January 7, 2016
Authored by: Jerry Blanchard
Watching loan participation activity over the last decade has been like watching the progression of a car on a roller coaster. The early to mid-2000’s showed the car heading ever upward and then in 2008-09 it hurtled downwards at breakneck speed. The last several years have shown a resurgence as the car begins climbing slowly back up the track. Not surprisingly, the FDIC has taken notice of that trend and issued a Financial Institution Letter on Effective Risk Management Practices for Purchased Loans and Purchased Loan Participations in November of 2015.
The reasons why lenders want to sell either loan participations or whole loans and others want to purchase them remain the same today as they were a decade ago. Sellers may have loan to one borrower issues that a loan participation may cure, they may be seeking to reduce overall exposure to a particular borrower or industry or they may find that providing loan product for other institutions is a profitable venture as it may generate gains on sale as well as servicing income depending on how the sale is structured. Buyers are looking to broaden their geographic and industry diversity in order to better manage the overall credit risk inherent in their portfolio and it may be more cost-effective to source loans from another lender than trying to originate them yourself. Another, more recent development, has been the purchase of loans from peer-to-peer non-bank lenders who operate on a national basis.
When the US economy hit the skids in the 2007-2010 time frame with its corresponding bank failures, it became clear that in many situations loan participations had not generated the expected benefits. There were several reasons for this, the most significant being that simply obtaining geographic diversity of ADC loans still left a lender susceptible to outsized losses when that segment of the economy ground to a halt. Too many community banks failed to realize that true diversity in a loan portfolio means that ADC can only be a portion of the entire portfolio, not the entire portfolio, even if you have geographic diversity. The perceived reduction in risk was therefore illusory.