When it comes to investments, Patelco Credit Union ($4.0B, Pleasanton, CA) weighs all of its options and isn’t afraid to think outside of the box to provide returns to its 278,000 members. The credit union had a total loan portfolio of $2.33 billion and a secondary market portfolio with $595 million, not including premiums, in assets as of Dec. 31, 2013. Here, Cory Schwab, vice president of commercial and secondary market loans, discusses how the credit union uses secondary market lending as a critical part of its investment portfolio.
When did Patelco become involved in secondary market lending?
Cory Schwab: Patelco first became involved with taxi medallion loans in 1994. During the late ’90s to the mid-2000s, the credit union migrated into commercial real estate participations as well. Starting in early 2010, we expanded our secondary market lending activity into additional asset classes.
CU QUICK FACTS
PATELCO CREDIT UNION
data as of 12.31.13
HQ: Pleasanton, CA
12-MO SHARE GROWTH: 3.04%
12-MO LOAN GROWTH: 11.05%
ROA: 1.32 %
What do you define as secondary market lending?
CS: There are a number of different asset classes that we look at, including conventional commercial real estate participations, conventional commercial and industrial participations, consumer flow programs, first mortgage pools, HELOC pools, auto pools, government guaranteed loans, and leases.
Does Patelco focus on particular asset classes within that umbrella? Do you only purchase loans from other credit unions?
CS: Patelco continually evaluates all asset classes outlined within our policies and procedures; however, our focus regularly shifts as market conditions change or balance sheet needs arise. This allows us to not only maintain a diversified portfolio but also assist in the balance sheet management of the credit union.
We do look beyond credit unions when evaluating loan sources to maintain sufficient deal flow. The primary sources we use include credit unions, CUSOs, banks, financial companies, and brokers.
What are some of the benefits of secondary market lending?
CS: There are a number of benefits, but before I address those, I want to emphasize that it is important to ensure your credit union has the proper resources, personnel, and structure in place to be successful and profitable.
At Patelco, we benefit in several ways from our secondary market portfolio. As a community-based credit union, the majority of the loans we make directly are to members within our local area. The secondary market lending program allows us to diversify geographically. It also helps us mitigate interest rate risk and increase income by gaining exposure to different asset classes and pricing structures. The secondary market lending program’s portfolio total return consistently exceeds other assets held on our balance sheet. Lastly, our program is structured in such a way that it supports our lending initiatives. It generates a reliable cash flow stream that finances or supports direct and indirect programs that deliver value back to our members.
You mentioned having the right resources in place. What specifically should credit unions consider as they create a new program?
CS: Credit unions often use loan purchases or participations as a savior for balance sheet stagnation or earnings issues. This isn’t necessarily a good business practice as it often leads to a lack of asset class and participation understanding at origination and on an ongoing basis. This becomes evident when specific assets start to, or have, deteriorated. A successful program requires an understanding of asset class correlation and disparity along with a knowledge base of institution-wide lending and balance sheet management.
Credit unions considering a new secondary market lending program also need to consider the increased regulatory scrutiny and audit complexity that comes along with loan purchases. Taking time to review regulations such as Part 723 and NCUA’s recently issued participation guidance will help you understand what is expected of each institution in terms of member business and secondary market lending. Some of these regulations might be new to your credit union, especially if you have not been involved in participations previously or are diversifying into a different asset class that your institution does not currently offer.
How do you evaluate specific loan pools? What are some of the critical questions you ask?
CS: A key question, and perhaps the first one you should ask, is “why is the institution selling?” Its motive can provide valuable insight before you even begin looking at the details of the asset itself. It is also important to review the selling institution’s policies and procedures as well as its overall financial condition.
In addition to a thorough understanding of the selling party’s motivations and processes, you must also have a clear understanding of what risk your own credit union is willing to take on, what kind of loans you want to buy, and how much due diligence you are able or willing to conduct to ensure the assets are a good fit for your strategy.
At Patelco, we conduct a sample file review to ensure pool-level information is accurate, the institution’s policies and procedures are followed, and we fully understand the risk characteristics of the loans. In addition to this review, we also evaluate the overall pool composition to ensure alignment with internal pricing, interest rate forecasts, and balance sheet composition objectives.
Last, but certainly not least, credit unions should fully understand the transaction documentation, often a participation agreement, and what will happen if there is a servicing mishap, a loan goes bad, or there is an institutional failure. This can help you protect your interest and the serviceability of the portfolio should something unforeseen happen down the road, despite your due diligence.
Any other advice for credit unions considering loan purchases or participations?
CS: Yes. Credit unions should understand what their total risk appetite is and think through various scenarios to make sure they are comfortable with each deal, even if factors change down the line.
Communicating expectations to your partners is vital to a successful program. At Patelco, we try to frame the expectations and clearly define the process and timeline from the beginning. We get involved early in the process so we can have a hand in the pricing and structuring of deals. This has been beneficial for us and is different than coming in after a participation has been organized.
Being able to work within the scope of the participation agreement and being willing to accept the decision of a larger group, even if it is not the same decision you would come to, is important in the overall transaction process.
In the past, several institutions found themselves in trouble after buying loan participations for the cash flow and viewing them as instruments that were not likely to fail. Today, it is important for credit unions to do their own research and due diligence to ensure the loans they purchase are fully vetted and are in line with their expectations.