Participating in Success

How loan participations can meet the needs of both buyers and sellers

By Bob Burrell

The ability to generate loans is not spread evenly throughout the credit union community. As of September 2003, only 1,467 credit unions, from a total of some 9,664 nationwide that filed call reports, had loan-to-share ratios in excess of 85 percent. At 90 percent, the number drops to 940, 570 topped 95 percent and only 323 had loans exceeding shares. In fact, more than half of all credit unions had loan-to-share ratios below 65 percent. 

The two markets that dominate credit union lending—autos and 1-4 family residential first mortgages—are highly competitive; many credit unions just do not have the infrastructure or membership base to compete efficiently. In fact, most of the growth in auto loan portfolios in 2003 came from indirect lending activities and many credit unions just do not have the resources to manage the extra challenges faced in that market. Only 379 credit unions reported having originated $10 million or more indirect auto loans in the first nine months of 2003. This is remarkable when you consider that indirect auto lending now makes up nearly 10 percent of the dollars for all credit union loan originations. 

It is also not just smaller credit unions that can’t make enough loans, only seven of the 25 largest credit unions in the nation have loan-to-share ratios greater than 85 percent and eleven are below 65 percent. On the other hand there are some credit unions that do not have the capacity to hold all the loans that they could generate. Clearly there is an opportunity and a need to find some way of re-distributing the excess loans from this group to other credit unions desperately seeking loan assets to utilize excess member funds. 

The loan participation market was once dominated by brokers and characterized by one-off transactions. The largest transactions tended to be “fire sales” by motivated sellers desperate to get assets off their balance sheets. Frequently the expectations of both buyers and sellers were not met and the reporting and payment flows were somewhat erratic. However, a number of credit union entities are now bringing liquidity and standardization to the market, which will open the way for many more credit unions to “participate’ in loan participations. The numbers in the September call reports suggest some reporting issues may exist; however, it looks like between $700 million and $800 million loan participations were traded in the first nine months of 2003.

What regulation permits

NCUA regulations permit credit unions to buy up to a 90-percent participation in nonmember loans that were originated by other credit unions. The originating credit union is required to retain at least 10 percent of the loan. Regulation 701.22 and 701.23 further clarify the responsibilities for buyers and sellers as follows:

Seller must:

Only make loans to members.

Retain 10 percent of loan.

Retain original or copies of the loan documents.

Use same underwriting criteria as for retained loans.

Execute a master agreement before the transaction takes place.

Obtain board approval for sale.

Buyer must:

Only participate in loan types that it is legally empowered to make.

Only participate in loans to its own members or members of the selling credit union.

Execute a master agreement before the transaction takes place.

Obtain board approval before disbursement of funds to seller.

Retain copies of the master agreement and schedule of loans purchased.

Ensure individual loan purchases do not exceed 10 percent of unimpaired capital and surplus.

Clearly, the buyer must also ensure that proper due diligence is performed on the loans being purchased. The amount of due diligence of course will vary with the nature of the transaction. The buyer undoubtedly will be more diligent when undertaking credit exposure than where the seller provides full recourse on any credit losses to the buyer. 

The familiarity of the buyer with sellers underwriting and collection practices, the type of loan and the demographics of the borrowers will also play a deciding role in how much due diligence is required.  

WesCorp’s loan participation program

Using WesCorp as an example, let’s take a look at how a typical participation might work using an intermediary that acts as a principal. In our program WesCorp acts as a principal in all transactions, standing between the buyer and the seller. When a credit union wishes to become a seller, WesCorp credit staff performs a full due diligence review of the credit union’s underwriting and collection activity. This encompasses both a statistical review of the seller’s portfolio and loss history and an on-site review. The on-site review involves examining sample loan files and talking to the staff involved in both underwriting and collections. 

Once a seller has executed a master agreement, WesCorp staff will update the reviews on an annual basis as long as transactions are outstanding. This is important particularly to WesCorp in a recourse transaction since we provide the recourse to the buyer and receive an offsetting recourse commitment from the seller. We are on the hook for any problems. 

Our master agreement is fairly standard and does not seem to present any major problems to either sellers or buyers. Once the master agreement is executed and the due diligence reviews completed, WesCorp can quote a purchase yield to a seller almost immediately. Since WesCorp acts as a principal, and is ready to position the loans until buyers are found, settlement can take place as soon as is practicable. We will also quote forward-delivery prices for a couple of months out for loans in the pipeline. In fact, we have one existing relationship where we quote a buy rate each Monday and the seller closes loans in to that commitment for the rest of the week. Of course we do retain the right to change the rate during the week if interest rates move significantly. This arrangement ensures the seller knows what rate they need to quote and removes the necessity to hedge their pipeline. 

Once a participation pool has been purchased, WesCorp then prepares an offering notice that is then put on our Web site (www.wescorp.org) and sent out by e-mail to all buyers who have registered their interest in buying that type of loan. In the current liquidity environment, participation pools typically trade that same day. WesCorp handles all the reporting and disbursements to the buyer. On the other side, WesCorp works with the seller to track the principal and interest payments. We have installed a master loan processing system that can mirror the sellers servicing system and is designed specifically to provide comprehensive investor reporting. 

Ideally, we would like to have regular sellers send us portfolio data on a monthly basis so that we can track delinquency, loss and prepayment activity over time. We are also able to assist the seller in selecting the loans for sale. The portfolio monitoring capability also helps optimize the selling price since the additional data can highlight superior credit performance and ensure the best sales price is obtained. The master servicing system also could be used solely for portfolio analysis and tracking. We have the ability to perform static pool analysis to identify and track performance trends by a wide number of loan characteristics (see InsideRISK, Volume 4, Number 3). Virtually all transactions are closed at par with variation in pricing coming in the participation rate passed through to the buyer. WesCorp takes out a small spread to cover both up-front and ongoing expenses. 

WesCorp provides liquidity to sellers by acting as a principal and avoids the need to wait for buyers. Our balance sheet, which currently stands at $24 billion, can easily accommodate even large transactions. We also plan to provide liquidity to buyers by making secondary markets in the participation pools that we originate. As mentioned earlier, pricing is typically established at par (i.e., the pro-rated principal balance of the loan) with a participation rate being set by WesCorp on each side of the transaction. 

The seller keeps all coupon income and service charges on the entire loan and then passes through the agreed participation rate to WesCorp. WesCorp passes on the agreed participation rate to the buyer. Typically, we take out ten basis points, however, that number may vary depending on changes in market rates while we hold the position, how long we hold the participation on our books before it is sold, and whether we incur any hedging expenses. 

The cashflows are handled differently in recourse and non-recourse transactions. In a recourse transaction, the seller advances scheduled principal and interest on all loans whether or not they actually receive any funds from the borrower. If a loan is delinquent for 90 days, the seller is then required to re-purchase that particular loan for the outstanding principal balance. In this way the buyer is never waiting for any delinquent funds. Also, remember that the recourse agreement to the buyer is directly from WesCorp not the seller. 

In a non-recourse transaction, the situation is different. Because the buyer is also participating in the credit losses on their participations, we only pass through principal and interest as collected. There is no requirement to repurchase the loan and the buyer will have to recognize any charge-offs at the same time as the seller. Since only actual funds received have been passed through, the buyer will not have to refund any loss amounts to the seller. 

Recourse vs. non-recourse

There are two major decisions driving the seller to choose a recourse or a non-recourse sale—accounting treatment and price. There has been much debate about whether a recourse participation transaction can obtain true sale treatment under FAS 81. Clearly a non-recourse transaction does represent a true sale and the seller can remove the assets from its balance sheet. This is clearly a major issue if the seller is trying to manage their capital position. 

On the other hand there is a significant difference between the pricing on a recourse and a non-recourse transaction. The price differential does not only reflect the likely loss exposure on the loans, the buyers of each type look at the purchases in a totally different light. In a recourse transaction, the buyer has no credit exposure and a direct guarantee from WesCorp. This is quite similar to an investment in a WesCorp CD.

Recourse buyers tend to look at the loan participation as an alternative investment; consequently recourse transactions price somewhere around 40-50 basis points more than the rate on WesCorp CDs with a similar maturity profile. On a non-recourse transaction, the buyer has no guarantee and has full credit exposure to the borrower for their portion of the loan balance. As a result, buyers of non-recourse loans look at these participations as loans and expect a commensurate loan rate. Non-recourse loan participations typically trade at rates close to the average loan rate in the market less a consideration for the servicing expense. The pricing on recourse and non-recourse participations do not move in tandem and reflect the supply demand pressures in different markets. The rate differential between recourse and non-recourse loans participations has varied between 50 and 250 basis points.

New hybrid product 

Recently, WesCorp has developed a new hybrid product that will achieve the true sale accounting treatment while allowing the seller to retain a good part of the credit exposure and secure pricing closer to a recourse transaction. We have completed the first couple of transactions under this new program. Any potential sellers interested in this particular program should contact us for more details.

Opportunities in the participation market

Sellers:

a)                    Reliable outlet for excess loan production.

b)                   Ability to meet member loan demand that is in excess of balance sheet capacity. Capacity to handle periods of rapid growth.

c)                   Timely execution because WesCorp acts as principal.

d)                   Tool to manage reserve position.

e)                   Ability to build servicing revenues without having to hold entire balance on balance sheet.

f)                    Additional source of liquidity.

g)                   Ability to mitigate credit exposure.

h)                   WesCorp’s portfolio analysis capabilities.

Buyers:

a)                   Source of high-yielding assets.

b)                   Standardized offerings and WesCorp due diligence reduce ongoing operational overhead.

c)                   Ability to utilize WesCorp’s infrastructure for due diligence requirements reduces up-front infrastructure requirements.

d)                   Any recourse commitment is directly from WesCorp.

e)                   WesCorp will make a secondary market for participations that we originated.

Conclusions

If you are in a position to make good loans to your members, make them. Don’t worry about funding or capital leverage; firstly serve the needs of your members. If liquidity is a concern, sell the loans with full recourse. That way, you obtain exactly matched funding and a good yield. If capital is a problem, sell the loans without recourse. The cost will be higher, but you have satisfied your member needs and have earned an extra spread on the portion retained plus at least the servicing fee on the portion sold. Given the extremely high credit quality of loans typically created by credit unions, you should also look at WesCorp’s “Hybrid” product. This will attract sale treatment but be priced closer to recourse transactions.

If you have excess liquidity but are not in a position to make good loans to your members, consider loan participations as an investment alternative. Where WesCorp offers recourse, you will earn a good spread above where you could buy a WesCorp certificate of similar maturity. Where recourse is not offered, you will earn an even better yield. There will be credit risk involved, but again as credit union loans have traditionally been of excellent credit quality and as WesCorp has performed due diligence, the enhanced yield should prove more than adequate to offset any potential credit concerns.

As noted above, there are several steps that need to be taken to be involved in the loan participations market. We suggest that you address and satisfy those requirements in advance so that you are fully prepared to enter that market when you have the need as either a buyer or a seller or both. 

If you have any questions relating to this article or how loan participations might fit into your asset/liability management strategies, please contact Lorena Paredes at (800) 442-4366, ext. 6426, or e-mail loanparticipation@wescorp.org.