Small Banks Slowly Reconsidering Loan Participations

Starved for growth, community banks are reconsidering sharing their lunch with competitors if it means winning bigger loans.

Loan participation was fraught with distrust when collapsing real estate markets scarred ties among bankers. But there are murmurs of new partnerships as community banks vie to take commercial loans away from larger banks.

"With loan demand being so weak … we're very much open to participations," says Tim Pettus, president at First Farmers & Merchants Bank in Columbia, Tenn. "We're seeing more larger banks and superregional banks in middle Tennessee calling on the best clients and the interest rate challenge is very much there."

Like many banks, First Farmers saw a huge inflow of deposits in 2011 but few loan opportunities. Pettus says that five years ago, about 78% of his bank's deposits were being lent out. Now, that ratio is down to 56%.

"Community banks are really going to need to diversify … and there are great opportunities to do that slowly, but surely" with a participation or syndication, says John Delaney, co-founder of Alliance Partners, which manages BancAlliance, a Chevy Chase, Md., loan cooperative for community banks.

Though there is interest, bankers say participations have been slow to resume after past deals soured, leaving some banks with losses after the lead bank failed.

"We scrutinize every participation opportunity just like we were the ones making the loan," Pettus says. "It has to be an arms' length transaction."

Among the biggest blows for trust was the May 2009 failure of Silverton Bank in Atlanta. Participation loans made up about 55% of its $1.1 billion in real estate loans in 2007, according to research by Jones Day. The law firm estimates that such loans were even higher when the bank failed. Many participating banks took losses when the bank went into receivership.

Most of the loans that "came through Silverton were monster deals like $240 million and everyone took $2 million to $4 million. … So you're one bank among 20 to 50 in line waiting to get paid," says Bennett Brown, president of American Enterprise Bank of Florida in Jacksonville, Fla. "I don't think there are a lot of people who want to participate because so many have been burned."

While Brown says his bank did not do any large deals with Silverton, the widespread impact it had on many bankers changed how participations are handled. Now most participations are commercial loans in the banks' market and with local competitors. Bankers say that regulators are keen on making sure banks stick to the markets they know. The further out a bank looks geographically, the higher the risk.

"Out-of-market loan participations were a contributor to many bank failures," says John Corbett, an executive vice president at CenterState Banks Inc. who also runs the company's bank. "You would find a small bank originating a $25 million to $30 million loan then it was getting carried out all over country. … There's a case to be made for local, in-market participation."

Contracts usually have a clause requiring a lead bank to buy back the loan if it underperforms. Participants treat contracts more like marriage vows than short-term agreement.

"We invite our participating banks to come down and meet the borrower, walk [over] the collateral and get comfortable with the entire relationship," Brown says, who has only sold loan participations thus far. "I might agree to [buying] one if I've walked it and met the borrower."

Participations are still viewed as risky. Some bankers are still grappling with older relationships that face downgrades largely from lower real estate values, delaying resurgence in activity.

"They're all subject to credit risk and downgrade every day," says Chip MacDonald, a partner at Jones Day. Still, banks "need yield and earning assets and that's what they are going for."

Even in healthier states such as Texas, some bankers say they are starting to look at buying into participations to diversify.

"Almost all of us have concentrations that we'd like to diversify somewhat," says Robert Messer, the chief financial officer of American National Bank of Texas. The bank was had sold participations before the downturn. As competition heats up, he says the bank is looking for "strategic" participants, mostly larger community banks that are nearby.

Delaney says a shift to more loan buyers than sellers makes it tough for smaller banks to partner with regional banks. All banks want more commercial loans to reduce reliance on real estate.

"Bankers are very careful about who they want to have in their participation," says Steve Brown, the president and CEO of Pacific Coast Bankers' Bank. "If they find one quality loan in their market, the last thing want to do is have someone take it away."