Buying Participations – The Good, The Bad, and (Hopefully Not) The Ugly08.18.2015
Participations are a key tool in managing a credit union’s member business loan cap. Buying MBL participations offers diversification by asset class and geography. Yield on MBL participations is often double that of consumer loans. But there are costs and risks associated with even the smallest MBL participation. Here are the key success factors to effectively expanding your credit union’s balance sheet using MBL participations.
As a participation buyer, the two biggest mistakes a credit union can make are to 1) short-cut participation underwriting, and 2) not perform the appropriate lead lender due diligence.
Underwriting Properly. Prudent lending and regulatory standards for participations require a full, independent underwriting of the entire loan. Simply writing a cover memo recapping the lead lender’s credit analysis and approval is not acceptable underwriting. You must invest in proper analysis on the full loan amount (not just the portion you are buying) to ensure the borrower’s cash flow is adequate to service the debt.
Due Diligence on the Lead Lender. Additionally, you must conduct proper due diligence on the selling credit union (or financial institution) to ensure they have the right expertise, systems, and infrastructure to originate and manage the loan. Talk with the seller on the phone and get a feel for their expertise. Look at the depth of their staff – do they only have one real expert, and if that person leaves, do they have a back-up?
And of course, your examiners will be closely scrutinizing your work in both these areas.
Do not go ‘on the cheap’ in these areas – many past problems associated with MBL participations were a direct result of inadequate underwriting and due diligence by each participant, and you do not want to join that crowd.
Understand the Market. Another key success factor is to understand the nuances of the commercial real estate collateral. Do thorough homework on the market where the commercial property is located. Online research works well - be sure to document your analysis and conclusions. A site visit to the property is best, but is also the most costly. The larger the participation you are buying, the more important it is to consider a site visit. Finally, grill the lead lender on details of the property. Closely examine things like lease terms and tenant roll-offs, characteristics of the area surrounding your property, and what the alternatives are should the lenders have to foreclose and resell the property.
High Yield vs. Loan Quality. Many credit unions make their buying decisions based almost solely on the yield. You must look beyond that though, and ask questions: Why is this loan priced above market? Is this a higher risk borrower, property or location? Or is this a market niche where the seller has a price advantage? If the seller has truly priced their loan based on risk, the “A” credit will carry a lower yield – but that presents a great opportunity for you to buy into a high quality credit.
Participant Voting Rights. Look closely at the master participation agreement to understand what happens in the event of borrower default. Is the lead lender in sole control of decisions? What are your voting rights as a participant? The best participation agreements allow a majority of participants to control the vote, even if the lead lender is not part of that majority.
Tremendous Opportunity on the Horizon. The proposed NCUA Regulation 723 eliminates non-member participations from the MBL cap. This creates a tremendous buying opportunity for credit unions as participation buying will not have regulatory limits. However, use participations wisely as a balance sheet management tool. Set “house limits” commensurate with your credit union’s risk tolerance. All it takes is one bad participation to wipe out profits from many good ones, so be judicious about the loans you buy and do your homework.
About Larry Middleman
Larry Middleman, President/CEO and Founder of CU Business Group, LLC has 35 years of credit union and commercial banking expertise. Larry founded CUBG in 2002 and has built it into the largest business services provider in the industry, serving more than 490 credit unions in 46 states. As a CPA and banking executive, Larry has done extensive work with financial institutions across the U.S. on product design, pricing, process improvement, and sales management. Larry consults with credit unions nationwide on business services program development, strategies, and pricing.