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Loan participations - Benefits and Pitfalls for Credit Unions

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  1. CU’s are not permitted under NCUA regulations to purchase a participation certificate. Under the participation loan regulations, it must be purchasing an interest in a loan, not the pool in general.Originating CU must retain at least 10% interest in the loans.
  2. Significant Accounting and Regulatory Implications to Accounting for Loan Participation Sales, Including SBA LoansFASB Accounting Standards Codification (ASC) Topic 860 (formerly FAS 140 and FAS 166) has modified the accounting for transfers and servicing of financial assetsWhile this amended guidance has a meaningful impact on companies that have “qualifying special-purpose entities,” it also created the concept of a “participating interest” which has a significant impact on how credit unions account for loan participations. his amended guidance becomes effective for transfers of participating interests on or after Jan. 1, 2010 for calendar year companies.
  3. Participation loans offer the best of cooperative philosophy of credit unions put into practice - sharing the risk among borrowers while sharing the rewards of attractive yields. Challenges include complexity and regulatory scrutiny. Here are some of the pros and cons. Loans participation lending requires experience, constant oversight and
  4. Board of Directors oversight of loan participation is critical and part of the Board’s responsibility.
  5. Commercial loan participations have been an area of the highest risk.Credit risk: credit scores, loan to value limits, concentrations in volatile or unstable markets or geographic locations, concentrations in certain types of investment projects, use of borrower provided 3rd party information and analysis of appraisal assumptions.Interest rate risk: varies base on loan size and type, fixed or variable, must fit within ALM policyLiquidity: Buying credit union must have sufficient liquidity to fulfill loan participation obligations; resolving lines with unfunded commitments (i.e. construction loans) add to complexity. Buying CU must consider adequacy of liquidity to meet members future loan demand, be able to monitor cash flows and additional funding sources if needed.Transaction risk: involves understanding all aspects of the transaction to be able to assess potential risks and properly account for cash flow streamsCompliance risk: NCUA regulations concerning loan participations, appraisals
  6. Strategic risk: net effective yields should be favorable and on par with member loansReputation risk: Buying CU should have adequate internal controls, staffing, business recovery plans and other resources. Delays or defaults could jeopardize on going relationship between buyer and seller and lead to litigation
  7. Loan rate can’t be more than 18% and must not collect its share of any pre-payment penalties.Conflicts – seller may have different underwriting standards, buying CU should ensure loan product is within its established risk tolerance and adheres to its standardsFinancial condition – seller must be able to repurchase the participation under terms of the agreementExperience – Is the selling CU experienced with loan product underwritten?Staffing – has the selling CU maintained experience staffing?Trade area – knowledgeable of market conditions throughout the trade area for servicing or defaultsLoss of control – Does the buying CU have mechanisms in place to maintain proper oversight?Legal – agreement have representations and warranties? Example: seller often warrants compliance with regulatory rules and legal requirements. Buyer represents authorized to enter into agreement.Remedies for breach? Define how information will be shared? Status reports on loan payments, accrual, exit strategies, notification of adverse loan conditions, collection procedures
  8. I recommend documenting post closing review and at least annual review of loan status
  9. Selling CU: keep loans in the system and record a contra account for portion soldPurchasing CU: records a GL account for each loan participation loan pool, with a sub-ledger maintained listing each loan in the pool
  10. Q&E factors to consider are: (1) Delinquency trends, (2) Economic conditions affecting participation loan borrowers i.e. real estate loans in CA or MI, (3) current FICO scores of participation loan borrowers compared to FICO scores when loans were underwritten, (4) changes in appraised real estate values (or other collateral).