Participations Are the Key Enabling Tool for CU Loan Diversification

In uncertain and volatile markets, many credit unions are looking to rebalance their portfolios but may find methods they have traditionally relied upon suddenly unavailable. On the other hand, loan participations continue to be an efficient and surgical tool to fine-tune a financial institution’s balance sheet in a manner that aligns with evolving risk/return targets. Selling or buying loans in uncertain markets should not be viewed as panic selling nor as an imprudent purchase; rather immense potential benefits abound in doing so. Remaining active in loan participations in the coming months will prove to be a powerful risk-management tool for all parties.

The aim of diversification is to construct a diverse portfolio of assets, including loans, that exhibits a superior expected risk-return profile. The typical objective is to maximize expected returns for a given threshold of risk, or conversely, to minimize risk for a given level of expected return. While expected return has an inherently quantitative definition, a credit union will have more flexibility in choosing how it defines and reduces risk through a combination of quantitative and qualitative measures.

Distinction Between Diversification and Liquidity

Depository institutions often rely upon two metrics to optimize the risk-return goals of their balance sheet assets: Asset diversification and liquidity and asset utilization (leverage). In theory, these measures of risk are approached both jointly and in a dynamic fashion with an institution’s liability management and potentially other hedging activities. However, in practice this is often not the case. A credit union’s liabilities are often relatively static, and institutions often lack control over deposit activity. As a result, there is usually much greater focus on the management of assets when credit unions exercise meaningful control along with the terms under which credit is extended, either directly or through asset purchases. Let’s turn our focus to asset diversification.

Many credit unions and banks are less diversified than they ought to be with respect to certain geographies, industries, employers or asset classes. Moreover, credit unions in particular face additional pressures and regulatory constraints that often cause them to become even more concentrated than similarly situated banks.

Loan Participations for Diversification

While a lack of diversification is more understandable in the case of credit unions, the risks are no less great, and the negative consequences are no less severe. In most cases the best, and perhaps only, way for credit unions to mitigate these risks will be through loan participations, which provide credit unions with access to a much more diverse pool of loans without investing resources to expand their footprints or areas of lending expertise. Although alternative methods exist for achieving diversification, these often tend to be too slow, disruptive to members, or not financially viable over the long term.

Participations enable credit unions to diversify across a wide variety of characteristics:

• Geographic: Consider a loan portfolio with 100% of borrowers in a single county, versus a portfolio of loan participations diversified across the nation.
• Employer/Industry: Consider a loan portfolio in which most borrowers work for the same local employer or in the same local industry, versus a loan participation portfolio diversified across numerous employers and industries.
• Asset Class: Consider a loan portfolio consisting entirely of home equity loans versus a portfolio of loan participations consisting of first-lien mortgage, auto, solar panel and home equity loans.
• Credit Quality: Consider a loan portfolio consisting of a narrow range of FICO scores versus a loan participation portfolio with a wider range of FICO scores but the same average score (and where the nonprime loans were originated by a credit union with expertise in making and servicing such loans).
• Borrower Types: Consider a portfolio of consumer-only loans versus a loan participation portfolio containing a mix of consumer and business loans.

Technology Makes Participations Easy

Historically, loan participations were administratively laborious to arrange and maintain. Legal agreements, the logistical constraints of due diligence and the ongoing performance monitoring have all contributed to participations being viewed as a last resort in terms of managing balance sheet risks.

Technological advances have removed these friction points, allowing credit unions to use these loan participation technologies to manage risks more nimbly and deliberately. As is the case with many technologies, recent innovations in loan participation technologies have democratized the space. Smaller institutions are able to use tools and strategies that were formerly only available to their more sizeable counterparts. Accordingly, institutions both large and small now also gain access to a much wider market of opportunities that previously would have been only presented to larger players or not available at all.

Choosing a Diversification Strategy

Pursuing diversification through participations first requires that the organization define its diversification goals. This begins with identifying risks (and opportunities) to which the credit union is overexposed (or underexposed) and having a reasonable method of measuring exposure to such risk. This does not have to be a complex exercise, and often the most obvious risks are the ones that are the most important to address, such as a heavy concentration in auto loans to borrowers located in a few neighboring counties who work for the same large employer.

These types of balance sheet observations can usually be readily made by existing staff. Furthermore, new data analysis platforms can also help staff identify more subtle balance-sheet concentrations and where participations might offer a solution. With the aid of insightful data analysis tools, achieving robust, quantitative diversification does not require Wall Street risk management training nor capital markets expertise.

This qualitative-heuristic approach to lending diversification may be criticized as not academically rigorous and lacking in probabilistic-statistical measure of risks as such as return-variance, market co-variance or value-at-risk. Keep in mind these are statistical measures of risk – not definitions. Moreover, many financial institutions simply lack the data to undertake lending diversification in the fully-quantitative fashion that may be available for other asset classes like equities. Even institutions that invest in sophisticated risk analytics capabilities should not rely solely on them or consultants to define the credit union’s fundamental exposures.

Risk management is never easy, especially in times such as these when pivots need to be seriously considered as previous shortcomings become exposed. However, risk management must always be forward looking, especially during these unstable times. Loan participations are a powerful tool for credit unions seeking to proactively manage the risk in their loan portfolios.

Ian Lampl is CEO of the New York City-based lending technology company LoanStreet.

Michael Lanzarone is Head of Corporate Development & Marketing for LoanStreet.