The selling interest in mortgage loans is common in the lending sector since it allows the initial lender to boost liquidity and seek additional funding options while lowering its risk profile. Despite these clear benefits, several less evident dangers are involved with the purchase and sale of participation interests that can generate major problems if lenders fail to detect and mitigate them quickly. Therefore, as a lender, you need to understand the agreement’s structure before participating. Key risks to be considered before becoming a participating lender include:
- Exculpatory Clause for the Lead Lender: Lead lenders to create participation agreements in the form of a buy/sell agreement, declaring that the lead lender is transferring economic rights in the linked loan to the participant(s) without forming an agency relationship. The lead lender should include broad exculpatory language in the participation agreement, emphasizing that they will have no fiduciary responsibility to the participants.
- Borrower’s Default: There is always the potential that the borrower will default on the underlying loan, regardless of the scope and quality of the due diligence. In the event of borrower default, a properly prepared participation agreement should clearly state the rights, duties, and obligations of the lead lender and the participants.
Creating a loan participation agreement, like any other loan investment strategy, takes careful analysis and expert drafting to ensure that all parties’ rights and obligations are clearly defined from the start. As a proactive lender looking to mitigate these risks, you need to effectively assess the terms of the participation agreement to ensure they adequately cover all relevant risks.
To read more about participation agreements and the associated risks, click here.
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