FRESNO, Calif. - Their numbers may be small, but some credit unions looking to diversify their mortgage portfolios in the midst of a low-interest rate environment are reaping the benefits of a loan participation program. Though only 6% of all credit unions hold participations loans, some have seen their loan-to-share ratios increase by an average of 2.5% as of the first quarter of 2003, according to Callahan & Associates. Industry watchers still consider the loans to be in the infancy stage for credit unions even though they've been around for more than a decade. "They've been around for 10 years but a key benefit to buyers, especially now, is the cash flow aspect of participations as an investment," said Jim Mulford, president of Jim Mulford Consulting, a loan participation broker. "With interest rates where they are, you want your money back quickly to reinvest as rates climb back up." The way a loan participation program works is a credit union, which can be either the seller or originator, locates a conglomerate of loans that may share similar traits such as rate or type. The average term and weighted average yield are identified so that the rate and term of the participation can be determined. NCUA stipulates that the originating credit union keep a minimum of 10% of the loan. Generally, when establishing a new relationship with a lender, a participating credit union may share the risk equally with a 50/50 split. As a result, the participant credit unions or the purchasers of the loan, retain essentially the same rights, share the same risks and reap the same rewards as the originating credit union. There is a perception that loan participation is a viable option for credit unions in the midst of tight liquidity crunches and while that may be true, some find that a loan participation can offset a mortgage-laden portfolio, Mulford said. By participating off a portion of the mortgage slice, a credit union can obtain a more stable diversification. Likewise, those looking to improve their return on assets, can use a process that allows for the same funding to be reused to generate fee income. Paragon Financial Group, the CUSO for Paragon Federal Credit Union uses the following example to explain the `multiplier strategy': a credit union participates 90% of $1 million in auto loans four times, each time retaining 10% of every loan, and the return of 8% yields closer to 10%, said James Milhaven PFG vice president. This only works if the credit union has the volume to roll over the funded portion each time it enters the participation market. Still, "there is a safety factor that cannot be overlooked," Milhaven said. "Most permissible investments are removed from probable default risk and that is not always the case with loans. It is vital to ascertain that the loans are underwritten according to sound practices and if so the risk is minimal, and as long as they are priced appropriately, a much better investment." Milhaven said smaller credit unions with limited resources can also have the muscle to vie with larger credit unions through participation loans in a low-rate environment. Indeed, Countryside Federal Credit Union, with $56 million in assets and 8,600 members, ventured into participation loans in 1998, and has seen a payoff that has fueled its "tremendous loan engine." As of June 2003, Countryside had $30.7 million in first and second mortgage loans, with nearly $6.5 million reflected on the books, the balance participated, said Gerd Henjes, Countryside's president/CEO. "We were constantly facing a liquidity crunch because the lending side was so strong," Henjes said. "You get back the principle and the interest and it just simplifies your life." An added benefit is that loan participations can actually improve a credit union's capital position when used to replace brokered deposits or borrowed funds, Mulford said. "Because a participation is carried on your books as a contra-asset, your capital ratio does not deteriorate as it would with other types of funding sources," Mulford said. Ironically, Evangelical Christian Credit Union's first loan participation client in 1986 was to a bank. Since then, it has amassed one of the most successful programs in the nation, selling to 42 credit unions with $750 million in loan participations. The credit union made the difficult decision to cease its consumer lending operation, instead choosing to pursue a niche - lending to churches - a market that was woefully underserved, said Kevin Bates, ECCU's participation loan coordinator. "Our members were going elsewhere for auto, home and consumer loans. There's a high amount of liquidity, people aren't borrowing, they're going to places like Ditech," Bates said of ECCU's decision to stop offering consumer loans. "Zero percent car loans are moving members away from credit unions. It was a difficult decision for us but we've found a viable niche market (with churches)." In a low-interest rate environment, Bates said "a well, underwritten, low-interest rate loan can easily stack up against a corporate CD." "You compare $5 million in an investment at your corporate at 3.5% but if you can get the same $5 million at 4.5% (through a loan participation loan), you increase your share and the equity you would use for your investment." Strong loan demand drove Norlarco Credit Union in Fort Collins, Colo. to venture into loan participation two years ago, said Charles Mabry, president/CEO. Since 2001, Norlarco sold more than $120 million in loans and purchased $10 million. "It's been profitable for us," Mabry said. "We originate the loans and keep 10%. We keep a bit of the margin and continue to make up for the portions we sell. It's a great way for us to balance our portfolio." Norlarco, which has $280 million in assets and 42,000 members, has an added buffer against default risk through its shared CUSO, Centennial Lending. The credit union, along with Premier Members Federal Credit Union and Warren Federal Credit Union are Centennial's owners, which enables sharing of each participation loan and "spreads the risk out among the three of us," Mabry said. Historically, credit unions needing funds went to their members first and then to the brokered CD market, Mulford said. But since most CDs cap at $100,000, "this became cumbersome to manage," Mulford said. Depending on the region of the country and the financial makeup of the membership, loan participations are "not for everyone." "When I first started digging into the idea of loan participations, I found that credit unions in the upper Midwest were having a field day with loans while credit unions in California and Florida couldn't give money away," Mulford said. "I also found that credit unions with higher salaried FOMs seemed to have less loan demand than those whose members were equal to or below average." [email protected]