subsidy.”