In 2012, the NCUA reported nearly 1,500 federally insured credit unions had loan participations with total balances of nearly $13 billion.
That figure may be the result of credit unions using CUSOs to underwrite, document and service loans. CUSOs locate prospective borrowers through loan brokers then select a credit union to be the loan seller based on where the borrower is a member or would qualify for membership.
Critics have argued that participations originated through loan brokers may pose some dangers. For one, if the loan is offered by a loan broker after it’s been declined by local lenders and is then offered to an out-of-state credit union, it can put that buying credit union in a high-risk situation. Secondly, in some cases, these borrowers may be desperate and willing to pay fees that are twice or three times what a credit union would normally charge, critics have said.
Over the past few years, a handful of high-profile credit unions have gotten into some trouble with their commercial lending efforts, some tied to CUSOs that worked extensively with loan brokers.
In cases involving Telesis Community Credit Union, Texans Credit Union and Eastern Financial Florida Credit Union, one commonality was the CUSO platforms were used, said Bill Beardsley, president of Michigan Business Connection, a commercial lending CUSO in Ann Arbor that serves more than a dozen credit unions.
“CUSOs can be the electric spark as well as the lightning rod for business loans. They attract a lot of attention in and outside of the industry,” Beardsley said. “Credit unions are becoming more mature as the sources and originators of quality business loans. Telesis reminds us to know the risks you’re getting into.”
Credit Union Times obtained a business loan and participation loan broker agreement used by a billion-dollar credit union on the West Coast. In it, there are several sections devoted to how a broker is compensated. For instance, the broker agrees that any loan it submits to the credit union that was obtained through another broker or lender, should the loan go bad, the originating broker will not hold that credit union responsible for it.
While this particular agreement appears to be airtight, protecting the credit union in the event a loan goes bad, some contracts may not offer as much protection.
Broker arrangements are very similar to indirect auto lending. Basically, a CUSO or other broker brings the loans to the table and then the credit union funds them, said Harvey Johnson, CPA and senior manager at PBMares LLP, a regional accounting and consulting firm based in Newport News, Va.
“These just happen to be larger and much more risky loans,” said Johnson, who is a member of the Association of Credit Union Internal Auditors and has written extensively on credit union business lending.
If a credit union decides to use a loan broker for participations or member business loans with or without a CUSO, Johnson said he recommends a similar framework that is often used internally for indirect lending. The set of criteria should be agreed upon up front between the broker and credit union, he advised. For instance, a credit union may state it will only accept loans with A, B, and C criteria.
Johnson said a quality control function at the credit union would then review all loan participations bought by the credit union to make sure they were consistent with the underwriting criteria provided and agreed up by the credit union and the broker.
“Usually, if there are problems, then the credit union does not have to purchase or fund the loan. It’s kept by the broker or CUSO, and they will find someone else to take it,” Johnson said.
In a 2008 supervisory letter on evaluating loan participation programs, the NCUA said selling credit unions should notify buying credit unions if a loan was sourced through a loan broker and the borrower was not an existing member. This puts participants on notice that information about the borrower may not be based on direct knowledge of the seller, the agency offered.
“In these type transactions, selling credit unions should verify that all third-party reports, such as appraisals and environmental studies, were obtained in an arm’s length, independent transaction, and in full compliance with regulatory guidance,” according to the NCUA.
Some critics have said that one of the dangers is when CUSOs work through loan brokers, the transactions are purely commission driven and this could be a problem because there might be some question about whether a credit union involved in a participation loan is getting the most safe and sound deal.
Eastern Financial Florida CU was placed in conservatorship in 2009 and merged into the $3 billion, Melbourne, Fla.-based Space Coast Credit Union that same year after the defunct cooperative’s worth due to millions of dollars in commercial lending losses. Eastern Financial secured these types of loans through CU Business Capital LLC, a CUSO it launched that went out of business in 2010.
William McCluskey remembers the promise of CU Business Capital during his stint there. He is now the CEO of Willow Capital Group, a Centerbrook, Conn.-based firm that provides commercial loan origination, underwriting and closing for more than 30 credit unions managing a servicing portfolio of nearly $330 million.
“They built $250 million in loans. They were chasing loans that they should not have,” McCluskey said. “They built a CUSO to service the loans, and they thought the loans were good. A lot of them went bad.”
Part of what led to CU Business Capital’s downfall was the CUSO didn’t build a participation network on the way up, McCluskey offered.
“This holds you in a check,” he added. “Unfortunately, under the old CUSO model, we witnessed a lot of pressure to originate loans that were rationalized with ‘We put $200,000 into this.’”
Willow Capital’s strategy is to build networks, which currently includes one with eight New England credit unions that are in getting to know each other so they can understand who they’re lending from, McCluskey said. There are no capital requirements to join, he noted.
Another consideration for working with loan brokers that have arrangements with CUSOs is if the latter has a national model.
“If you’re lending outside of your market, you’re relying on someone else to make sure it’s a qualified loan,” said Linda Kennedy, president/CEO of Business Lending Group LLC, a CUSO in Appleton, Wisc., that serves four credit unions.
Johnson said the broker relationship goes back to two common words found in NCUA guidance: due diligence.
“A broker is going to make its money by placing money. There’s inherent risk there unless they own the CUSO that does the brokering,” Johnson said. “Regardless of how it gets on the books, it’s the credit union’s responsibility to do their own underwriting.”
With all of the shared costs and shared risks that advocates tout in favor of participation loans, Johnson said technically, it puts the credit union away from the borrower, which can be a disadvantage.
“The more layers that are in between, the greater the risk and the more I want my attorney involved,” Johnson said.