No minimums: The new rule for loan participations

Liquidity.  Every credit union seems to need it.  Yet, no one seems to know where to find it.  At the end of 2018, the credit union industry’s collective loan-to-share ratio was at an all time high of 85.6%. But look a little closer and you’ll discover that it is really the tale of two markets.

Large credit unions, and especially those with assets greater than $500 million, are over-concentrated with loans and desperate to diversify their balance sheets. Many are brushing up against their limits on non-member deposits and find the costs of raising additional capital through CDs to be too high to profitably fund new loans. At the other end of the spectrum, there are thousands of smaller credit unions — especially those with assets less than $250 million — that have very low loan-to-share ratios and are eager to purchase higher-returning loans.

Naturally, it would make sense that larger credit unions, flush with loans, would trade with these smaller credit unions, who are flush with excess cash.  Yet, there are far fewer transactions between large and small credit unions than you might expect.

Why is this the case?  Historically, selling and buying loan participations was viewed as an activity only large credit unions could, well, participate in.  To most in the industry, the process was opaque and complex, requiring a significant amount of effort that only larger credit unions could afford. What’s more, it was also fraught with long lag times, difficult contract negotiations, and arduous monthly financial and regulatory reporting and reconciliations. The result:  large credit unions preferred to sell in the biggest sizes possible to as few institutions as possible — and as infrequently as possible. Inevitably, that meant selling to other large credit unions that had balance sheets big enough to absorb those large loan sales. Hundreds, if not thousands, of smaller credit unions were simply left out on the sidelines, even though they had plenty of liquidity to put to work.

But today’s loan participation market is fundamentally different, even if this old way of thinking all too often remains. The truth is that the most costly and burdensome roadblocks have been removed. Minimum purchase requirements no longer exist. Now, no credit union is too small to participate.  

How could this be?  Technology and standardization. First, technology is greatly reducing the cost and administrative burden that led to large deals involving larger institutions. New software platforms are streamlining the upfront due diligence process and new tools are automating the ongoing financial and regulatory reporting requirements for all parties. As a result, buying and selling credit unions can partner with as many other credit unions as possible without bearing any additional administrative burden. It’s as easy to trade with 100 institutions as it is with a single one.   

Second, the increasing prevalence of standard participation agreements means that another significant friction in the deal-making process has been removed. Today, credit unions no longer need to hire expensive lawyers to craft bespoke contracts, and can instead leverage standard legal agreements used by hundreds of credit unions. That not only saves on legal fees but allows both parties to close a lot faster.

The upshot of these two innovations to the loan participation process means that it is just as efficient to work with smaller credit unions as it is with a larger one. As a result, the market is now open to purchases of any size:  there really are “No Minimums.” In fact, it is not uncommon to see purchases that are even smaller than $1 million.

This development is a true win-win. Smaller-sized deals expand the universe of potential buyers. That provides large credit unions more liquidity to fund new loan growth and greater diversification. Smaller credit unions, meanwhile, get the chance to obtain better interest earning assets and more efficiently deploy their capital at lower risk.

If you have been avoiding participations because you thought your credit union was too small or if you are a large credit union avoiding sales to small credit unions, we encourage you to look again at new participation technologies or as CUNA puts it:  Open Your Eyes to a Credit Union.