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
Nearman, Maynard, Vallez, CPAs
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
Nearman, Maynard, Vallez, CPAs
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
Nearman, Maynard, Vallez, CPAs
Accounting Issues
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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
Nearman, Maynard, Vallez, CPAs
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
Nearman, Maynard, Vallez, CPAs
Best Practices – Due Diligence
Nearman, Maynard, Vallez, CPAs
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
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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
Nearman, Maynard, Vallez, CPAs
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
Nearman, Maynard, Vallez, CPAs
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
Norlarco Credit Union
Nearman, Maynard, Vallez, CPAs
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
Norlarco Credit Union
Nearman, Maynard, Vallez, CPAs
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
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Lack of oversight in RCL program resulted in:◦Overreliance on guarantees,◦Underreported delinquencies,◦Misclassification of loans, and◦Declining borrower credit quality
Norlarco Management Errors
Nearman, Maynard, Vallez, CPAs
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
Norlarco Management Errors
Nearman, Maynard, Vallez, CPAs
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]
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