The Pros and Cons of Participation Loans
Managing these loans requires a careful and calculated approach.
Loan participations offer the best of cooperative philosophy put into practice—sharing the risks among borrowers while sharing the rewards of attractive yields. But they also offer challenges due to their complexity and increased regulatory scrutiny.
Balancing the risks and rewards is key to successfully implementing and maintaining a loan participation program at your credit union, according to “Loan Participations,” a white paper from the CUNA Lending Council.
Experience is critical in participation lending, says Brad Mundine, regional manager of credit union protection risk management at CUNA Mutual Group. “If a participation loan doesn’t fall within the credit union’s general loan policy, it’s difficult to be underwritten in accordance with the credit union’s appetite for risk.”
Managing participation loans requires a careful and calculated approach from experienced lending staff, he says. These loans also require constant oversight as market risk and credit risk change over the loan term. If your credit union doesn’t have the necessary on-staff expertise to manage these loans, vendors or third-party underwriters might be options to investigate.
If your credit union decides to partner with a vendor, Mundine suggests taking these steps before signing a third-party agreement:
- Use a formal request for proposal (RFP).
- Check out the third party with the Better Business Bureau and other consumer organizations. Have problems surfaced in the past?
- Check vendor insurance coverage types—professional liability, employee error, and omission. Review what's covered and what’s not. Is there too much uninsurable risk?
- Review vendors' audited financials—including income statements and balance sheets.
- Have an attorney review your contract/agreement with the vendor.
- Conduct a formal cost-benefit analysis.
- Request and conduct interviews with references.
- Verify vendor endorsements by any trade associations.
- Review the organization, management, and ownership structure—board of directors and management team.
- Review the lead lender’s host loan servicing system to determine if it can handle computation and reporting of participation interests.
Next: Board due diligence
Board due diligence
The board, in its role as watchdog, needs to ensure that management has a thorough understanding of the risks, underwriting, pricing, and terms of each loan program, whether it’s member business lending, real estate, or construction lending, he adds.
In fact, since loan participations are more complicated and have stirred the attention of regulators, the board’s role requires special attention, notes the white paper. Participation loans should be reported to the board on a monthly basis as a separate program, with trends in loan growth, charge-offs, and delinquencies.
Mundine suggests boards consider a series of questions and action steps in their deliberations and due diligence for loan participations.
Questions for boards to ask about loan participation proposals include:
- Where is the opportunity coming from? Is it a credit union service organization (CUSO), a credit union, or another third party?
- Is the loan participation a good fit for our credit union? Is it compatible with the organization’s business plan?
- What can we expect to see in loan growth and other key financial projections? What parameters and ratios are needed to track the effectiveness of the program?
- What is the credit union’s ability to underwrite? Does the lending staff have specific experience in, for example, commercial real estate, if that skill is required? If not, are vendors vetted that can provide that service?
If the credit union decides to undertake loan participations, Mundine says the board should:
- Develop a loan participation policy, and propose a change in bylaws if needed;
- Ensure that the credit union conducts its own independent analysis of every participation loan undertaken, regardless of the lead lender’s reputation in a given area of lending;
- Develop an annual plan for participation loans; and
- Monitor the plan by tracking variances in key ratios—delinquency, loan growth, charge-offs—on a monthly basis.
Next: Loan participation case studies
Loan participation case studies
The council white paper also includes several case studies from credit unions actively involved in loan participation programs. Among them are:
- Delta Community Credit Union, Atlanta, which has successfully built a diversified portfolio of participation loans, including auto, residential and commercial real estate, cooperative housing, taxi medallion, and commercial equipment loans.
- Evangelical Christian Credit Union, Brea, Calif., which is one of the largest providers of credit union loan participations in the U.S. The credit union began its loan participation program in 1990 and has originated over $4 billion in participations during the past 20 years. It services a participation portfolio of just over $2 billion today.
- Arizona State Credit Union, Phoenix, with experience in a wide range of loan participation types, describes how it handled adversity with a restaurant loan, a hotel loan, and a land loan. The lesson: When you enter into a participation purchase or sale, you might not expect to have to deal with the specific terms of the participation agreement. In reality, you do; and often those terms are outside your control.
- Sandia Laboratory Federal Credit Union, Albuquerque, N.M., which shares its loan participation policy, developed and approved by its board. The policy reflects National Credit Union Administration regulations and covers the basics of making participation loans.
The white paper also includes a section on small credit unions’ experiences with participation loans. While this type of lending is more common among larger credit unions, participation loans can provide smaller credit unions with the advantages of risk-pooling, sharing expertise, and bottom-line rewards.
Sometimes partnering with other credit unions through a CUSO is an effective way for a smaller credit union to take advantage of the benefits of loan participations. This can also allow the credit union to serve members it might otherwise have to turn away.
Next: Pros and cons
Pros and cons
The conclusion of the white paper: Consider the pros and cons of loan participations and your credit union’s particular situation before getting involved.
Pros include that loan participations:
- Provide a source for selling loans to keep under the 12.25% business lending cap;
- Offer geographic and loan type diversification; and
- Provide an average loan yield that can be three times the amount of the average investment.
- Increased complexity of loan participations;
- Greater risk; for example, when large participation loans go bad, hefty dollar losses are shared by all; and
- Greater regulatory scrutiny, particularly following recent exposure of some banks’ excessive risk-taking. NCUA expects credit unions that put loan participations on the books to have the experience and expertise to assess risk. The burden is on the credit union to prove it.
Loan participations “have numerous advantages but are complex and attracting regulatory attention,” notes the white paper. “They need to be ‘done right’ to work, and require quality partners and resources or access to those resources. Programs profiled in this paper seem to indicate that the risks, if managed prudently, are well worth taking.”