Credit Unions Need to Rethink Capacity

In the past couple of weeks, I have heard from several credit unions that were interested in purchasing a construction and development (C&D) participation, but they were being mindful of the NCUA cap of 15% of net worth.  These credit unions were concerned that if they approached their 15% cap, then they would be unable to fund other C&D projects for their members.  I think it is important to be mindful of this, but it is a concern that can be mitigated by using the CUSO for leverage.

For example, assume you are a credit union that has only $1 million in C&D capacity.  It is important to understand that if you have a member who comes to you with a $2 million C&D request, you can still lend to this customer.  How?  The obvious answer is to find a participant who can fund the other $1 million of C&D.  You can then fully fund the loan, but now, you will not be able to make any more C&D loans to other members who come to you with requests.

There is also another way to do this without exhausting your capacity.  Say that same member needs a $2 million C&D loan, and you still only have $1 million in capacity.  You may participate out the loan to other credit unions; however, to do this, you only need to retain 10% of the loan.  That means, you can lead the participations with 10% of $2 million, which is $200,000, and find participants for the remaining $1.8 million.  The advantage to this approach is that you now have helped your member fund a $2 million C&D loan while only using $200,000 of your C&D capacity.  Therefore, if you have another member who needs a C&D loan, you still have $800,000 in remaining C&D capacity.

If a credit union only has $1 million in C&D capacity and is willing to participate with other credit unions, the lead credit union actually has up to $10 million in C&D loans they can originate.  That is what we call “leverage” in the financial world, and it is a common practice.  When a credit union or bank makes a loan, it actually uses a small amount of its own money to make the loan, usually around 10%.  Where does the other 90% of the money come from?  It comes from your deposits, other peoples’ deposits and businesses who deposit money at that institution.  Depository institutions leverage their own capital with deposits as their primary means of getting business done, so a credit union with $1 million in capital can use $9 million in deposits to make nearly $10 million in loans!

Leverage is one of the fundamental principles that make financial institutions work, but it will require a paradigm shift to understand leverage goes beyond simply deposits and capital.  Leverage is always about expanding capacity with limited resources.  If a credit union already leverages their capacity to make loans by using deposits, why should they be hesitant or skeptical to leverage their C&D capacity through participations?  The lead credit union can remain the face of the relationship, and most importantly, be able to retain a relationship regardless of size and internal capacity.  Again, this is the fundamental principle of leverage, which a credit union or bank uses every day.

And as a side note to C&D limits, I think it is also important to mention that by choosing C&D projects wisely, the utilization of the C&D capacity can be relatively short-lived.  When I say choosing wisely, I mean taking on projects that result in income-producing properties and are well underwritten to deal with typical construction risks.  This will result in a relatively short-lived C&D loan, which means a relatively short duration of occupying C&D capacity.  A typical construction project should be completed within 12 months, give or take 6 months.  I think it is important to consider this too when you consider to fund a C&D loan.  It may count against your C&D limits, but it should only count against your limit for about 12 months.  And the best part is, after having taken on the burden of using your C&D capacity for a short time, you should be rewarded at completion by holding onto a relatively low maintenance asset with a decent yield for years to come.--Trevor Plett