Participations: A Tool for Asset-Liability Management and Fee Income

When someone mentions a loan participation, you probably don’t realize how narrow of a definition you are creating in your mind. You are probably thinking about a new loan, in which you must sell some off to a credit union or purchase from another credit union. You are probably thinking this is necessary, because a credit union is faced with a limit on the amount of loans to one borrower. While the above may be a reason to engage in participating, it is only the tip of the iceberg.

While participations were likely started to manage around lending caps, sophisticated institutions have learned they play a more important role. These institutions are using participations to diversify their loan portfolio for the sake of spreading out industry risk and geographic risk. An institution may not be near their limit to one borrower, but perhaps that borrower brings additional commercial real estate exposure that adds to a mounting concentration in the same community. In this circumstance, an institution can sell off part of this loan to limit their exposure, and purchase a different loan in an unrelated industry in a different community to balance the risk.

The very fact that loans can be bought and sold present another significant balance sheet tool. Loans can be sold to free up liquidity, or loans can be readily purchased to invest excess liquidity. I have read several Funds Management policies, which suggest that loans could be sold as part of generating contingent liquidity, yet these institutions never bought or sold loans. For this tool to be effective, you need to identify partner organizations who can assist with this, such as a CUSO that manages participations.

Some institutions actively seek to participate loans as a way to generate additional income. An institution can make money through participating by collecting servicing fees and collecting origination fees. The servicing fee is collected out of interest income, and it is for the ongoing need to monitor and keep current documentation on the loan. This is a large responsibility, and will affect the credit quality of all loan participants, so purchasing institutions are hesitant to jump into bed with a seller, unless they are really trusting of the institution leading on the loan.

As you already know with origination fees, they are paid simply for the time and effort put into getting the loan approved and funded.  Participating helps rack up greater origination fees. Say your limit in lending to one borrower is $1 million. Say you make a $1 million loan and collect a 1% origination fee, so you will collect $10,000 for your hard work. And, you can’t lend to that person any more.

Now instead, assume you originate a $1 million loan and participate out 90% of it, meaning you only hold onto $100,000. You still originated a $1 million loan, charged a 1% origination fee and collected $10,000. That is $10,000 in fee income for holding onto a $100,000 loan. Not bad! In fact, you only are required to hold onto 10% of any participation loan, so you can make 10 loans for $1 million to the same borrower. That would allow you to generate $100,000 in origination fees for having the same $1 million exposure to the same borrower.

Harkening back to balance sheet management, an institution may participate out an existing loan so it may make a new loan to the same borrower. Not all loan participations need to be new loans, and there is a market for seasoned performing loans that have already been booked. You can book your limit to one borrower with one transaction, but then later sell out some of that loan to make room for a new project with the same borrower.

Now, we see that loan participations are a powerful tool for a number of reasons, and not simply a means to manage around a lending limit. They help diversify risk, create liquidity, create investment opportunity, and offer good fee income too!