Loan Participations - Benefits and Pitfalls; understand credit union loan participation accounting issues and what NCUA examiners are looking for

1. LOAN PARTICIPATIONS -ACCOUNTING AND REGULATORY ISSUES DeLeon & Stang, CPAs and Advisors Allen P. DeLeon, CPA (301)948-9825 allen@deleonandstang.com

2. Agenda – Issues to be covered What are participation loans? Participation loans vs. loans secured borrowing Participation loan policy Accounting and allowance for loan losses issues Regulatory issues – what are NCUA examiners looking for? Internal audit of participation loans

3. What are participation loans? Participation loans are loans made by multiple lenders to a single borrower. Several credit unions, for example, might chip in to fund one extremely large loan, with one the “lead credit union.” This lending institution then recruits other credit unions to participate and share the risks and profits. The lead credit union typically originates the loan, takes responsibility for the loan servicing of the participation loan, organizes and manages the participation, and deals directly with the borrower.

4. What are participation loans? (continued) Loan participations can, and often do, take the form of a loan pool underwritten by one credit union, which later sells a portion of the loan pool to other credit unions. NCUA regulations: No participation loan certificates; Must be % of each loan Must be at least 10% interest retained by originating CU

5. Participation interest vs. secured borrowing A participating interest requires: Proportionate ownership interest in an entire financial asset; All cash flows (excluding fees for servicing or other services that are arms length) to be divided among participants in proportion to share of ownership; Rights of each participating interest holder have the same priority (i.e. there can be no recourse and no participating interest holder is subordinated to another); No party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to do so.

6. Participation interest vs. secured borrowing (continued) If a transfer of a portion of a financial asset does not meet the definition of a participating interest, the transaction must be accounted for as a secured borrowing. All credit unions are encouraged to review their participation agreements to determine if they conform to the new definition of a participating interest.

7. Loan Participations - Pros and cons Pros Provide a source for selling loans Stay under loan caps Geographic and loan type diversification Average loan yield much higher than average investment yield Cons Increased complexity Greater risk, if large participation loan goes bad Greater regulatory scrutiny No control over loan underwriting

8. Common Pitfalls Projects which fail to meet expectations; risks associated with large commercial participation loan projects Originating CU being taken over by NCUA, resulting in staff turnover, lack of servicing talent to handle defaults Loan modifications, obligation of lead CU Failure to meet obligations to advance funds Absence of updated credit information

9. Board of Directors actions Approve a loan participation policy Approve by-laws changes if applicable Ensure independent analysis of every participation loan pool purchased Develop an annual plan Ensure management is monitoring and monthly reporting to the Board key ratios Delinquency Loan growth Charge-offs

10. Participation loan policy Written policy required by NCUA Risk assessment Strategic planning Due diligence Risk measurement Monitoring Control

11. Participation loan policy (continued) Risk assessment Credit risk assessment Interest rate risk assessment Liquidity risk assessment Transaction risk assessment Compliance risk assessment

12. Participation loan policy( continued) Strategic planning Strategic risk assessment Reputation risk assessment

13. Participation loan policy (continued) Due diligence Conflicting interests Financial condition Loan product experience Significant staffing changes Trade area Loss of control Contract and legal review Loan underwriting

14. Participation loan policy (continued) Risk measurement, monitoring and control Post closing review Monitor financial health of originating credit union Annual review of loan pool status

15. Accounting and allowance for loan loss issues Accounting issues Is the accounting treatment supported by agreement or legal opinion? Is there a uniform policy for accounting for collected points and fees? Separate sub-ledgers maintained for participation loans or loan pools? Is interest calculated using contractual terms? Are delinquency reports segregated by individual participants? Are timely reports received from selling credit union?

16. Accounting and allowance for loan loss issues (continued) Allowance for loan loss issues Are loan participation identified and addressed in the ALLL methodology? Are participation loan charge-offs and recoveries tracked separately and by loan pool? Q&E factors considered?

17. Regulatory issues – What are NCUA Examiners looking for? Same due diligence as if CU originated the loan itself: Comfort with originator or lead lender Separate and independent risk assessment and credit decision Risk rate the credit Meet CU’s lending requirements Pre-closing review of documentation

18. Regulatory issues – What are NCUA Examiners looking for? (continued) Regular monitoring of the credit: Collection of financial information Analyze the financial information Maintain loan administration and review Appropriate and proactive risk grade the credit

19. Keys to success Each participant perform independent financial analysis Each participant has reviewed loan documents Participations should be non recourse to the lead lender Document who makes the decision for a work out, lead or majority Use a qualified attorney

20. Internal audit of participation loans Review policy Select sample of new participation loans Review and evaluate due diligence and compliance with regulations Review payment history, delinquency and charge offs Examine the adequacy of allowance for loan losses Report findings and make recommendations

21. List of Resources 1. NCUA -regulations, Parts 701, 722, 723, and 741. http://www.ncua.gov/RegulationsOpinionsLaws/rules_and_regs/NCUA%20R%20&%20R%20Book%201%20May%208%202008.pdf 2. NCUA Letter to Credit Unions No. 07-CU-13, December 2007 - Evaluating Third Party Relationships. 3. NCUA Letter to Credit Unions No. 08-CU-20, September 2008 - Risks to Credit Unions. 4. NCUA Letter to Credit Unions No. 08-CU-10 April 2008 – Mortgage Loan Fraud Report. 5. NCUA Letter to Credit Unions No. 08-CU-12 May 2008 – Suspected Money Laundering in Residential Real Estate Industry Report 6. NCUA AIRES Questionnaire - Loan Participations. http://www.ncua.gov/CreditUnionResources/aires/aires.html

22. List of Resources 7. Federal Deposit Insurance Corporation. Risk Management Manual of Examination Policies, Section 3.2 – Loansoan Participations. http://www.fdic.gov/regulations/safety/manual/section3-2.html#introduction 8. Office of the Controller of the Currency. OCC’s Comptroller’s Handbook, Loan Portfolio Management. http://occ.gov/handbook/lpm.pdf 9. Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and servicing of Financial Assets and Extinguishments

23. QUESTIONS