Copyright Credit Union National Association, Inc. Aug 2007| [Headnote] |
| A growth strategy enables CUs to enjoy a piece of the business loan pie. |
The pressure to better serve community needs, diversify asset base, and grow earnings is a major impetus for member business loan growth in credit unions. Yet one growth opportunity languishes in the credit union movement member business loan participations.
At year-end 2006, credit unions reported $24 billion in member business loans, a 24% increase from 2005, according to Credit Union National Association (CUNA) data. While several dozen large credit unions perhaps skew the totals, more than 2,000 credit unions now have member business loans on their balance sheets. During the next several years, credit union member business loan growth will accelerate.
Definition
"A loan participation is an interest in a loan originated by another lender which issues undivided fractional interests in the loan," according to "The Securities Activities of Banks," by Melanie Fein. "A participating lender typically has no direct legal relationship with the borrower, but rather relies on the originating or 'lead' lending financial institution to hold the loan collateral in trust and collect and distribute principal and interest payments to the participating lenders. The rights and obligations of the parties are governed by a loan participation agreement."
A simpler definition of a loan participation is a loan shared by a group of financial institutions that join together to make a loan too big for any one of them to make/keep alone.
Legal and regulatory considerations
A longstanding common banking practice is to sell, or participate, excess loans to another financial institution. The participating financial institution buys a portion of a loan from the primary originating lender. The originating financial institution is legally required to retain at least 10% of the loan amount and normally performs all the servicing and payment processing functions. Each month, the interest and principal payments (received) are divided on a pro-rata basis between the various lenders.
Each financial institution records its proportional share as an asset. From an accounting standpoint, the seller records a "contra-asset." Each institution records its proportional share of interest income on a monthly basis.
The originating/servicing lender usually earns a fee and/or interest percentage for initiating and servicing the loan. For example, if the stated interest rate on the underlying loan is 8.5%, the buying institution might receive 8%, with the seller retaining 0.5% as a servicing fee and extra income for originating the loan.
Both financial institutions (seller and buyer) jointly sign a legal contract, a participation agreement that defines die arrangement's terms and conditions.
Credit unions can participate (share) loans with ofher credit unions, commercial banks, savings banks, investment houses, and so forth. There are minimal legal restrictions in this regard other than requiring the originating financial institution to retain at least 10% of the loan, and the purchased loan must meet all lending policy guidelines, such as the 80% maximum loan-to-value, according to the National Credit Union Administration's (NCUA) Rules and Regulations (Part 723). The borrower need not meet the membership criteria of the acquiring credit union, so long as it meets those of the originating credit union. And in fact, the two credit unions might be in different geographic regions.
In the past, some credit unions have bought and sold participations in consumer loan portfolios involving both car loans and residential mortgages. Member business loan participations have been less frequent.
Annually, the selling credit union will perform its normal "loan review" and send a copy to each purchaser of fhe participation. On a less formal basis, die participation buyer may contact the selling institution from time to time to check on the status of the loan and related collateral.
Business loan participations typically are sold without recourse. The buyer accepts any risk of default or nonpayment by the borrower. As a result, the primary market for member business loan participations is among well-collateralized "A" quality business loans, usually secured by commercial real estate.
If the original lending credit union were to merge, the servicing would become the responsibility of the merged entity. In the unlikely event of a credit union failure, one of the other participants or an appointed receiver could assume the lead role.
Overview
Credit unions may sell, or participate, a portion of a member business loan for three reasons. The first two are related to regulatory limits, and the fhird relates to diversification:
1. Business loans can comprise only 12.25% of any credit union's total assets, according to NCUA regulations. A fast-growth credit union might approach this regulatory limitation but still have sizable opportunity to lend more in its local business community. By selling participations, it can continue to serve its community's needs and simultaneously increase earnings by retaining service fees.
2. The maximum amount credit unions can lend to a borrower (one obligor) is 15% of net worth. If a business member is building a new facility, the monetary need may exceed the credit union's legal limit. Participating the excess to another credit union resolves this concern.
3. Participations diversify and/or reduce risk in fhe loan portfolio. If a financial institution becomes concerned about having too much lent in a certain indus- try or neighborhood, it might minimize that risk by participating out a portion of those loans. Today, most credit unions don't have significant loan concentrations to warrant such concerns.
If a credit union's loan-to-deposit ratio were lower than desired, it might purchase loan participations to enhance profitability.
Participation partners
The general consensus is that there's a strong appetite for purchasing business loan participations within the credit union movement. And credit unions have a variety of potential partners:
* Local credit unions. Opportunities include funding a local enterprise, large apartment project, or new shopping center.
* Business lending CUSOs (credit union service organizations). In several regions, credit unions have formed CUSOs to make member business loans. These CUSOs can facilitate member business loan participations for their members within their region, as well as swap participations nationally.
* CU System Funds(TM). Launched in March 2005 by 
CUNA Mutual Group, CU System Funds was created to purchase credit union-originated member business loan participations and sell shares in the pool of loans to investor credit unions. Loans from a single credit union originator can't exceed 10% of fund assets, and the fund requires sellers to retain at least mat same percentage interest in the loan. Shares in the investment funds then are offered to credit unions and affiliated entities.
This approach is unique in that it combines the loan participations purchased into a fund structure and sells ownership shares back to the credit unions as an investment in a mutual fund. In this case, the securities (earning assets) aren't counted as loans or loan participations on the acquiring credit union's balance sheet.
This approach seems to hold great promise, but growth to date has been moderate, limiting CUNA Mutual's ability to purchase high quality business loans for the fund.
* Commercial banks. These banks actively have bought, sold, and administered loan participations to each other for many decades. While banks remain a possible outlet for credit union loan participations, other credit unions more likely are the preferred primary partners.
Profitability impact
Potential buyers of loan participations expect a reasonable rate of return. At the same time, if the loan is priced properly, the selling institution also can profit.
The norm is for the selling institution to retain all loan fees paid at origination - typically 1% - and also retain 0.25% to 0.5% of the interest-rate earnings. Thus, the buyer may earn an 8% rate on its portion of a loan participation, when the loan originally was priced at 8.5%. The borrower continues to pay the 8.5% rate each month, but the originator/servicer pays the participant the 8% rate, retaining 0.5% as additional earnings. A key benefit to the seller is the retention of that "extra" 0.5% interest earnings each month on an asset no longer owned. The net effect is to boost the selling institution's return on assets (ROA).
If a credit union generates a large number of member business loans and participates 90% of them, the seller's ROA increases materially.
Default risk
As with any business loan, there's a potential risk of default or nonpayment. To minimize this risk, member business loan participations usually are limited to "A" quality loans. Applying a nine-point risk rating scale widely used in commercial banking, credit unions should consider purchasing only loans rated 4.0 or better.
Participation defaults are rare but can occur. Historically, fewer than 1% of member business loan participations default, according to the Federal Deposit Insurance Corp., and there is usually at least partial recovery in those instances. Charge-offs on member business loans have been less than 50 basis points. In the event of default, the selling institution is responsible for pursuing the collection efforts. Often, the other loan participants also become involved as creditors.
Member business loan participations usually are collateralized by real estate or equipment. In a default, the original lending credit union will foreclose, sell the property, and remit proportional recovery proceeds to the other participants.
Opportunities
Member business loan participation opportunities include:
1. Local generation. Credit unions should target larger business loans, particularly real estate member business loans, with the intent to participate the "excess amount" to other local credit unions with whom they have established working relationships. Typically these loans are $500,000 to $5 million. In addition to meeting their members' (and the community's) needs, they can increase ROA while diversifying risk.
2. Participation purchase. Credit unions with lower loan-to-share ratios might consider purchasing member business loan participations to diversify their loan mix and raise earnings. Generally, diese participation amounts are $250,000 to $1 million. At present, there are many more buyers than sellers.
3. CUSOs. The larger CUSOs (and their principal members) can seek larger real estate lending opportunities in tiieir regions to parcel out the loans to fheir memberships. Depending on the CUSO, the loans range from $3 million to $30 million. Credit unions may compete with banks in this domain because credit unions typically have lower cost of funds fhan banks. This latter arena is where the largest opportunity seems to exist and could provide significant earnings enhancement.
4. National. There's no mechanism for credit unions to lend to the major corporations in the Fortune 500 or S&P. Perhaps a new industry-sponsored, national CUSO could address these bigger lending opportunities. Large, publicly held corporate borrowers are the most stable, with long earning histories and strong balance sheets. A $100 million-plus corporate loan could be parceled out safely to several dozen credit unions if a centralized administrator/servicer were available. In many cases, local credit unions are linked to these companies through historical select employee group relationships, but none of the credit unions are large enough to seek the parent companies' business loans.
Meantime, even without the large corporate sector, expansion of member business loan participations to smaller business borrowers presents a tremendous opportunity for growth. If your credit union isn't currently involved as either a buyer or seller of participations, perhaps it's time to rethink your strategy.
| [Sidebar] |
| FOCUS |
| *CUs may sell, or participate, a portion of a member business loan due toregulatoty constraints and diversification.*There's a strong appetite for purchasing business loan participations in the CU market. |
| *CUs must understand the risks and rewards involved. |
| [Sidebar] |
| $24 billion |
| CU member business loans at year-end 2006. |
| [Sidebar] |
| Twenty-three percent of CUs offer business loans. |
| [Reference] |
| RESOURCES |
| * CUNA: buy.cuna.org, select "lending." |
| * CUNA Mutual Group: cunamutual. com. |
| * NCUA: ncua.gov. |
| [Author Affiliation] |
| JERRY GOLDSTEIN is a credit union consultant in St. Louis. He assisted Alliance Credit Union, Fenton, Mo., in establishing a member business lending program. Contact him at 314-569-1481 or at gold40@aol.com. |
My Research
