FRBSF Economic Letter
2007-16; June 22, 2007
Credit Unions, Conversions, and Capital
While credit unions have been able to convert their charters
more easily since the late 1990s, two conversions of very
large credit unions--over $1 billion in assets each--in
2006 have put the issue on the front burner for the industry.
This Economic Letter outlines some costs and benefits
to their member-owners of credit unions' converting to
stock
thrifts and describes one way to reform the process in
order to spread the benefits of conversion more broadly
to credit union members.
Background
In recent decades, thoroughgoing financial deregulation
has erased many of the charter-based distinctions in
the activities, assets, and funding and other regulations
between
credit unions, thrifts (including savings banks and savings
and loans), and commercial banks. Nevertheless, some
salient differences remain. Credit unions are member-owned,
are
largely exempt from income taxes, are restricted to serve
specified (but increasingly liberalized and overlapping)
fields of membership, and have more restrictions than
other depositories on their investments and lending.
The deposit and loan customers of mutuals are also their
member-owners; thrifts may be mutuals or stock-owned,
while commercial banks are stock-owned. In contrast to
the shareholders
of stock-owned firms, who can buy or sell (and use the
proceeds of) shares as they wish, individual credit union
members do not have rights to withdraw or sell their
ownership stakes. Their inability to access already-accumulated
capital
individually can affect whether a credit union decides
to convert to a mutual thrift and later to become stock-owned.
Conversions and controversies
Recent easing of regulations pertaining to credit union
conversions, the large size of some recent converts, the
potential for many more conversions, and the
incentives for and results of converting make the issue of conversions contentious
in the credit union industry.
 The 1998 Credit Union Membership Access Act effectively
lowered the regulatory hurdles for credit union conversions.
Figure 1 shows the numbers and total assets
of credit unions that converted to other charters from 1995 through June 2007.
Over this period, 33 credit unions with total assets of $7.7 billion converted
(or merged with non-credit unions), comprising only about 1% of total credit
union assets and less than 1% of credit unions.
One concern expressed in the credit union industry is
that converting to a mutual thrift charter is often a step
en route to abandoning mutuality and becoming
stock-owned. Of 20 credit union conversions from 1995 through 2003 (excluding
mergers with mutual thrifts and the more recent transactions), 17 have already
issued some stock or have merged with another stock-issuing institution. Two
credit unions have reorganized as mutual holding companies that have not yet
sold stock. From 1975 to 2006, 1,870 thrifts converted from mutual to stock-owned,
accounting for more than half of the decline in the number of mutual thrifts
and a shrinking of mutuals' share of assets in all depositories from 24% to
1% over that period.
At what cost benefits?
Because so many credit unions have at least some stock
ownership soon after converting, it is perhaps most relevant
to consider the costs and benefits of converting
from a credit union to a stock thrift. Converting credit unions commonly cite
the following advantages of thrift charters: (1) absence of field of membership
restrictions, (2) fewer constraints on investment and lending, and (3) greater
flexibility in raising capital. Credit unions that become thrifts also take
on some additional obligations, such as paying income taxes
and complying with the
Community Reinvestment Act and other regulations.
For very many credit unions, the additional obligations
of conversion outweigh the advantages. For them, operating
as credit unions often results in better
interest rates and services for their customers. The larger the (net) benefits
of their credit unions, the more likely members will prefer not to convert.
On the other hand, converting offers an opportunity otherwise
not currently available to (the members of) credit unions:
Converting makes it possible to distribute
to the members, for them to use personally in whatever way they see fit, the
entire market value of the ongoing institution. Thus, unfettered ability to
convert allows members to choose whether to receive the
net benefits of belonging and
using their credit unions' financial services or to convert and thereby gain
access to the accumulated value of the assets that they own.
Credit union members would be expected to weigh the ongoing
benefits of potentially better credit union interest rates
and services against the amount for which
they could sell their stakes in the institution. One way to quantify a credit
union's benefits to its members is to compare the "credit union rate of
return" (calculated as the ratio of the likely ongoing benefits to the cash
proceeds from a sale) to the rate of return on a comparable investment.
It may well be that most credit unions provide rates
of return sufficiently high that their members are better
off if their credit unions do not convert. For
other credit unions, the benefits that they offer may be so low, relative to
their capital ratios and other factors that contribute to high market values
for their credit unions, that their members might benefit from conversions.
Increased capital and profitability partly account for
the many hundreds of mutual thrift
conversions during the 1990s. Reduced restrictions and the increasing incentives
of rising capital ratios likely will spur more credit unions to convert.
The standard
conversion method
Current regulations require mutual thrifts that are converting
to stock ownership to use the so-called "standard conversion method" (or a similar two-step
method). Members do not exchange their group ownership for individually owned
shares but, rather, exchange their ownership stakes, pro rata, for options to
buy shares in the initial public offering (IPO) of shares of stock. This differs
from a typical IPO, after which prior owners have either publicly tradable shares
or the cash proceeds from having sold their shares.
Under the standard conversion method, priority rules
first grant members options to buy IPO shares, typically
in proportion to their deposits as of some prior
cutoff date. The value of the IPO shares is based on the appraised value of
the thrift, which takes into account the thrift's existing,
or "old," capital,
its going-concern value, and the "new" capital that the IPO will raise
via selling the IPO shares. (Going-concern value encapsulates the value of a
firm due to its expected profitability.)
The larger the sum of the old capital plus the going-concern
value, the larger the amount by which the total market
value of the stock thrift exceeds the amount
of the new capital that is raised by selling IPO shares. The prices of conversion
IPO shares would be expected to rise immediately to the total market value
of the stock thrift. Because the pre-IPO capital and going-concern
values are often
substantial, we typically observe substantial "pops" in the prices
of conversion shares in their first days of trading: The first-day increases
in the stock prices of the 17 conversion IPOs of former credit unions had a median
value of 19%.
If each member entirely exercised his options to buy
IPO shares, then each member would hold a pro rata portion
of the shares of stock in the stock-owned thrift,
having been a pro rata owner of the mutual and having contributed a pro rata
portion of the newly raised capital by purchasing IPO shares. In that case,
the members would participate pro rata in first-day pops
in the prices of the IPO
shares.
Typically, however, only a small percentage of members
exercise their options to buy these shares. Members who
buy no IPO shares receive nothing. If a member
does not entirely exercise his options, then the surrendered value accrues
to those who buy the IPO shares, including other, perhaps
better-informed, members
(including "insiders," such as managers and directors), as well as
external investors.
Recognition that the standard conversion method, in practice,
often gives better-informed members and outsiders opportunities
to benefit financially is widespread and
longstanding. However, when converted thrifts had little value other than their
just-invested capital, members who did not buy IPO shares did not surrender
much. The low capital and going-concern values of converting
thrifts during the 1980s
meant that the transfers from nonbuying to buying members and to external investors
were then likely relatively small. Colantuoni (1998) reports that first-day
pops then averaged less than 6%. As the capital ratios
and profitability of converting
thrifts rose, so did first-day pops, as expected. Citing growing concerns about
the large first-day pops, the Office of Thrift Supervision (1994) revised its
appraisal standards. But, so long as converting thrifts have economic value,
adjusting appraisal standards cannot eliminate first-day pops--or their resulting
transfers from nonbuying members (Wilcox and Williams 1998).
Capital ideas
Improved capital and profitability of mutual thrifts
call for improved conversion methods. For at least a decade,
analysts have suggested that the standard conversion
method should be used only for conversions of severely undercapitalized thrifts
(Unal 1997 and Colantuoni 1998). Its capital-raising feature, however, can
hardly be the justification now for the standard conversion
method: Average capital
ratios are now in double digits and rising; profitability has been strong.
Experience indicates that most members surrender their
ownership during conversions and that many better-informed
insiders do not. Critics of conversions often point
out that management and directors might have conflicts of interest: Better-informed
insiders have incentives to advocate conversions and then to exercise their
resulting options to buy IPO shares and to institute what
may be generous, stock-related
compensation packages (Colantuoni 1998 and Chaddad and Cook 2004).
At issue, then, are the possible reforms that could protect
members of mutuals, regardless of their level of financial
sophistication. One option (Wilcox 2006)
builds on demutualization methods that have been used often in conversions
by mutual insurance companies in the United States and
depositories in other countries
(Chaddad and Cook 2004). For example, under current legislation, the National
Credit Union Administration could allow individual credit unions to convert
directly into commercial banks in a process whereby ownership
of the new bank, in the
form of shares of stock, could be distributed for free to members, who then
could retain their shares or could receive the cash proceeds
from selling their shares
at market value. In particular, one recommendation is to distribute shares
approximately in proportion to members' historical average
savings and loan balances, which
likely better approximate (than deposit balances as of a given date) their
individual contributions to the economic value of the mutual.
Such a process could reduce the unknowing surrenders
of valuable assets by less-savvy members who, under current
regulations, do not receive all, and typically do
not receive any, of the large amounts of preconversion value of their converting
credit unions and thrifts. James Wilcox
Visiting Scholar, FRBSF, and
Professor, Haas School of Business, UC Berkeley
References
[URL accessed June 2007.] Chaddad, Fabio R., and Michael L. Cook. 2004. "The
Economics of Organization Structure Changes: A U.S. Perspective
on Demutualization." Annals of Public and Cooperative
Economics 75(4), pp. 575-594.
Colantuoni, Joseph A. 1998. "Mutual-to-Stock
Conversions: Problems with the Pricing of Initial Public
Offerings." FDIC
Banking Review 11(4), pp. 1-9.
Office of Thrift Supervision. 1994. "Conversions from
Mutual to Stock Form: Interim Final Rule with Request for
Comments." 59 Federal Register, pp. 22,725-22,735.
Unal, Haluk. 1997. "Regulatory Misconceptions in Pricing
Thrift Conversions: A Closer Look at the Appraisal Process." Journal
of Financial Services Research 11(3), pp. 239-254.
Wilcox, James A. 2006. Credit Union Conversions to
Banks: Facts, Incentives, Issues, and Reforms, Filene
Research
Institute, Madison, WI.
Wilcox, James A., and Zane Williams. 1998. "Predicting
Excess Returns with Public and Insider Information: The
Case of Thrift Conversions." Research Program
in Finance Working Paper RPF-283, UC Berkeley.
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
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