“Diversification is an established tenet of conservative investment.” — Benjamin Graham
A diverse loan portfolio is key to an effective risk mitigation strategy. By reducing concentration within the portfolio, credit union managers can ensure their institutions are not overly exposed to risk in their home markets. There are many strategies that can accomplish this goal, but buying and selling loan participations is ultimately the most efficient method available.
The more loans, the merrier
Diversification begins with increasing the number of assets. Imagine an asset purchased at 50 that in one year returns either 0 (50% probability) or 110 (50% probability). The expected return is 55, a 10% return. But with only one such loan, you experience only one outcome: a -100% return or a 120% return. The standard deviation is 110%.
With two assets, there are four possible outcomes, and the standard deviation declines to roughly 78%. Standard deviation falls with the square root of the number of assets, so quadrupling the number of loans halves it. Keep adding loans and the distribution keeps tightening, with diminishing improvements at each step.
There is an important caveat: this requires that all assets are independent, a requirement that is unlikely to hold in the real world.
Correlation: when bad things happen in threes
Correlation is the likelihood that two events occur (or don’t) together. It is measured by the correlation coefficient, ρ (rho), which ranges from 1 (perfectly correlated) to -1 (perfectly negatively correlated). High correlation offsets the benefit of adding assets; if every loan were perfectly correlated, it would be as if you held a single loan.
Correlation arises in a credit union’s assets from:
- Asset concentration: home or auto prices tend to move together.
- Geographic concentration: field of membership limits can concentrate loans in a small area exposed to natural disasters or a local slowdown.
- Industry concentration: loans tied to a single company or industry.
- National and global economy: slowdowns that hit all loans.
The last two are difficult, if not impossible, to diversify away. But the first three are very attainable, especially with access to loans in the secondary market.
Participations to the rescue
Broadening underwriting can help, but it is slow, limited by available cash, and has no guarantee of success. Loan participations let a selling credit union rapidly reduce concentrations in its existing portfolio and let a buying credit union quickly add diversity to its own. For credit unions low on cash, selling participations first raises the funds to buy participations elsewhere.