In the areas of the country hardest hit by the recession and credit crisis, the loan participation market has dried up. It's a given that the economy has to improve in order to get the juice flowing, but bankers and other industry experts say that to get banks trusting each other again, participation deals will also need greater transparency, and better underwriting. Also, without a surge in core deposits, many banks will be reluctant to buy into loan deals originated by other banks.
Participations are important to community banks. By offloading some of the loan to other banks, an originating bank reduces its exposure to a certain sector or customer, while allowing it to retain the borrower's deposits. For participants — particularly those in markets with weak loan demand — such deals can be a means for deploying excess capital.
But loan participation also means a bank is piggybacking on another's risk — and may share the blowback as loans sour, as many banks found out in 2008. In its year-end earnings report, for example, First Commonwealth Financial Corp. in Indiana, Pa., blamed fourth-quarter loan losses on out-of-market loans originated by other banks. And Glacier Bancorp in Montana wanted no part of soured loans from participations when it agreed in February to buy National Bank & Trust in Wyoming. It structured the deal so that National Bank's bad loans stayed with the bank's owners.
James McKillop, president and chief executive of the Independent Bankers' Bank of Florida in Lake Mary, said that in recent quarters, bankers have become gun-shy about buying pieces of loans originated by other banks-and it's no wonder. In the fourth quarter, his bank charged off 2.6 percent of its loans, according to its fourth quarter filings. It had zero charge-offs in the fourth quarter of 2007.
McKillop said up until the second quarter of last year, Independent Bankers Bank, which has more than 315 banks as clients, was executing approximately $25 million per quarter in loan participations.
Then the economy really started to tank last spring and it took shared-loan deals with it. McKillop says that the $425 million-asset bank didn't invest a single dollar in participations in April and May. Activity hasn't returned to what it once was, he says, but it has picked up somewhat. It's now doing about $5 million in participation deals per quarter.
In order to get this market moving again, credit analysts have to be able to look at a loan that's outside of its market and feel confident that it's a quality credit. "Those degrees of confidence are very small right now," he says. Of the banks that have gotten back into the participation market in Florida, he adds, "they're still not interested in buying a loan participation that may not be easily understood or clearly describe the downside risks."
Bankers and analysts expect the loan participation market to return with a healthier economy, but with some added transparency in these loans that will eventually lead to greater confidence among loan officers to make these deals, says Luther Klein, senior manager at global consultant Accenture.
"It's going to return in earnest," he says. "As we move away from the credit crisis and the credit crunch you'll start really seeing a growth in this industry as individual banks will be more apt to try and de-leverage or reduce their risk in individual counterparties. With that said, you'll see more growth in the more standardized loan participation." That means a move away from more complex deals with unique language, more accurate reports and more accurate information, "so that they know the exact risks that they are taking," he says.
Increased funding is another necessity for a return to normalcy, says Patrick Redmond, president and chief executive of Viking Bank in Seattle. He says that as regulators have begun to look closer and clamp down on non-core funding sources like brokered deposits, banks are being forced to shrink their balance sheets.
Bankers are in dire need of deposits. Many bankers are simply shying away from loan originations if there is no potential to get the deposits that come with them, he says. The participation market won't come back "until the funding comes back in a way that banks are willing to do things on the margin or with less of a relationship," he says.
For this to happen there needs to be an increase in the amount of attractive loans in the pool. There's a mass hunt for good credit deals, which is driving down the interest rates on these loans, says Brad Copeland, chief credit officer at the $8.6 billion-asset Umpqua Bank in Portland, Ore.
"The deals that I'm seeing come through on a participation basis, if the credit quality is very strong then the pricing is very thin," Copeland says. "...In such a poor economy it's very difficult to participate in deals that show marginal profitability or that are bleeding red ink right now."
Of course, the market won't pick up until loan demand returns, says Steve Brown, president and chief executive of San Francisco's Pacific Coast Bankers' Bank. "You've got a lot of customers, small businesses, simply not putting a lot of growth into their own company," says Brown, whose bank has $683 million of assets. "As a result they don't need as much loan activity."
And those businesses that had taken out loans in the past aren't drawing on their lines of credit and are instead waiting for the economy to rebound, says William Fallon, president and chief executive of The Bankers' Bank of Kentucky in Frankfort. He says that his $61 million-asset institution has at least $12 million in unfunded commitments ready for construction projects that have yet to get underway.
Banks are particularly skittish about participating in construction and development loans. Silverton Bank in Atlanta (formerly The Bankers Bank) has been aggressive in buying into other banks construction loans and it paid the price when the housing market collapsed and construction ground to a halt. At Dec. 31, 10 percent of its loans were past due. Nexity Bank, a correspondent bank in Birmingham Ala, has been hammered so hard on losses from participation deals that it is said to be actively shopping for a buyer.
Still, some bankers' banks have managed to avoid the land mines by sticking to strict underwriting standards. TIB-The Independent Bankersbank in Irving, Texas, has clients in 47 states, including problem regions of the west and southeast, yet its net charge-offs and past due loans in the fourth quarter were well below industry averages. "We're pretty disciplined as far as staying in the things that we know," says Greg Todd, senior vice president and director of communications at the $2 billion-asset TIB.
And if shared deals have dried up in northern New England, James Delamater, the president and chief executive officer at Northeast Bank in Lewiston, Maine, hasn't seen it. He says activity at his $616 million-asset bank has picked up "substantially," as the conduit market has all but vanished and large banks have reined in lending.
"As those conduits have now either gone out of business or stopped doing business and those pools don't exist, we have clients that did their refinancing with these entities are now are desperate to find a bank to restructure or refinance their debt," he says. "Not only are we seeing more requests for participations but we're calling around to other banks and requesting more participations."