January 25, 2012

Mary Rupp, Esquire

Secretary of the Board

National Credit Union Administration

1775 Duke Street

Alexandria,VA 22314-3428

Re:      Proposed Amendments to 12 CFR Parts 701 and 741 Pertaining to Loan Participations

Dear Ms. Rupp:

This is a comment letter to the proposed changes in the loan participation regulation.  Loan participations are very important to credit unions as they generate liquidity, assist in the management of loan concentration issues, provide favorable returns for credit unions that do not have a significant lending demand, diversify lending risk by asset class and geographic concentration, and are a tool to manage the aggregate business lending cap.  Credit unions understand loans.  For credit unions seeking yield, there is a much higher likelihood that credit unions will understand the risks in buying loan participations more so than investment products.  Loan participations move capital from cash rich credit unions to loan rich credit unions to enable the system to put credit union capital to work for members.  Loan participation interests purchased by banks add liquidity from outside of the credit union system.

I have always viewed the loan participation rule as critical to the success of credit unions.  The previous loan participation rule only permitted credit unions to enter into loan participations prior to the funding of a loan.  In 1995 I lobbied Chairman D’Amours to change the loan participation rule to give credit unions the same power as banks and permit credit unions to buy loan participation interests in closed loans as well.  The rule was changed in 1996 and loan participations have delivered on the benefits cited above.

I welcome the review of the loan participation regulation as it is in need of revision.  When considering the benefits and risks of loan participations, I ask the Agency to focus on the larger picture and do not cripple the benefits of loan participations to the vast majority of credit unions to address the failures of a few.

1.         Part 701.22 now applies to state chartered federally insured credit unions (“FISCUs”) in addition to federally chartered credit unions (“FCUs”), collectively “FICUs”.  I do not have a comment on the proposition that would apply uniform rules to all FICUs.  As a practical matter, all credit unions tend to follow Part 701.22 in order to have the widest possible number of potential loan participation buyers.  There are state chartered credit unions that have investment authority to invest in loans and loan participations.  For example,Georgia chartered credit unions may invest in loan participations on loans issued by a financial institution regardless of the percentage retained by the financial institution and regardless of whether the borrower is a credit union member.  I ask that NCUA clarify that it is not attempting to pre-empt or otherwise curtail state credit union investment powers in loans through this proposed regulation.

2.         The underwriting standards in purchasing a loan participation interest may not be less stringent than the underwriting standards in originating the same loan.  I support this requirement.

3.         The originating credit union must retain at least a ten percent interest in the loan throughout the life of the loan.  The proposal requires the originator to hold on to 10% of the face value of the loan for the life of the loan; to have “skin in the game”.  I understand and do not quarrel with this requirement as a general principal.  I understand that NCUA wants the originator to have an economic interest in the performance of the loan so that the originator is incented to originate performing loans. Some credit unions use the sale of loan participations to manage their aggregate business lending cap.  If the retention requirement was (a) 5%, or (b) 10% for at least a five year period without a default, or (c) at least 1% with a contractual duty to share in 10% of any losses, credit unions would have more ability to manage the aggregate business lending cap.  Even at 5% of the loan balance there is an economic incentive to underwrite good loans.  Any flexibility on this retention requirement would be very helpful to credit unions and flexibility can be achieved without adversely affecting the underlying principal of enlightened self-interest.

4.         A credit union may not buy loan participation interests from a single originator that in the aggregate exceeds 25% of the purchasing credit union’s net worth.  There is no ability to seek a waiver from this restriction. The proposal appears to be intended to act as a firebreak keeping the ills of one originator’s loans from spreading to a small group of credit union participants.  While this rule addresses one type of risk, the unintended adverse consequences created by this rule greatly exceed the benefit of the rule.

The undeniable fact is that good loan participations are built on good due diligence.  It is equally undeniable that good due diligence starts with a foundation of a good relationship between the originating lender and the participants.  Currently there are many participation relationships where credit unions regularly sell and buy from each other.  In most of these relationships, the credit unions have done extensive due diligence on each other, know each other well, and have a high confidence level in the quality of the loan products they buy from each other.  That is why many credit unions limit their loan participation partners.  Some of these relationships are centered around a commonly owned CUSO where the CUSO provides uniform underwriting and servicing.  For every story of a bad loan participation relationship, there are dozens upon dozens of good ones.  The yield from good quality loans is shared among trusted partners and grows capital.

This proposal will disrupt those relationships. Credit unions will not stop searching for yield.  Loan participation interests will always be a source of yield.  Credit unions will search for other loan participation partners and they will be forced to deal with credit unions they do not know.  If due diligence is done correctly this proposal will cause the cost of due diligence to rise significantly as new partners are vetted; and, if done incorrectly, shortcuts will be taken and lending risks will increase.

There are issues with the application of this rule to credit unions involved in lending CUSOs.  There are mortgage and business lending CUSOs that close loans in the CUSO’s name and sell the loans in whole or in part to credit unions.  Their model is to aggregate the expertise to make the loans and then share loan yields among each other.  The credit union owners have done extensive due diligence in setting up the CUSO lending model and the vast majority of these CUSOs have enabled credit unions to be effective and safe lenders.  This proposal will cripple those operations.  Many credit unions involved in lending CUSOs will be out of compliance on day one of the enactment of the proposal and for no good reason.  It makes no sense that a CUSO could sell whole loans to a credit union as an eligible obligation without these concentration limitations but be limited on the number of loan participation interests the CUSO can sell to the same credit union.  Other questions are raised as well.  If a credit union buys loan participation interests both from a CUSO and a credit union owner, does that mean that the buying credit union has a 25% net worth limitation from the CUSO and another 25% net worth limitation from the credit union owner or is it combined?

The fact that a credit union buys loan participation interests from a small number of originators does not by itself pose a risk as long as the credit union has done proper due diligence on the quality of the loans and the originator’s lending practices.  A safe originator will be safe for all buyers and a poor originator will be risky for all buyers.  Prior to implementing absolute restrictions on transactions, we recommend that NCUA issue guidance (not a regulation) that would require due diligence on the originators that includes an evaluation of the delinquency rates on the types of loans being offered for sale.  If the delinquency rate exceeds industry averages, the buying credit union should not purchase more than a limit specified by NCUA for a particular credit union through the examination and supervision process.

If there is a limit on loan participation interest purchases, we recommend that additional latitude be given to buying credit unions that have demonstrated that the buying credit unions are well capitalized as defined by Prompt Corrective Action, Part 216 of the Federal Credit Union Act.  Well capitalized credit unions have the capital to absorb risk and therefore the level of capital should be part of the risk evaluation prior to cutting off successful loan participation relationships.

I understand the concern of NCUA; however, I recommend a different approach to the problem – an approach that does not break-up loan participation relationships that have proven over time to be successful.  The industry cannot mature and grow if our regulations do not respect credit unions that are well managed and opportunity is taken from them due to the sins of others.  This regulatory approach forces credit unions to reconsider the value of the credit union charter and hinders the ability of credit unions to rebuild capital.  There is no reason why any concentration provision is not subject to waiver for good cause shown.

5.         A credit union may not buy loan participations interests in loans to a single borrower or group of associated borrowers where the aggregate amount exceeds 15% of the purchasing credit union’s net worth.  This provision can be waived.  I do not object to this revision but note that commercial lenders analyze loans based on whether the cash flow for a particular loan is sufficient in amount and segregated from other cash flows of the borrower and associated borrowers.  I hope that this would be a factor in a waiver application.

6.         Clarification of comments regarding pools of loans. The proposed Section 701.22 states that the loan participations do “not include the purchase of an investment interest in a pool of loans.”  In the comments to Part 701.22(c), it states, “This provision clarifies the existing prohibition against an FCU purchasing a participation certificate in a pool of loans.”  As I understand it, loan participations are permitted if a group of loans is purchased as long as loan participation interests are conveyed for each loan and the loan participation interest is not a single interest in the aggregate group or pool.  I recommend clarifying this as it will cause confusion.

7.         Recommended new term:  Regarding the ability of credit unions to sell loan participations in a loan purchased under the eligible obligation rule.  I note that when a credit union buys an eligible obligation, the credit union can never sell a loan participation in that loan as the originator of the loan would not be a participant.  There is liquidity risk in a credit union being locked into that position.  I recommend that a credit that buys an eligible obligation be considered an originator for purposes of the 10% originator retention requirement.  Clearly the selling credit union would have “skin in the game”. I note that an originator does not retain “skin in the game” when it sells an eligible obligation to a credit union yet it is permissible for the credit union to buy the whole loan.

8.         Recommended new term:  Regarding the ability of a purchaser of a loan participation interest in buying a loan where the originator obtained a regulatory waiver.  Another liquidity risk occurs when a credit union obtains a waiver, such as a waiver from the personal guarantee requirement.  Currently, a credit union that buys a loan participation interest in such a loan must also obtain the same waiver.  That renders the loan participation interest unsalable from a practical standpoint.  No buyer wants to go through the waiver process. I recommend that if the originator obtains a waiver for a loan, a credit union that buys a loan participation interest in that loan does not also have to obtain the same waiver.

9.         Recommended new term:  Regarding organizations eligible to buy a loan participation interest.   Is there a safety and soundness reason to prohibit the sale of a participation interest to a non-financial institution such as an insurance company?  If a credit union could sell to institutional investors, there would be an opportunity to bring in more liquidity from outside the credit union marketplace to serve members.

I thank you for the opportunity to comment on this important proposal.

Very truly yours,

Guy A. Messick

Addressing credit unions that were well run and prudent, I am sorry that you were adversely affected by all of this.   It is easy to see that your patience is tested when your hard earned capital is depleted by assessments through no fault of your own.  To add insult to injury, you have an examiner that lectures you to build up your capital while also telling you to reduce the risk in your lending portfolio that earns income to build capital.  If that were not enough, your sizable non-interest income from interchange fees and overdraft fees is being drastically reduced by Congress.

This is a lousy hand of cards to play but play them you must.  You have some choices to make.  The temptation is to “hunker down”,  trim some costs and staff, increase a fee or two, and weather the storm until things get back to “normal”.   You hope the capital will hold out until you can find a way to earn money again.  This is your heart talking.  Your head knows that there is new normal and the traditional credit union model of living off of the net interest margin is gone forever.

Albert Einstein said, “Problems cannot be solved within the framework in which the problems were created.”   If we are to solve the problems of the traditional credit union model, we must look outside the credit union world for answers.  The outside business world is evolving from the traditional top-down all in-house run organization to a more nimble organization that uses a combination of in-house and out-sourced service solutions that provide superior and accountable services at a reduced cost.  Credit unions need to emulate that model in order for the industry to sustain itself.

CUSOs and collaboration work to generate income and reduce expenses.   There are examples of credit unions and CUSOs that have generated over a million dollars in non-interest income and saved over a million dollars in operational expenses for credit unions.  Collaboration works but there has to be the right mindset, a sense of urgency and the will to implement it.

Now is the time for the regulators and the regulated to consider how we can build a business model that works in today’s environment.  Maybe that model includes risk based capital and secondary capital but it will surely include an extensive network collaboration model.  In this model, credit unions will share resources for operational services such as compliance, IT support, HR, internal auditing, due diligence etc.  Credit unions and regulators will permit these CUSO networks to act on behalf of the member credit unions for due diligence and operational oversight for the services offered.  The credit unions will remain independent entities. The CUSO network will be invisible to the members of the credit unions.  How can credit unions, particularly small credit unions survive without collaboration? The supervision of credit unions will be much more efficient and effective with CUSO networks.

We are at a pivotal point in the history of credit unions.  Credit union regulators and credit union leaders have an opportunity to make transformational changes that will insure the survival of credit unions for generations.  If this opportunity is not seized quickly, we will witness the slow motion liquidation of many credit unions. The risk of doing nothing has now exceeded the risk of change.

Some CUSOs benefited from corporate credit unions as investors and lenders. However, the loss of the corporate credit unions as a capital and liquidity source is not of great significance to most CUSOs. CUSO capital and lending potential in the industry is less than 15% of the industry’s CUSO investment capacity and less than 10% of the industry’s CUSO lending capacity.

CUSOs that make residential mortgage loans, member business loans and credit card loans need more capital and liquidity than CUSOs providing other services. Often, the owner credit unions’ CUSO investment and lending powers are not sufficient to fully fund the opportunities presented. In those cases, loans and capital from the corporate credit unions will be greatly missed. In addition, the amount of large scale operational services CUSOs is growing in number and scale. The day is not far off when operational services CUSOs will have greater capital and loan demands that could have been aided by a strong corporate credit union system.

Despite the corporate melt-down and the resulting reduction in available capital, there is still plenty of capital in the industry at this time. We need to find new means of moving capital from capital-rich, opportunity-starved credit unions to capital-starved, opportunity-rich credit unions and CUSOs. A corporate credit union is essentially a collaboration of credit unions to aggregate capital for investments and liquidity. CUSOs, also collaborations of credit unions, have the tools to meet many of the capital and investment challenges facing credit unions. Let’s talk about some cases in point.

TMG Financial Services Inc., a CUSO out of Iowa, buys credit card portfolios from credit unions desiring to sell their portfolios to a credit union-oriented lender. To fund this operation, TMGFS has a collateralized advance program that takes loans from credit unions to fund the purchase the portfolios. The loans earn very favorable returns for the lending credit unions in today’s marketplace. The credit unions participating in CAP do not have to be sellers of credit card lending portfolios. Any credit union can participate. To date, more than $115 million has been raised from over 60 credit unions. TMGFS has filled two roles previously filled by corporate credit unions. It has facilitated the movement of capital from one credit union to another and has provided a return on that capital to the lending credit unions.

Natural person CUSOs that issue loans have approached TMGFS and asked if it can help raise loans from credit unions to fund the liquidity needs of their lending operations in order to take advantage of opportunities presented to the CUSOs. To this end, TMGFS has formed CU Structured Finance LLC. Its first client is an established mortgage lending CUSO that used to rely upon a corporate credit union for a warehouse line of credit. CUSF is putting together a syndicate to fund a one-year line of credit commitment at rates higher than can be obtained by traditional credit union investments.

Other CUSOs are looking to fill other service needs of the industry. There are CUSOs that are exploring the creation of registered mutual funds with the underlying assets of student loans, member business loans or residential mortgage loans. These mutual funds would have high quality control over the loan products in order to earn a registered investment status. If approved by all the regulators involved, the funds would enable credit unions to buy high-quality performing investments in the very assets that drive credit unions: loans to members.

These mutual fund shares may take the place of loan participations in a credit union’s portfolio. This might be a good thing as the quality control in the registered mutual funds would tend to be higher industrywide than presently demonstrated in the purchase of individual loan participations. By selling into registered mutual funds, credit unions can reduce loan concentration risks and credit unions can better manage the aggregate member business lending cap.

The very existence of these funds will elevate the loan quality as more and more credit unions will want to be able to meet the underwriting criteria to sell loans into the funds. Facilitating the movement of capital and liquidity within the industry is essential and CUSOs are equipped to be that facilitator.

One final role for CUSOs in the corporate credit union world is to use CUSOs to invest and hold investment securities for corporate credit unions in order to reduce risk in the corporate credit union and the share insurance fund. In the hands of innovative people, CUSOs are able to find solutions to many of the issues facing the industry, including those issues posed by the reduced role of corporate credit unions.

Owing to the fact that CUSOs are so vital to the movement, let’s look at how they evolved and, more importantly, where they are going.

Collaboration 1.0 – Singly-Owned Financial Services CUSOs

The first generation CUSOs were mainly singly owned entities providing investment, insurance, and other financial services. They were formed primarily for regulatory purposes, taking up tasks generally denied to credit unions proper.   In revenue sharing arrangements with third party financial service providers, credit union regulations did not permit a credit union to accept any funds beyond reimbursement of the out-of-pocket costs incurred by the credit union.  CUSOs were used to avoid that restriction.  The CUSOs received revenue from the service provider and the CUSO paid the credit union owner dividends.    The non-interest income generated from these non-traditional financial services is still a welcomed addition to the credit union’s bottom line. For example, CUSO Financial Services, LP, a broker/dealer CUSO 75% owned by credit unions, since 1998 has paid $365 million to credit unions in networking fees and $15 million in owner dividends. Some title insurance agency CUSOs have earned their credit union owners over $1 million in a single year.

Collaboration 2.0 – Multi-Owned CUSO Hubs

The second generation of CUSOs developed so credit unions could collaboratively provide themselves such operational tasks as IT services, collections, shared branching, and lending services (mortgage, indirect, business and credit cards).  A few multi-owned CUSOs organized to jointly manage investment and insurance services for a group of credit unions.  These CUSOs were organized as hubs, with the CUSO in the middle.  Typically the CUSO assembled the people and technology; the credit unions received services from the CUSO; and the CUSO was paid by the credit unions.  The credit unions got the benefits of leveraging their resources by dramatically decreasing the costs of operational services while elevating the level of service. For example, there is an IT services CUSO saving each of its large credit union owners about $1 million annually owing to increased efficiencies and increased buying power.  And Ongoing Operations, a disaster recovery/business continuity CUSO, has saved credit unions an average 40% – 50% compared to third-party solutions, all the while providing better service.        The next generation of CUSOs will not be constructed as hubs but as fully integrated networks in which credit unions provide services to other credit unions through the network and are paid for it.  The networks will also provide income and member acquisition opportunities for its member credit unions.  A little fuzzy?  I’ll explain.

In order to save money, scale is not enough.   You have to manage capacity and have the technology and business model to be effective and efficient.  If you need a collector but can only have enough work for a half-time position do you incur the additional and redundant costs of hiring a full-time collector?  If you do but then the need is no longer there, do you lay off the collector?  To circumvent these problems, what if credit unions were in a network with other credit unions where certain credit union collectors were made available to the network on an as-needed basis?  Under this arrangement, managing capacity for the serviced credit union becomes a whole lot easier and cheaper.  The credit union employing the collector would be paid a fee for the collector’s services and earn income on its otherwise idle capacity.  All of this could happen without the CUSO independently employing persons to provide the services.

Think of the network CUSO as a switch.  A request for services from a credit union needing additional capacity would come into the CUSO and that request would be matched with a credit union having excess capacity.  While services are being provided, the person would be working as an agent of the CUSO and not as an employee of the credit union.  The CUSO would handle the payment for the services between the credit unions.

An advantage to credit unions in a network model versus the hub model is that the credit unions have a means to transform their underused capacity into an income-producing asset.  The annual aggregate cost of operating credit unions in the United States is over $28 billion. In a network model, credit unions get a piece of that pie with an asset they already have. An additional benefit is less pressure to lay off a productive employee in slow times because the network will re-distribute the credit union’s over-capacity to other credit unions. Excellent services would be rewarded, because the persons providing the best services would be the most requested.

The for-profit business world is moving to just such networked models. Jobs are brokered out to workers who bid on projects and assemble to perform the work on a “just-in-time” basis. To keep up, credit unions should adopt some of the same practices.  Although the concepts are a bit trickier to realize in a regulated financial institution, they can be accomplished.

While the cost savings for in-network credit unions will be substantial, the networks’ more significant role will be to proactively seek out and provide growth and income opportunities for its member/owners.  The mindset is that the network is an active agent for the growth of its member credit unions.  The network will be paid by credit unions for delivering new credit union members, and for new income producing and new cost reduction opportunities.

The CU*Answers Network

An example of a network including some of the features I am proposing has been established by CU*Answers, a Michigan CUSO that provides core IT services to medium and small credit unions. CU*Answers created a network for struggling small and medium credit unions. The network offers a two-year “scholarship” of free IT services; credit unions that take advantage of the scholarship join the network.  At the end of two years, the credit union decides whether to merge or remain independent. If the credit union remains independent, it signs a five-year IT agreement with CU*Answers.  If the credit union merges with a credit union in the network, there is no charge, or if with a credit union outside the network, then there is a charge.

With an investment of providing two years of IT service, CU*Answers gives a struggling credit union a chance of making it on its own as well as the experience of being a part of the network. Likely the network will retain the credit union’s members either as part of the reinvigorated credit union or as merged.  More members mean more market share and more scale for the network and its credit unions.

Network CUSO Principles

Below are 12 principles on which I believe a new kind of network CUSO would operate:

1. Collaboration is consensual. A network earns the loyalty of the participants by providing value. Barriers to move in and out of a network are low or non-existent. Termination clauses are short and do not mandate fees or penalties. Credit union members use core services to be in the network and may elect optional services.
2. The owners are exclusively credit unions and all owners must be network participants.  The co-interest of owners and users insure the focus on the quality of the network’s performance.
3. The network is governed by CEOs of the credit union participants.   The CUSO Board is elected by the credit union owners and composed of credit union CEOs who have the strategic vision and decision-making authority to keep the interests of the CUSO aligned with its credit union members.
4. Services are brought quickly to the market.  A network organizes initiatives and deals with the due diligence and contract reviews on behalf of participating credit unions to create the efficiencies that fully leverage the network benefits.
5. Performance standards are met and measured.  The credit unions and network have mutually acceptable and measurable standards to judge the network’s performance.
6. The network is accountable.  If a network is not performing, it is in the interest of the owner/users to correct the problem. If a problem is not corrected, a credit union may readily withdraw from the service or the network.
7. Fee structures encourage and reward usage.  Tiered pricing and rebates are used. Transactional pricing is the norm.
8. Personal member information is protected from unauthorized disclosure.  Employees from other credit unions who are working for an employee-sharing CUSO network are provided member information as needed to perform the task requested but a network’s technology and practices prevent unauthorized disclosures.
9. Except for personal member information, everything is transparent and shared.  The power of sharing best practices and policies raises the performance level for all participants. The transparency of the business relationships creates trust and credibility.
10. Credit unions control the personal member interaction. A network interacts with credit union members only as agreed by the credit unions.
11. Network capital investment is not driven by returns.  Because all investment returns come from fees charged to the owner/users, there is little incentive to drive up revenue at the expense of the owner/users.  While some returns may be built into the model, it should not be a driving force of the network.
12. A network rewards performance.  Employees providing excellent services are sought out. A network and its managers are rewarded for delivering outstanding service to members. Performance-based rewards encourages personal entrepreneurship to deliver innovative and effective solutions.

How We Get There: NACUSO and Classes

The skills necessary to successfully build a network model are not intuitive.  In order to jump-start the development of these skills in the credit union industry, the National Association of Credit Union Service Organizations (NACUSO) is partnering with Pepperdine University to provide a Collaboration Professional Certification.  The Certification will require completion of a year of web-based classes and a collaboration project.  The first class began in October 2009 to be followed by new classes every six months.

Collaboration is a powerful tool that can leverage credit union capabilities through networks. But it takes vision, leadership, and effort. Now is the time to set up 3.0 CUSOs.

Guy A. Messick, NACUSO General Counsel, Messick & Lauer P.C., 610-891-9000, gmessick@cusolaw.com,  www.CUSOLaw.com

The National Credit Union Administration (NCUA) announced last year that it would be stepping up its examination of credit union oversight of service provider relationships.  In December 2007 it published Letter to Credit Unions No. 07-CU-13 which shared with credit unions the guidance the agency had given to its examiners on how to assess if a credit union is adequately evaluating and monitoring its third-party relationships.  And in April 2008, NCUA publicly released in Letter to Credit Unions No. 08-CU-09 its new examiner questionnaire that addresses what it considers the three elements of an effective program:  Risk assessment and planning; effective due diligence; and risk measurement, monitoring, and control.

While credit unions may have very close relationships with the CUSOs they invest in and do business with, NCUA has made clear that credit unions must do appropriate due diligence reviews and monitor the performance of the CUSOs with whom they partner.  What is the appropriate level of due diligence involving an organization that is controlled by credit unions and dedicated to serving credit union clients?

Risk assessment, planning and “criticality”

Determining the level of necessary due diligence starts by assessing the “criticality” of the service to the credit union.  What does “criticality” mean in practice?  I recommend dividing the services provided by third parties, including by CUSOs, into:  Highly Critical; Critical; and Non-Critical.

• Highly critical services are services that (a) support a core service of the credit union, and (b) the impact of failure would cause an immediate and significant member service issue and/or safety and soundness issue for the credit union. An obvious example of a highly critical service is the credit union’s core data processing system.

• Critical services are services that (a) support a core service of the credit union, and (b) the impact of failure is mitigated by the fact that the credit union has alternative service options that would prevent a significant and immediate member service issue or safety and soundness issue.  An example of a critical service might be mortgage lending services that are being provided through the assistance of a CUSO, but if the CUSO fails, the credit union has the internal resources to continue to provide the service until the credit union finds a more permanent solution.

• Non-critical services are those that (a) do not support a core service of the credit union, and (b) the impact of failure would not cause a member service issue or a safety and soundness issue for the credit union, such as the janitorial service for the branches.

Effective due diligence

The basic purpose of doing due diligence is to determine that the third party arrangement is a fair deal and good value for the credit union.  The credit union will have to do some research on the costs of providing the services internally and the costs charged by a CUSO or other service providers for a similar level of service.

Examiners will expect the appropriate levels of scrutiny of the CUSO’s experience, business model, cash flows, and financials.  If the CUSO has been providing a service to the credit union for a number of years, that should typically reduce the level of due diligence review warranted, even for a highly critical service.

Although some credit unions may use the request-for-proposal process as a due diligence tool for critical services, remember that due diligence is an expense both for the credit union and the vendor, so make sure the information sought is truly relevant to answering these three key questions:  What experience does the CUSO and/or its key people have in delivering the services promised?  Is the business plan realistic and achievable?   And do the financial statements provide reasonable assurance that the CUSO can fulfill the agreement?  An important due diligence step is to speak to both current credit union clients and credit unions that are no longer clients of that CUSO.

How to evaluate “start-up” CUSOs

I is not unusual for a CUSO to be a start-up operation, but that shouldn’t disqualify the CUSO from being considered.  In a start-up situation, a thorough analysis of the business plan and staff experience – key due diligence steps — can be excellent predictors of the success of the CUSO.

For example, several credit unions in Washington D.C. were not happy with the business continuity services being offered in the marketplace. If there was an anthrax scare or severe weather that displaced a credit union from its offices, the services available in the marketplace did not guarantee that the credit unions would have a place to operate from remotely.  The credit unions decided they needed a more secure business continuity solution and formed a CUSO called Ongoing Operations, LLC.

Under any due diligence analysis, there was risk with investing and using a new company for this highly critical service.  However, the credit unions determined that the staff involved was well qualified and the business plan was achievable.  Today Ongoing Operations, LLC has three state-of-the-art business continuity centers in Maryland, Oregon and Colorado that are serving a rapidly growing nation-wide credit union client base.

How the CUSO agreement can control risks

The contract formation stage is the time to identify and manage the risks of the CUSO relationship.  The CUSO has the obligation to disclose all fees and expenses and how income is dispersed.  The credit union is entitled to a fully transparent view of the business model so that all participants and their incentives are known.  This transparency should extend to the termination process or what NCUA refers to as the “exit strategy.”  Termination costs may be a hook to keep a credit union in an unsatisfactory relationship.  For example, I have represented credit unions that have terminated their relationship with a broker/dealer, only to find out that the broker/dealer is imposing transfer fees for individual retirement accounts (IRAs) that include its internal costs of the termination process.

The key concern in using any third party is protecting the member relationship.  The contract should state that the CUSO will comply with applicable privacy laws and will employ verifiable safeguards to protect the member information.  There needs to be a provision that the CUSO will not continue to solicit members after the contract has terminated.  The contract should also acknowledge that the CUSO has no proprietary rights to the member relationship and will cooperate with the transfer of the business as the credit union dictates.

If a CUSO will see member information from multiple credit unions, the credit unions will want the CUSO to protect against the disclosure of a credit union’s confidential member information to one another.   The contract should give the credit union the right to obtain injunctive relief to stop a violation of the confidentiality and non-solicitation provisions.

The duties of the parties must be clearly stated in the agreement, including regulatory compliance. It is critical to the management of the relationship that the performance expectations be objectively and measurably stated.  You cannot monitor and manage unless you can objectively measure.  The performance needs to be monitored through a reporting process and compared to the expectations. I strongly recommend that a senior level staff person be assigned to monitor and manage third party relationships.

The failure to meet the performance expectations should have consequences that the non-defaulting party can implement, such as termination of the agreement.  I always recommend that the parties have a no-cause termination provision which has a relatively short notice period.  The ability to terminate quickly without cause is a powerful incentive for a party to be responsive to the other party’s concerns.

What difference does it make who owns the CUSO?

Most third party service provider agreements will have terms related to warranties, indemnification, limitation of damages, and mandatory insurance.  This is where the devil is in the details, and a contract presented to the credit union can be very one-sided.  There may be wide disclaimers in the warranty section, mismatched indemnifications or very limited damages exposure that will come as a big surprise if a problem arises.  This is where risk allocation becomes an art.   CUSOs tend to be better risk-sharing partners than other third party service providers, because they focus on serving credit unions — some or all of which are the owners of the CUSO.

Some CUSOs have non-credit unions as co-owners.  The non-credit unions may be the founding individuals or they may be part of a business model, such as a joint venture with a title insurance agency.  The interests of non-credit unions are not going to be the same as the credit union owner/clients and the potential for eventual conflict is high.  It is especially important in this situation that there are clear exit procedures for the owners should an irreconcilable dispute arise.

For CUSOs exclusively providing services to owner-credit unions, the owner-credit unions are engaged in due diligence and risk management on themselves.  To borrow from a famous phrase, “We have met the vendor and it is us.”  In these situations, one credit union owner/client should not impose a duty of warranties and indemnification on the other owners.  It is my opinion that the risk of services should be borne by each credit union, just as if the service was provided internally by the credit union’s employees. Nonetheless, the credit unions need to assure themselves that their aggregate effort and their involvement in the CUSO is prudent.  In fact, NCUA will expect each credit union to document how the relationship relates to the credit union’s strategic plan.

CUSOs can provide a great service to their credit union clients by putting together a comprehensive due diligence package and credit-union-friendly agreements.  CUSOs are a means to insure the survival of credit unions as we know them, and the successful management of these relationships is critical.

Guy Messick is an attorney with the law firm of Messick & Lauer P.C. in Media, Pa., and serves as the general counsel of the National Association of Credit Union Service Organizations (NACUSO).  He provides legal and consultation services to credit unions and CUSOs.  His firm maintains a website at www.cusolaw.com.  He may be contacted at 610-891-9000 or gmessick@cusolaw.com .

A buying credit union can only buy loan participations in loans it is authorized to make.   This means that the buying credit union must have policies and procedures in place for the type of loan in question.  For example, it must have a business lending policy in place if it is buying loan participations in business loans, even if the credit union never originates a business loan of its own.   The buying credit union must have an employee on staff or a person under contract with two years business lending experience in the types of business loans it is buying.

Prior to purchasing a loan participation, the buying credit union must review the underwriting package for the loan in order to determine whether the loan meets its loan policy and approved underwriting criteria.   Just because the loan is well underwritten and appropriate for the seller, does not mean it is appropriate for the buyer, as the buyer’s risk tolerance or concentration issues may be incompatible for the loan in question.

If a buyer is not familiar with the seller and, especially if the buyer expects to have an ongoing relationship with the seller, I recommend a due diligence visit by the buyer to talk to the seller’s lending personnel.  More information can be gathered at such meetings and the buyer can get a gut check of whether the seller will be a good partner.  Gut checks should not be underrated.

Almost all current loan participations are without recourse due to true sale considerations.  Most selling credit unions want the loan participation to be a true sale under FASB 140 in order to remove the proportionate repayment risk and the amount of the loan participation from its regulatory cap.   The seller and buyer should be in agreement as to whether the loan participation sale is intended to be a true sale.

Given the world we live in today, buyers and sellers should also check on the economic health of their partners.  A problem could arise if the loan participation is with recourse and the seller does not have the ability to buy back a defaulting loan.  Another problem could occur if the servicer (usually the seller) is no longer able to service the loan.  In that case the loan participation agreement should permit the other participants to appoint a substitute servicer.

A problem could develop if more money is needed from the participants and a participant cannot or will not contribute.  Examples of this include costs of collection or maintenance of abandoned collateral.   If a participant is not able to contribute its portion of such expenses, the agreement should provide that the servicer shall deduct the amount from the sums otherwise due to the delinquent participant.

There is no filing of record that a loan participation interest in a loan has been sold.  The seller is the only party of record for mortgage and UCC recordings.  This is the practice of the financial services industry.   If loan participations were separately recorded, the official records would be cluttered and the marketability of the assets pledged could be hindered.  The seller holds title as a fiduciary for all the buyers.  However if the seller fails to record a lien or negligently or fraudulently releases a lien prematurely, all participants are at risk. I recommend that the buyers periodically and independently confirm that all liens for outstanding obligations remain in place so if there is a problem, the buyers can act at the earliest opportunity.  This means there is an ongoing due diligence function by the buyers.

With good due diligence practices, buying credit unions are more than able to manage the lending risks.  The payoff for all participants is that credit union members are being served and a good return is being earned.

Guy Messick is an attorney with the law firm of Messick & Lauer P.C. in Media, Pa., and serves as the General Counsel of the National Association of Credit Union Service Organizations (NACUSO).  He provides legal and consultation services to credit unions and CUSOs.  His firm maintains a website at www.cusolaw.com.  He may be contacted at 610-891-9000 or gmessick@cusolaw.com .

In today’s environment, a sluggish economy has reduced loan demand and investment options yield anemic returns.  These factors greatly reduce the ability of credit unions to earn revenue to operate and re-build capital.  While interest rates on loans are low, they yield a much better return than Wall Street investment options permitted for credit unions.  Even credit unions with low loan demand can earn interest income through loan participations.

Loan participations are the most efficient means to move liquidity from cash-rich credit unions to loan-rich credit unions.  The cost of funds for lending is better managed with the use of loan participations. Loan participations among credit unions enables money to flow within the industry to where it is most needed to serve members.

Loan participations also spread lending risk, which done well is a good thing.   Even well written loans can go bad.   By spreading the risk among several credit unions, the impact of the lending risk on any one credit union is mitigated.   However, NCUA has expressed concern that credit unions are buying loan participations without verifying that the underwriting of the loan by the seller conforms to the buying credit union’s risk tolerance. Loan participation interests have been purchased with little or no analysis of the risks.   Spreading the risk on poorly written loans is counterproductive.  The buying credit union has to do its due diligence, review the underwriting package and make an independent decision whether the loan participations meets its policy and risk tolerance.  Just because the selling credit union made the loan, does not mean it was a good loan or that it is appropriate for the buying credit union.

Finally, loan participations help manage regulatory constraints on credit unions, most notably borrower concentration limits and aggregate member business lending caps.   By selling loan participation interests in loans, a credit union is able to count only the retained portions of the loans toward these regulatory limits.  Note that the member business regulations requires such a sale to be a “true sale” which means that the sale has to be without recourse (the buyer takes the loan repayment risk for the portion of the loan purchased) and the loan cannot be reached by creditors of the seller.  Some examiners have required credit unions to obtain true sale opinions on loan participations which are very costly, time consuming and are impractical to do on a per loan basis.

The NCUA loan participation rule has not been modified for years.   NCUA has expressed a desire to update the rule.  I am personally recommending action on the following points:

1. If the originator/seller is not a credit union but a CUSO or bank, the regulation should state the level of retention required by the CUSO or bank to qualify the loan for participation with a credit union.
2. The level of retention necessary to have “skin in the game” should be lowered to 5% of the original face value which will free up funds to help manage the aggregate business lending cap.
3. If a loan is sold in whole as an eligible obligation, the credit union buyer should be able to sell loan participations interests in the loan without the originator being involved.  Under the current regulation, loan participations in such a loan can never be sold.
4. To determine whether the sale of a loan participation interest is removed from the books of the seller for regulatory purposes, limit the requirement to a non-recourse sale and not a true sale. By doing so, there will not be a need to obtain a legal opinion that the true sales criteria has been met over and above the non-recourse term.  The true sales opinion requires extensive research of debtor-creditor law in the states where the participants are located. The regulatory requirements do not have to be held hostage by complicated and changing accounting rules that accountants themselves are reluctant to opine upon.

Loan participations are a valuable tool for credit unions.  As with all tools, skill and care must be used to make sure the tool works for you and not against you.

Guy Messick is an attorney with the law firm of Messick & Lauer P.C. in Media, Pa., and serves as the General Counsel of the National Association of Credit Union Service Organizations (NACUSO).  He provides legal and consultation services to credit unions and CUSOs.  His firm maintains a website at www.cusolaw.com.  He may be contacted at 610-891-9000 or gmessick@cusolaw.com .

The myths of credit unions developed in the formative years of credit unions.  Credit unions were a movement then, not an industry.  Members were drawn to credit unions because credit unions met the financial needs of members who were underserved and overcharged by the banks.   Credit unions had better rates and intimate, customized service levels.  Member ownership and self-government gave members a sense of empowerment and independence from the factory owners and bankers who otherwise ruled their worlds.   The “goodness” of credit unions was self-evident and did not have to be marketed.   From those myths we tell ourselves that only credit unions really care about the members and know how to serve them.   Only we know what is best for our members.   These myths comfort credit unions with a false sense of security that the natural order of things will always contain credit unions and people will know through their DNA about the “goodness” of credit unions.

These myths will kill us.   If credit unions are so obviously better than banks, why do we not grow market share?  Why are we losing the battle for the youth market?  Why do our members also use banks and other financial providers?  It is time we see credit unions not through our traditional prism but through the prism the world sees us.

Myth 1:  Credit union’s fees for services are lower than the competition and at greater service levels.  Does anyone really believe this anymore? In today’s world, members can choose financial service providers that have scale and market power to deliver financial services at fees much more favorable than credit unions can offer and at greater convenience, such as ING Direct and Lending Tree.

Myth 2:  Credit unions go out of their way to give people a hand when they need it.  There is no doubt that credit unions do this and I hope they continue to do this.  Having said this, credit unions cannot stay in business by having a portfolio of “character” loans.  In today’s world, credit unions must use objective safe and sound underwriting criteria or they will go out of business.

Myth 3:  Credit unions are better because they member owned.  Sounds good but what is the tangible benefit?  Dividend returns are a powerful means to drive home the membership difference.  At DFCU Financial Credit Union in Michigan, a patronage dividend of 50 basis points is paid on loan and deposit balances.  The more a member uses the Credit Union, the more value the member perceives and receives.  This is a game changer. In the four years that the program has been in place in a state where the population is declining, membership has grown 5% and the average deposit balance per member has grown over 23%.  If you give members a tangible benefit for doing business with you over your competition, they will come…and bring their money.

Myth 4:  Only credit union people know how to best serve their members.  This is paternalistic nonsense.  Members want to be empowered to interact with the credit union on their terms.  The world outside of credit union is full of very innovative and effective people.  There are credit unions that are open to new ideas and innovation.  They are open to finding the best service solution whether that is delivered by their employees or in collaboration with CUSOs and third party service providers.  The credit unions that use an open sourced business model to deliver best of breed services to their members will be the surviving credit unions.

Myth 5:   It is insulting and manipulative to sell to members and credit unions are above that.  There is a reason that a large portion of the media and the public is ignorant about credit unions and credit union growth is stuck in a rut.  Credit unions need to sell themselves to be heard in the very competitive financial marketplace.   The world sees credit unions as just another box of cereal on the supermarket shelf.  Why would the consumer select the credit union cereal over the bank cereal?  If a credit union is proud of its product offerings, promote and sell them.  Find the competitive advantages for your credit union and promote them aggressively.

The mission of credit unions is a noble one.  People helping people.  But we will not survive as an industry unless we see credit unions as a business, a business that needs to use all the tools of business to survive.   We will survive if we embrace our structure and provide best of breed services wherever those services can be sourced and if we provide tangible member benefits.  It is not enough to provide great service and benefits, we need to effectively communicate the credit union difference and use proven sales techniques in order to be heard by our members and potential members.   It is time to shed the myths that are holding us back and embrace the world as it is not as a nostalgic fiction.   Members will be better served and credit unions will survive to serve them.

The taxes were assessed upon the following types of income:

1. Financial Services such as networking fees paid by an affiliated broker/dealer;
2. Credit Life and Credit Disability Insurance (collectively “Credit Insurance”); and
3. Accidental Death and Dismemberment Insurance (“AD&D”).

The taxpayer, Bellco, has the burden of proof to show that the income was not subject to the Unrelated Business Income Tax. On some points Bellco lost due to inadequate records. Bellco often had to reconstruct records over many years as the UBIT issue was not a consideration at the time some of these services were provided.

The Court focused on whether the income was substantially related to one of the two purposes of Bellco which the IRS agreed is to promote thrift among the members (“thrift function”) and to provide a source of credit upon reasonable terms (“lending function”). The Court also looked to see if the payments were royalties as royalties are not subject to UBIT.

The first decision in the case was on November 12, 2009. The Judge decided the following on a Summary Judgment Motion:

1. Bellco has a networking agreement with CUSO Financial Services, LP (“CFS”) wherein CFS provides non-deposit financial products to enable members to plan and invest in their future. The Court concluded that this meets the thrift function and therefore all the networking fees derived from the services to members are not subject to UBIT. Any networking fees derived from services to non-members is subject to UBIT.

2. Bellco is a co-owner of Member Gateways, LLC. Member Gateways is a co-owner of CFS. While some of the profits from CFS and other sources are filtered to Bellco through the Member Gateways relationship, Bellco did not prove the substantial connection to the thrift function and therefore the income from Member Gateways is subject to UBIT.

3. First Choice Credit Union merged into Bellco. Since Bellco could not establish some of the sources of the income that came over to Bellco, that income is subject to UBIT.

The second decision was issued on Good Friday April 2, 2010. The Judge decided the following after a trial:

1. Bellco has a Credit Insurance Plan for direct and indirect lending programs that pays off the balance of a loan should a member die or is disabled during the term of the loan. This product is the source of the famous credit union slogan, “The debt dies with the member.” The testimony established that Bellco ran a good program that gave good value for the services and was not primarily profit driven. The Court found the Credit Insurance products promoted thrift as a valuable part of a member’s financial planning and therefore the income derived by Bellco on these products was not subject to UBIT. There was certain undefined Credit Insurance income which did not have adequate records to establish the source of that income and so it was subject to UBIT. Finally, Bellco is a co-owner of CUILA, an indirect lending CUSO. There were not sufficient records to establish that the source of the income was Credit Insurance and so it was subject to UBIT.

2. The income from the AD&D products was deemed a royalty and not subject to UBIT. The testimony showed that the only function of Bellco was to manage its brand, e.g., checking to see that advertisements were not offensive to the members. All substantive work was being done by AD&D providers in a turn-key operation.

Conclusion

This was a great victory for Bellco and credit unions. If a credit union can tie the income to a thrift function or royalty, the income derived from the activity will not be subject to UBIT. This was true for networking fees from investment services, credit life and credit disability as long as the credit union is not primarily driven by profits and AD&D. While the IRS can appeal, this case and the Wisconsin case are two big victories.