Participation loans are back en vogue, leaving some to wonder if bankers have learned from past mistakes.
Banks are eager to put deposit funding to use, prompting some executives to give loan participation a second chance. Still, it's debatable whether banks are exercising enough restraint with these credits, given their dubious history during the financial crisis.
Bankers say they are generally more conservative with underwriting standards, and some industry observers argue that lenders are requesting much more documentation while completing more thorough due diligence. But there could be a loosening of standards as bankers get more aggressive in the pursuit of higher yields, some observers warn.
"I would be surprised if there were any fundamental changes," says Terry Keating, executive vice president at Accord Financial. "The risk you have when buying into participations is the fact that you have much less control over your destiny if things go bad."
As interest rates remain low and many borrowers stay cautions, banks are considering participations to grow and diversify loans books. Interest in joining credits has outpaced growth in the number of banks that are looking for participants in a loan, industry observers say.
Generally, banks "want to keep as much of a loan as they can on their books," says Steven Brown, president and chief executive of Pacific Coast Bankers' Bancshares in Walnut Creek, Calif.
CenterState Banks (CSFL) in Davenport, Fla., has received stronger than expected interest in a recently launched effort to make commercial loans available to community banks, says Chris Nichols, the $2.4 billion-asset company's chief strategy officer. BancAlliance, which helps connect its members with loan participations, had its first member-originated credit earlier this year.
Despite growing interest, memories are still vivid of the financial crisis and problems that stemmed from troubled participation loans. Silverton Bank's failure in May 2009 caused a number of smaller banks who participated in the Atlanta bank's loans to take losses.
Participation loans do not deserve such a bad reputation, some industry observers say. Banks that are doing participations are largely avoiding speculative deals. They instead want commercial-and-industrial loans, rather than the construction and land development credits that were prevalent before the last recession, they say. Floating rates are also very attractive.
"In the C&I world, it might be less important where the borrower is headquartered and banks are more focused on the company's business model," says Lori Bettinger, president of BancAlliance. "If one company is acquiring another, they want to make sure the deal makes sense. Does the combined company generate enough cash flow?"
Executives are conducting more due diligence and requesting more documentation in a more formalized manner than before, Brown says. It might even make sense for a community bank to buy a participation beyond its market to diversify as long as the bank fully understands the borrower and the associated risks, he adds.
Heightened regulatory scrutiny should also help keep underwriting in check, some experts say.
Banks considering joining BancAlliance are usually concerned about how loans are resolved if trouble sets in, Bettinger says. In the past, this process could be chaotic, so BancAlliance developed a system to make it smoother. The group also encourages its members to clearly define their risk appetite and then underwrite any participations themselves, she adds.
"Anyone we speak with says, 'We need to do our own underwriting,'" Bettinger says. "Banks are very focused on that and I'm not sure if nine years ago that would have been at the forefront."
CenterState launched its "National-to-Local Loan Program" in April, where it buys into larger credits on the secondary market and then sells off parts of those to other banks. CenterState is focused on buying loans with the top three leaders in a given industry, such as health care.
Despite solid interest, some community banks have lingering concerns, Nichols says. These loans are often with huge corporations so a community bank wouldn't have a relationship with the borrower. Some banks also lack the expertise to underwrite the loans.
If the loans were to go bad, the smaller banks would have little say in the outcome. (For instance, CenterState may buy a $100 million piece of a $2 billion credit facility.) In these circumstances, a bank with a small piece of the credit has little say.
Still, the rewards could outweigh the risks, Nichols says. The participations are a way for a small bank to efficiently diversify. The risk profile of these credits is also "better than the average community bank credit," he says.
"You can look at your balance sheet and design the exposure you want," Nichols adds. "We like these credits for diversification but banks need to feel comfortable with the underwriting and understand the businesses."
But concerns linger that banks will revert to their bad habits. Before the financial crisis, banks got involved with participation loans outside of their core markets without understanding regional economic factors, Keating says. Terms and rates also deteriorated.
This could happen again as there a temptation to chase yield or growth, says Randy Dennis, president of DD&F Consulting Group. Also, relying on the "underwriting of the originating bank is a habitual problem," he adds. Dennis, who has looked at dozens of failed banks in recent years, says soured participation loans were frequently "the No.1 issue."
"There are groups pitching participation loans as a good source of quality loans but for a good loan there will be a low yield," Dennis says. "Instead banks want 4% or 5% and that makes me nervous."