Loan participations - Benefits and Pitfalls for Credit Unions
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Loan Participations - Benefits and Pitfalls; understand credit union loan participation accounting issues and what NCUA examiners are looking for
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Loan participations - Benefits and Pitfalls for Credit Unions
- 1. LOAN PARTICIPATIONS -ACCOUNTING AND REGULATORY ISSUES DeLeon & Stang, CPAs and Advisors Allen P. DeLeon, CPA (301)948-9825 allen@deleonandstang.com
- 2. Agenda – Issues to be covered What are participation loans? Participation loans vs. loans secured borrowing Participation loan policy Accounting and allowance for loan losses issues Regulatory issues – what are NCUA examiners looking for? Internal audit of participation loans
- 3. What are participation loans? Participation loans are loans made by multiple lenders to a single borrower. Several credit unions, for example, might chip in to fund one extremely large loan, with one the “lead credit union.” This lending institution then recruits other credit unions to participate and share the risks and profits. The lead credit union typically originates the loan, takes responsibility for the loan servicing of the participation loan, organizes and manages the participation, and deals directly with the borrower.
- 4. What are participation loans? (continued) Loan participations can, and often do, take the form of a loan pool underwritten by one credit union, which later sells a portion of the loan pool to other credit unions. NCUA regulations: No participation loan certificates; Must be % of each loan Must be at least 10% interest retained by originating CU
- 5. Participation interest vs. secured borrowing A participating interest requires: Proportionate ownership interest in an entire financial asset; All cash flows (excluding fees for servicing or other services that are arms length) to be divided among participants in proportion to share of ownership; Rights of each participating interest holder have the same priority (i.e. there can be no recourse and no participating interest holder is subordinated to another); No party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to do so.
- 6. Participation interest vs. secured borrowing (continued) If a transfer of a portion of a financial asset does not meet the definition of a participating interest, the transaction must be accounted for as a secured borrowing. All credit unions are encouraged to review their participation agreements to determine if they conform to the new definition of a participating interest.
- 7. Loan Participations - Pros and cons Pros Provide a source for selling loans Stay under loan caps Geographic and loan type diversification Average loan yield much higher than average investment yield Cons Increased complexity Greater risk, if large participation loan goes bad Greater regulatory scrutiny No control over loan underwriting
- 8. Common Pitfalls Projects which fail to meet expectations; risks associated with large commercial participation loan projects Originating CU being taken over by NCUA, resulting in staff turnover, lack of servicing talent to handle defaults Loan modifications, obligation of lead CU Failure to meet obligations to advance funds Absence of updated credit information
- 9. Board of Directors actions Approve a loan participation policy Approve by-laws changes if applicable Ensure independent analysis of every participation loan pool purchased Develop an annual plan Ensure management is monitoring and monthly reporting to the Board key ratios Delinquency Loan growth Charge-offs
- 10. Participation loan policy Written policy required by NCUA Risk assessment Strategic planning Due diligence Risk measurement Monitoring Control
- 11. Participation loan policy (continued) Risk assessment Credit risk assessment Interest rate risk assessment Liquidity risk assessment Transaction risk assessment Compliance risk assessment
- 12. Participation loan policy( continued) Strategic planning Strategic risk assessment Reputation risk assessment
- 13. Participation loan policy (continued) Due diligence Conflicting interests Financial condition Loan product experience Significant staffing changes Trade area Loss of control Contract and legal review Loan underwriting
- 14. Participation loan policy (continued) Risk measurement, monitoring and control Post closing review Monitor financial health of originating credit union Annual review of loan pool status
- 15. Accounting and allowance for loan loss issues Accounting issues Is the accounting treatment supported by agreement or legal opinion? Is there a uniform policy for accounting for collected points and fees? Separate sub-ledgers maintained for participation loans or loan pools? Is interest calculated using contractual terms? Are delinquency reports segregated by individual participants? Are timely reports received from selling credit union?
- 16. Accounting and allowance for loan loss issues (continued) Allowance for loan loss issues Are loan participation identified and addressed in the ALLL methodology? Are participation loan charge-offs and recoveries tracked separately and by loan pool? Q&E factors considered?
- 17. Regulatory issues – What are NCUA Examiners looking for? Same due diligence as if CU originated the loan itself: Comfort with originator or lead lender Separate and independent risk assessment and credit decision Risk rate the credit Meet CU’s lending requirements Pre-closing review of documentation
- 18. Regulatory issues – What are NCUA Examiners looking for? (continued) Regular monitoring of the credit: Collection of financial information Analyze the financial information Maintain loan administration and review Appropriate and proactive risk grade the credit
- 19. Keys to success Each participant perform independent financial analysis Each participant has reviewed loan documents Participations should be non recourse to the lead lender Document who makes the decision for a work out, lead or majority Use a qualified attorney
- 20. Internal audit of participation loans Review policy Select sample of new participation loans Review and evaluate due diligence and compliance with regulations Review payment history, delinquency and charge offs Examine the adequacy of allowance for loan losses Report findings and make recommendations
- 21. List of Resources 1. NCUA -regulations, Parts 701, 722, 723, and 741. http://www.ncua.gov/RegulationsOpinionsLaws/rules_and_regs/NCUA%20R%20&%20R%20Book%201%20May%208%202008.pdf 2. NCUA Letter to Credit Unions No. 07-CU-13, December 2007 - Evaluating Third Party Relationships. 3. NCUA Letter to Credit Unions No. 08-CU-20, September 2008 - Risks to Credit Unions. 4. NCUA Letter to Credit Unions No. 08-CU-10 April 2008 – Mortgage Loan Fraud Report. 5. NCUA Letter to Credit Unions No. 08-CU-12 May 2008 – Suspected Money Laundering in Residential Real Estate Industry Report 6. NCUA AIRES Questionnaire - Loan Participations. http://www.ncua.gov/CreditUnionResources/aires/aires.html
- 22. List of Resources 7. Federal Deposit Insurance Corporation. Risk Management Manual of Examination Policies, Section 3.2 – Loansoan Participations. http://www.fdic.gov/regulations/safety/manual/section3-2.html#introduction 8. Office of the Controller of the Currency. OCC’s Comptroller’s Handbook, Loan Portfolio Management. http://occ.gov/handbook/lpm.pdf 9. Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and servicing of Financial Assets and Extinguishments
- 23. QUESTIONS
Notas do Editor
- 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.
- 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.
- 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
- Board of Directors oversight of loan participation is critical and part of the Board’s responsibility.
- 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
- 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
- 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
- I recommend documenting post closing review and at least annual review of loan status
- 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
- 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).