A properly managed and risk-focused loan participation program can increase asset yields, improve earnings, generate additional loan growth, reduce risk by diversifying the loan portfolio and assist with balance sheet management. For the loan originator, the sale of loan participations can enhance liquidity and provide for increased funding for business and member-focused products and services.
Before beginning a loan participation program, here are the basics every credit union needs to understand.
Key Elements of a Sound Loan Participation Program
A loan participation is a loan where one or more eligible organizations share the risk associated with the loan by purchasing a portion of the loan from the originating or lead lender.
As with all loans, proper and thorough due diligence is critical. Due diligence begins by thoroughly addressing your loan participation policy, agreements and your risk assessment and monitoring processes.
Section 701.22(b)(5) of NCUA’s rules, which discusses loan participations, requires you to establish a written loan participation policy. The policy must include loan underwriting standards and due diligence expectations tailored to your risk comfort level. This means you, not the originating credit union, should determine acceptable credit standards, collateral requirements, loan types, documentation expectations, servicing arrangements and aggregate- and single-borrower participation limits.
Individual credit unions are expected to evaluate the originating credit union’s financial condition and loan performance record. Your due diligence review must be independent of the originating credit union, though it may be outsourced to a qualified third party.
You should conduct and document your own credit and risk analysis. Relying solely on the credit memos of the lead lender or using outdated financial and collateral valuations are not sound business practices. Ultimately, your institution assumes the risk associated with these products. Therefore, any decision to engage in a loan participation deserves the same consideration in evaluating risk as other loans and should meet your credit standards.
Section 701.22 of NCUA’s rules also requires all loan participations be supported by a written agreement between the participants. The agreement must include:
- Specific loan information such as participants and amounts,
- Information on the interest portion retained by the originating lender,
- The location and custodian for the original loan documents,
- Conditions necessary to gain access to financial and other loan-performance information,
- Information on the borrower and the servicer, and
- Information on the duties and responsibilities of the parties involved in the participation.
Finally, prior to execution, your credit union’s independent counsel should review your loan participation agreement.
Loan participations require ongoing risk monitoring and risk management appropriate for the type and level of risk the loan poses to the credit union. As with all loans, credit unions should perform regular reviews of the financial condition, business environment and operations of the borrower and principals involved. In addition, you should work closely with the originating or lead lender, and request any information necessary to remain fully informed of the risk associated with the borrower.
In sum, loan participations offer an attractive opportunity to boost your loan volume, diversify risk and enhance your earnings. However, you need to be comfortable that the loan originator is able to manage the risk associated with the loan transaction in a way that aligns with your institution’s credit standards. Thorough due diligence, at a participation loan’s inception and active oversight throughout the life of the loan, along with a comprehensive participation agreement, will ensure you meet the goals of your program and the strategic goals of your credit union.