Loan participations offer the best of cooperative philosophy put into practice-sharing loan risks among borrowers while sharing the rewards. But they also offer challenges due to their complexity and increased regulatory scrutiny.
In a white paper recently published by the CUNA Lending Council, titled "Loan Participations," a variety of business models are examined for using this loan type. A loan participation simply defined is a loan made by more than one lender and serviced by one of the participants. The lead lender typically, but not always, services the loan and is required by NCUA regulations to keep 10% of the loan.
There are compelling reasons to consider loan participations, among them that they can be a lifeline to small business owner-members who are suffering and continue to face quite a few obstacles in a tough economy.
The additional benefits of loan participations can be considerable: a source for selling loans to remain under the 12.25% business lending cap, geographic and loan type diversification, and the fact the average loan yield can be three times the amount of the average investment. But along with the benefits, loan participations are more complex and when the loan goes south-literally as was the case recently with real estate participations in southern Florida-the misery of hefty dollar losses is shared with all.
The Elusive Metric
Risk appetite is an elusive metric to measure, especially in a potential lending partner. A meeting of the minds of what is considered acceptable risk is essential among partners; it's a vital ingredient in the mix for a successful life of the loan participation. Risk compatibility is a function of a potential partner's capital, management, aptitude and type of loans made.
The lead lender in loan participations has a critical role to play in decision-making that can include up to eight parties or more, a situation that can sometimes seem like too many chefs watching over the stew. Achieving consensus with a group of that size can be a challenge, but necessary when problems surface and work-outs are needed.
Since loan participations are more complicated and have stirred the attention of
regulators, the board's role requires special attention. Participation loans should be reported to the board on a monthly basis as a separate program with trends in loan growth, charge-offs and delinquency.
Loan participations have declined in 2009, but a small recovery was witnessed in the first quarter of 2010. The reasons for the decline? Tightening of credit, lingering effects of the recession, and as many of those interviewed for this paper say, some credit unions have lost their appetite for a loan type that brings more risk than wanted.
As the graph shows, credit union loan participations showed a steady increase in volume from 2005 with $9.1 billion in all outstanding purchased participations to its height at $11.3 billion in 2008, but dropped 10.3% in 2009 to $10.1 billion. There was a slight recovery in the first quarter of 2010 as participations increased to $10.2 billion outstanding.
A more telling example of the lingering effects of a sour economy can be found in the declining average outstanding participation loan balance. There was a slight decline in 2008 to $24,156 from $25,907 in 2007. This past year, 2009, witnessed a 22% decline to $18,816 average outstanding loan participation balances.
Since loan participations are more complex and have stirred the attention of regulators, board governance requires special attention. Participation loans should be reported to the board on a monthly basis as a separate program within the overall loan portfolio with trends in loan growth, charge-offs and delinquency.
Questions You Should Ask
As one CU experienced in loan participations has noted, experience is critical in participation lending. "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," this person observed.
Among the questions a board should ask:
* Where is the opportunity coming from? Is it a CUSO, credit union or another third party?
* Is the loan participation a good fit for your 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?
While participation loans are being used by both large and small credit unions alike, this loan type is typically found with the larger organizations. But as the Council white paper reports, participation loans can provide a small credit union the advantages of risk pooling, sharing expertise and the rewards. The $31-million Sierra Point CU in South San Francisco, for instance, works through the CUSO Business Partners, Inc. and has a waiver from NCUA allowing it to invest 22.5% of its assets in business loans. At the end of June 2010, Sierra Point had $6.3 million in loan participations. SPCU takes a conservative approach to lending. Their average loan-to-value is 47% for real estate loans.
After interviewing lending executives for this paper, the take home stressed by all is that independent due-diligence must be completed on each new loan, even though the lead lender has completed due diligence and has a solid reputation.
Jim Jerving has authored numerous white papers, and is a frequent contributor to Credit Union Journal. For info: www.cunacouncils.org.