Loan Participations The good, the wise and the ill-advised

Loan Participations The good, the wise and the ill-advised

Presented by: Chris Vallez, CPAPartner Nearman, Maynard, Vallez CPAs, P.A.

One of the top five firms auditing credit unions over $40 million in assets per Callahan and Associates’ 2011 Guide to Credit Union CPA Auditors

Exclusively auditing credit unions since 1979

Performed thousands of credit union audits, hundreds of credit unions over $500m in assets

Nearman, Maynard, Vallez CPAs

Speaker Biography CHRIS VALLEZ, CPA

Chris is a Partner with Nearman, Maynard, Vallez, CPAs, P.A. A firm working exclusively with credit unions for over 30 years. As a Partner, Chris is responsible for all aspects of credit union audits. Over the last 22 years, Chris has worked on hundreds of audits.

In addition to being a Partner of the firm, Chris is Chairman of the firm's Accounting and

Auditing Standards Committee. The primary objective of this committee is to increase the production capability, efficiency, and quality of service offered by the firm.

Chris first volunteered on the AICPA’s Depository Institutions Expert Panel (2004 – 2007).

In 2005, he was asked to serve on the Steering Committee for the AICPA National Conference on Credit Unions and in 2007, was appointed the committee Chairman. Chris has assisted in the review of the AICPA’s audit guide for Depository and Lending Institutions, Financial Institutions Industry Developments Audit Risk Alert, and other documents.

Outline Loan participations, the basics

Accounting issues

Best practices

Regulatory issues

Case Study

What is a loan participation◦ Par-tic-i-pa-tion (noun) the condition of sharing in

common with others (as fellows or partners) Responsibilities of originator

◦ Underwrites the loan◦ Normally services the loans◦ Notify participants of changes in financial condition of

borrower, material changes in value or lien status of collateral, occurrence of default

Responsibilities of participant◦ Due diligence, funding ability, understand agreement

Loan Participations, the Basics

Nearman, Maynard, Vallez, CPAs

A tool for portfolio management Improves loan to asset ratio, yield Provides portfolio diversify Reduces concentration risk Increases credit availability to consumers

Might help to comply with regulatory requirements

Loan Participations, the Basics


Codification section 860 “Transfers and Servicing”

Transfers with continued involvement or no continued involvement◦ Servicing agreements◦ Recourse arrangements◦ Guarantee arrangements◦ Agreements to purchase/redeem transferred assets

Continued involvement might require accounting as a secured borrowing rather than as a sale

Accounting Issues

Requirements for sale treatment, the transfer must:◦ Be structured so there are proportionate

ownership rights with equal priority to each participant

◦ Have no recourse (other than standard representations and warranties) to any participant

◦ Have all cash flows divided proportionately among the participants, excluding servicing fees

◦ Not allow for the entire financial asset to be pledged or exchanged unless all participants agree

Accounting Issues

Participating interest must also meet the conditions for surrender of control

Violation of the surrender of control test would require secured borrowing accounting

Loan remains on originating credit union Originating credit union records borrowing Participating credit union records note

receivable Best to get a legal opinion to address the

isolation test given the NUCA’s conservatorship powers


Accounting Issues

Renewals, restructures, and modifications should be reviewed to determine if loan is “new” loan or continuation of “old” loan ASC 310-20-35-9 through 11

If “new” loan evaluate under 860-20 If “old’ loan, transfer would not need to be

re-considered Reserve in allowance account based on loan

type


Accounting Issues


Responsibilities and delegation of authority◦ Boards delegation to management◦ Management’s responsibilities

Approved activities◦ What circumstances can participations be entered

into Due diligence

◦ Due diligence of third parties◦ Review of loans to be purchased◦ Minimum IDC rating

Elements of the participation agreement

Best Practices - Policies

Perform independent credit analysis of borrower Perform independent underwriting analysis of loan Understand the loan, collateral, liens, business

plan Understand participation agreement, especially in

case of default and legal remedies Run searches on the background of borrowers Perform property level due diligence Each loan will require its own level of due diligence


Best Practices – Due Diligence

Know your risk tolerance Ideally, the loan originator should share

similar underwriting standards and risk tolerance as the participant

Know the ability of other participants to fulfill there funding obligations, especially important in a construction loan

Beware of brokered loans Maintain portfolio diversity


Best Practices – Due Diligence


Participation agreements should address

Terms and conditions of the participation

Affirmative representation and warranties

Applicable disclaimers Expectations of each party Address the event of default

Loan Participation Agreements

Current rule 701.22, 701.23 & 741.8◦Limits investment in participations

individually and in aggregate◦Requires a written master participation

agreement◦Puts in place requirements of the originating

and purchasing credit unions◦Rules on purchase, sale and pledging of loans◦Limits the institutions a credit union can

purchase loans from

Regulatory Issues

Proposed rule change, Dec 15, 2011◦Reason for proposed rule◦Focus on those purchasing loan participations◦Details regulatory expectations◦Also addresses: loan participation policy loan participation agreement ongoing monitoring of loan participations

◦Focus on natural person credit unions, corporate credit unions subject to section 704 of R&R

Regulatory Issues


Prevents purchase of loan originated with less stringent underwriting standards

Adds maximum limit on participations and concentration limits

Limits are measured based on net worth rather than unimpaired capital and surplus

Concentration risk:◦ Same originator (25%limit) (since repealed)◦ One borrower or group (15% limit),◦ Types of loan (e.g., industry or loan product)

Regulatory Issues


Participation agreement must clearly delineate the roles, duties, and obligations of all parties ( originating CU, servicer, and participants)

Agreement must include notice and disclosure of ongoing financial condition of the loan, borrower and servicer

Agreement must specify the loan(s) to be purchased

Rules apply to all federally insured credit unions

Regulatory Issues

Information included herein is from the NCUA’s “Material Loss Review” report #OIG-09-01

Norlarco Credit Union chartered in 1959 to serve employees of Colorado State University

May 15, 2007 CU placed into conservatorship Nov. 2007, NCUA accepts bids selecting Public

Service CU Feb 2009, CU liquidated

Norlarco Credit Union


Late 2001, CU begins program with First American to finance and service construction loans

August 2003, agree to fund $30m per month, partly due to low demand in auto and home equity LOC loans

Agreement required First American to◦ Obtain permanent financing at loan’s maturity ◦ Buy back loans that cannot get permanent financing◦ Make interest payments on loans > 45 days past due



Dec 2003, First American enters into agreement with Palm Harbor in which Palm Harbor agrees to buy back loans that cannot get permanent financing

Oct 2004, RCL program begins to fund construction loans in Lee County Florida

Oct 2004, First American enters into agreement with First Home Builders of Florida (FHBF). FHBF makes significant financial commitments until permanent financing obtained



Description 12/02 6/04 9/05 3/06 9/06 12/06 3/07

CAMEL 2 3 3 3 3 3 4Net worth 9.28% 8.86% 8.03% 8.42% 9.33% 9.49% 8.63%Delinquency 1.89% 2.41% 1.19% 0.76% 0.95% 0.83% 2.14%Net Chg.-offs 0.28% 2.07% 1.27% 0.77% 0.80% 1.21% 1.21%Opt. expense 4.45% 3.84% 3.65% 3.25% 3.35% 3.38% 3.54%Asset growth 13.49

%-2.80% 25.51

%-5.19% -8.06% -6.12% .32%

Loan growth 8.28% -15.0% 46.39%

74.36%

15.29%

11.69%

-6.69%

Ratios

Failed to conduct a due diligence review of its relationship with its third-party vendor

Failed to adequately oversee the RCL program Created a concentration risk by committing to

fund $30 million per month in construction loans

Failed to develop an adequate Asset-Liability Management (ALM) policy

Failed to develop adequate policies and a strategic plan to guide the RCL program

Norlarco Management Errors


Lack of oversight in RCL program resulted in:◦Overreliance on guarantees,◦Underreported delinquencies,◦Misclassification of loans, and◦Declining borrower credit quality



Created a concentration risk by committing to funding $30m per month

Concentration risk in a single residential construction lending program

Geographic concentration in Lee County Failed to develop an adequate ALM policy Failed to develop adequate policies and a

strategic plan



Financial condition of the institution is no guarantee of future performance

An inattentive or passive Board is a precursor to problems

The Institution may reach a point at which problems become intractable and supervisory actions are of limited value

Observations and Lessons Learned

Management actions created credit, liquidity compliance, and strategic risks

Specifically, ignoring sound risk management principles by committing a significant portion of assets to a risky Residential Construction Lending (RCL) program without adequate controls in place to oversee the program’s daily operations

Management Errors

Management’s poor strategic decisions over its lending practices, as well as the inability to find adequate funding sources to meet commitments, created risks that Norlarco management did not, or could not, effectively manage

Eventually, management’s inability to effectively manage the risks its own actions had created, led to Norlarco’s failure

Management Errors

Did not view the participation program and the participation agreements as safety and soundness concerns fraught with risk

Did not associate the rapid rise of loans sold through participations as a potential safety and soundness concern to Norlarco, or to the NCUSIF,

Notes on Examiners

Conclusion Perform appropriate due diligence based on loan type

Know who you are doing business with

Know the participation agreement Monitor performance

Questions and answersChris Vallez, [email protected]

Documents

Loan Participations The good, the wise and the ill-advised