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.
The second major reason for the outsized losses was the reliance by purchasers on the underwriting by the loan originator. This is an issue that did not arise in this last economic meltdown, one can look back to the collapse of the Penn Square Bank in 1982 to see the damage caused by overreliance on the lead bank’s underwriting. Penn Square had grown its assets from $62 million in 1977 to $520 million in 1982, primarily through extensions of credit to the oil and gas industry. It soon became apparent that there was a healthy appetite from other banks across the country for loan participations that Penn Square was selling. When Penn Square failed it was servicing roughly $2 billion in loans it had sold participation interests to much larger banks such as Seafirst and Continental Illinois. Continental Illinois alone had purchased $1 billion in loan participations from Penn Square. Continental Illinois was the 7th largest bank in the US when it later failed.
The responsibility to underwrite the loans or loan participation being purchased is a key to managing the credit risk. The Financial Institution Letter sums it up as follows:
Financial institutions that purchase loans or participations should perform the same degree of independent credit and collateral analysis as if they were the originator. To do so, it is necessary for the institution to ensure it has the requisite knowledge and expertise specific to the type of loans or participations purchased and that it obtains all appropriate information from the seller to make an independent determination. The institution should perform a sufficient level of analysis to determine whether the loans or participations purchased are consistent with the board’s risk appetite and comply with loan policy guidelines prior to committing funds, and on an ongoing basis. This assessment and determination should not be contracted out to a third party.
Interestingly, we have recently seen a move by some buyers to add a paragraph to the loan participation agreement or whole loan sale agreement to the effect that the buyer is specifically relying upon the loan originator’s underwriting. In effect, the buyer wants to simply outsources all of the loan underwriting to the originating lender. What could go wrong? Well, first of all, it puts the buyer in the headlights of the FDIC immediately. There is no question that such an institution runs a high risk of being cited for unsafe and unsound banking practices in its next regulatory exam. Some banks may simply be unaware of the regulatory guidance in this area. Sometimes the cause may be the fact that one of the parties is using a lawyer who may be well versed in real estate and contracts law but who does not have the necessary banking law background to understand the implications of such a provision. While the fundamental concept of a loan sale may be easily enough understood by a commercial lawyer, a bank really needs counsel from a lawyer who understands the regulatory overlay when drafting participation or loan sale agreements.
Assuming for a moment that the regulators did not have an issue with shifting to the seller the responsibility for underwriting the loan, the seller should, if it thought it through, push back very, very hard. While sellers generally find it acceptable to give certain limited representations and warranties about the loan documents, a representation about loan underwriting can dramatically increase the originating seller’s potential liability if the loan later becomes troubled. Of great significance to the loan seller is the fact that claims for negligent underwriting can pose the risk of punitive damages being assessed against the originating lender. That additional level of lender liability risk is not something that the originating lender generally factors into its pricing for the sale of the loan participation or whole loan.
In our practice representing financial institutions we have come across a myriad of variations of loan participation and loan sale agreements. We have advised both buyers and sellers and understand the business and regulatory issued involved in such transactions. We understand not only the importance of the right language on the front end but we also understand the issues that can arise in the servicing of loans.