Participate in the fight against NIM compression

During the past year, net-interest margin (NIM) compression has become a pervasive challenge for many credit unions.  More broadly, many credit unions are experiencing difficulty generating sufficient revenue because of a lack of interest income and seemingly few sources of material, non-interest fee income. Yet, a well-known and simple tool is available to fight this NIM compression – selling loan participations.

Based on current loan participation volumes and trading patterns, it is clear that many more credit unions should sell loan participations to make their lending balance sheet generate material non-interest fee income to fight NIM compression.  Unlike most strategies to generate additional income from balance sheet assets, selling loan participations neither requires taking on additional credit nor market risks.  And, with today’s technology and market standardization, scaling the necessary operational processes has become relatively simple. Moreover, given the disruption many credit unions are experiencing in their direct lending channels, robust current buy-side demand for high-quality participations makes this an opportune time to enter the market regularly as a seller. 

How Participations Generate Scalable Fee Income 

When a credit union sells a participation in a loan or pool of loans, the selling credit union typically sells at a premium while also committing to continue to service the loan in exchange for an ongoing servicing fee (sometimes referred to as a “Servicing Strip”).  Most commonly, credit unions will sell participations subject to NCUA regulations that require a minimum 10% hold.  The following example illustrates typical participation economics for a hypothetical $100 loan (pool) yielding 3% with a 10% hold:  

While a single participation sale does generate both ongoing servicing fee income and a gain on sale, a single sale is only a building-block to starting a profitable long term strategy.  When combined with unserved loan demand, the cash generated from the participation sale can be re-lent to members (or new members should the credit union be expanding).  Assume for simplicity that these new loans are similar to the original pool and thus also yield 3%.  When this lend-participate-reinvest strategy is continuously repeated, the income-generating effects become dramatic: 

Starting with the same $100 of lending capital, a credit union undertaking a scaled participations sales strategy can generate significantly more income: 

• Pre-participation: $3/year interest; total IRR of 3.0% 

vs.  

• Scaled participations: $3/year interest, plus $4.5/year fees, plus $18 of gain on sale; total IRR of 9.1% (i.e., 7.5/{100-18})

This increased income generation is achieved without any increase in overall credit risk and while actually reducing risk by diversifying the balance sheet amongst more loans.  Credit unions can even serve more members too.

Time to Reassess the Operational Ease of Participations 

The current environment of NIM compression is putting pressure on many credit unions, including those with seemingly optimized balance sheets, to seek additional sources of income.  For many credit unions, selling loan participations is an attractive and effective solution.  Technology and other market developments have made selling participations much easier from an operational perspective.  Now any credit union, regardless of size or sophistication, can sell participations at scale. Given the compelling math of selling participations to generate additional income, it is more important than ever for credit unions to leverage this incredibly powerful tool. Simply put, credit unions have all that they need to fight NIM compression one participation at a time!

Co-Author: Michael Lanzarone