Purchasing Loans and Participations to Enhance Earnings
By: Laura Pringle
September 18, 2012
On September 12, 2012, the FDIC issued a reminder (FIL-38-2012) titled FDIC Advisory on Effective Credit Risk Management Practices for Purchased Loan Participations. The issues covered in this Financial Institution Letter have been important for all financial institutions and particularly for community banks for many years. This reminder is timely for all financial institutions in view of the increased efforts to originate and purchase loans to gain earning assets. Also, the need to monitor those loans and participations which have already been booked is extremely important.
Discussion of New Emphasis on Current Requirements
The PRINGLE Safety & Soundness Program has since its inception several decades ago included provisions which are now included in this reminder. These loan policy and procedures requirements include effective loan policy guidelines, written loan participation agreements, independent credit analysis and review procedures, and a comprehensive due diligence process. This newly issued reminder includes the following recommended practices as described in this Advisory:
This Advisory is a reminder of the importance of underwriting and administering loan participations in the same diligent manner as if they were being directly originated by the purchasing institution and, specifically, the following practices are recommended to ensure that participation lending is conducted in a safe-and-sound manner:
Loan Policy Guidelines for Participations – The loan policy should outline procedures for originating and purchasing participation loans, require thorough borrower due diligence at origination and over the life of the participation, and mandate an assessment of the purchasing bank’s contractual rights and obligations. Commitment limits for aggregate purchased participations, out-of-territory participations, and loans originated by individual lead institutions should be considered.
Loan Participation Agreements – A written loan participation agreement should fully describe the lead institution’s responsibilities, establish requirements for obtaining timely borrower credit information, address remedies upon default, and outline dispute resolution procedures.
Independent Credit and Collateral Analysis – Banks that purchase participation loans should perform the same degree of independent credit and collateral analysis as if they were the originator.
Due Diligence and Monitoring of Participations in Out-of-Territory or Unfamiliar Markets – Management should exercise caution and perform extensive due diligence of participations involving an out-of-territory loan or credit facility to a borrower in an unfamiliar industry. Management should ensure the obligor, source of repayment, market conditions, and potential vulnerabilities are clearly understood and monitored.
Thus, each of these practices, which have been reemphasized in this Advisory, are again squarely before us for examination preparation.
Interagency Guidelines Address Purchasing Loans and Participations
The Interagency Guidelines Establishing Standards for Safety and Soundness, which were adopted on July 10, 1995, included provisions addressing credit risk program considerations for the purchase of loans and participations. Pursuant to those provisions, examiners were at that time, and consistently through the years, instructed to consider the following as examiners conducted their reviews of ongoing loan purchase programs:
- Third-party underwriting standards;
- Recourse arrangements with written documentation outlining the rights and obligations of each party;
- Lending limit implications;
- Bank review of third-party paper with independent analysis of credit quality;
- The Bank’s ability to reject loans under the program;
- Financial capacity of third party;
- Back room support;
- Termination clauses;
- Legal, accounting, and loan review analysis of the program; and
- Agreement by the obligor to make full credit information available to the selling bank and agreement by the selling bank to provide available information on the obligor to the purchaser.
These considerations continue to be important wherever loan participations are part of a strategic plan to increase earnings.
Lending Limit Considerations
As referenced above, there are lending limit considerations which are important to remember when purchasing and selling participations. Where a participation agreement provides that repayment must be applied first to the portions sold, a pro rata sharing will be deemed to exist only if the agreement also provides that, in the event of a default or comparable event defined in the agreement, participants must share in all subsequent repayments and collections in proportion to their percentage participation at the time of the occurrence of the event. Generally, it is required that when an originating bank funds the entire loan, it must receive funding from the participants before the close of business of its next business day. If the participating portions are not received within that period, then the portions funded will be treated as a loan by the originating bank to the borrower. If the portions so attributed to the borrower exceed the originating bank’s lending limit, the loan may be treated as nonconforming rather than a violation, if the originating bank had a valid and unconditional participation agreement with a participating bank or banks that was sufficient to reduce the loan to within the originating bank’s lending limit; the participating bank reconfirmed its participation and the originating bank had no knowledge of any information that would permit the participant to withhold its participation; and the participation was to be funded by close of business of the originating bank’s next business day.
Going forward, not only the previously cited provisions, but also these new reminders, will be cited and important for implementation to be prepared for upcoming Safety and Soundness Examinations. Proactively addressing these reminders in Board meetings and with loan underwriting staff and with those conducting independent loan review is strongly recommended.
This Article was also published at Wolters Kluwer’s Compliance Headquarters™ website: www.complianceheadquarters.com.