Much of our financial and banking system is based on the concept of shared risk. If a person comes into a credit union to get a home mortgage, the duration risk of a 30 year loan is shared by passing it on to the secondary market. If a business loan is short on adequate history or collateral, that risk may be shared with the SBA or a USDA government agency. When a young farmer wishes to purchase land, equipment, or livestock, that risk may be shared between the lender and the FSA.
For years, credit unions and banks have been able to share risk between each other with the use of participating portions of loans to the others. This participating of credit has provided great benefit to the participating institution. If they are in a growing area, they are able to serve larger numbers of customers than they would otherwise. They are also able to avoid concentration risks easier with one borrower, a set of borrowers, a geographic area, or within an industry. This is done while the institution keeps its relationships and earnings with valuable clients.
There is also benefit to the institution with excess capital that wishes to increase its yield on good earning assets that may not be adequately available within its trade area. They may seek a higher rate than one can find on Treasury or Agency issues. After all, strong, adequate earnings are essential to the long term success of an institution. I think all of us are aware that the margin on auto loans is not very conducive to producing even average earnings in today’s world. And while placing funds in safer investments like Treasuries may make you sleep well at night, the lack of solid earnings and interest rate risk associated with long term bonds could be problematic.
I am not advocating placing all your institution’s assets into participation loans. But, I do think a balanced diet with some of these is beneficial to the health of the institution, just like a balanced diet is good for your personal health. But there are several things the buyer should know before plunging right in.
Know your lead institution and servicer. You should have adequate knowledge of the lead lender in the deal and also who will be servicing the credit. This will start with a good loan file that is well documented and explained. Watch how the files are managed to gauge the comfort level of the servicer. If you have a lender or a servicer who cannot defend their loan that is probably not the loan seller you want to be with. I often request that the investors on the loans we service, contact us with any questions they have with the credit.
Know your industry. You should have a good knowledge of the company’s industry. This should be something that is defensible if you decide to invest your money into. A danger here would be to invest into an industry that you have no knowledge of, like a taxi cab medallion or loan to an oil service company if you have no understanding of the industry.
Know you have to underwrite the loan as if it were originated by you. This is necessary to fully understand the credit, company, collateral, and sponsors. If you can’t underwrite it; you probably should not do it.
Know you will face greater scrutiny with participation loans. It is a fact that a participation loan to a regulator is like a red cape to a bull. Investing in these will invite greater scrutiny even though the use of participating lending is advocated by regulations as a way to help manage risks. This forces the buyer to understand the credit and be able to defend why it is prudent to invest in it.
Shared risk with participation lending is a challenge but also can be quite rewarding if handled correctly by all parties involved. The loan buyer has the ability to reap great results for the furtherance of their institution with good participations.