Today, more than 2,000 credit unions are offering participation loans. The total outstanding balance of participation loans increased 28% in 2021, from $46 billion to $59 billion – and it did draw NCUA's attention as an Examination Priority for 2022. In this episode, Mark Treichel interviews Steve Farar on loan participation and eligible obligations. Listen to this conversation to hear what NCUA will consider when reviewing your loan participation. Tune in also for a discussion on the difference between participations and eligible obligations.
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Participation Loans & Eligible Obligations With Expert Steve Farrar
Credit Union Exam Solutions
I'm pleased to be joined by Steve Farrar. Steve, how are you doing?
I'm doing just fine.
Steve, the last time we chatted, it was on Capitol. Before that, we talked about the NCUA exam priority letters. One of those priorities was a discussion on loan participation. Our topic is about loan participations and eligible obligations. Before we jump into specifics, for those of you who may not have read those episodes or don't know your background, could you give us a little bit of your biography in credit unions?
I started out as an examiner out here in Montana and quickly had to deal with a couple of failures of small institutions around my hometown, which led me to do problem resolution for NCUA for the next fifteen years. I went to the central office and worked on a problem resolution to more of a national level and training problem case officers. I ended up doing a lot of regulatory work at the end of my 35-year career.
It was a great career. You and I worked together on the West Coast and the East Coast. You played a big role in a lot of NCUA policies that people deal with out there, like the capital rule that we discussed and training the examiners and the problem resolution. I’m excited to walk through this topic with you. This topic of the loan participations is in the priority letter in 2022. One of the reasons you pointed out in the past episode is because of the growth in that area. Could you speak to the numbers that you're saying that NCUA sees as well on these topics?
When you look at the trends in 2021, you can certainly see why this garnered NCUA's attention for the examination priority letter and the outstanding balance of participation loans went from $46 billion to $59 billion. That was a big jump compared to all the prior years, which was interesting because some of the other big programs had come to an end. The taxi program was winding down and certainly in a fee outstanding amount of those. Participation loans are now up to 4.7% of loans. The eligible obligations also increased significantly.
They went from 1.69% of loans of the 3%. That was also a pretty big jump. The good side is the performance of participation in loans improved, especially when you carried to prior years. Once again, I think that's the losses from the taxi medallion loans coming off the system to now delinquencies down to 0.4% and it was running around 0.7% in prior years and charge offs. I'll charge it off in 2021. They were also down to 0.18% compared to 0.30% in 2020. The performance on them is quite good. I don't have much on yields, but I suspect that they're pretty healthy.
You touched on the fact that the medallion losses have rolled off and that can assist the numbers. You and I are both familiar from our time at NCUA with different roles that we played relative to how those taxi medallion loans performed, or at the end of the life of most of those, how they did not perform very well. What could have been gleaned from that medallion situation?
That one is interesting because you had the loans that had a nice yield to them. They had a few credit unions producing a large volume of them. They couldn't absorb it all into their books. It became widespread participation there. It was like, “They're doing so good,” but we always tended to forget that they were unique and that was an asset, almost like art. In a participation loan, you can do participation loans that you don't normally underwrite. The thing is, I know some of the credit unions way out here in the West in rural areas that were participating in taxi medallion loans. You're like, “What would they really know about that business?” They did purchase participations in them.
Those tended to be ones that are quick to say, “We're just going to write all that off when they started doing bad,” but the losses in that program ended up being the last report I could look up with $750 million that the insurance fund lost. The losses are much greater when you tend to take into the amount of capital that was lost in the credit unions invested in them.
In my career, it was fortunate that I also worked with some of the other big types of participation loans that are out there and that the church participation loans are one that we’re pretty widespread and tended to perform quite well. When you're looking at those types of loans, they are quite different to look at. How comfortable were those purchasers in being able to look at those types of loans which they don't normally grant? We'll touch on some of those as we go through this presentation.
When you bring up certain types of loans being booked by certain credit unions and having high concentrations, and then earlier you mentioned, was it 4.7% of loans that are in participations? Did I have that right?
Yes. Participation loans to total loans.
One thing I used to say as a regional director is you can put a little bit of something in any amount and you can probably manage that risk. It was in situations where people got a little bit too much bulk that either on their own books or they liked that yield so much that they went after a little bit too much of it. Another observation about the medallions as you were talking about them reminded me of something.
A former NCUA Board Member, Mark McWatters, when the topic came up, would talk about the horse and buggy. The horse and buggy were a great way of getting around this country until the automobile came along. There was a correlation in the taxi medallions, Uber, Lyft, and those companies came along.
It changed the game. It looked low-risk until there was a seismic event. Sometimes those seismic events can cause losses. I'll leave it at that. NCUA handles things in different ways. They have guidelines and regulations to deal with different things. In this instance, as we're talking about participations and eligible obligations, there are regulations for both of these. What are your thoughts? Any comments you want to make relative to the regulations on both participations and eligible obligations?
You might start doing participation loans because you need liquidity.
I don't want to go into a lot of detail because these two regulations are not lengthy and they're fairly easy to understand. The participations are covered under 701.22. The eligible obligations are in 701.23. To apply these, you have to identify a few specific things for each of the loans. Number one is, who's the originating lender? Who the borrower initially contracts for the loan is generally the answer for that one. Is it a whole loan purchase or a partial loan purchase?
You need to know that. The loan type carries into this regulation the borrower's membership status. That one comes up. Your CAMEL code comes into play for some of the regulations and what can be purchased. Generally, if you're a CAMEL 1 or 2, you have the ability to do more under these regulations. The big picture of the participation regulation is the originating lenders continue to participate throughout the life of that loan.
That's a strength of participation loans, in that they always have skin in the game. The federal credit unions must maintain at least 10% of the outstanding balance. The state credit unions must retain at least 5%, but that can be subject to the state law. The borrower has to become a member or be a member of one of the participating credit unions. It must be a loan that the credit union is empowered to grant.
You can't exceed the member business loan limit by buying participation loans because they count towards those limits. There are limitations upon buying from one lender that’s greater than $5 million or 100% of net worth. There is a COVID increase to that limit that will go through one more year. They just extended that. Now you can go up to 200% of net worth and that type of limitation.
The credit union should have policies on this that would limit each type of loan purchase and the single borrower limit. There is a need for a written agreement with the originating lender. This does apply to state credit unions under 741. The big picture on eligible obligations is primarily purchasing whole loans of their members is generally what it was designed for. It allows for the purchase of loans from liquidating credit unions and the general facilitating of the loan pools.
This is where the CAMEL 1 and 2 credit unions can generally purchase eligible obligations of non-members far from a federally insured credit union. That helps the industry with that part there and keeps it in healthy credit unions. The investment committee must approve the purchase. This has to be the same thing. It has to be a loan that the credit union’s empowered to grant.
There's a limitation on the outstanding balance of eligible obligations of 5% of unimpaired capital and surplus. There you can get exclusions to that amount. Under both of these policies, there are waiver provisions inside of them. That's described in the regulation. If you're going to do this, read the regulation because it isn't going to take a lot of your time.
Steve, we've had some conversations with some credit unions that may not necessarily read the regulations or understood the regulations and may have acquired loans that they thought were participation loans, but in reality, they were eligible obligation loans. They found themselves in a situation where they had different limits. They had the 5% of unimpaired capital and surplus and/or they may not have the CAMEL code that worked with how they acquired those loans. It's important, buyer beware, to understand what it is that you're purchasing.
Is it a participation? Is it an eligible obligation? Obviously, in the end, it's the borrower's ability to repay and what's the collateral. There's that side of it that makes the asset similar, but how you recorded on the books can have a material impact on how NCUA will respond. It's your policy that decides how much you have in participation loans, as opposed to the regulation that can decide how much you can have in eligible obligations. Any comments on what I've said there?
All those things always come down to what you and I have talked about over the years. You always start with everything, “Can we?” You have to get through the, “Can we do that?” by knowing the regulation, the limitations, and then you get to the, “Should we do this?” We'll cover this here on the later part of this. Knowing the regulation helps you clear that, “Can we do this?” hurdle.
You mentioned that the rule participations apply to state charters under 741, which is a 741.8 perhaps, the purchase and assets of assumption of liabilities. Anything you want to add on that topic?
That’s where it references some of the specific parts of the regulation that apply to state charters. It doesn't add a lot other than to say you’re subject to the rules almost the same as the feds.
Let's get into the whys and the hows. Why would a credit union decide that they want to sell participation loans are eligible obligations from what you saw in your career at NCUA?
It is a great tool available for managing your risk and your balance sheet. The main reason that we've seen it, it didn't really work for the taxi ones, was you would like to use it for eliminating concentration risk. That comes in pretty handy as long as people recognize that there's only so much of this type of loan that we want to put on their balance sheet, but we have a lot of demand for it.
We can go ahead and make those loans and find credit unions that are willing to buy those participations. It also can be used if a credit union has a loan that they would like to do, but it's a large loan and they would like to be able to spread some of that risk out so you can accommodate a larger loan than normal.
You might start doing participation loans because you need liquidity. That's a fairly common one. It can improve earnings. I did see in some of the Koreans’ active participations in that they held the 10%. These were a commercial type loan, but that borrower had to have compensating balance with them as part of the loan. They also charge servicing for the participation loans. If you take all of the earnings that they had on top of that 10% that they held, it was a high yield on that.
A strength of participation loans is they always have skin in the game.
There is one way that you can improve earnings because it's a little bit leveraged. Sometimes you would do it to comply with regulatory requirements. In that, by improving earnings, you need some improvement to your net worth ratio. You may be able to do some participations to allow you to improve your net worth ratio.
The other one is to manage interest rate risk. If you want to offload because of maybe the fixed rate on some of your loans you want to participate, you could change your interest rate risk a little bit. There are lots of reasons why somebody would want to sell them. They cover a whole bunch of ways that credit unions can manage their balance sheet and income saving.
You had excellent reasons that are discussed. Let's flip that. Why would a credit union want to purchase participation loans or eligible obligations in your mind?
Generally, the bigger reason somebody might want to do it is they don't like the yield that they're getting on their investments and they have excess liquidity. It's a product out there. You're active in the industry and help your fellow credit unions meet loan demand within the system. The other thing is you could have staff that has the ability and experience to do certain types of loans, but you're not getting that demand out of your own membership.
We want to take advantage of staff expertise that can evaluate the type of participation loan that's out there. It's a great way to take advantage of building up a new loan type by going slow at the start. You can improve earnings because the yield on these is certainly going to be higher than in investments. Those are the immediate reasons, but I don't know if you can come up with any more on that.
You mentioned that 2,000 credit unions are doing it. That's 40%. It’s done at every asset level, but there may be some smaller credit unions who have issues with their field of membership, yet they want to maintain their autonomy and they can find some loans that actually fit what their risk appetite is, where they might want to do some of that. It provides them again to remain a small credit union, as opposed to getting gobbled up and as part of the mergers that happen every year.
To highlight, you talked about people helping people and credit unions helping credit unions. One real nice thing about credit unions is if I've got low in demand and you don't, there's a way that we can make these types of loans or eligible obligations that help my members and your members at the same time because it improves your profitability and allows me to make loans to my members.
That’s a good summary of why people would want to on both sides. NCUA wants to make sure that you do it in a safe and sound manner. Credit unions want to make sure they do it in a safe and sound manner. There are risks in anything that you do. There's a risk to walk outside the door. There's a risk for me to get into the car and drive to the grocery store. There are risks in doing participation loans and eligible obligations. What are your thoughts relative to that?
It does open the door to all kinds of new types of risks that credit unions can look at. One of the interesting things is in the regulation that you can purchase the loan even if the credit union doesn't originate that type of loan. That creates the potential for danger because credit unions can purchase loans that are not all that good at looking at, and they've done that.
That's why it becomes important to know what you're buying. The other thing that comes into play is proper accounting. These things can get complicated if you start having other issues that would make them necessarily not even participation loans or eligible obligations. If you start dealing with recourse and repurchase options and then you start dealing with secured lending.
You need to make sure that your accounting people are able to have the knowledge to properly guide you, properly accounting and recognizing those. Understanding all of the contractual rights that come about for these things is important. You're going to deal with agreements. You might want lawyers to be able to look at that and understand that.
Reporting on the Call Report can also be a little bit tricky. If you have good accounting, you'll get that right. It's easy to get nicked on your Call Report because of poor reporting.
I've talked a little bit about the agreement. You have to have that timely credit information and notice of changes of borrower status that the originator would have to share with you. The requirement to consult with participants to modify the loan and actions on defaulted loans, that part was actually specifically mentioned in the post-mortem of the taxi loan situation.
It said that a number of adjustments were made to the loans the participants were not aware of. That agreement should also cover things like resolution in the event of disagreement between the parties. That covers a whole part of the things. NCUA and some other documentation have identified some unsafe and unsound operating policies and practices in loan participations. It all comes down to due diligence because you're dealing with third parties.
You have to know who you're doing business with. That's important. You have to do your due diligence on the individual loans and the loan policies that you're buying them from an investigation of the individual borrower's credit position, same as any other loan that you would look at, the condition of the security properties, adequacy of appraisals.
If you're not reviewing the reports provided by the service or that’s unsafe and unsound, because sometimes they are giving good reports, but nobody at the credit union’s looking at it as well. The originator is taking care of it while you still have the responsibility to look at that loan. You need to have all of the copies of the original documents. That's a requirement.
You should have all of the relevant documents. It could be some of the legal opinions and those types of things involved with the loan. Sometimes you could be looking to purchase loans with a higher yield. Certainly, the higher the yield, it usually means more risk. You have to make sure that you have evaluated why that yield is higher, or is it due to risk, and is that appropriate.
The higher the yield, the more risk.
If you're going to do participations, you might want to start off small and do a few and make sure that you've got all of the accounting and everything together versus saying, “We're doing participation loans. Let's do a whole bunch of them,” and then end up in trouble with your examiner. Those are the general unsafe and unsound things that can be brought up by getting involved in these programs.
On the topic of tiptoeing into a new product, NCUA always looks at things that you do new, how you are doing them. One thing I used to say was, “We want to see you crawl before you walk and walk before you run.” That's a good way to get into any program. You talked about the Call Report and make sure you fill that out. It's also my understanding that the ability to code on the 5,300 relative to eligible obligations, NCUA wasn't even asking the right questions yet.
I believe they've resolved that with this last cycle. I was having a conversation with a client who mentioned that change is frustrating for people. The new rules, the Call Report, and the new instructions, this one particular credit union, which is a pretty big credit union, was having some challenges deciphering this new call report.
I'm sure NCUA will work the kinks out. Those instructions can be complicated, especially when they're changed, but you do want to make sure you reported correctly. You talked about the agreements. I refer to bell curves all the time. There are good agreements, bad agreements, and mediocre agreements. That can run both ways.
They can be good for the seller but bad for the buyer, or good for the buyer and bad for the seller. You shouldn't negotiate those so that everybody in the agreement is treated appropriately. If you don't like what you see there, you should negotiate to get terms that make more sense for your credit union. You mentioned due diligence. I'll touch on that. There's a letter to credit unions on third-party due diligence.
It's pretty old now. That comes up in exams a lot. It's one of the things that you will see and cited as examiner findings are cited in document resolutions. You need to understand your third parties and you need to do due diligence relative to them. You hit the main points. Those are some that I wanted to highlight myself. We're getting closer to wrapping this up. We've talked about the regulations on both eligible obligations and loan participations. Are there any other resources that if someone wants to do their due diligence or consider getting into this if they haven't done so that you would recommend anybody look at?
I'll touch on the ones that I tend to spend any time on and share with anybody getting into this. Mark touched on the third-party letter. That one is from 2007 and 2008. NCUA issued an evaluating loan participant programs supervisory letter. That one is pretty good. It covers a lot of areas and it has a questionnaire in there that can be filled out.
It has a lot of questions and covers all of the areas that we talked about on this one. There's a narrative. It's very good on that. The other item that I go through, if you're looking for that one, it'd be Letter to Credit Unions 08-CU-26 from November 2008. The other item I look at any time that I'm dealing with the regulation is the preambles, the last major change to any of this rule.
Both 701.22 and 701.23 were published in June of 2013. You can go to the federal register and find the preamble, those rules from 2013. That contains a lot of the minutia that you might find helpful. The FDIC’s examination policies under the loan section do have parts that talk about long participations that seem to carry over pretty well, especially when it talks about risks that could be included in these types of products. Those would be a quick list of other resources.
Before we wrap this up, I want to touch on a couple of things you said there and make an analogy. You referenced FDIC and NCUA guidance. Credit unions are not required to follow FDIC rules, but reading them and coming away with an a-ha moment or something that you can use to supplement your program is worthwhile looking at as you build out your programs. The analogy I want to make is what I came up with when we were talking to Vin Vieten on commercial lending. Steve, you're good at highlighting and pulling things out of the preamble because the preambles can show what the intent of the board is.
What we pointed out in that last episode is you can look at the preamble of the proposed rule, and you can look at the preamble of the final rule to see what changed. There's also the final rule. If you look at a movie or a play that you go to, movies and plays have three acts. Using an analogy to regulations, the last act of regulation is the actual final rule. If you only watched the last 1/3 of a movie and looked at the final rule, you wouldn't really understand how you got to that point.
The preamble helps explain how NCUA got to that point. You can look at the preamble of the proposed, which I would view as the first act. I would view the preamble to the final as the second act and then the regulation as the final act. To understand the context of what NCUA is trying to do relative to the regulations, I would look at all three acts, the preamble of the proposed, the preamble of the final, and then the final rule. Steve, I appreciate everything you've talked about here. I want to thank you for your time. Readers, I appreciate you spending your time with us. I hope to have you read down the road for another episode. We'll talk to you again.