By Guy A. Messick
Loan participations are extensively used by credit unions, principally in member business loans and consumer mortgage loans. By allowing credit unions to share in the making and managing of a loan, participations provide an attractive investment alternative and help credit unions manage liquidity, lending risk and regulatory constraints. However, the loan participation regulation needs to be amended to keep up with the changing financial marketplace.
In today's environment, a sluggish economy has reduced loan demand, and investment options yield anemic returns. These factors greatly reduce credit unions' ability to earn revenue to operate and re-build capital. While interest rates on loans are low, they yield a much better return than the investment options permitted for credit unions. Even credit unions with low loan demand can earn interest income through loan participations.
Loan participations, in which credit unions essentially make loans cooperatively, 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 enable money to flow within the industry to where it is most needed to serve members.
Loan participations also spread lending risk. Done well, spreading lending risk is a good thing. Since even well-written loans can go bad, spreading the risk among several credit unions mitigates the impact of the lending risk on any one credit union. 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.
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 about whether the loan participation of interest 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 on 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 regulation requires such a sale to be a "true sale," which means 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. Getting such an opinion is very costly, time consuming and 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:
- If the originator/seller is not a credit union, but a credit union service organization or a 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.
- The level of retention necessary to have "skin in the game" should be lowered to 5 percent of the original face value. This would free up funds to help manage the aggregate business lending cap.
- If a loan is sold in whole as an eligible obligation, the credit union buyer should be able to sell participation interests in the loan without the originator being involved. Under the current regulation, loan participations in such a loan can never be sold.
- 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 Messick & Weber P.C., Media, Pa., and serves as general counsel for NACUSO. He provides legal and consultation services to credit unions and CUSOs. Contact him at 610.891.9000.
Also read "Participations: Mitigating the risks" by Messick.
And tune in for Current Issues in Credit Unions, a podcast series hosted by Messick and other CU attorneys.
