Loan Servicing Policies and Procedures

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					                                                                Loan Fund

                                               Tip Sheet
                                                                                                Number 5, June 2005
                                                               Published by the Economic Development Finance Service




                 Loan Servicing Policies and Procedures


S
       ound underwriting is only half of the lending               Projections;
       challenge. No matter how solid a loan appears               Personal financial statements; and
       when initially made, effective servicing is                 Personal tax returns.
required to ensure that the borrower stays compliant
                                                                Section 2
with loan covenants; to respond to borrower problems
                                                                   Account information; and
early in order to prevent defaults; and, in the event of a
                                                                   Contact information.
default, to protect the lender’s ability to recoup its
investment. According to the policies and procedures            Section 3
manual for the Philadelphia Industrial Development                 Information about the loan presented to loan review
Corporation (PIDC) in Pennsylvania, servicing tracks               committee over the years.
loan repayment, insurance maintenance, the borrower’s
financial health, and how well the company is meeting           Section 4
employment objectives.                                             Running memos and analysis.

Including servicing standards in a loan fund’s policies         Section 5
and procedures manual is an important part of fund                 Correspondence.
management. The manual is helpful for new staff and             Section 6
loan review committee members and is a guide for
                                                                   Insurance; and
applying annual review, collection, and other standards
                                                                   Other
to all loans in the portfolio.
                                                                East Central Regional Development Commission in
Servicing Files                                                 Mora, Minnesota, recommends also including a summa-
                                                                ry sheet for each loan. It should include general infor-
Servicing files provide a complete history of the life of       mation about the loan, such as business contact infor-
a loan. They should be both detailed and easy to navi-          mation, federal identification number, loan structure,
gate so that the loan officer, the lender’s finance officer,    other lending sources, payment dates, job creation,
auditors, federal agency overseers, and others can              North American Industry Classification System
quickly learn the loan’s status. Dana Sumner, of                (NAICS) number, Uniform Commercial Code (UCC)
Development Finance Training and Consulting (DFTC),             continuation filing reminder, and dates to request finan-
suggests that files include the following sections:             cial statements.
Section 1
   Loan information;                                            The Annual Review
   Jobs impact data;                                            Loan fund staff should conduct formal visits of their
   Collateral information;                                      borrowers at least once a year (unscheduled and infor-
   Year-end business financial statements;                      mal visits at other times are also recommended) for a
   Interim financial statements;                                variety of reasons, including getting an update about the
   Business tax returns;
business’ market, discussing problems faced by the bor-            Financial Statements
rower, checking the condition of loan collateral, and              Good portfolio management practices necessitate that
finding out if the company is still compliant with loan            borrowers submit financial statements on an annual
requirements. A site visit form can be used to docu-               basis (new companies should submit quarterly finan-
ment these findings. This form, as well as a memo                  cials). Submission requirements are detailed in the
summarizing the visit (including such sections as site             commitment letter.
review, interview with borrower, financial review, and
action needed), are submitted to the loan review com-              While certified public accountant (CPA)-audited finan-
mittee and filed.                                                  cial statements are preferred, loan fund professionals
                                                                   accept CPA-reviewed statements, CPA-compiled state-
Impact Data                                                        ments, and tax returns. PIDC uses the following sub-
Federal agencies and usually require periodic reports              mission requirements:
from the loan funds they capitalize. As time-consuming
as these reports can be to prepare, their ultimate value is           Borrowers with less than $1 million in annual rev-
in demonstrating the important role played by loan                    enues have to submit at least corporate and personal
funds in economic development. Borrowers are an                       tax returns;
indispensable source of employ-                                                            Borrowers with between $1
ment and other impact data includ-                                                         million and $2 million in rev-
ed in these reports.
                                         Borrower Information to                           enues have to submit at least
                                                                                           CPA-compiled statements and
The Rural Electric Economic              Check on Annual Basis
Development, Inc. (REED) Fund                                                              corporate and personal tax
in Madison, South Dakota, has its                                                          returns;
                                             Additions/improvements/changes to
borrowers complete an annual                 collateral;                                   Borrowers with between $2
business impact survey to evaluate           Changes in ownership or control of            million and $10 million in rev-
the social and economic impact of            business;                                     enues have to submit at least
its loan portfolio. It collects and          Proof that property taxes are current;        CPA-reviewed statements and
keeps confidential information               Proof that liability, property, auto,         corporate and personal tax
such as the number of full- and              worker’s compensation, and life               returns; and
part-time employees, benefits pro-           insurance policies are current and
vided, total amount of payroll               paid promptly;                                Borrowers with more than $10
witholding taxes, total wages and            UCC dates verified for renewal; and           million in revenues have to
salaries paid, taxes paid, and sales         Annual financial statements and tax           submit CPA-audited state-
activity by geographic area. PIDC            returns received.                             ments.
annually asks for the number of
                                                                                         The purpose of requesting finan-
employees by position to track the       Tips from Dana Sumner, DFTC.                    cial statements is to determine the
borrower’s compliance with mutu-
                                                                                         borrower’s ability to continue
ally agreed upon employment
                                                                                         servicing their debt. Variances,
goals set prior to loan closing.
                                                                   discrepencies, and trends can be identified by compar-
Insurance                                                          ing current year financial statements to projections and
Loan funds also are responsible for making sure that               previous years’ financials. Loan fund professionals
tangible assets in which they have a security interest are         should not hesitate to ask questions about such red flags
insured. According to PIDC, borrowers are required to              as fast growth, decreasing net worth, increasing officer
provide liability and property insurance for the asset on          compensation, and new debt.
an ongoing basis until the loan has been fully repaid.
                                                                   To improve borrowers’ compliance with submitting
They also need to annually submit an insurance binder
                                                                   documents, some loan funds incorporate into the com-
that specifies the following information:
                                                                   mitment letter and promissory note language about
   Nature of the insurance provided;                               penalties that go into effect when documents that are
   Appropriate insurance limits;                                   required annually are not received. To induce borrow-
   Expiration date;                                                ers to be more punctual, loan funds can impose an inter-
   Correct identity of named insured; and                          est penalty of, say, 5 percent on each monthly payment
   Correct identification of PIDC as loss payee and/or             during the period that information is not received.
   mortgagee.
Risk Rating Update
Once a borrower’s financial statements have been
reviewed, their risk rating is updated as part of the loan       The Importance of Using
fund’s portfolio management. The Southeast Alaska                Loan Servicing Software
Revolving Loan Fund (RLF) in Juneau, Alaska, assigns
risk ratings that range from 1 (exceptional -- loans with        A growing number of loan funds are turning
strong primary and secondary sources of repayment) to            to loan servicing software packages to track
3 (satisfactory -- loans with moderate primary and sec-          loans, generate reports, and increase the effi-
ondary sources of repayment or weak primary and                  ciency of their operations. While EDFS does
strong secondary sources of repayment) to 5 (substan-            not advocate any one program, it does urge
dard -- loans for which repayment is inadequately pro-           loan fund professionals who do not currently
tected by the capacity of the borrower or the collateral         have a program to consider the benefits of
pledged) to 7 (loss -- loans which have been partially or        investing in one.
completely written off). To reduce the risk of delin-
quency and default, technical assistance and increased           Loan servicing software programs facilitate
attention should be provided to borrowers with higher            the work of loan fund professionals in such
and worsening risk ratings.                                      ways as compiling and tracking information
                                                                 on loans in the portfolio, preparing a variety
Changes in risk ratings are communicated to the loan
                                                                 of necessary forms and reports, and linking
review committee. It is policy at the Southeast Alaska
                                                                 loan fund financial data with the parent orga-
RLF that a problem loan report is completed within 30
                                                                 nization’s accounting system. In a broader
days of a rating downgrade and updated quarterly. The
                                                                 sense, purchasing a software program is one
report includes a description of the problem and the
                                                                 of a number of strategies for raising the stan-
loan’s status, an evaluation of primary and secondary
                                                                 dards of professionalism of the loan fund
sources of repayment, a description of appropriate
                                                                 community.
upgrade and downgrade triggers, and a strategy and
action plan for rectifying the problem.
                                                                 For more information, visit
Changes in Collateral and Owners/Guarantors                      www.nado.org/edfs for a copy of Loan
Occasionally, a loan’s collateral, owners, and/or guaran-        Servicing Software: A Buyer’s Guide, free for
tors change during the life of the loan. If so, the loan         EDFS members, $10 for nonmembers.
should be re-analyzed to determine the impact of such
changes on the viability of the loan. If needed, addi-
tional collateral is taken. The loan file should include
documentation of the board’s approval of the change.

Collection Policies                                             Some loan funds mail monthly invoices prior to the
                                                                due date, while others provide a payment coupon
Collection procedures should be explicit about the fol-         booklet at the loan closing.
lowing:
                                                                The most effective and reliable means of collecting
   When and how payments will be made;                          is by debiting a borrower’s bank account on a partic-
   When the fund manager will review files for late             ular date each month with electronic funds transfers
   payments;                                                    (EFTs) through the Federal Reserve’s Automated
   Notification procedures in the event of delinquency          Clearing House (ACH). This approach reduces
   and default;                                                 paperwork for the loan fund and borrower and
   Penalties to be charged; and                                 improves the cash flow of the fund. According to
   The role of attorneys and/or third-party collection          EDFS members, ACH/EFT software is available at a
   agencies.                                                    reasonable cost.

Payment Schedule and Method                                  Reviewing Files for Late Payments
Loan fund professionals use various systems for collect-     To be sure late payments are identified on a timely
ing payments:                                                basis, loan officers print a payment history on a regular
                                                             basis; weekly or bi-weekly on a set day is preferred.
   Borrowers can be given an amortization schedule at        Loan servicing software can automatically prepare these
   the loan closing so they know payment amounts and         aging reports.
   due dates.
Late Payment Procedures                                                     Penalties
Loan funds usually offer a grace period of 10-15 days.                      Penalties are usually applied as soon as the grace period
                                                                            expires. These can take the form of late fees (a set dol-
Once this period has passed, a loan fund staff member                       lar amount or percentage of the amount due), or an
calls the borrower to determine why the payment is past                     increased interest rate until the borrower pays, such as
due and to request the payment. For legal purposes,                         raising a rate that is normally 5 percent up to 18 per-
calls should be documented and a letter sent to the bor-                    cent.
rower detailing the conversation.
                                                                            Delinquencies can impact risk ratings. ACEnet
Others send a letter informing the borrower their pay-                      Ventures, Inc. in Athens, Ohio, has a policy that bor-
ment is late, that the lender could demand full payment                     rowers who are more than 30 days late will be reviewed
of the loan if the monthly payment is not made, and that                    and considered for a lower rating; those over 60 days
the borrower risks legal action if no payment is                            delinquent will be classified with a lower rating. A lack
received. Penalty fees are sometimes added as soon as                       of response results in the lowest rating and potential
the grace period ends.                                                      legal actions.
If the delinquency persists, additional letters are sent,
usually at the 30- and 60-day late points; at least one                     Reports
EDFS member declares the entire unpaid loan balance
immediately due and payable 11 days past the grace                          Loan funds are obligated to provide the following
period. Meetings with the borrower can be held during                       reports to their borrowers and funding agencies:
this period to discuss the possibility of restructuring the                 Borrower
loan to ensure repayment and providing technical assis-                       1098 report of interest paid;
tance as needed. Also during this period, the loan fund                       Report of annual servicing fees; and
manager can bring the matter before the loan review                           Outstanding principal balance.
committee to discuss options.
                                                                            Funding Agency
After 90 days without payment, the loan is declared in                        Annual and other periodic reports;
default, and the fund can refer the case to a third party                     Problem loans report; and
collection agency and/or an attorney for legal action,                        Report of violations of programmatic requirements.
which could include foreclosure and auction of assets.
Borrowers are liable for the lender’s legal fees.
                                                                            For More Information
Regardless of the timetable a loan fund uses to notify
past due borrowers, it is important that the timetable be                       DFTC: Dana Sumner, 207.923.3030,
applied consistently in all cases so there is no hint of                        dsumner@devftc.com;
partiality on the part of the fund. In addition, loan fund                      East Central Regional Development Commission:
borrowers could one day be eligible for a bank loan, so                         Pat Oman, 320.679.4065;
they need to be familiar with collections procedures that                       PIDC: Jean DeBellis, 215.496.8153, jdebellis@pidc-
approximate those used by banks. Finally, sound col-                            pa.org;
lection procedures safeguard the loan fund’s assets; low                        REED Fund: Linda Salmonson, 605.256.8015,
delinquency and default rates mean the loan fund can                            lsalmonson@eastriver.coop; and
make more loans faster.                                                         Southeast Alaska RLF: Margaret O’Neal,
                                                                                907.463.3662, moneal@jedc.org.




 This project is funded by a grant from the US Small Business Administration (SBA). SBA’s funding should not be construed as an endorsement of
                any products, opinions, or services. All SBA-funded projects are extended to the public on a nondiscriminatory basis.

                   Economic Development Finance Service (EDFS) is a program of the
            National Association of Development Organizations (NADO) Research Foundation
                      400 North Capitol St., NW, Suite 390, Washington, DC 20001
      Phone 202.624.7806    Fax 202.624.8813      Email bamt@nado.org    Web www.nado.org/edfs