Following sound business practices will guide your CU through a complex regulatory maze.
Loan participations are helping credit unions manage liquidity and interest-rate risk, and address problems with the member business lending cap. More than 1,300 credit unions currently engage in loan participations, about half of which involve member business loans.
Engaging in loan participations means your credit union must pay attention to a lot of details—not only those found in regulations but also those needed for sound business practices.
A participated loan is owned proportionately by all the participants, who typically divide the cash flow in proportion to their ownership share. No one participant has priority over the others, and no “right to transfer” exists for the entire loan unless all participants agree.
Current regulatory requirements
Section 701.22 of NCUA’s Rules and Regulations defines a “participation loan” as “a loan where one or more eligible organizations participate pursuant to a written agreement with the originating lender.”
The originating lender is the credit union that has the loan contract with the member. Eligible organizations are defined as federal and state-chartered credit unions, credit union service organizations (CUSOs), federally insured banks and thrifts, and any state or federal government agency. Trade associations are not eligible organizations.
The loan participation requirements in Section 701.22 as of early 2013 include the following:
In December 2011, NCUA proposed a number of changes to Section 701.22, some of which were highly controversial. The agency’s proposed amendments included:
NCUA also proposed to clarify the distinction between the purchase, sale, and pledge of eligible obligations for federal credit unions under Section 701.23 (where the borrower must be a member) and loan participations under Section 701.22.
The agency is expected to adopt changes to its loan participation rules in 2013, although it has made clear it won’t finalize the concentration limits as proposed.
Elements of a good policy
Whether or not NCUA imposes additional requirements, a good policy for a credit union wanting to purchase loan participations should:
NEXT: Elements of a good contract
Elements of a good contract
A well-drafted loan participation agreement, which contains the contractual terms that govern the actual process, is essential. The devil is truly in the details, or more accurately, the lack of details.
An agreement must clearly identify the parties to the agreement, their roles, and the loan participation interests being purchased. Provisions will address underwriting standards, collections, representations and warranties, trustee duties, servicing provisions, and administrative responsibilities such as the custodian for the original documents. Standard representations and warranties should include assurances that the borrower is a member of the originating lender and the loan isn’t in default.
An agreement that provides some flexibility about the various parties’ roles has some merit. When a party knows that it could be the seller in one transaction and the buyer in the next under the same agreement, the parties tend to negotiate more mutually beneficial agreements.
If you structure an agreement with some flexibility, you should clearly specify the parties’ roles in the participation certificate, which is attached to and incorporated into the agreement. The certificate, of course, also identifies the loans in which a credit union purchases a participation interest and the terms of the particular transaction.
Regulators expect purchasers of loan participations to treat the transaction with the originating lender as a third-party relationship. This requires due diligence of both the seller and the loans. And certainly for larger loans and all member business loans, the purchasing credit union should perform underwriting as if it were originating the loan.
Typically, the loan participation agreement’s representation clause specifies that the purchaser must independently review the seller’s loans and related documentation to make sure they meet the purchasing credit union’s underwriting standards.
If the purchaser reviews only a sampling of loans before the purchase, the credit union should consider whether or not it will review additional loans after the purchase. Often the seller will agree on a window of six to 18 months within which it will repurchase loans for any misrepresentation. (Fraudulent misrepresentations would have no time limit.)
The loan participation agreement should clearly delineate the servicer’s duties and responsibilities. The agreement should state that the servicer serves as trustee with a fiduciary duty to each participant because this fact could be disputed if not clearly stated. The agreement also should spell out when and how to replace a servicer.
Parties also need to identify collection policies and procedures. The loan participation agreement should specify when servicing staff will notify the nonservicer participants of problems and what ability they have to weigh in on what action to take—certainly involving a major action such as foreclosure.
The loan participation agreement often allows the servicer (who may be the originating lender owning only 10% of the loan or even a third party) to call all of the shots, even when major problems exist. I’ve seen examiners very concerned with this arrangement because the credit unions with the most risk don’t have any control over the asset.
One action that isn’t advised in the event of a default is for the agreement to provide for the seller’s repurchase of the loan. This is a “participation with recourse” and the participation won’t be treated as a “true sale” for accounting purposes.
A selling credit union enters into a loan participation arrangement to move the asset off its books, and the purchasing credit union buys the participation to bring the asset onto its books. These actions address issues of liquidity, interest-rate risk, and, in the case of a member business loan, the lending cap.
This accounting treatment is permissible only when the transaction qualifies as a true sale. When the transaction fails to meet all the elements of the Financial Accounting Standards Board’s definition of a “true sale,” it’s a securitized borrowing. And failing to meet the Dodd-Frank Act’s definition of a “participating interest,” the transaction potentially could be a swap. Appropriately worded representations and warranties that may provide for a repurchase don’t violate these definitions.
Obviously, you should take a great deal of care to meet the accounting requirements and legal definitions, and to make sure that contract terms don’t undermine the parties’ intentions. Engaging professionals with the necessary expertise will help you through this process.
Loan participations can be effective tools, but you must address “devilish details” for both compliance purposes and sound business practices. And expect NCUA to require even more details this year.
But if your credit union has adopted good policies, agreements, due-diligence processes, and monitoring systems, it will have a sound loan participation program.
KATHERINE WEBER is the principal of The Weber Firm LLC, a law firm focused on representing credit unions and CUSOs.