Loan participation programs have gained popularity in the financial institution space in the last five years. As of Q3 2012, more than 1,300 financial institutions were utilizing these programs. Financial institutions with more than $1 billion in assets are the most active in the market, with approximately 70% of those institutions utilizing participation loans.
There are various benefits to these types of programs, as well as multiple compliance and due diligence items to evaluate. Today, we will dissect how a financial institution could benefit from participation loans, and in my next post, we will go through the ins and outs of compliance and regulations.
What is loan participation?
A loan participation is an instrument that allows multiple lenders to participate or share in the funding of a loan. The originating lender underwrites and closes the loan, and subsequently—or sometimes simultaneously—sells portions of the loan to other participants. In most cases, the originating lender will service the loan and remit each participant's share of principal and interest to them as they are received by the servicer. Participating institutions share in the funding of a loan, becoming an “owner” of a portion of the loan with all benefits of full performance and if non-recourse, all associated risks of loss, as if the participant had originated the loan itself.
The Benefits of a loan participation program
Financial institutions can use loan participations as an integral part of their balance sheet strategies. Those that sell participations may enhance their liquidity, interest rate risk management, and ability to serve customers. They may also benefit from a diversified balance sheet, higher loan-to-share ratio, and increased earnings. A major motivation for a loan participation program is to meet the needs of customers in conjunction with certain requirements of the institution. Let’s take a look at some of the other benefits of loan participation programs:
Larger Loans Can Be Originated
Selling loan participations allows the lead financial institution to originate an exceptionally large loan that otherwise may have been too large for them to fund by themselves. By engaging other financial institutions as participants, the lead financial institution can remain within its own legal lending limits and still acquire sufficient cash for funding the loans.
Financial institutions that buy loan participations share in the profits of the lead financial institution. If a lending institution isn’t doing much business on its own—or is in a slow market—it can team up with a profitable “lead financial institution” in a healthier market to generate more lending income.
Selling loan participations allows a financial institution to reduce its credit risk to a customer or specific community that has greater than average risk. In addition, loan participation programs allow institutions to diversify their assets—investing in a variety of loan types reduces the risk and exposure to potential losses such as a severe economic downturn or a natural disaster.
Enhanced Customer Relationships
Selling participation loans allows the lead financial institution to keep control of an important customer relationship, instead of sharing the relationship with other competing financial institutions.
Shared Servicing Responsibilities
If the originating lender possesses the capabilities to handle the servicing, that institution may service the loan on behalf of all of the participants. However, many financial institutions don’t have the operational capacity to service multiple loan participations; therefore, they prefer to employ a third-party servicer to service the loan on behalf of the lead institution. This arrangement reduces the administrative burden on the participating institutions.
Properly managed loan participation programs can be beneficial to financial institutions, whether they're buying or selling loans. Loan participations may provide selling financial institutions with a mechanism to manage regulatory limits, interest rate, liquidity, credit and geographic concentration risks, as well as an enhanced ability to serve customers. Financial institutions buying loan participations may benefit from diversifying their balance sheet, using excess liquidity, and increasing revenue.
Whether selling or buying, financial institutions have similar risks in monitoring and managing loan participations. Selling financial institutions’ risks are centered in regulatory compliance, full disclosure, and credit administration. Buying financial institutions’ risks are centered in risk assessments, strategic planning, due diligence, contracts and legal review, underwriting credit risk, and internal controls. Stay tuned for my next blog post as we go into detail about the compliance and due diligence responsibilities for both lead and participating institutions.
Has your institution considered loan participations? What are some of the biggest concerns that your leadership team has when it comes to "pulling the trigger" on becoming a loan participant?
This blog is brought to you by our guest blogger, Mike Dorsett, President of Portfolio Performance LLC. Mike has assisted many buying credit unions in the participation loan process, to include: locating participation opportunities, development of participation policy and credit risk matrix, seller due diligence, analysis of pool characteristics and loan economics, loan file due diligence, and final evaluation.