Loan Participations The good, the wise and the ill-advised

1. Loan Participations The good, the wise and the ill-advised Presented by: Chris Vallez, CPA Partner Nearman, Maynard, Vallez CPAs, P.A.

2. Nearman, Maynard, Vallez CPAs • One of the top five firms auditing credit unions over $40 million in assets per Callahan and Associates’ 2011 Guide to Credit Union CPA Auditors • Exclusively auditing credit unions since 1979 • Performed thousands of credit union audits, hundreds of credit unions over $500m in assets

3. Speaker Biography CHRIS VALLEZ, CPA • Chris is a Partner with Nearman, Maynard, Vallez, CPAs, P.A. A firm working exclusively with credit unions for over 30 years. As a Partner, Chris is responsible for all aspects of credit union audits. Over the last 22 years, Chris has worked on hundreds of audits. • In addition to being a Partner of the firm, Chris is Chairman of the firm's Accounting and Auditing Standards Committee. The primary objective of this committee is to increase the production capability, efficiency, and quality of service offered by the firm. • Chris first volunteered on the AICPA’s Depository Institutions Expert Panel (2004 – 2007). In 2005, he was asked to serve on the Steering Committee for the AICPA National Conference on Credit Unions and in 2007, was appointed the committee Chairman. Chris has assisted in the review of the AICPA’s audit guide for Depository and Lending Institutions, Financial Institutions Industry Developments Audit Risk Alert, and other documents.

4. Outline • Loan participations, the basics • Accounting issues • Best practices • Regulatory issues • Case Study

5. Loan Participations, the Basics • What is a loan participation • Par-tic-i-pa-tion (noun) the condition of sharing in common with others (as fellows or partners) • Responsibilities of originator • Underwrites the loan • Normally services the loans • Notify participants of changes in financial condition of borrower, material changes in value or lien status of collateral, occurrence of default • Responsibilities of participant • Due diligence, funding ability, understand agreement

6. Loan Participations, the Basics • A tool for portfolio management • Improves loan to asset ratio, yield • Provides portfolio diversify • Reduces concentration risk • Increases credit availability to consumers • Might help to comply with regulatory requirements Nearman, Maynard, Vallez, CPAs

7. Accounting Issues • Codification section 860 “Transfers and Servicing” • Transfers with continued involvement or no continued involvement • Servicing agreements • Recourse arrangements • Guarantee arrangements • Agreements to purchase/redeem transferred assets • Continued involvement might require accounting as a secured borrowing rather than as a sale Nearman, Maynard, Vallez, CPAs

8. Accounting Issues • Requirements for sale treatment, the transfer must: • Be structured so there are proportionate ownership rights with equal priority to each participant • Have no recourse (other than standard representations and warranties) to any participant • Have all cash flows divided proportionately among the participants, excluding servicing fees • Not allow for the entire financial asset to be pledged or exchanged unless all participants agree

9. Accounting Issues • Participating interest must also meet the conditions for surrender of control • Violation of the surrender of control test would require secured borrowing accounting • Loan remains on originating credit union • Originating credit union records borrowing • Participating credit union records note receivable • Best to get a legal opinion to address the isolation test given the NUCA’s conservatorship powers Nearman, Maynard, Vallez, CPAs

10. Accounting Issues • Renewals, restructures, and modifications should be reviewed to determine if loan is “new” loan or continuation of “old” loan ASC 310-20-35-9 through 11 • If “new” loan evaluate under 860-20 • If “old’ loan, transfer would not need to be re-considered • Reserve in allowance account based on loan type Nearman, Maynard, Vallez, CPAs

11. Best Practices - Policies • Responsibilities and delegation of authority • Boards delegation to management • Management’s responsibilities • Approved activities • What circumstances can participations be entered into • Due diligence • Due diligence of third parties • Review of loans to be purchased • Minimum IDC rating • Elements of the participation agreement Nearman, Maynard, Vallez, CPAs

12. Best Practices – Due Diligence • Perform independent credit analysis of borrower • Perform independent underwriting analysis of loan • Understand the loan, collateral, liens, business plan • Understand participation agreement, especially in case of default and legal remedies • Run searches on the background of borrowers • Perform property level due diligence • Each loan will require its own level of due diligence Nearman, Maynard, Vallez, CPAs

13. Best Practices – Due Diligence • Know your risk tolerance • Ideally, the loan originator should share similar underwriting standards and risk tolerance as the participant • Know the ability of other participants to fulfill there funding obligations, especially important in a construction loan • Beware of brokered loans • Maintain portfolio diversity Nearman, Maynard, Vallez, CPAs

14. Loan Participation Agreements • Participation agreements should address • Terms and conditions of the participation • Affirmative representation and warranties • Applicable disclaimers • Expectations of each party • Address the event of default Nearman, Maynard, Vallez, CPAs

15. Regulatory Issues • Current rule 701.22, 701.23 & 741.8 • Limits investment in participations individually and in aggregate • Requires a written master participation agreement • Puts in place requirements of the originating and purchasing credit unions • Rules on purchase, sale and pledging of loans • Limits the institutions a credit union can purchase loans from

16. Regulatory Issues • Proposed rule change, Dec 15, 2011 • Reason for proposed rule • Focus on those purchasing loan participations • Details regulatory expectations • Also addresses: • loan participation policy • loan participation agreement • ongoing monitoring of loan participations • Focus on natural person credit unions, corporate credit unions subject to section 704 of R&R

17. Regulatory Issues • Prevents purchase of loan originated with less stringent underwriting standards • Adds maximum limit on participations and concentration limits • Limits are measured based on net worth rather than unimpaired capital and surplus • Concentration risk: • Same originator (25%limit) (since repealed) • One borrower or group (15% limit), • Types of loan (e.g., industry or loan product) Nearman, Maynard, Vallez, CPAs

18. Regulatory Issues • Participation agreement must clearly delineate the roles, duties, and obligations of all parties ( originating CU, servicer, and participants) • Agreement must include notice and disclosure of ongoing financial condition of the loan, borrower and servicer • Agreement must specify the loan(s) to be purchased • Rules apply to all federally insured credit unions Nearman, Maynard, Vallez, CPAs

19. Norlarco Credit Union • Information included herein is from the NCUA’s “Material Loss Review” report #OIG-09-01 • Norlarco Credit Union chartered in 1959 to serve employees of Colorado State University • May 15, 2007 CU placed into conservatorship • Nov. 2007, NCUA accepts bids selecting Public Service CU • Feb 2009, CU liquidated

20. Norlarco Credit Union • Late 2001, CU begins program with First American to finance and service construction loans • August 2003, agree to fund $30m per month, partly due to low demand in auto and home equity LOC loans • Agreement required First American to • Obtain permanent financing at loan’s maturity • Buy back loans that cannot get permanent financing • Make interest payments on loans > 45 days past due Nearman, Maynard, Vallez, CPAs

21. Norlarco Credit Union • Dec 2003, First American enters into agreement with Palm Harbor in which Palm Harbor agrees to buy back loans that cannot get permanent financing • Oct 2004, RCL program begins to fund construction loans in Lee County Florida • Oct 2004, First American enters into agreement with First Home Builders of Florida (FHBF). FHBF makes significant financial commitments until permanent financing obtained Nearman, Maynard, Vallez, CPAs

22. Ratios Nearman, Maynard, Vallez, CPAs

23. Norlarco Management Errors • Failed to conduct a due diligence review of its relationship with its third-party vendor • Failed to adequately oversee the RCL program • Created a concentration risk by committing to fund $30 million per month in construction loans • Failed to develop an adequate Asset-Liability Management (ALM) policy • Failed to develop adequate policies and a strategic plan to guide the RCL program

24. Norlarco Management Errors • Lack of oversight in RCL program resulted in: • Overreliance on guarantees, • Underreported delinquencies, • Misclassification of loans, and • Declining borrower credit quality Nearman, Maynard, Vallez, CPAs

25. Norlarco Management Errors • Created a concentration risk by committing to funding $30m per month • Concentration risk in a single residential construction lending program • Geographic concentration in Lee County • Failed to develop an adequate ALM policy • Failed to develop adequate policies and a strategic plan Nearman, Maynard, Vallez, CPAs

26. Observations and Lessons Learned • Financial condition of the institution is no guarantee of future performance • An inattentive or passive Board is a precursor to problems • The Institution may reach a point at which problems become intractable and supervisory actions are of limited value Nearman, Maynard, Vallez, CPAs

27. Management Errors • Management actions created credit, liquidity compliance, and strategic risks • Specifically, ignoring sound risk management principles by committing a significant portion of assets to a risky Residential Construction Lending (RCL) program without adequate controls in place to oversee the program’s daily operations

28. Management Errors • Management’s poor strategic decisions over its lending practices, as well as the inability to find adequate funding sources to meet commitments, created risks that Norlarco management did not, or could not, effectively manage • Eventually, management’s inability to effectively manage the risks its own actions had created, led to Norlarco’s failure

29. Notes on Examiners • Did not view the participation program and the participation agreements as safety and soundness concerns fraught with risk • Did not associate the rapid rise of loans sold through participations as a potential safety and soundness concern to Norlarco, or to the NCUSIF,

30. Conclusion • Perform appropriate due diligence based on loan type • Know who you are doing business with • Know the participation agreement • Monitor performance Questions and answers Chris Vallez, CPA cvallez@nearman.com