Loan Participations: Mitigating the Risks
The advantages of loan participations to an originating/seller credit union are that the seller obtains liquidity to serve other members, has a tool to manage regulatory loan caps and spreads its lending risks. The advantage of loan participations to a buying credit union is the ability to earn a good return on assets. Getting a good return on assets is critical in this economic environment which has low loan demand and low yields on investments. However, this need invites the temptation to jump into loan participations without adequate due diligence. Unless the buying credit union does its due diligence to understand the loans it is buying, it cannot evaluate whether the lending risks are reasonable.
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 buyerâ€™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 sellerâ€™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 firstname.lastname@example.org.