Loan Participations: Lessons Learned During a Period of Economic Malaise
by Michael Poprik, Managing Examiner, Community and Regional Supervision, Federal Reserve Bank of Richmond
In the past, some community banks viewed loan participations as an effective way to diversify risk, supplement organic loan growth, leverage another lender’s expertise, or gain access to a market segment. However, these exposures also posed risks that may not have been apparent until it was too late. During the recent economic downturn, some banks experienced stress in their loan participation portfolios. As a result, many community banks reduced their exposure to loan participations and have since vowed to participate only in "good deals" going forward.
The most common type of loan participation is an agreement that transfers a stated ownership interest in a loan to one or more banks or other entities. The lead bank typically retains a partial interest in the loan, holds all loan documentation in its own name, services the loan, and deals directly with the customer for the benefit of all participants.1 Based on this structure, a participant may believe that the lead bank, not the participant, is responsible for the bulk of underwriting and credit risk management of the participation. Regulators, however, expect each participant to maintain a robust risk management program regardless of whether loan participations are purchased or sold. During the last period of precrisis economic growth, participants’ understanding and risk management of purchased loans often failed to meet these expectations, resulting in purchased loans that were not well understood or monitored.
As community banks reenter the lending arena, some institutions are considering purchasing loan participations because local loan demand remains weak. Therefore, the timing is right to discuss sound principles of risk management for portfolios of loan participations. This article offers several ways to strengthen board and senior management oversight of loan participations, including:
- Establishing and following sound policies and procedures
- Applying the bank’s own underwriting standards, policy limits, and monitoring guidelines
- Diversifying the bank’s loan portfolio
- Being wary of lending outside of the bank’s areas of expertise
- Avoiding entering into a relationship that is too complicated to understand
- Knowing the agreement details, including the lead bank and all participants
- Understanding how the participation will be sold
Establish and Follow Sound Policies and Procedures
During the period of economic expansion that preceded the most recent downturn, sound lending policies and procedures were often bypassed as banks sought to grow their loan portfolios. For example, many community banks sought to capitalize on the benefits associated with rising real estate values even when those values were rising most rapidly outside of their local markets. Therefore, many banks purchased loan participations, some of which resulted in concentrations in real estate loans that were located in distant and unfamiliar markets, were not well underwritten or managed, and were of questionable value, which ultimately led to loan losses.
Effective risk management for loan participations includes establishing board-approved policies and procedures. These policies and procedures should ensure that management:
- Limits the aggregate amount of loans purchased from and sold to a single outside source;
- Limits the total amount of loans purchased and sold;
- Limits the aggregate amount of loans to particular industries;
- Ensures that participation agreements with originating banks are comprehensive;
- Completes a thorough analysis and documents the credit quality of obligations purchased;
- Completes a detailed analysis of the value and lien status of the collateral;
- Complies with appraisal regulations and guidelines;
- Maintains full, independent credit information on the borrower throughout the term of the loan;
- Applies appropriate underwriting standards; and
- Documents collection procedures.
Apply the Bank’s Own Underwriting Standards, Policy Limits, and Monitoring Guidelines
One aspect of loan participations that was often overlooked during the period leading up to the recent downturn was the need for purchasing banks to apply their own underwriting standards, policy limits, and monitoring guidelines to each participation purchased. While it may seem convenient to accept a credit package prepared by another bank, it is imprudent to assume that the other bank’s underwriting and documentation standards are sufficient. The information provided to the participant typically presents the credit in the best light possible and is meant to sell the participation and provide funding for the loan. The purchasing bank may also find it helpful to understand the relationship the lead bank has with the borrower and how much credit exposure the lead bank is willing to retain.2 This may provide some insights into the lead bank’s overall view on the quality of the credit.
When considering a loan participation, bank management should conduct its own due diligence, including a thorough review of the loan purpose, repayment sources, borrower and guarantor financial information, and collateral coverage. If real estate is taken as collateral, appraisals should meet regulatory guidelines and be reviewed by the purchasing bank’s appraisal review function for reasonableness. A bank considering a loan participation should not assume it has been provided with all the information necessary to make a prudent decision. Bank management should independently gather and assess all necessary information before making a decision.
For example, one bank in the Fifth District found out the hard way that if a participation is for a construction project, bankers should visit the site to verify that work is being completed as reported by the borrower and the firm hired to sign off on the draw request. In this case, the bank had a project that was fully funded when only a small amount of work had actually been completed. The banks turned to the guarantor for support, but the guarantor, a well-known property developer, was arrested and ultimately sentenced to 16 years in prison for fraud relating to a historic tax credit program. In retrospect, there were red flags that, if noticed sooner, would likely have made banks more cautious about participating in projects involving this guarantor.
It is also critical to understand all loan agreements. In some cases, limited guarantees turned out to be even more limited than anticipated. In one instance, individual guarantors called upon to provide support noted that their limited guarantee applied to the entity that owned the borrowing entity. As such, their limited guarantees were reduced even further by the ownership structure of the borrower. Unfortunately, the bank participants were left without the level of protection they thought they had negotiated.
Diversify the Bank’s Loan Portfolio
Loan participations can be an acceptable method to diversify a bank’s loan portfolio. However, management should consider various factors to ensure that purchased loans’ risk exposures are different than the loans currently in the bank’s portfolio. During the pre-crisis rise in real estate values, management of some banks believed that real estate loans purchased out of their loan market would diversify their exposure to real estate-related loans. It turned out, however, that real estate location alone did not necessarily provide that desired diversification. For example, making loans on oceanfront condominiums in the Outer Banks of North Carolina is similar to making loans on oceanfront condominiums in Hilton Head, South Carolina, because each location is primarily impacted by the same economic driver: tourism. An honest assessment of the economic drivers of each market is key to ensuring diversity in loan participations. Additionally, a bank could be better served by limiting aggregate risk to industries and diversifying the portfolio by participating in more than one loan type (for example, commercial real estate).
Be Wary of Lending Outside the Bank’s Area of Expertise
It is easy to assume that a lead bank offering a loan participation is knowledgeable about the industries it is underwriting. Bank management should keep in mind that credit memorandums are designed to gain approval by the board loan committee and may oversell the positives. In addition to reviewing the credit information with a critical eye, bank management should complete its own underwriting. The underwriting process may reveal that the participating bank is lending outside of its area of expertise. For example, during the recent downturn, some agriculture-focused community banks found that their efforts to diversify by buying participations in out-of-area commercial real estate projects led to significant problems. While the projects were not overly complex, the banks lacked the expertise and experience in the business line to accurately assess the risks of the individual projects. By not having the proper expertise, coupled with limited control and borrower access, these banks frequently ended up with little control over collection activities.
When purchasing participations, the bank is purchasing both a specific loan and a relationship with the lead bank and all other participants. It is imperative to understand with whom the bank is doing business.
Avoid Entering into a Relationship That Is Too Complicated to Understand
Examiners reviewing loan files occasionally identify a loan relationship as "too complicated to understand." This informal phrase is used when an examiner believes the bank has entered into a complicated loan participation without fully understanding the credit, borrower, collateral, or guarantor. This often occurs with purchases of larger loans with more complex or financially savvy guarantors than would be typically seen at a community bank. To assist the bank in calculating a global debt service coverage ratio, these guarantors often provide tax returns that are delivered by the truckload, leaving bank lending personnel to piece together their numerous inter-related limited liability companies with information that may or may not reflect their current status.
In lieu of deciphering complicated tax returns, bankers in these situations often limit the guarantor analysis to a review of the personal financial statement, especially if that statement shows substantial net worth. This practice has proved to be risky. For example, if the guarantor is a real estate developer, its net worth may be overstated if it relies on inflated real estate values and lacks information on contingent debt. During the real estate downturn, the net worth of many real estate developers promptly vanished, and no guarantor support could be provided because contingent liabilities on other real estate projects were greater than the value of real estate the bank had financed. Also, any liquidity the guarantor reported often disappeared to service other debt. If a bank is not able to understand and clearly present the purpose for the loan, how it will be repaid, the operations of the business, and what support the collateral or guarantor provides, it may want to reconsider whether the loan is worth pursuing.
Know the Agreement Details, Including the Lead Bank and All Participants
When purchasing participations, the bank is purchasing both a specific loan and a relationship with the lead bank and all other participants. It is imperative to understand with whom the bank is doing business. The purchasing bank should ensure that the lead bank has the expertise and staff to appropriately administer the credit, determine how the lead bank will handle a workout situation, and know what the rights are under the participation agreement, particularly in the event of default. In addition, the purchasing bank should ensure that participants have a say in restructuring the debt and should understand that the smallest bank in the group may have a very different perception of what an appropriate workout situation looks like versus the largest participating bank’s perception.
For example, a bank purchased a participation in a condominium project that was out of its market area. The bank purchased a small piece of the large credit and had participated not just with smaller community and regional banks but with a large financial institution as well. The building was completed, but because of the downturn in the real estate market, all of the original buyers of presold units canceled their contracts with only nominal penalties, and the guarantors did not provide meaningful support. The large financial institution’s workout strategy was to liquidate the property as quickly as possible in order to redeploy the funds tied up in this nonearning asset. The smaller banks, however, could not accept the losses related to this liquidation scenario. Because of the structure of the participation agreement, their voice was not heard, as the controlling interest could dictate the terms of any restructure or workout plan. To minimize their losses, the smaller banks ultimately opted to buy out the large financial institution’s participation in order to take a more measured approach to liquidation. While the potential loss on this loan would have been a pittance for the large institution, it could have wiped out over a year’s worth of earnings at the smaller banks. To minimize their losses, the smaller banks wound up taking on more risk than was originally approved when the original participations were purchased.
Understand How the Participation Will Be Sold
While the primary focus of this article is on expectations for managing purchased loan participations, there are similar expectations for how the participation will be sold. Specifically, the same underwriting and diversification guidance noted above are applicable, but the difference is in truly understanding the legal obligations of a lead bank. The participation and loan agreements identify what information the lead bank is responsible for delivering to participants. Most often, this includes periodic financial information and correspondence with the borrower, among other items. Loan agreements tend to vary and could include quarterly debt service coverage covenants or specific construction draw requirements that must be monitored or executed by the lead bank. Failure to execute duties set out in participation agreements can subject the lead bank to legal risk, as participants might surmise that a borrower’s deteriorating repayment prospects are related to improper administration or covenants that are no longer effective because they were never enforced. A bank acting in a lead capacity should ensure it has the resources and expertise necessary to properly administer credits and adhere to participation agreements.
Many institutions used loan participations inappropriately during the period of economic expansion before the recent financial crisis. Sound underwriting standards and risk management were, at times, ignored in a quest for increased earnings. While loan participations can play a meaningful role in managing a bank’s loan portfolio, they should be approached as any other credit, with a systematic use of sound underwriting and risk management practices that balance the risk and reward of these relationships.
This list of best practices is not inclusive, and community banks are encouraged to review relevant regulatory guidance3 on this issue, including risk management guidelines found in the Commercial Bank Examination Manual.4
- 1 Loan participations can also be structured with several lenders coming together to each fund a share of the loan. In these cases, each lender documents its own share of the exposure and maintains its own relationship with the borrower.
- 2 While it can be a positive sign when the lead bank chooses to retain a large credit exposure, some smaller banking organizations may be unable to retain as large an exposure as the lead bank, for example, because of legal or internal lending limits, even when the bank has a very favorable view of the borrower and the credit.
- 3 See guidance on the Federal Reserve Board’s public website, for example, at www.federalreserve.gov/bankinforeg/topics/topics.htm.
- 4 See www.federalreserve.gov/boarddocs/supmanual/cbem/cbem.pdf.