Lessons In Due-Diligence In Buying, Selling Loan Participations

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Credit unions know the loan participation market can be a useful tool both for buyers looking for an investment and sellers seeking improved liquidity.

What they may not know, however, is how to go about doing the due-dilegence.

That was the message from Matt Morris III, who led an educational session at WesCorp's Credit Union Outlook 2004 conference. Morris is an investment services consultant for WesCorp.

"Loan participations offer great opportunity at minimal risk," he said. "Sellers sell loans as a management tool. They do so to avoid borrowing. It allows them to fund ongoing loan demand without moving their balance sheet around. On the purchase side, everyone wants to buy loans right now. Loan participation offers competitive investments for credit unions."

The genesis of loan participation was in NUCA Regulation 701.22. The regulation defines loan participation roles, as well as requirements for both the originating CU and those looking to purchase.

But one issue not specifically mentioned in 701.22 is due diligence. Morris said "doing the homework" should be regarded as mandatory whether buying or selling.

For CUs looking to sell loans, Morris' suggested checklist has two columns: "infrastructure" and "data." The infrastructure side includes obtaining board approval and performing a thorough review of key policies, such as lending, collection and ALCO. The data side consists of generating key loan figures, a credit data model, monthly payment data, performance history and complete loan files.

On the operational side, he recommends sellers draft a "master loan participation agreement" for consistency. In addition, CUs should have written loan sales objectives, target loans and pricing objectives. "It takes time to get documentation reviewed because the process possibly involves using outside counsel," Morris said.

The checklist he recommends to CUs looking to purchase a loan participation is similar to that for sellers. The infrastructure column likewise includes obtaining board approval and reviewing ALCO and loan participation policies. In addition, Morris advises a uniform purchase approval process and a standardized list detailing which loans are acceptable material for purchase.

Buyer Beware

Instead of a data column, Morris' checklist for loan purchasers has an "operations" column. This consists of gathering legal documentation, clarifying pricing, developing an understanding of seller, broker and servicer roles, tracking performance, and performing due diligence.

"When analyzing the seller, it is very important that a credit union understand what it is buying," he said. "For example, if a credit union is purchasing auto loans, it must find out if those include loans for recreational vehicles or motorcycles."

"As part of due diligence, it is important to challenge the performance assumptions," he continued. "Payment method is something many people don't ask about. If a credit union expects car payments to arrive monthly, but doesn't ask, it might get them weekly or bi-monthly. This disrupts cash flow and causes difficulty for the accounting department."

Morris said WesCorp has its own loan participation program and has learned the value of doing homework. He said WesCorp is a principal, not a broker-it buys the participation and puts it on its books.

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