Loan Participations Offer a Solution to Pressures on Credit Union Earnings

Among the many challenges posed by the COVID-19 pandemic to lives and livelihoods, credit unions need to be concerned about their own financial health. Accelerated share growth as members hoard cash, coupled with weak loan demand due to economic uncertainty, may leave credit unions awash in liquidity and starved for interest-earning assets. Fortunately, there is a solution, in the form of loan participations, to absorb excess liquidity and bolster assets with attractive yields.

Credit unions were showing signs of excess liquidity even before the economic impact of COVID-19. According to the NCUA, share growth for federally insured credit unions was 8.2% in 2019, up 300 basis points from 2018. Conversely, loan growth slowed to 6.17%, which is well below the 9-10% growth rate of the past few years and also substantially behind share growth.

And that was before the impact of COVID-19. Preliminary data for credit unions that have reported for the first quarter of 2020 show the average loan-to-share ratio dropped from 83.89% in Q4 to 81.71% in Q1, while the average share balance rose from $10,862 to $11,094. The lockdown economy has left members with fewer outlets to spend their money, causing cash to build up. At the same time, conservative borrowers have been reluctant to seek credit, and typical sources of loan volume such as the auto and housing sectors have been disrupted. Auto loan volume, for example, is expected to decline by 40-50% in 2020 by some estimates.

Credit unions that are able to maintain existing loan growth may find that it comes at the sacrifice of yield, especially in traditional asset classes like auto loans, where recent actions by the Federal Reserve to lower rates have compressed those margins even more. In the current environment, the industry’s net interest margin fell to 2.98% for Q1, down from 3.17% for Q4. What’s more, credit unions will not be able to offset margin pressures with fee income, which has declined for more than a decade. For example, interchange fees have been impacted by the reduction in credit card usage during the pandemic. Loan participations can provide credit unions access to higher-yielding asset classes that help them diversify their portfolios and increase their ROA in this very difficult environment.

Participations Solve Asset-Generation Problem

Clearly, credit unions face the challenge of deploying liquidity into assets that carry an appropriate risk-adjusted return. Purchasing participations in private student loans and other consumer finance assets can be a viable solution. For example, the weighted average coupon on a portfolio of refinanced student loans might range from 3.5% to 7.5%.

Loan participations offer an alternative to generating whole loans with attractive risk-adjusted yields, which can be difficult to obtain even in a more robust demand environment. To originate private student loans, for example, a credit union would need to create its own program or partner with an outside provider. Another limitation is the requirement that the borrowers be credit union members.

To avoid these complications, participations allow multiple lenders to share in the funding of a pool of loans. The originating (or lead) lender underwrites and closes the loans, in accordance with a credit union’s stated underwriting standards, and sells participations to the lending group. Each institution that shares in the funding of a loan thus becomes an “owner” of a portion of the loan portfolio.

A 2018 study by Cornerstone Advisors, sponsored by LendKey, modeled the effect of deploying 10% of excess capital in loan participations with a 5% return, and found that a $500 million credit union could boost ROA from 0.54% to 0.77% and ROE from 5.77% to 7.97%.

In today’s “COVID-19 economy,” credit unions face a triple threat of rising liquidity, slack loan demand and low yields. Growing the portfolio with higher-yielding assets is a challenge in this environment. But loan participations – especially if generated through an efficient and robust technology platform – can provide a solution to credit unions’ liquidity and earnings challenges.

Christian Widhalm is Chief Revenue Officer for LendKey Technologies, Inc., a New York City and Cincinnati-based provider of a white-labeled lending platform.