The truth (and myths) about buying loan participations

Buying loan participations enables credit unions to diversify their balance sheets, more profitably deploy excess liquidity, and increase revenue. However, too many credit unions remain on the sidelines because they are uncertain if they will be able to correctly assess the credit risk or manage a cumbersome due diligence and post-sale reporting processes. Much like sales of loan participations, several myths linger and continue to discourage purchases of  loan participations. However, new technology enables savvy buyers to automate and more accurately manage the loan participation process. Thus, it’s important to have the latest knowledge when determining whether this is the right strategy for your credit union. Here are some common myths about buying loan participations — and the facts to debunk them.  

Myth: Participation loans are just the “bad”loans — risky and of low quality.

The Truth:  Most lenders agree that one of the best indicators of whether a loan will perform is whether it is currently performing.  This adage is why such a large percentage of the participation market consists of performing, seasoned loans. While loans can go bad, including participated loans, it is a complete myth that selling credit unions specifically seek out loans they expect to under-perform.  If anything, sellers care deeply about their market reputation for quality loans and servicing.  Furthermore, buyers have contractual rights set forth in the participation agreement, covering critical terms such as how a loan can be modified and, in special circumstances, the removal of the lead credit union as servicer.  The combination of seasoned loans, marketplace reputation, and contractual rights is why more and more credit unions are leveraging loan participations to complement their organic originations.  

Myth: Buying a loan participation means venturing into the unknown

The Truth:  Quite the contrary. Today, buyers know the selling credit union upfront and receive robust due diligence on the underlying loans quickly and cost-effectively. Technology enables  buyers to obtain granular data on the seller and individual loans so a purchasing credit union knows exactly what it is buying. Buyers can review a host of information including: the seller’s origination, servicing, collection, repossession, audited financials, as well as historical (charge-off) performance in secure online data rooms, in conjunction with the ability to review the particular loans, all online.  Additionally, with modern participation reporting tools, buyers can receive timely and accurate monthly reports covering both financial and regulatory information.  

Rather than entering the unknown, buyers should consider the participation technologies they are using so that they can ensure they are receiving the right information both before the transaction and over the life of the loans.

Myth: The NCUA and Examiners tend to be critical of credit unions that purchase loan participations. 

The Truth:  Not true. In fact, the NCUA is quite supportive of loan participations. Over the past few years, NCUA has conducted numerous webinars (here and here) and issued regulatory guidance to support an effective and well-run participation program (found here).

To be sure, the NCUA and Examiners will always review new and existing participation programs to make sure that credit unions are engaged in safe and sound practices.  But, in many ways, the failure to have a well-grounded participation program is a risk unto itself as that generally means the credit union has less diversification, less liquidity or less income or less of all of the above than if the credit union had a well-designed and implemented program.

Myth: All monthly participation reports are the SAME. 

The Truth:  The quality, accuracy, and timeliness of participation reporting varies dramatically.  Purchasing credit unions should absolutely seek to review the proposed monthly participation reports before making a purchase and understand the typical timeline for their delivery.

Many credit unions fail to enter into the participation marketplace because they believe they cannot get timely, accurate monthly reports. However, nothing could be further from the truth.  Having the right technology partners ensures that buyers receive the right reports, covering the full month, on time.

On the other hand, many credit unions that are current purchasers have simply ceded to monthly reporting that is inaccurate, delayed or only covering a partial month. Many believe this to be the status quo, with no alternative solutions. Some credit unions presume, or worse yet, just hope that monthly reporting errors are not material.  This belief could not be further from the truth.

Credit unions who actively purchase participations, or are interested in doing so, should demand what they are contractually and regulatorily entitled to:  timely, accurate and robust monthly reports, covering the full reporting period, delivered in time to close monthly financial statements and quarterly regulatory reports.  Great reporting is not wishful thinking — it is a legitimate ask and requirement. The key to obtaining it boils down to working with the right technology partners.

NCUA Weighs in on Reporting 

In 2018, the NCUA’s Office of General Counsel issued an opinion highlighting the need for accurate monthly reporting as the failure to do so is oftentimes a regulatory failure as well.  Factoring in this updated guidance along with upcoming CECL requirements, detailed, accurate and timely ongoing reporting is no longer optional. 

Myth: Credit unions can only purchase the types of loans they originate 

The Truth:  Generally, credit unions can participate in any loan they are “empowered” to make.  This means that so long as the purchasing credit union has the appropriate policies in place and has the internal expertise to understand the credit risk, there is no specific requirement that a credit union only purchase the kinds of loans that they organically originate.  In fact, part of the point of having a participation program is to diversify the purchasing credit union’s risk profile and leverage the skills and talents of other credit unions. For example, while a credit union may not have the internal marketing capacity to originate residential mortgages, it does not mean that the credit union cannot purchase residential mortgages from another credit union.  Rather, as long as the purchasing credit union has the appropriate policies in place for residential mortgages and understands the risks of such lending, a purchasing credit union can very well make that purchase.

The regulations that cover loan participations, which can be found here, do not place restrictions on the types of loans credit unions can purchase. Still, it’s important to thoroughly understand the type of assets being purchased and the risks associated with them.  This may mean hiring a skilled third party to perform due diligence on the assets. It’s also imperative to clearly specify the types of loans allowed for purchase in a loan participation policy.