Buying and selling eligible obligations: An alternative to loan participation

Buying and selling loans allows credit unions to manage and leverage risk on their balance sheet.  Typically, credit unions use the loan participation powers laid out in NCUA Regulations Part 701.22.  The eligible obligation regulation in Part 701.23 is less utilized.  Perhaps the term “eligible obligation” sounds off-putting.   If NCUA used the term “eligible loan” perhaps it would garner more attention.  In any event, credit unions should understand this valuable tool because it is another way credit unions can buy and sell whole loans and portions of loans.  Let’s look at the eligible obligation rule and how it compares with the loan participation rule when credit unions buy and sell portions of loans as eligible obligations. 

Membership Requirement

In a loan participation, the borrower must be a member of at least one participant credit union.  Typically, the buying credit union does not have to make the borrower a member when buying from another credit union because in order for the originating/selling credit union to make the loan the borrower must be a member of the originating/selling credit union.  If the seller is a bank or CUSO, then the buying credit union would have to either (i) make the borrower a member or (ii) ensure the borrower is a member of another participating credit union.

An eligible obligation is different.  The buying credit union must make the borrower a member in order to buy a loan, unless the transaction qualifies for one of the exceptions in the rule.  There are exceptions to the membership requirement if the credit union is buying mortgage loans and student loans in order to aggregate with its own portfolio to sell to the secondary market.  The purpose of this power is to give credit unions more volume in the secondary market to obtain better sale terms.  Another exception is the purchase of loans from a liquidating credit union.  All the above types of transactions would almost always involve the sale and purchase of whole loans.

The most relevant exception to compare to the loan participation regulation, where portions of loans are sold, mirrors the old “Reg Flex” exception.  If the buying credit union is “well capitalized” under Part 702 and has a CAMEL rating of 1 or 2 for the previous two consecutive examination periods the buying credit union can buy a whole loan or a portion of a loan from a federally-insured credit union without regard to membership.  If this exception applies, the membership issue is irrelevant to the buying credit union and no different than with a loan participation.

Parties

Credit unions can only enter into loan participation agreements with other credit unions, CUSOs, federally insured financial institutions and state and federal government agencies.

Under the eligible obligations rule, a credit union can buy a whole loan or a portion of a loan from any source.  A credit union can establish a loan participation-like relationship with any lender if it buys a portion of a loan.  The lender can service and remit payments that mirror a loan participation relationship.

Skin in the Game

The loan participation rule requires that federal credit union originators/sellers retain 10% of the principal and state chartered credit unions, banks or CUSOs must retain a minimum of 5% of the principal.  In the case of a sale of a portion of a loan, the eligible obligations rule does not have any minimum retention amounts.

Types of Loans

Both rules only permit credit unions to buy loans they are authorized to make.  Buying credit unions need to have loan policies in place to cover the types of loan participations or eligible obligations purchased, even if the buying credit union does not make direct loans of the same type.

Limitation of the Amount of Purchases

Both rules impose the limit on loans to one borrower.  The loan participation rule does not have a stated aggregate restriction on the amount of loan participation interests that may be purchased.  Under Part 701.23(b)(4) of the eligible obligations rule, the total amount of eligible obligations that a credit union can purchase is five percent of the credit union’s unimpaired capital and surplus, roughly the asset size less reserves.

Indirect Loan Exception

Buying loans, particularly from car dealers, is a widespread practice.  While that power is based in the eligible obligations rule, the rule carves out an exception to treating these loan purchases as eligible obligations if certain conditions are met. Under Part 701.23(b)(4)(iv), the purchase of an indirect loan will not be classified as an eligible obligation and subject to the 5% limitation if the credit union makes the final underwriting decision before the loan is made to the borrower and the loan is assigned to the credit union very soon after the loan is closed by the dealer.  In practice NCUA expects a car loan to be assigned to the credit union within a week of the loan closing.   In NCUA General Counsel Opinion Letter Number 97-0546 dated August 6, 1997, NCUA will deem that the credit union has made the final underwriting decision if the decision is solely based on the credit union’s objective underwriting criteria (e.g., credit score, debt ratios, gross income) which can be applied without the use of discretion.  In other words, the credit union does not have to actually approve each loan made at the car dealer if there is an automated process that applies the credit union’s objective criteria.

Conclusion

Understanding the eligible obligations rule, gives your credit union more options.  I recommend that you develop an eligible obligations policy and use the tools provided by the rule.