High Risk Bad Credit Signature Loans by ogr17517

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									    CREDIT AND
COUNTERPARTY RISK:
“RISK ASSET” REVIEW


         February 22, 2000

            David Dudley
  Federal Reserve Bank of New York
          CREDIT RISK
       ANALYTICAL FACTORS
• Level, trend, and types of risk in asset portfolios

• Effectiveness of loan administration:
   –   Formal lending and investment policies
   –   Volume and trend of past due loans
   –   Adequacy of credit files
   –   Adequacy of credit review system

• Volume of classifications:
   –   Weighted classification ratio
   –   Total classification ratio
   –   Level and trend of ratios and dollar amounts
   –   Composition of these assets                      2
        CREDIT RISK
     ANALYTICAL FACTORS
• Level, trend, and composition of nonperforming,
  nonaccrual, and renegotiated loans, and foreclosed
  assets

• Volume of concentrations in excess of 25% of
  Tier 1 Capital (and reserves)

• Volume and character of insider and intercompany
  transactions
                                                   3
   CREDIT RISK MANAGEMENT
     EVALUATION FACTORS
ORIGINATION           ADMINISTRATION                 COLLECTION
Strategy              Portfolio Assessment           Payment Processing
Expertise             Concentration Management       Collection Thresholds
Disclosure            Performance to Terms           Workout/Restructuring
Credit Analysis       Asset Review                   Term Changes
Credit Decision       Risk Management and Control    Write-off Management
Pricing/Structuring   Loan Loss Reserve Management   Recovery Management
Products/”Add-ons”




                                                                   4
     CREDIT RISK PROBLEMS

1. Poor or adverse selection.
2. Over-lending/concentrations.
3. Failure to establish/enforcement repayment schedules.
4. Self-dealing.
5. Technical incompetence.
6. Competition.
7. Lack of supervision.
8. Incomplete credit information.
9. Overemphasis on income.
10. Lack of attention to changes in economic conditions.
                                                    5
WHY HAVE LOAN ADMINISTRATION?

Risk management versus risk avoidance!
  – Loan Portfolio: significant contributor or drag on
    earnings.
  – Lending function requires active management.
  – Loan quality impacts capital adequacy.
  – A definition: “The establishment and
    implementation of policies and procedures that
    optimize the lending function by maintaining
    proper credit standards.”

                                                    6
            CREDIT CULTURE
    POLICY, PROCESS and REVIEW

•   Balance between growth and quality.
•   Approval system with accountability.
•   Diversification of risk.
•   Define sales and market strategy
•   Independence loan review and risk rating.
•   Centralized credit policy function.
•   Credit quality incorporated in performance reviews.
•   Credit Policy authority independent of lending and marketing.

• Requires enforcement and commitment by
  management at all levels!                                  7
   THE FIVE ELEMENTS OF
   LOAN ADMINISTRATION
• Loan Policy - sets forth clear policies and specific
  procedures.
• Loan Approval Process - uniform and consistent
  with accountability.
• Loan Monitoring - from day one throughout life of
  loan.
• Loan Review - objective evaluation of individual
  loans and portfolio.
• Problem Loans - deteriorated situations that threaten
  repayment.                                        8
LOAN POLICY - FIRST ELEMENT
A comprehensive Loan Policy includes:
• Objectives
   • Performance Objectives: growth, earnings, liquidity, leverage.
   • Compliance and Law Regulations - also non-discrimination.
   • Lending Authorities
       • Board and senior management responsibilities
       • Delegation to loan committees or individuals
       • Maximum amounts to be extended
   • General Approval Criteria: the criteria used in evaluation of loan
     requests.
• Defined Trade Area
• General Fields of Lending - commercial, consumer,
  secured, unsecured, etc.                                       9
LOAN POLICY - FIRST ELEMENT
• Desirable Loans - legitimate, economically productive
  enterprises in the area.
• Undesirable Loans - specific prohibitions as to purpose or
  borrower.
• Collateral and Appraisal policies
• Loan Administration - broadly define credit administration
  process and responsibilities
   - origination         - administration and collection
   - credit analysis     - review
• Miscellaneous Credit Exposure - contingent liabilities,
  settlement risk, etc.                                10
LOAN POLICY - FIRST ELEMENT
 • Insider Loan Policy
 • Adherence to Loan Policy - responsibilities for
   compliance.
 • Nonaccrual Loans
    – Eligibility following past due interest and/or principal
    – Conditions necessary for exemption
 • Allowance for Loan Losses Allocation - a risk
   assessment judgment.
    – To specific commercial credits
    – To identified sub-portfolios
                                                                 11
LOAN APPROVAL PROCESS-
  THE SECOND ELEMENT
• Loan Committees
  – Best lenders
  – Good Learning experience
  – Uniformity


• Signature System
  – Timely responses
  – Clear responsibility


                               12
LOAN APPROVAL PROCESS-
  THE SECOND ELEMENT
• Standardized Presentation for All Credit
   –   Purpose
   –   Repayment sources
   –   Financial analysis
   –   Collateral evaluation
   –   Structure and terms, Pricing
   –   Loan documentation

• Field Examinations for Secured Loans
   – Adequacy of controls
   – Collateral evaluation
   – Performance trends                      13
      GENERAL LOAN
DOCUMENTATION REQUIREMENTS
Legal - U.S. Business Law
1. Note.                      9.    Stock powers.
2. Security agreement.        10.   Assignment of insurance.
3. UCC Filing (financing      11.   Title (car, boat).
   statement).                12.   Mortgage/Deed of trust.
4. Guaranty (collateralized   13.   Copy of deed.
   or not).                   14.   Assignment of leases
5. Subordination agreement.   15.   Title insurance policy
6. Corporate resolution.      16.   Loan agreement
7. Participation agreement.
                                                      14
8. Form U-1.
      GENERAL LOAN
DOCUMENTATION REQUIREMENTS
Credit
1. Loan application.         7.   Key-man insurance
2. Commitment letter.        8.   Appraisal.
3. Tax returns.              9.   Credit bureau report.
4. Personal financial       10.   Credit memorandum.
   statements.              11.   Correspondence.
5. Business financial       12.   Loan review.
   statements.              13.   Inspections.
6. Evidence of insurance.   14.   Other
                                                     15
THE 5 C’S OR 5 P’S OF CREDIT
    Character    People
    Capacity     Payment
    Capital      Purpose
    Collateral   Protection
    Conditions   Prospects



                              16
   PEOPLE OR CHARACTER
Measures borrower’s “willingness to pay”
    Payment History
    Credit Report
    Information from Other Lenders
    Information from Loan Discussion



                                           17
   PAYMENT OR CAPACITY
Measures borrower’s “ability to pay”
    Payment Source
    Income to Debt Service
    Cash Flow to Debt Service
    Living Costs and Other Income



                                       18
     PURPOSE OR CAPITAL
How was the money used?
    Purchase Asset?
    Working Capital?
    Debt Refinance?

What is the Leverage Position?
    Debt to Worth
                                 19
PROTECTION OR COLLATERAL
What are Bank’s options if the loan is not paid?
    What is pledged collateral?
    Lien position? Perfected?
    What is market value?
    Easily marketed?

Borrower’s Financial Strength:
     Analyze Net Worth
     Adjust for Changes in Debt and Assets Value

Review Encumbered Assets                           20
PROSPECTS OR CONDITIONS
Borrower’s Circumstances:
     Within the Industry
     Cyclical Trends
     New Developments
     New Laws and Regulations
      (e.g., EPA Cleanup)

                                21
THE 5 C’S OF BAD CREDIT
       Complacency
       Carelessness
       Communication
       Contingencies
       Competition



                          22
          LOAN MONITORING -
          THE THIRD ELEMENT
• Tracking - Key Elements
  –   Interim results
  –   Agings of receivable and payables
  –   Inventory levels
  –   Borrowing levels
  –   Actual vs. plan
  –   Credit file maintenance

• Risk Rating Determines Degree of Monitoring
  –   Responsibility of loan officer
  –   Rating consistently reflects risk
  –   Degree of risk relates frequency of monitoring
  –   Risk ratings influence loan pricing
                                                       23
       LOAN REVIEW -
    THE FOURTH ELEMENT
• Review of Individual Credit by Objective Third Party
   – Confirm risk ratings
   – Identify deteriorating situations
   – Monitor remedial action


• Review of total portfolio
   – Industry concentrations
   – Identification of economically weak industries
   – Aggregate findings to be reported to the Board


                                                      24
PROBLEM LOAN ADMINISTRATION -
      THE FIFTH ELEMENT
 • Performance - One of Three Ways
 • There Will Always Be Problem Loans
 • Cost of Problem Loans
    –   Lost interest and principal
    –   Absorption of loan officer time
    –   Legal costs
    –   Morale

 • Early Identification is Critical!
 • Three Lines of Defense
    – Loan Officer
    – Loan Review
    – Outside Examiners                   25
 STAGES OF A PROBLEM LOAN
• Salvageable - where deterioration first occurs
   –   Financials deteriorate
   –   Loan not performing as expected
   –   Borrower’s attitude changes
   –   Situation requires action

• Greater Fool Phase - business is salvageable but…
   – Deteriorating signs continue
   – Management resists
   – Find a different lender


                                                      26
 STAGES OF A PROBLEM LOAN
• Workout - The Twilight Zone - problem worsens
   – More loans critical
   – Question business servicing
   – Setting of conditions prior to new funding


• Liquidation - The Titanic Zone - glub, glub
   – Creditors take possession of assets
   – Assets liquidated
   – Realization of losses


                                                  27
          STEPS IN
PROBLEM LOAN ADMINISTRATION
 • Workout Specialists
    –   Efficient and objective
    –   Technical expertise and experience
    –   Establish an agreed upon workout plan
    –   Separate from origination function
    –   Manage lender liability

 • Strategy for Recovery
    – Obtain additional collateral
    – Reduce outstandings


                                                28
          STEPS IN
PROBLEM LOAN ADMINISTRATION
 • Borrower Has To Do The Restructure
    – Obtain management’s cooperation
    – Show the risk of liquidation


 • Additional Funds?
    – Documentation and legal preference are critical


 • Strategy for Recovery
    – Obtain additional collateral
    – Reduce outstandings
                                                        29
          STEPS IN
PROBLEM LOAN ADMINISTRATION
 • Role of Attorneys in Liquidation
    – Bankers must retain control of business decision
    – Lawyers are expensive


 • Charge Off Administration
    – Continue collection efforts
    – Borrower should be unaware of charge-off




                                                         30
SYMPTOMS OF TROUBLED LOANS
 FINANCIAL
   Leverage
   – Trend
   – Industry norm

  Profitability
   – Gross profit margin
   – ROE and ROA
   – Debt service coverage

  Liquidity
   – Working Capital
      • Current ratio
      • Quick ratio
      • Receivable, inventory, payable turns
   – Cash Flow                                 31
SYMPTOMS OF TROUBLED LOANS
 NON-FINANCIAL
  Financial Data
   – Timeliness of receipt
   – Adequacy of content


  Changes in Management Style
   –   Turnover of key people
   –   Quality of forecasts
   –   Inability to meet budget
   –   Detailed knowledge of operations

                                          32
SYMPTOMS OF TROUBLED LOANS
 NON-FINANCIAL
   Changes in Industry, Market or Product
   – Awareness of changes
   – Management plans in anticipation


   Changes in Communication Patterns
   – Lack of openness, reluctance to discuss
   – Incomplete financial data
   – Surprises !


   Adverse News from Public Services, Suppliers   33
SYMPTOMS OF TROUBLED LOANS
 LOAN OFFICER
   – Ignorance
      • lack of training or inexperience

   – Workload
      • excessive workload impacts problem detection

   – Procrastination
      •   Hoping problem will go away
      •   Avoiding the unpleasant
      •   Ego; admission of failure
      •   External forces; problem beyond control
      •   Fear of management retribution
      •   Reaction to the community
      •   Lender liability potential !!                34
            SUBSTANDARD
An asset that is inadequately protected by the
current sound worth and paying capacity of the
obligor or of the collateral pledged, if any. Assets
so classified must have a well-defined weakness
or weaknesses that jeopardize the liquidation of
the debt. They are characterized by the distinct
possibility that the bank will sustain some loss if
the deficiencies are not corrected.
                                                 35
          CHARACTERISTICS OF A
           SUBSTANDARD ASSET
• Significant deviation from the original source of repayment
• Diversion of repayment funds
• Delinquency
• Carry-over debt
• Failure to clean-up a short-term operating line
• Numerous extensions and/or renewals without identified
  sources of repayment
• Significant negative trends in financial statements
    – deterioration in accounts receivable, decrease in net worth,   36
      decrease in profitability, cash flow, working capital
                DOUBTFUL
An asset that is classified Doubtful has all the
weaknesses inherent in one classified Substandard
with the added characteristic that the weaknesses
make collection or liquidation in full on the basis
of currently known facts, conditions, and values
highly questionable and improbable.


                                                37
         CHARACTERISTICS OF A
           DOUBTFUL ASSET
• All of the Substandard characteristics plus a loss exposure
  that cannot be readily defined with present circumstances
  and conditions
• Undetermined value of collateral
• The possibility of loss is extremely high, but because of
  certain important and reasonably specific pending factors
  that may work to the advantage and strengthening of the
  asset, its classification as an estimated loss is deferred until
  its more exact status may be determined. Pending factors
  include proposed merger, acquisition, or liquidation
  procedures, capital injection, perfecting liens on additional
                                                             38
  collateral and refinancing plans.
                     LOSS
An asset that is considered uncollectible and of
such little value that its continuance as a bankable
asset is not warranted

This classification does not mean that the asset
has absolutely no recovery or salvage value but
rather it is not practical or desirable to defer
writing off this basically worthless asset even
though partial recovery may occur in the future.39
        CHARACTERISTICS OF A
            LOSS ASSET
• Severe delinquency

• Unsecured

• Statutory bad debt --- 180+ days past due

• Not well secured and not in the process of collection

                                                          40
          SPECIAL MENTION
An asset that has potential weaknesses that
deserve management’s close attention. If left
uncorrected, these potential weaknesses may
result in the deterioration of the repayment
prospects for the asset or the institution’s credit
position at some future date.

Special Mention assets are not adversely
classified and do not expose an institution to
sufficient risk to warrant adverse classification. 41
            EXAMINATION RATIOS
• Total Classifications =            Total Classification Ratio
  Tier 1 Capital + LLR

• 20%*SS+50%*D+L =                   Weighted Classification Ratio
  Tier 1 Capital + LLR

• Delinquency statistics
   –   90+ days past due/Total loans
   –   Nonaccrual loans/Total loans
   –   Nonperforming loans (NPLs)/Total loans
   –   NPLs+foreclosed assets/Total loans+foreclosed assets
   –   Total past due loans/Total loans                       42
    LOAN LOSS RESERVE
METHODOLOGY AND ADEQUACY
    General Rules:
•   Loan loss reserves must always cover known and potential
    losses
•   US accounting rules and the FFIEC's Interagency Policy
    Statement on Loan Loss Reserves (12/93) govern the booking
    and maintaining of loan loss reserves
•   Provisioning is general and expensed against current earnings;
    specific provisions are equivalent to charge-offs
•   ICERC-mandated (minimum) reserves against sovereign
    exposure are specific
•   Reserve methodologies are unique to each institution but the
    fundamental techniques can be generalized
•   General philosophy: Provision and charge-off now; recover 43later
    LOAN LOSS RESERVE
METHODOLOGY AND ADEQUACY
  What is not clearly defined:
• What asset exposures can be charged-off against the LLR?
   – Loans-yes, securities-no, ORE-no, derivatives-not so clear

• Loss timeframe is variable
   – FFIEC (life of loan) vs. FASB (1 year)  FFIEC loses
   – securitized assets (at transfer, life of loan)

• What are differences between LLR and "holdback" or "liquidity"
  reserves?

• "Adequately reserved" vs. "Over-reserved" -- cushion

• The "Art" vs. The Science                                       44
 LOAN LOSS RESERVE ACCOUNTING
• Beg. Balance LLR
  + Provisions                   earnings impact
  - Charge-Offs                  no direct impact to earnings
  + Recoveries                   no direct impact to earnings
  +/- Adjustments                mergers, sales, acquisitions, etc.
  End. Balance LLR
• Provisioning expenses reduce current taxes, if tax authorities have
  evidence that estimated losses and actual cash losses are "close;"
  otherwise, actual losses are charged against income (for tax
  purposes)

• An observation: Consumer loan losses are generally absorbed
  through current provisioning while commercial loans require longer-
                                                                45
  term provisioning
       LOAN LOSS RESERVE
    GENERALIZED METHODOLOGY
• Known and potential losses = expected losses + unexpected losses

• Loan-by-loan analysis for problem assets
   – full and timely recovery prospects
   – collateral considerations

• General weighting for remainder of portfolio
   – loss rate
   – possible bond proxy data use

• Level and trend of problem loans
  Level and trend of nonperforming loans

• Local, national, and international economic conditions
                                                             46
• Portfolio composition and growth; concentrations
         LOAN LOSS RESERVE
       ENHANCED METHODOLOGY
• Increased granularity of bank-specific loan data
   – portfolio type, product type, risk rating - regulatory or internal, loan officer,
     branch, vintage
   – bond proxy data used as sanity check

• Correlations between industries, geographies, and portfolios

• Long-term loss data collection effort
   – migration analyses
   – “boom” and “bust” cycle data collected

• “Base” and “worst” case scenario analyses (dynamic)

• Tax adjustment factors
                                                                                47
          WHAT’S THE LOSS?
• $500 million commercial real estate loan
  $625 million appraised value “when completed”

• Two years later, project is bankrupt because of major
  economic downturn

• Loan is now $500 million and $100 million of
  interest receivable

• What are the considerations for loss potential?
                                                    48
            WHAT’S THE LOSS?
  What are the considerations for loss potential?

• Appraised Value
   – function of completion
• Completion costs?
• Maintenance costs
   – landscaping, security, weather, deterioration
• Taxes
• Legal fees
• Sales costs
   – brokerage, advertising, leasing concessions?
• Time
   – foreclosure to sale
• Funding cost of carry, “Return?”
                                                     49
  Result? Interest reversal, charge-off of ?
      A SIMPLE TOOL FOR
 LOAN LOSS RESERVE ADEQUACY
• Using (admittedly) rough loss estimates for classified
  assets and a generalized loss rate for the rest of the
  portfolio, examiners can test loan loss reserve adequacy

• Excess/(Shortfall) = Current LLR-15%*SS-50%*D- L-
                       (3 yr. net loss rate*rest of portfolio)

• Static analysis, assumes that we classified correctly, loss-
  rates assumption-driven, arbitrary three year timeframe

• Bottom line: We expect better bank-specific             50
               methodologies !!!
      FINAL THOUGHTS
• Beware the fallacy of precision !

• It’s a model --- evaluate the assumptions
               --- review the performance

• Watch the short-run and the long-run !




                                              51
The End

								
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