“Where do I even start?”
Deciding to begin whole loan trading in the secondary market is a huge leap for any institution. Not only are whole loan trades long and cumbersome — they’re also extremely complex and require a lot of forethought.
Even with 15 years of experience in the banking industry and after strategically advising hundreds of financial institutions on balance sheet management, I’ve found that educating financial institutions on how and when to execute a whole loan trade still requires a lot of time and consideration.
To guide my thinking, particularly for whole loan purchases, I always look to answer 3 main questions:
What do I need to earn from this trade for it to make financial sense for my institution?
What type of diversification do I need to achieve in my portfolio from this trade?
How much risk am I looking to absorb?
Why these three? Each question gives me insight into not only the type of loans and transactions I should be looking at, but also the type of trading partner I’m looking to engage with and the level of complexity I can expect from this transaction. Here’s how I try to answer each question:
1. What do I need to earn from this trade for it to make financial sense?
More so than just looking at the expected yield from a trade, this question asks you to dig into the full monetary benefits a loan trade can bring. With so many institutions searching for loan growth in their communities, organic loan growth has become harder and more expensive to compete for. So, I would look to answer how much money will my bank or credit union save in origination costs from a whole loan trade. Will these loans bring me a larger opportunity to cross sell new borrowers from new markets? Also, how much in fees would I save in using an online loan trading platform
over legacy brokers in the market?
2. What diversification do I need in my portfolio?
While this is often a regulatory concern and question, determining the type of loans that I want to acquire is often a larger strategic initiative. For example, do I need to do a loan trade to achieve our residential loan growth targets for the quarter? Will I be able meet my CRA loan target needs without a whole loan trade? Or do I need to buy a niche loan pool to reduce concentration in core parts of my loan portfolio?
Being able to answer these questions and knowing how to execute them efficiently is critical in engaging in a whole loan trade.
3. How much risk am I willing to absorb?
Like the answers around diversification, determining how much risk your institution is prepared to absorb is key when preparing to enter a whole loan trade. One key insight to get here is not just around what level of risk in the loan asset type, but the credit characteristics within those asset types as well. So are you only looking to acquire prime borrowers in unsecured consumer loans? Does a barbell distribution of risk work if it brings you the loan assets you need?
While there will be more questions asked during a whole loan trade and many more answers needed to complete one, answering the big three questions above will ensure your institution can begin its journey of trading in the secondary market with confidence.