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Washington Bankers Association

June 2014

Credit & Risk Review Executive Development Program 2014

Jeffery W. Johnson

Bankers Insight Group, LLC

770-846-4511

jeffery.johnson@bankers-insight.com

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TABLE OF CONTENTS

Credit and Risk Review entails management of the entire credit administration area of banks.

Management of credit risk is vitally important for banks because poor asset quality is the number

one reason why banks fail. As you recall, Asset Quality is the second factor in the CAMELS rating

system utilized by regulators to measure the health of financial institutions. Therefore,

understanding this aspect of banking is very important for bank management.

There are seven distinct characteristics well managed and successful banks have in their Credit

Administration area. This course will evaluate the reasoning and requirements for each of these

characteristics so that the participant can begin the process of developing such a culture within their

respective organization. The seven characteristics are as follows:

1. Well Defined Credit Culture Established and Supported by

a. An Effective Loan Policy

2. Highly Effective Risk Assessment and Credit Underwriting System by

a. Choosing the right personnel to be Credit Analysts, Lenders or Loan Administrators

b. Knowing how to balance Risk and Rewards through proper credit, ratio and cash

flow analysis

c. Knowing how to report risk assessment by writing effective credit memoranda

3. Highly Effective Credit Committee that

a. Considers all pertinent information

b. Allows members to express their opinion “freely”

c. Records Minutes that matter

4. Utilize Credit Risk Rating to Identify Risk in the Loan Portfolio by:

a. Clearly defining credit grades and applying them to various types of borrowers

b. Utilizing a clear, objective and measurable loan grading system

5. Loan Documentation Procedures that will:

a. Identify the Borrower’s legal structure

b. Identify, value and properly classify the collateral (emphasizing appraisal reviews)

c. Evidence the debt outstanding

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d. Attach the bank’s security interest in the collateral

e. Perfect the bank’s lien position in the collateral

6. Effective Loan Portfolio Management by:

a. Defining the expectations of loan officers in the management of their loan portfolio

b. Using Loan Agreements, Covenant Compliance Reports and other monitoring tools

to manage the loan portfolio

7. Problem Loan Management and Accounting

a. Identifying problem loans, managing and accounting for them

b. Adopting prudent commercial real estate loan workout strategies for problem loans

c.

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BACKGROUND:

Credit Risk Administration Defined

Credit Administration is the oversight of all activities related to a bank’s credit process ensuring the

bank’s largest balance sheet asset – the loan portfolio – maintains its value.

It comprises the entire credit process

policy/procedure, underwriting guidelines,

application – underwriting-approval-documentation

booking – servicing

credit management

portfolio management

monitoring delinquencies (to include overdrafts)

problem credit management

regulatory reporting – regulatory compliance

A/L Management

financial reporting (ALLL)

Risk Management is:

A continuous process (not a static exercise) of identifying risks that is sometimes subject

to quick and volatile changes. The identification of risks may result in opportunities for

portfolio growth or may aid in avoiding unacceptable exposures for the institution.

A subjective evaluation driven by the experience of the lending and credit policy

management team of your financial institution.

Effective credit risk management is achieved through:

A comprehensive credit policy; augmented by

Supporting underwriting and portfolio management guidelines; implemented by

Qualified staff; executing

Efficient processes and procedures from application through payoff.

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It should be pointed out that hope is not an effective risk management strategy!”

Primary Causes of Loan Loss

Poor Initial Selection of Risk

Timidity

Over lending

Documentation Flaws

Failure to Implement Approval Terms and Conditions

(Vaughn Pearson, Problem Loan Fundamentals, RMA Web seminar)

Key words: Discipline & Integrity

TECHNIQUES FOR MAINTAINING A HIGH QUALITY LOAN PORTFOLIO

No one thing assures a high quality loan portfolio…

It is the aggregation of all people and processes from application through payoff

But it is only as effective as one underlying fundamental – A well-defined Policy

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EFFECTIVE HABIT #1:

WELL DEFINED CREDIT CULTURE SUPPORTED BY A GOOD LOAN POLICY CULTURE

The above factors are items that can be established and measured. But what about those

intangibles? You know, those things that people do, think, say and behave without any formal

instructions from some type of a policy. I am talking about “Culture”. Culture is the key attitudes

and behaviors of members of a group. It is what people think and what people do. For an example,

a sales culture exists in a bank when these attitudes and behaviors are pro-selling and selling is

perceived as legitimate and important. It is part of the job.

A bank’s credit culture is the sum of its credit values, beliefs and behaviors. It is what is done and

how it is accomplished. It exerts a strong influence on a bank’s lending and credit risk

management. Values and behaviors that are rewarded become the standards and will take

precedence over written policies and procedures.

What is the dominate Culture within your bank? Let’s discuss this

RISK PROFILE

A bank’s risk profile is more measurable than its credit culture. A risk profile describes the various

levels and types of risk in the portfolio. The profile evolves from the credit culture, strategic

planning, and the day-to-day activities of making and collecting loans. Developing a risk profile is

no simple matter as it varies from bank to bank. Some banks approach credit very conservatively,

while growth –oriented banks may approach lending more aggressively

It is all about achieving a good CAMELS Rating!

C

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The Importance of a Loan Policy "Tune-Up"

The fortunes of FDIC-insured institutions have been closely tied historically to how well they

managed credit risk. A written loan policy, approved by a bank's board of directors and adhered to

in practice, is of critical importance in ensuring that the bank operates within prescribed risk

tolerances. In today's fiercely competitive and challenging lending environment, an up-to-date

policy, appropriate to an institution's lending function and business plan, may be more important

than ever. This article summarizes features and benefits of an effective policy, details warning

signs and potential consequences of an outmoded policy, and offers practical advice about

reviewing and updating a loan policy.

Elements of an Effective Loan Policy

Written loan policies vary considerably in content, length, and specificity, as well as style and

quality. No two institutions share the same tolerance for risk, offer the same product mix, and face

the same economic conditions. An effective loan policy should reflect the size and complexity of a

bank and its lending operations and should be tailored to its particular needs and characteristics.

Revisions should occur as circumstances change, and the policy should be flexible enough to

accommodate a new lending activity without a major overhaul.

During risk management examinations, examiners make a determination about the adequacy of an

institution's loan policy. Bank examiners are guided in their review by regulations, examination

guidelines, and common sense: Is the policy up-to-date and are important areas adequately

addressed? The FDIC Manual of Examination Policies lists broad areas that should be addressed in

written loan policies, regardless of a bank's size or location (see box below).1

A Loan Policy Should Address...

General fields of lending

Normal trade area

Lending authority of loan officers and committees

Responsibility of the board of directors in approving loans

Guidelines for portfolio mix, risk diversification, appraisals, unsecured loans, and rates of

interest

Limitations on loan-to-value, aggregate loans, and overdrafts

Credit and collateral documentation standards

Collection procedures

Guidelines addressing loan review/grading systems and the allowance for loan and lease

losses

Safeguards to minimize potential environmental liability

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A loan policy should include more detailed guidelines for each lending department or function. For

example, the real estate lending department should comply with specific guidelines appropriate to

the size and scope of its operations. In fact, as part of the Interagency Guidelines for Real Estate

Lending Policies, the federal banking agencies list 57 areas to be considered in written policies on

real estate lending, ranging from zoning requirements to escrow administration.2

In addition, in 1995, the federal banking regulatory agencies established basic operational and

managerial standards for loan documentation and credit underwriting.3 These standards also should

be incorporated into a bank's written loan policy. For example, loan documentation practices

should take into account the size and complexity of a loan, the purpose and source of repayment,

and the borrower's ability to repay the indebtedness in a timely manner. And among other things,

underwriting practices should include a system of independent, ongoing credit review and

appropriate communication to management and the board of directors.

Benefits of an Effective and Up-to-Date Loan Policy

A sound loan policy, established and overseen by the board of directors, reflects favorably on the

board and management. When a board sets forth its expectations clearly in writing, management is

better positioned to control lending risks, ensure the institution's stability and soundness, and fulfill

oversight responsibilities. An effective and up-to-date loan policy increases the likelihood that

actual loan documentation and underwriting practices will satisfy the board's expectations.

Furthermore, a well-conceived policy clearly and comprehensively describes management's system

of controls and helps examiners identify high-risk areas and prioritize and allocate examination

time.

In 1997, the FDIC began implementing new, risk-focused examination processes.4 During a risk-

focused examination, examiners focus on areas that represent the greatest risk to the insured

institution. A written policy is tangible evidence of the processes that have been established to

identify, measure, monitor, and control risks in the lending area. An incomplete or inadequate

policy makes it more difficult to identify potentially high-risk areas and may raise supervisory

concerns about an institution's risk management practices.

Signs That a Loan Policy Needs a Tune-Up

A recent cover date does not provide adequate assurance that a policy is current. Only a careful

review of the entire policy will reveal the extent of any shortcomings; however, even a cursory

review can provide clues that a policy needs an overhaul. Common red flags include:

The policy has not been revised or reapproved in more than a year.

Multiple versions of the policy are in circulation.

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The table of contents is not accurate.

The policy is disorganized or contains addendums from years past that have never been

incorporated into the body of the policy.

The policy contains misspellings, typos, and grammatical errors.

Officers and directors who no longer serve are listed, or new ones are not listed.

The designated trade territory includes areas no longer served, or new areas are omitted.

Discontinued products are included, or new products are not addressed.

New regulations are not addressed.

In addition, a review of lending decisions may identify areas where management is departing from

the specifics of the loan policy, such as:

Actual lending practices vary significantly from those outlined in the policy.

Numerous exceptions to policy requirements have been approved.

Policy limits are being ignored.

Exceptions to policy should be few in number and properly justified, approved, and tracked. If

actual practices vary materially from the written guidelines and procedures, the source of this

discrepancy should be identified, and either actual practices or the written policy should be

changed. Management may conclude that specific sections of the written policy are no longer

relevant. A case is then made to the board of directors to amend the policy to reflect different, but

still prudent, procedures and objectives.

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Potential Consequences of an Inadequate Loan Policy

Outdated and ineffective loan policies can contribute to a range of problems. Introducing a loan

product that is not adequately addressed in the written loan policy can create a variety of challenges

for the lending staff and involve risks that management did not anticipate.

If lending authorities, loan-to-value limits, and other lending limitations are not revised when

circumstances change, a bank could be operating within guidelines that are too restrictive, too

lenient, or otherwise inappropriate in light of the bank's current situation and lending environment.

If guidelines do not comply with current laws and regulations, lending decisions may not reflect

best practices or regulatory requirements. Imprudent lending decisions can have a ripple effect. A

loan policy that does not anticipate the risks inherent in an insured institution's lending practices

can lead to asset quality problems and poor earnings. In turn, earnings that do not fully support

operations increase an institution's vulnerability to adverse movements in interest rates, a downturn

in the local economy, or other negative economic events.

The Loan Policy Updating Process

A bank's loan policy is not a static document, but rather should be revised as the institution,

business conditions, or regulations change. A comprehensive annual review, in addition to more

limited reviews as needed, will help ensure that a loan policy does not become outdated and

ineffective. The frequency and depth of the reviews will depend on circumstances specific to each

institution, such as growth expectations, competitive factors, economic conditions, staff expertise,

and level of capital protection. Planned changes to an institution's lending function or business plan

should prompt a modification to the policy. Pertinent criticisms and recommendations made during

recent audits and regulatory examinations should be considered during the updating process.

In certain situations, a loan policy can be updated effectively through addendums or supplemental

memorandums, but if carried too far, such "cobbling together" can result in a cumbersome and

disorganized document. It is best to merge supplementary materials periodically into a logical place

in the main document. The updating process also includes identifying obsolete or irrelevant

sections of the policy. For example, a bank might have entered a new field of lending a few years

ago and modified its loan policy at that time. However, when it became obvious the bank could not

compete successfully in this field, management wound down the operations. The loan policy

should reflect the decision to exit that lending niche.

Compliance testing, conducted as part of the updating and audit processes, will help management

determine whether staff is aware of and adhering to the provisions of a loan policy. An institution's

board of directors should demonstrate their commitment by emphasizing that noncompliance is

unacceptable. Loan staff, executive officers, and directors should be able to demonstrate some level

of familiarity with all provisions—more so with the provisions that affect their daily

responsibilities. Awareness and knowledge of the policy's specific provisions can be promoted

through periodic training that stresses the need for the policy to keep pace with current lending

activities and clarifies any areas of ambiguity or uncertainty. Specific areas that may benefit from

review are

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ranges for key numerical targets, such as loan-to-value ratios or loan portfolio segment

allocations

responsibility for monitoring and enforcing loan policy requirements

documentation requirements for various classes of loans

remedial measures or penalties for loan policy infractions

preparation and content of loan officer memorandums

individual and committee lending authorities

Conclusion

A current and effective loan policy is a tool to help management ensure that a bank's lending

function is operating within established risk tolerances. Such a policy is more likely to be consulted

and followed by staff and contributes to uniform and consistent board-approved practices.

Therefore, insured institution staff, borrowers, and regulators will be well served by the

implementation of a process that helps ensure that a bank's loan policy remains comprehensive,

effective, and up to date.

Footnotes

1 See FDIC Manual of Examination Policies, Section 3.1 - Loans (I. Loan Administration - Lending Policies).

2The Interagency Guidelines for Real Estate Lending Policies describes the criteria and factors that the bank regulatory agencies expect insured institutions to consider when establishing real estate lending policies. These guidelines, which took effect March 19, 1993, address loan-to-value limits for various categories of real estate loans.

3The Interagency Guidelines Establishing Standards for Safety and Soundness, which implements Section 39 of the Federal Deposit Insurance Act, was adopted on July 10, 1995

4On October 1, 1997, the FDIC, Federal Reserve, and state banking departments implemented a risk-focused examination process. To allocate examination resources effectively, on-site procedures are customized on the basis of a bank's overall risk profile. In April 2002, the FDIC implemented a streamlined examination program called MERIT (Maximum Efficiency, Risk-Focused, Institution Targeted Examinations). This program was applicable to banks that met basic eligibility criteria, such as total assets of $250 million or less and satisfactory regulatory ratings. In February 2004, the FDIC expanded the use of MERIT to eligible, well-rated banks with total assets of $1 billion or less (see FIL 13-2004).

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LOAN POLICY OUTLINE COMPARED WITH A CLIENT’s POLICY

I. Loan Policy Addressed in Client Policy

Table of Contents NO

Introduction NO

Lending Objectives YES

External Policy Goals NO

Internal Policy Goals NO

Lending Philosophy YES*

Compliance Assessment Area YES*

Out of Territory Lending YES

Legal Lending Limit YES

II. Loan Administration

The Executive Loan Committee YES

The Officers Loan Committee YES

Loan Administration YES*

Lending Officers NO

The Role of the Lending Officer YES*

Authority to Make Loans YES*

Approval of Loans YES*

Current Loan Authorities NO

Individual Lending Authority NO

Expiration of Approvals NO

Loan Operations Department NO

III Lending Criteria

Desirable Loans NO

Undesirable and Problem Loans YES*

Unacceptable Loans/Prohibited Loans YES

VI Definition of Loan Types

Consumer Loans YES

Real Estate Loans YES*

Interim Construction Loans NO

Commercial Loans YES

Unsecured Loans YES

Secured Loans YES

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V Credit Guidelines Addressed in GCB’s Policy

Loan Applications NO

Financial Statements NO

Types of Financial Statements NO

Analysis of Financial Statements NO

Frequency of Financial Statements and Follow-up Procedures NO

Waiving Financial Statements NO

Confidentiality of Information NO

Deposit Relationships NO

Fee Reimbursement NO

Government Regulations NO

Guarantors YES

Credit Investigation YES

Credit Files YES

Renewals YES

Capitalization of Interest NO

VI Loan Documentation

Signatures on Loan Documents NO

Computer-generated and Standard Credit Memo Form NO

Responsibilities for Loan Documentation YES*

Collateral Files YES*

Insurance YES

VII Loan Pricing YES*

VIII Commercial Lending

Commercial Loans-General YES

Unsecured Loans YES

Lines of Credit YES

Secured Credit YES

Loans Secured by Marketable Securities YES*

Accounts Receivable and Inventory Collateral Monitoring YES*

Loans Secured by Equipment YES*

Term Loans YES*

Letters of Credit NO

Loans to US Agencies or Other Government Bodies YES

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XI Real Estate Lending Addressed in GCB’s Policy

General Requirements YES

Interest Reserves NO

Loan to Value Limits for Real Estate Loans YES

Specific Requirements for Single-Family Owner-Occupied Dwelling NO

Construction Loans NO

Land and Development Loans NO

Commercial Mortgage Loans NO

Loans to Churches and Other Non-Profit Organizations NO

Home Improvement Loans NO

Home Equity Loans NO

Second Lien Real Estate Loans NO

XI Real Estate Appraisal Procedures

Selecting the Appraisal NO

Ordering Appraisals NO

Regulatory Requirements for Certified and Licensed Appraisers NO

Minimum Appraisal Standards NO

Appraisal Foundation Standards NO

Written Appraisals Requirements NO

Analysis of Deductions and Discounts NO

Market Value Prospective Values NO

When Federal Regulatory Standards are not Firm Requirements NO

Unsafe and Unsound Appraisal Practices and Policies NO

Real Estate Appraisal Reviews NO

Problem Loans and OREO Appraisal Policies YES

Environmental Requirements on Potential Borrowers YES

Environmental Audits YES

Phase 1 Environmental Audits NO

Historical Use Record Review NO

Regulatory Agency Review NO

Site Inspection NO

Phase 2 & 3 Audits NO

When an Audit is Needed NO

When to Use Bank Personnel to Perform Limited Audits NO

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XII Loans to Directors, Officers and Employees Addressed in GCB’s Policy

Directors and Executive Officers YES

Other Officers YES*

Reports of Officer Borrowings YES

Loans to Employees YES

XIII Overdrafts

Customers YES

Employees Who Are Not Directors or Executive Officers YES

Reports to the Board of Directors Regarding Overdrafts YES

XIV Loan Participations YES

XV Collection Procedures YES

XVI Charge Off Policy YES

XVII Extensions / Modifications / Repossessions YES*

XVIII ACH Origination NO

XIX Predatory Lending NO

XX Other Real Estate Owned YES

XXI Credit Grades YES

XXII Concentration of Credit YES*

XXIII Allowance For Loan and Lease Losses YES

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Addressed in GCB’s Policy

XXIV Loan Review NO

XXV Conflict of Interest NO

XXVI Policy Exceptions and Review YES*

XXVII Distribution of the Loan Policy NO

*Requires expansion, clarification or improvement

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EFFECTIVE HABIT #2

HIGH EFFECTIVE RISK ASSESSMENT AND CREDIT UNDERWRITING

Credit (Risk) Analysis is one of the most important functions performed by banks.

Since interest and fee income from loans represent the largest source of revenue for

banks, it is vital that thorough credit analysis be performed before loans are approved

and funded. Credit Analysis not only considers the financial condition of

prospective borrowers, but also considers non-financial factors which may impact

the ability to repay loans.

Proper Credit Analysis starts with analyzing the financial statements followed by

reporting the findings in a Credit Memorandum, then recommending a loan structure

that provides the borrower what they need while providing the bank with the highest

possible chance of being repaid. There is a very thin line between Financial Analysis

and Credit Analysis because many of the techniques utilized to make an assessment

overlap. However, the biggest difference is that Credit Analysis is appropriate when

money is on the line. It focuses on analyzing financial and non-financial factors with

the primary objective of determining the ability of a borrower.

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TYPES OF ANALYSIS

Common Sizing: Balance Sheet items as a % of Total Assets

Income Statement items as a % of Net Sales

Percent Change: Amount change shown as a percentage

Ratios: Mathematical relationship among logically related factors

Cash Flow: Determination of cash generation or usage from items on

the Income Statement and from the changes in the Balance

Sheet items from one period to another period

Comparative: Matching or contrasting to similar peer or industry data

Trend: Analysis of changes over at least a 3 year period

Indexing: Changes related to a designated base year

Forecasting: Forecasting financial statements to observe the likely

results based upon management’s assumptions

Breakeven: Determination of the level of Sales required to cover Fixed

Costs

Working Capital: Determine ability to meet current debt payments and to

measure working assets efficiency

Sustainable Growth: Rate at which a company can grow and maintain a certain

level of leverage (Debt to Worth position)

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RATIO ANALYSIS

I believe all borrowers being analyzed for financial soundness should be scrutinized to determine

five vital signs that are critical for an entities financial success. The method I recommend to check

these vital signs is referred to as:

LLAMOPCAFLO

(Pronounced: la-mop-ca-flo)

LLAMOPCAFLO measures an entity’s financial factors only. Non-Financial factors such as the

character of management or the condition of the economy are not measured through

LLAMOPCAFLO therefore; it is recommended that elements of the Five C’s of Credit should be

utilized in conjunction with LLAMOPCAFLO in order to develop a full assessment of an entity.

LLAMOPCAFLO is an acronym for the following:

LIQUIDITY

LEVERAGE

ASSET MANAGEMENT

OPERATIONS

CASH FLOW

If you stop and think about it, an entity’s financial woes occur in its inability to pay current debts as

they come due (Liquidity); or debt on their balance sheet is more than the owners’ equity

(Leverage); or management is not utilizing their assets (or may have the wrong assets) to generate

sufficient sales or to create profits (Asset Management); or the company may lose money as a

result of their operations (Operations); or the company may not be able to generate sufficient cash

flow to sustain the company or to pay down long-term debt (Cash Flow). If LLAMOPCAFLO is

utilized, these issues will easily be uncovered.

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Underwriting Commercial Loans

For the Commercial Borrower (manufacturers, wholesalers, retailers and service companies, a

review of the financial statements to determine the following factors should be conducted.

(“LLAMOPCAFLO”)

LIQUIDITY

LEVERAGE

ASSET MANAGEMENT

OPERATIONS

CASH FLOW

LIQUIDITY

Liquidity is a measure of the quality and adequacy of current (short-term) assets to meet current

(short-term) obligations as they come due.

Current Ratio

Calculation: Current Assets

Current Liabilities

This ratio gives a general indication of a firm’s ability to pay its current obligations. Generally, the

higher the Current Ratio, the greater the cushion between current obligations and a firm’s ability to

pay. A benchmark for this ratio has been 2 to 1. The higher the ratio reflects more current assets

available to cover Current Liabilities. However, the composition and quality of Current Assets is a

critical factor in the analysis of an individual firm’s liquidity.

Quick Ratio

Calculation: Cash + Marketable Securities + Accounts Receivable

Current Liabilities

Also known as the “Acid Test Ratio”, it is a refinement of the Current Ratio and is a more

conservative measure of liquidity. The numerator from the Current Ratio is adjusted by omitting

inventory (because of obsolesce, slow moving items and encumbered items). The ratio expresses

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the degree to which a company’s Current Liabilities are covered by the most liquid Current Assets.

Generally, any value of less than 1 to 1 implies a dependency on inventory or other Current Assets

to liquidate short-term debt

Accounts Receivable Turnover in Days

Calculation: Accounts Receivable

Net Sales X 365 Days

This figure expresses the average number of days that Accounts Receivable are outstanding.

Generally, the higher the ratio (i.e., the greater number of days outstanding), the greater the

probability of delinquencies in Accounts Receivable.

Inventory Turnover in Days

Calculation: Inventory

Cost of Goods Sold X 365 Days

This figure expresses the average number of days it takes for cash used to purchase raw material or

finished goods inventory to be sold to the end user. Generally, the higher the number of Inventory

days outstanding, the more the need for cash to carry this inventory.

Accounts Payable Turnover in Days

Calculation: Accounts Payable

Cost of Goods Sold X 365 Days

This figure expresses the average number of days that Accounts Payable are outstanding.

Generally, the higher the ratio (i.e., the greater number of days outstanding), the greater the

probability of the company being delinquent with its suppliers and other creditors.

Working Capital

Calculation: Current Assets minus Current Liabilities

Working Capital is the amount of Current Assets remaining after the Current Liabilities are paid.

This excess cash can be used to repay long term debt, invest in long term assets or pay a dividend.

The higher the working capital the stronger the entity.

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2007 2008 2009

Current Ratio 1.98 2.41 2.94

Quick Ratio 0.67 0.71 1.10

Working Capital 1,878,000 2,005,000 2,352,000

A/R Turnover Rate 7.0 8.1 7.4

A/R Turnover Days 52 45 49

Inventory Turnover Rate 2.9 2.7 3.1

Inventory Turnover Days 128 135 116

Accounts Payable Turnover Rate 6.9 13.0 13.5

Accounts Payable Turnover Days 53 28 27

Net Working Investment Analysis

When the Accounts Receivable, Inventory and Accounts Payable turnover ratios are calculated, the

results can be used to calculate the Net Working Investment (“NWI”) for the entity. Before the

NWI can be defined, a definition of the Operating Cycle must be established.

The Operating Cycle is defined as the time it takes for an entity to utilize its available cash to

purchase raw material; convert it to finish goods inventory and eventually sell it (for a

manufacturer): or purchase finished goods inventory and sell it to the end user (for a wholesaler

and retailer): or fund upfront expenses in order to provide a service (for service companies).

Therefore, the Operating Cycle can be calculated as follows:

Accounts Receivable Turnover (days) 49 $1,280,430

+ Inventory Turnover (days) 116 $2,205,935

= Operating Cycle 165 $3,486,365

At this point, this company’s Operating Cycle is 165 days long and equates to $3,486,365 being

tied up in this Cycle. This is a long time and a large sum that is not available to this company.

There are not too many companies that can go this far without some assistance from some source

of financing. What is the likely source of this financing?

One source is from suppliers which often provide interest-free financing for inventory, and this is

the most common form of short-term financing for businesses. These terms may be up to 60 days

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or longer. For our company, the suppliers are being paid every 27 days. This means the suppliers

are essentially providing 27 days of financing or carrying a portion of the amount needed over the

138 days of Operating Cycle. The Operating Cycle can now be adjusted by the support provided

by the suppliers as follows:

Accounts Receivable Turnover (days) 49 $1,280,430

+ Inventory Turnover (days) 116 $2,205,935

= Operating Cycle 165 $3,486,365

- Accounts Payable (days) (27) ( 506,961)

Financing Need After Accounts Payable 138 $2,979,404

From the above example, there is still a substantial need for financing after considering the

Accounts Payable. Is this the amount banks should cover? The answer is probably no because

companies may be able to provide some support themselves from the generation of cash flow. As a

result, this should be considered and included in the Net Working Investment model.

Strong profit margins, net of changes in working capital assets and liabilities, produce excess cash

flow. While profits repay long-term debt, this source of cash flow is also available to cover cash

needs resulting from a financing shortfall in a company’s operating cycle.

While this source of cash is, in theory, not available until after the receivables are collected, the

reality is that an Operating Cycle is started and ended almost on a daily basis for most companies.

Because of this, there is some daily excess cash flow spun off via profit margins and the

completion of an operating Cycle.

Our sample company is producing excess cash flow after existing debt service that could be used to

cover the financing gap shown. If the cash flow is presented on an annual basis, it will be

necessary to convert the amount of available cash flow after debt service based on the length of the

Operating Cycle ($835,332 - $132,643 X 138/365)

Accounts Receivable Turnover (days) 49 $1,280,430

+ Inventory Turnover (days) 116 $2,205,935

= Operating Cycle 165 $3,486,365

- Accounts Payable (days) (27) ( 506,961)

Financing Need After Accounts Payable 138 $2,979,404

Less: Amount Covered by Excess Cash Flow ( 265,674)

Remaining Financing Needs $2,713,830

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The final adjustment considers the existing equity in the Trading Assets (A/R + Inv) – (AP + AE).

While in theory the cash from existing equity in working capital assets and liabilities is not

available until the end of the Operating Cycle, for most businesses, new and old Operating Cycles

are started and completed nearly every day. Thus there is some ongoing daily “return of equity”

embedded in the trading assets.

If the Operating Cycle turns every 138 days, then the equity in the Operating Cycle is release in the

form of cash every 138 days on average. In summary, the cash generated from return of equity in

trading assets is available to cover the company’s cash operating expenses. The more equity a

company has built into its current assets, the lower the amount of financing needs. For our sample

company, the equity in trading assets is calculated as ($3,486,365 - $931,436 = $2,554,929)

Accounts Receivable Turnover (days) 49 $1,280,430

+ Inventory Turnover (days) 116 $2,205,935

= Operating Cycle 165 $3,486,365

- Accounts Payable (days) (27) ( 506,961)

Financing Need After Accounts Payable 138 $2,979,404

Less: Amount Covered by Excess Cash Flow ( 265,674)

Remaining Financing Needs $2,713,830

Less Amount Covered by Equity in Trading Assets (2,554,929)

Amount to be Financed by a Working Capital Line of Credit $ 158,901

We now see that the required amount of the Line of Credit is in the neighborhood of $160,000.

With this information, we are able to finally compare what our customers’ requests in a Line of

Credit with what we determine to be the true need.

Having this knowledge should accomplish the following goals:

Prevents loan officer from going to loan committed repeatedly to obtain the right amount

needed.

The risks of the Line becoming an “Evergreen Line” is substantially reduce if the customer

managers the credit facility properly.

Don’t Leave Your Customer’s Request for a Line of Credit Up for Chance

Educate Your Borrower on the Proper Use of Their Line

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Monitor the Activity of Your Borrower’s Line of Credit Quarterly (for strong companies) and

Monthly (for weaker companies); then, make necessary adjustments according to changes in

the Operating Cycle

Require a Monthly Borrower’s Certificate to Track Levels of A/R, Inventory and Cash

Collections

Know Your Customer’s Sustainable Growth Rate

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FINANCIAL IMPACT ANALYSIS

What is the financial impact on the cash flow of a company if Accounts Receivable, Inventory and

Accounts Payable turnover measured in days speed up or slow down. There is a definite positive

or negative impact that can be measured and will serve as justification for a need for additional

cash or an explanation for an excess of cash being generated. The methods to determine the

financial impact on these asset and liability accounts can be calculated as follows:

Accounts Receivable Turnover Financial Impact

Sales 9,545,000 = 1,178,395

Target Turnover Rate 8.1

Minus: Actual Accounts Receivable Balance - 1,280,430

= Positive or Negative Financial Impact (102,035)

Inventory Turnover Financial Impact

Cost of Sales 6,806,593 = 2,520,960

Target Turnover Rate 2.7

Minus: Actual Inventory Balance - 2,205,936

= Positive or Negative Financial Impact 315,024

Accounts Payable Turnover Financial Impact

Cost of Sales 6,806,593 = 986,463

Target Turnover Rate 6.9

Minus: Actual Accounts Payable Balance - 506,961

= Positive or Negative Financial Impact =(479,502)

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LEVERAGE

Leverage refers to the proportion of funds invested in an entity by the creditors in the form of loans

and the owners in the form of equity. Highly leverage firms (those with heavy debt in relation to

net worth) are more vulnerable to business downturn than those with lower debt to worth positions.

While leverage ratios help measure this vulnerability, it does greatly depend on the requirements of

particular industry groups.

Debt to Net Worth

Calculation: Total Debt divided by Tangible Net Worth

This ratio indicates the extent to which the company’s funds are contributed by creditors compared

to the owners. It expresses the degree of protection provided by the owners for the creditors. A

low ratio generally indicates greater long-term debt paying ability. A firm with a low debt/worth

ratio usually has greater flexibility to borrow in the future. A highly leveraged company has a

limited ability to absorb more debt.

2007 2008 2009

Debt to Tangible Net Worth 1.33 1.09 0.93

ASSET MANAGEMENT (EFFICIENCY) RATIOS

Asset Management or Efficiency Ratios measures management’s ability to utilize assets to generate

revenue or create value (i.e. generate a profit).

Asset Efficiency or Asset Turnover Ratio

Calculation: Total Sales

Total Assets

This ratio measures management’s ability to use its Total Assets to its best advantage. Since sales

are the numerator, it measures the ability of Total Assets to generate sales. A lower ratio from

earlier periods indicates that the existing assets owed at the time the ratio was calculated were not

as efficient in generating sales as in the past. This ratio is useful when considering a loan request

to increase operating and non operating assets.

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Net Fixed Assets Efficiency or Turnover Ratio

Calculation: Total Sales

Net Fixed Assets

This ratio is most useful for companies in which Fixed Assets represent a major portion of Total

Assets. It measures the extent to which Fixed Assets can generate revenue or sales. A falling ratio

indicates the existing Net Fixed Assets are not as efficient in generating sales as they were in

previous periods. It is most useful when considering a term loan request to acquire equipment or

other Fixed Assets.

Fixed Asset Usage Ratio

Calculation: Accumulated Depreciation

Gross Fixed Assets

This ratio is useful in determining how much usage the Fixed Assets has experienced. It is most

useful to lenders considering a request to finance new equipment. If the usage is less than 50%,

further justification should be required for new or replacement Fixed Assets.

Fixed Asset Life Ratio

Calculation: Net Fixed Assets

Depreciation Expense

Similar to the ratio above, this ratio indicates how much life is left in the Fixed Assets by taking the

Net Fixed Assets and dividing it by the current year’s depreciation expense. This ratio should

complement the above ratio. For example, if the Fixed Assets Usage Ratio indicates usage of 90%,

you would not expect the Fixed Assets Life Ratio to show 8 years of life left.

2007 2008 2009

Asset Turnover Ratio 1.86 1.81 2.02

Net Fixed Asset Efficiency Ratio 11.4 9.2 10.1

Fixed Asset Usage Ratio 0.67 0.65 0.66

Net Fixed Asset Life Ratio 5.2 years 6.4 years 4.8 years

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OPERATIONS (PERFORMANCE OR PROFITIBILITY RATIOS)

Gross Profit Margin

Calculation: Gross Profit

Net Sales

This ratio expresses Gross Profit as a percentage of Net Sales. It measures how many dollars out of

each dollar of sales remains to cover all operating expenses (those that are not directly related to

the costs required to produce the good or service). The higher the margin, the more funds available

to cover operating expenses.

Operating Profit Margin

Calculation: Operating Profit

Net Sales

This ratio expresses Operating Profit as a percentage of Net Sales. It measures how many dollars

or cents out of each dollar of sales remains to cover other non-operating expenses including:

Interest, Extra-Ordinary Expenses, Taxes, etc. The higher the margin, the more funds available to

cover these items.

Net Profit Margin

Calculation: Net Profit

Net Sales

This ratio expresses Net Profit as a percentage of Net Sales. It measures how many dollars or cents

out of each dollar of sales remains as profit. The higher the margin, the more profitable the

company.

2007 2008 2009

Gross Profit Margin 22.8% 25.8% 28.7%

Operating Profit Margin 6.1% 6.0% 9.4%

Net Profit Margin 1.9% 2.6% 5.2%

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Return on Stockholders Equity

Calculation: Net Income divided by Stockholder’s Equity

This ratio expresses the profitability of the company’s operations to owner after income taxes. It

can be compared to alternative investments available to the owners.

Return on Investment (Assets)

Calculation: Net Income divided by Total Assets

This ratio measures the effective utilization of the assets of the company in generating profits or

creating value.

2007 2008 2009

Return on Equity 8.3% 9.8% 20.5%

Return on Assets 3.4% 4.7% 10.6%

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COVERAGE RATIOS

Financial Ratios measure the ability of a borrower to meet its financing obligations including

Interest Expense, Principal Payments on Long-Term Debt and other fixed charges such as Lease

Payments.

Interest Coverage Ratio

Calculation: Earning (profit) before Interest, Taxes, Depreciation & Amortization

Annual Interest Expense

This ratio is a measure of a firm’s ability to meet interest payments. It measures the number of

times all interest paid by the company is covered by earnings before interest charges and taxes. A

high ratio may indicate that a borrower would have little difficulty in meeting the interest

obligations of a loan. This ratio also serves as an indicator of a firm’s capacity to take on additional

debt.

500 + 97 + 0 + 196

97

= 8.3 Times

Cash Flow / Debt Coverage Ratio

UCA Tradition

Calculation: Net Profit 500 500

Plus: Non-Cash Charges 196 196

+ Change in Accounts Receivable 282

+ Change in Inventory 187

+ Change in Accounts Payable (532)

+ Change in Accrued Expenses ( 49)

= Cash After Operating Cycle 584 696

Minus: Dividends Declared (243)

+ Change in Net Worth 0

= Cash After Financing Cost 341

Less: Current Portion of Long-Term Debt (134) (134)

= Cash Available for Other Debt 207 562

+ Change in Gross Fixed Assets (219) (219)

= Financing Surplus (Requirement) ( 12) 343

The Cash Flow calculation shown above is more comprehensive than the traditional formula of Net

Profit plus Depreciation because it considers changes in working capital requirements of

companies which either generate or use cash. By using the above calculation, the analyst can see

the impact upon cash at various target points as shown by the bold lines in the formula. The

definitions of cash at each target point are as follows:

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Cash After Operating Cycle: This is the Cash remaining after considering the operating

performance of the entity plus or minus the impact of the change in

Net Working Investment (Accounts Receivable plus Inventory minus

Accounts Payable plus Accrued Expenses.

Cash After Financing Cost: This is the Cash remaining after considering the impact of any

dividends paid and/or owners’ withdrawals from the company.

Cash Available

For Other Debt: This is the Cash available to meet future debt payments. It measures

the company’s ability to take on additional debt. It is measured

before Fixed Assets increases or decreases because changes in Fixed

Assets are generally at the discretion of management.

Financing Surplus

(Requirement): This is the Cash Surplus or Requirement the company experienced

after considering the major items that impact cash. If a Financing

Surplus resulted, the cash was used to pay down existing debt, pay

dividends or reinvested in the form of Fixed Assets or Equity. If a

Financing Requirement resulted, the company was required to

utilized its own cash, borrow, or raise equity to meet all their

obligations incurred during the previous year.

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DETERMINING CREDITWORTHINESS FOR REAL ESTATE LOANS

Real Estate Loans are those in which the primary sources of repayment are from the sale, leasing or

renting of the property to cover expenses and to service debt. If this fact does not exist, then loans

that are secured by real estate as “back-up” collateral are loans where the primary sources of

repayment are conversion of assets, cash flow or cash infusions from the personal assets of the

principles and not the underlying real estate. The latter scenario are considered normal commercial

loans and not real estate loans

Underwriting real estate loans requires a different approach. The basic requirements are to

determine the following:

• Capacity of Borrower

• Net Operating Income

• Debt Coverage Ratio (NOI / ADS) > 1.15

• Value of Mortgage Property

• Overall Financial Strength of Borrower

• Hard Equity Invested into Property (Including unencumbered equity in properties)

• Secondary Sources of Repayment

• Additional Collateral or Credit Enhancements

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CALCULATING NET OPERATING INCOME AND DSCR

Potential Gross Income (PGI)

Less: Physical Vacancy

Economic (Credit) Loss

Effective Gross Income (EGI)

Less: Operating Expenses

Real Estate Taxes

Hazard Insurance

Repair/Maintenance (Buildings)

Maintenance (Grounds)

Depreciation

Water/Sewer/Trash

Electric (Common)

Interest Expense

Management Fees

Leasing Commissions

Reserves for Replacement

_______________________________

_______________________________

Total Operating Expenses

Net Operating Income (NOI)

NOI = > 1.25 times

ADS

35

EFFECTIVE HABIT # 3

HIGHLY EFFECTIVE CREDIT COMMITTEE

So What Are the Seven Effective Habits of the Loan Committee?

1. Understand the Objectives of the Loan Committee

2. Led by Chairperson with the Right Temperament

3. Create and Maintain the Proper Loan Committee Member Mix

4. Set Standards on What Is Expected From Loan Officers Presenting Credit Requests

5. Timely Access to Relevant and Current Information

6. Maintain Open Lines of Communication that Encourage Questions and Expression of

Thoughts at all Times

7. Take Copious Minutes that Matters

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1. Understand Objectives of Committee

To grow the loan portfolio in a safe and sound manner

Place Safety and Soundness objective over Growth and Profitability objectives

Understand they are not the ruler of the bank but play a vital role in its success

Nurture and Develop Loan Officers into competent and responsible Relationship

Managers

Establish portfolio limits

2. Chairperson With Right Temperament

Usually the Chief Credit Officer of the Bank

Must have a keen awareness of the credit policy to enforce it without stifling growth of

the loan portfolio

Understand the strengths and weaknesses of loan officers and avoid situations that may

embarrass a sponsoring loan officer during a loan presentation

Fair in all dealings

Keenly aware of “Hidden Agenda” that may exist among the Loan Committee

members, Loan Officers and others connected to the credit approval process

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LOAN DISCUSSION / PRESENTATION

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3. Loan Committee Mix

Avoid “Stacking the Deck” with single minded individuals

Avoid creating a “Group Think” environment

Seek diversification by having members from or a background in:

◦ Lending (Commercial, Consumer & Real Estate);

◦ Credit Administration;

◦ Financial Management (Accounting or Investment);

◦ Auditing;

◦ Marketing;

◦ Operations

Individuals with different skills and approaches to solving problems

4. Set Expectations of Loan Officers

Committee should provide clear expectations for Loan Officers to follow such as:

◦ Underwriting Standards (Knowing the Committee’s and Individual’s “Hot

Buttons”)

◦ Loan Presentation Packages

◦ Loan Presentation Style

◦ Common Questions and Factors that should always be addressed

◦ Presentation of Exception Loan approval to require written justification with

demonstrated ability to track progress

5. Timely Access to Relevant Information

Loan Processing System should allow Loan Officers sufficient time to adequately

prepare the loan package for presentation

In cases where an immediate decision must be made, a system should be in place to

accommodate such requests

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Loan Committee Packages should be submitted to all Loan Committee Members in

enough time for them to read and reasonably understand the loan requests

Each package should contain a Strength and Weakness matrix to show what’s good and

bad about each credit and a well written analysis of the credit

For each weakness, a mitigating factor should be provided, if any.

6. Communications, Questions & Expression

Members should be encouraged to raise questions, issues and openly discuss their

feelings without fear of reprisal. In lending, “Silence is not Golden”.

Members should avoid having “hidden agenda” or favorite lending personnel

Loan Committee is not “Congress”. Trading votes should never be a common practice

in the Loan Committee

Patience should be a common virtue, which allows Loan Committee members sufficient

time to gain a full understanding of the request

As a Loan Committee Member, you should have a firm understanding of three areas after

each loan presentation:

◦ Who are we doing business with?

Character, Capacity, Capital, Collateral, Conditions & Can We?

◦ How will the loan proceeds be used?

Insure proper structure for best chance of being repaid

◦ How will they repay us?

Always have a Primary and Secondary Source of Repayment

7. MINUTES THAT MATTER

Detailed notes should be taken by the Loan Secretary to indicate the depth of discussion

held over the loan approval and reflect questions and concerns of the loan committee

members

Secretary to the Loan Committee should not be a Loan Officer or anyone that is

influenced by the Chairperson

Votes should be recorded with any dissenting votes duly noted and explained

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BOTTOM LINE

• Attend Loan Committee Meetings

• Pay Close Attention in Loan Committee

• Question Things You Don’t Understand

• Get Training In The Areas of Weakness

• Use Influence to Develop Business

• Help Shape The Loan Portfolio

• Hire Right People and Support Them

Seven Bad Habits

• “What time is Lunch?

• “What’s for Lunch?

• “Side bet among the participants on who will fall asleep first during loan presentations”

• “Another side bet on how long it will be for the member who fell asleep to “snore”

• “A key consideration among the committee members is the borrower’s Character & Social Network

Bankers Insight Group, LLC 38

41

HIGHLY EFFECTIVE HABIT #4

UTILIZE CREDIT RISK RATING TO IDENTIFY RISK IN THE LOAN PORTFOLIO

Regulators expect community banks to have credit risk management systems that produce accurate

and timely risk ratings. They consider accurate classification of credit among its top supervisory

priorities

Credit ratings are an approximation of the quality of the loan and the potential for complete

repayment. They are based on the financial institution’s underwriting standards. If a financial

institution's underwriting standards are weak, then the Credit Ratings will not properly the risk in

the loan portfolio. The standards act as signals that indicate the general quality of the individual

loans and the loan portfolio.

Before individual credit reviews can be performed, criteria for determining the quality of a loan

must be established. The standards require that financial institutions:

(1) Establish prudent underwriting standards that are clear and measurable

(2) Establish loan documentation procedures

(3) Establish review procedures for monitoring compliance with internal policies and regulations.

There are five key control attributes that should be present for the grading system to be effective.

They are as follows:

1. Definitions or attributes of each loan grade are stated clearly.

2. Loan officers and credit reviewers understand the definitions of the grades.

3. Loan grades are updated periodically.

4. Senior management reviews and approves loan grades and specific problem credits.

5. “Loss” credits deteriorate steadily through the grades and do not deteriorate suddenly from

grade 2 to grade 9.

Credit ratings are essential to other functions including:

1. Credit approval (who can approve)

2. Loan pricing

3. Credit administration

4. Allowance for loan & lease losses calculations

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EXPECTATIONS OF CREDIT RISK RATINGS

System should be integrated into the bank’s overall portfolio risk management

Board should approve the credit risk rating system and assign accountability for the risk

rating process

All credit exposures should be rated

Risk rating system should assign an adequate number of ratings

Risk ratings must be accurate and timely

Criteria for assigning each rating should be clear

Rating should reflect the risks posed by borrower’s expected performance and the

transaction’s structure

The risk rating system should be dynamic and change when the risk changes

The risk rating process should by independently validated in addition to regulatory

examinations

Banks should determine through back-testing whether the assumptions implicit in the rating

definitions are valid, i.e. whether they accurately anticipate outcomes. If assumptions are

not valid, rating definitions should be modified.

The rating assigned should be well supported and documented in the credit file

Examiners rate credit risk based on the borrower’s expected performance, i.e., the

likelihood that the borrower will be able to service its obligations in accordance with the

terms. Remember, Payment performance is a future event

Credit risk ratings are meant to measure risk rather than record history

DEVELOPMENTS IN RISK RATING SYSTEMS

Banks are developing more robust internal risk rating processes in order to increase the precision

and effectiveness of credit risk measurement and management

More and more banks are:

1. Expanding the number of rating they use, particularly for pass credits

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2. Using two rating systems, one for risk of default and the other for expected loss

3. Linking risk rating systems to measurable outcomes for default and loss probabilities

4. Using credit rating models and other expert systems to assign rating and support internal

analysis

Most significant change has been the increase in the number of rating categories (grades) especially

in the pass category

The number of pass ratings a bank will find useful depends on the complexity of the portfolio and

the objectives of the risk rating system

Less complex community banks may find that a few pass ratings are sufficient to differentiate the

risk among their pass rated credits:

Rating for loans secured by liquid collateral

A Watch category

One or two other pass categories

In addition to increasing the number of rating definitions, some banks have initiated Dual Rating

Systems (DRS)

DRS have emerged because a single rating may not support all of the functions that require credit

risk ratings

DRS typically assign a rating to the general creditworthiness of the obligor and a rating to each

facility outstanding

Facility rating considers the loss protection afforded by assigned collateral and other elements of

the loan structure in addition to the obligor’s creditworthiness

Obligor ratings support deal structuring and administration, while facility ratings support ALLL

and capital estimates

Below is an example of a Dual Rating System proposed in the past (by the accounting industry). This system was not widely accepted by bankers but the concept has some validity Risk of Default Probability of Loss Marginal No Risk of Loss Weak Low Risk of Loss Default Moderate Risk of Loss High Risk of Loss

44

The OCC and other regulatory authorities do not advocate any particular rating system rather; it

expects all rating systems to address both the ability and willingness of the obligor to repay and

support provided by structure and collateral. Such systems can assign a single or dual rating.

RISK RATING AND THE MANAGAMENT INFORMATION SYSTEM

A good MIS should enable the calculation of

– Volume of credits whose ratings changed more than one grade (double downgrades)

– Seasoning of ratings (time a credit holds grade)

– Velocity of rating changes

– Default and loss history by rating category

– Ratio of rating upgrades to rating downgrades

– Rating changes by line of business, officers & location

45

46

Special Mention (OAEM)

Included in this category are loans that do not presently expose the bank to a sufficient degree of

risk to warrant adverse classification but do possess credit deficiencies deserving the bank’s close

attention. Failure to correct deficiencies could result in greater credit risk in the future. Ordinarily,

such borderline credits have characteristics which corrective action by the bank would remedy.

Often in credit lines warranting Special Mention, it is the bank’s weak origination and/or servicing

policies that constitute the cause for criticism. The nature of this category of loan criticism

precludes inclusion of smaller lines of credit unless those loans were part of a large grouping listed

for related reasons.

Substandard Assets

A substandard asset is inadequately protected by the current sound worth and paying capacity of

the debtor or of the collateral pledged, if any. Assets classified Substandard must have a well-

defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized

by the distinct possibility that the institution will sustain some loss if the deficiencies are not

corrected.

Doubtful Assets

An asset 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 existing facts, conditions, and values, highly questionable and improbable.

Loss Assets

Assets classified Loss are considered un-collectible and of such little value that their continuance

as bankable assets is not warranted. This classification does not mean that the asset has absolutely

no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this

basically worthless asset, even though partial recovery may be affected in the future.

Technical Exceptions

Technical deficiencies in documentation of loans will be brought to the attention of the bank for

remedial action. Failure of the bank to effect corrections may lead to the development of greater

credit risk in the future. Moreover, the presence of an excessive number of technical exceptions is a

reflection on the bank’s quality and ability. During the course of the examination, the bank will be

given a listing of loans that possess technical deficiencies. Such a procedure is intended to expedite

47

early correction, of the deficiencies and, in normal circumstances, inclusion of such exceptions in

the report will be unnecessary. However, when spot checks reveal an excessive volume of

deficiencies in loans under the cut-off point, regulatory agencies will insert the applicable technical

exceptions page in the report of examination. Such a procedure adds emphasis to the importance of

the documentation and provides support for the regulatory agencies’ Comments and Conclusions

schedule. Regardless of the size of the loan, existence of an inordinate number of technical defects

will be emphasized.

Troubled Commercial Real Estate Loan Classification Guidelines Additional classification guidelines have been developed to aid the examiner in classifying

troubled commercial real estate loans. These guidelines are intended to supplement the uniform

guidelines discussed above. After performing an analysis of the project and its appraisal, the

examiner must determine the classification of any exposure.

The following guidelines are to be applied in instances where the obligor is devoid of other reliable

means of repayment, with support of the debt provided solely by the project. If other types of

collateral or other sources of repayment exist, the project should be evaluated in light of these

mitigating factors.

Substandard - Any such troubled real estate loan or portion thereof should be classified

Substandard when well defined weaknesses are present which jeopardize the orderly

liquidation of the debt. Well defined weaknesses include a project's lack of marketability,

inadequate cash flow or collateral support, failure to complete construction on time or the

project's failure to fulfill economic expectations. They are characterized by the distinct

possibility that the bank will sustain some loss if the deficiencies are not corrected.

Doubtful - Doubtful classifications have all the weaknesses inherent in those 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. A Doubtful classification may be appropriate in cases where

significant risk exposures are perceived, but Loss cannot be determined because of specific

reasonable pending factors which may strengthen the credit in the near term. Examiners

should attempt to identify Loss in the credit where possible thereby limiting the excessive

use of the Doubtful classification.

Loss - Advances in excess of calculated current fair value which are considered

uncollectible and do not warrant continuance as bankable assets. There is little or no

prospect for near term improvement and no realistic strengthening action of significance

pending.

48

WHO SHOULD ASSIGN THE RISK RATING?

Loan risk classifications should accurately reflect the risk of non-repayment. An institution’s

classification system should closely parallel those contained in the regulation (Special Mentioned,

Substandard, Doubtful, and Loss) both to promote accuracy in filing quarterly reports and to enable

examiners to test the accuracy of the classification ratings efficiently.

Typically, the loan officer will rate loans at the time a credit is booked. The loan officer will revise

the rating as a borrower’s financial condition changes or circumstances require. During the loan

review process, the loan review officer will independently rate each credit reviewed. This becomes

a verification of the loan’s rating.

The regulatory agencies pay considerable attention to loan grading. Typically, the examiner will

select credits and review documentation in order to determine whether or not the grading system is

reliable based on the examiner’s classification of assets.

When assigning a risk rating, it should reflect the following factors:

1. Financial and Credit Quality of the relationship

2. Credit File Documentation and Completeness

3. Regulatory and Policy Compliance

49

HIGHLY EFFECTIVE HABIT #5

PROPER LOAN DOCUMENTATION TO PROTECT THE BANK

The heart of any loan transaction is the loan itself and the documentation setting forth the terms and

conditions under which the loan is to be repaid by the borrower. Even the most marketable collateral

and the best drafted collateral and guaranty agreements may be of little assistance to a lender if there is

some flaw in the terms of or the documents evidencing the underlying loan transaction. Loan

documentation is simply the commitment of the negotiated loan transaction to paper. This

commitment serves two purposes:

It clarifies the deal so that each party understands the details of the deal

It transforms the deal to a legally enforceable form

There are five basic steps to be taken in the documentation of any secured transaction.

Each should be reviewed by the lender for every loan. They are as follows:

1. IDENTIFY THE BORROWER

Use the correct name

Type of legal entity

Who is authorized to represent the entity?

How do we know?

Is the borrower authorized to conduct its business under federal legal requirements?

2. IDENTIFY THE COLLATERAL

Who owns it?

Where is it located?

Does the borrower have the authority to pledge it?

3. EVIDENCE THE DEBT

What is the mutual understanding of the loan arrangement?

How much money will be borrowed?

How and when will it be repaid?

What happens if I default?

4. ATTACH THE COLLATERAL

How can a security interest be granted?

5. PERFECT THE SECURITY INTEREST

Public notification of the security interest

All secured transactions will have these basic components, in some form.

Remember, the documentation becomes important if the deal goes sour

50

It is important for the most fundamental aspect of any loan transaction be properly structured and

evidenced. The documents traditionally used to evidence debts arising from loan transactions, namely

the loan agreement and promissory note, are often used as companion documents to set forth the

parameters of the relationship between lender and borrower.

The promissory note is the central document to all loan transactions, as it evidences the debt. It

also outlines the terms of the loan. All notes must contain the following information:

The name of the lending institution

The date of the loan

The interest rate to be charged

Maturity date

Payment schedule

Any charges beyond the interest

Signature of borrower(s)

Promissory Notes

The promissory note is the basic instrument of lending as it evidences the indebtedness of the

borrower to the bank. The note serves to evidence the debt and the collateral that secures the note.

In addition, all collateral that the lender may take as security, is dependent upon the enforceability

of the note. Although the note identifies the collateral, the granting of a security interest in the

collateral must be accomplished by a security agreement. The Loan Agreement provides more

protection than the Promissory Note because it sets several parameters and expectations for the

borrower to follow

Definition

The Uniform Commercial Code (UCC) defines a note as a type of commercial paper. Commercial

paper is defined as any written promise or order to pay a sum of money. According to this

definition, commercial paper has two basic functions; it is a substitute for money, and it is a credit

device. Since this study guide deals with loan documentation, we will look at commercial paper in

its second function, a credit device.

The note is the simplest form of commercial paper. It is a written contract between two parties in

which one party, the maker, unconditionally promises to pay a specified sum of money to the

order of another party, the payee. If the note meets all of the following criteria, then it is also a

negotiable instrument and may be transferred to a third party as a holder in due course. The

formal requirements for negotiability may be briefly stated as follows:

The note must be dated

The instrument must be in writing and signed by the maker

It must contain an unconditional promise to pay a certain sum of money

51

It must be payable on demand or at a definite time (example: on 1/31/xx, or within 90 days)

It must be payable to order or bearer

Types of Promissory Notes

Single Advance Note

Multiple Advance Note

Revolving Lines of Credit

Demand Notes

Specific Maturity Notes

Fully Amortizing

Balloon Note

Loan Agreements

A promissory note generally serves as primary evidence of a borrower's indebtedness to its lender;

however, it is becoming more common to supplement (and in some cases entirely replace) a

promissory note with a loan agreement. Separate loan agreements are usually not warranted in

simpler, single advance loan transactions, and in such transactions you should expect to continue to

see the promissory note as the primary evidence of the borrower's obligation regarding such a loan.

However, in more complicated transactions, such as those involving construction loans, revolving

lines of credit or other multiple advance transactions, the use of a separate loan agreement may be

necessary or appropriate for the following reasons:

All loans have loan agreements. However, some loan agreements are more tangible than others.

At one end of the spectrum are lengthy agreements that have been formally drafted by legal

counsel. In the middle are pre-printed loan agreements, usually containing a security agreement

that banks may use for nearly any type of credit extended. At the other extreme are completely

informal oral agreements, which have little significance.

52

Many banks take the position that loan agreements are simply too complicated and often attempt to

avoid using them in loan transactions. However, loan agreements can benefit both the lender and

the borrower. While the borrower must have sufficient latitude to operate the company, certain

limitations must be placed on the business due to the bank’s credit exposure. Provisions in the loan

agreement must be drafted to guarantee adequate cash is conserved by the borrower to ensure

continued financial viability and to repay the bank’s loan.

In this section, we will discuss formal loan agreements that are generally used in large or workout

loans. By reviewing the components of this very formal and specific type of loan agreement, we

can examine in detail how a loan agreement works.

Definition

To begin, we need to define what a loan agreement is and what purposes it will serve. A loan

agreement is a legally binding document executed by the borrower and the bank with the following

objectives in mind:

Set forth the agreement between the bank and the borrower by clearly and concisely

defining the duties and responsibilities of both parties during the term of the loan

Establish restrictions and qualifications on the borrower’s activities and financial condition,

which are set out by affirmative and negative covenants

Cause the borrower and lender to work through various contingencies thus preparing an

alternative plan of action that both parties can agree to abide by should the original plan

become inoperable

Serve as a communication tool and monitoring device by requiring the borrower to submit

certain documents at specified times and to require notification of the lender about certain

plans of the borrower (Example: periodic financial statements and financial projections).

In order to accomplish all of the objectives outlined above, most loan agreements contain certain

common articles, provisions or paragraphs. These articles are discussed below in the order that

they generally appear in a loan agreement.

Recitals

This is the first paragraph of the agreement and will set out the parties of the loan, i.e. identifies the

borrower, the lender and the guarantors. It states the date the agreement becomes effective, and

declares that all parties agree to be legally bound by the terms of the agreement.

Loan Transaction

This paragraph identifies the loan including its amount; purpose; the promissory note(s) involved in

the transaction; interest rate; fees (facility, commitment or compensating balance fees, if any); costs

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and expenses attributable to the loan (who will pay them); limitations on advances and prepayment

penalties; and re-borrowing privilege (in the case of a revolving loan).

Collateral and Security

In this section, the debtor agrees to grant a security interest in collateral; procure guaranties from

specified third parties (these guaranties may be secured or unsecured); pledge life insurance and

procure subordination of certain other indebtedness. A cross-collateral clause may also be

employed, which gives the lender the right to apply the existing collateral to any future

indebtedness.

Representations and Warranties

The borrower warranties and represents the following to the bank:

The borrower is qualified to do business in all jurisdictions in which he/she conducts

business

The loan agreement does not violate or cause the borrower to violate any law

The agreement has been daily authorized, executed, delivered and is binding on its behalf

The borrower is not involved in litigation, either actual or threatened, that would affect

his/her financial condition

Information prepared and supplied is true and correct

No subordination of this debt will be granted

The borrower possesses all permits and licenses necessary to conduct business

The legal title is held to all assets, which secure this obligation

The borrower is in compliance with all laws and regulations that control his/her business

All taxes have been paid

No other outstanding bank debt exists unless disclosed

Conditions Present

This section requires the borrower to fulfill certain conditions before the bank will advance on or

renew the credit facility. Examples of some of these conditions are: all legal matters related to

advances and renewals of the facility must be acceptable to banks’ counsel; all articles of the

agreement must be complied with; all security interests must have been granted; and finally, all

documents have been delivered.

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Affirmative Covenants

In an affirmative covenant, the borrower pledges to perform some action or provide some

information specified in the loan agreement. Some common affirmative covenants you may see in

loan agreements include:

Punctual payment (usually within five days of the due date)

Accounting records that are kept in accordance with GAAP and open to inspection by bank

personnel at any time

Timely submission of the borrower’s and guarantor’s financial statements, accounts

receivable aging, annual audits, and tax returns

Maintenance of adequate insurance

Plant and equipment will be kept in good repair

All indebtedness will be discharged when due (including taxes)

Prompt notice will be given to the bank upon occurrence of default, change of name,

uninsured loss or movement of collateral that would require filing of new collateral

documents

Negative Covenants

Negative covenants are the exact opposite of affirmative covenants. Instead of the borrower

pledging to do something, he is now promising not to do something. Following are examples of

some negative covenants found in a loan agreement.

The borrower pledges not to:

Use the proceeds for the loan except for purposes set forth in the agreement

Make additions to fixed assets in excess of a certain dollar amount annually

Incur additional debt

Grant security interests without prior consent of the bank

Merge, consolidate or sell assets

Become guarantor or endorser of obligations of any person

Make loans in excess of a certain dollar amount or make investments that would impair its

liquidity

Declare or pay dividends without the bank’s prior approval

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Allow certain financial rations (e.g. working capital, debt-to-worth, debt service) to fall

below specified levels

Permit the loan’s principal balance to exceed predetermined levels

Events of Default

This section of the loan agreement will spell out the specific events of default. Listed below are a

few of the common events of default:

Nonpayment of principal and interest

Materially false or incorrect representations or warranties

Failure to perform according to the terms or covenants of the agreement

Sale or transfer of ownership in the borrowing entity without lender approval

Governmental control of a substantial amount of assets

Suspension or revocation of material franchises, licenses or permits

Failure of borrower to pay any levy or judgment

Borrower or guarantor becoming insolvent or filing bankruptcy, voluntarily or involuntarily

The section that spells out the events of default will also generally contain an acceleration clause.

The acceleration clause will tell the borrower that in any event of default, at the lender’s option, all

debt owed to the lender, including other notes, become due and payable immediately, without

presentment (demand of payment).

Miscellaneous

The final section of a loan agreement is the miscellaneous clause. This clause, just as the name

implies, takes care of anything the other clauses don’t cover. Generally, you will find that the

miscellaneous clause may contain any or all of the following:

The bank’s right to set off (a lending bank’s right to use funds of the borrower on deposit to

reduce the borrower’s indebtedness upon default)

The assignability of the agreement

The terms under which the agreement may be terminated

Which party shall be responsible for collection expenses in connection with the debt

So far, we have determined the legal entity and identity of the borrower in order to establish the

capacity to borrow; discussed the characteristics of the promissory notes evidencing the debt; and

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learned how the loan agreement acts as a means to formalize the intentions of both parties relating

to the loan transaction.

Up to this point, any of the documents we have analyzed could be used in either secured or

unsecured lending transactions. However, since today, most lending is done on a secured basis; we

need to look at the documentation necessary to secure a loan. However, in order to understand how

documents secure a loan, we first need a lesson in secured transactions.

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FFECTIVE HABIT #6

EFFECTIVE LOAN PORTFOLIO MANAGEMENT

No matter how good the initial decisions, if the credit is not professionally followed, the

bank is asking for trouble. Portfolio management should be performed from two levels,

Senior Management and the Loan Officer.

The ultimate responsibility of a bank’s safety and soundness is the Board of Directors

however, since it is not expected for Board members to actively participate in management

on a day to day basis, this responsibility is delegated to executive management of the bank.

When a bank’s total assets reach $300 million, it is usually recommended by regulators for

the bank to have a Senior Credit Officer and a Senior Loan Officer. Although their

responsibilities may have areas of overlap, there are some sharp differences. For example,

the Senior Credit Officer is primarily responsible for the overall credit quality of the bank

by enforcing credit policies, monitoring the types of loans being approved and managing

the approval process while the Senior Loan Officer is primarily responsible for good loan

business development, management of the lending staff and directly managing the loan

portfolio.

The SCO, SLO and the loan officers, for that matter must rely upon several management

reports to properly manage the loan portfolio. In other words, a bank’s Management

Information System (MIS) is critical to the lending process and management of the loan

portfolio. The following is a list of reports management should have on a frequent basis:

New Loans Report (Useful for loans made outside of loan committee)

Loan Renewed Report

Documentation Exception Report

Loan Grading Report

o Loan experiencing more than one grade change within one year

o Loans with the same grade for two years or more

o Number of loan upgrades and downgrades within one year

o Velocity of grade changes by officer, location, branch, etc.

Past Due Loan Report

Loans on Non-Accrual

Loans considered to be Trouble Debt Restructurings

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Classified Loan Management Reports

Loan to Value Exception Report

Allowance for Loans and Lease Losses Report

The responsibility of a lender is to monitor the quality and profitability of the borrower’s

total relationship on an ongoing basis. The lender’s responsibility doesn’t end once the loan

is made and documented. Because circumstances change, both within the borrower’s

business and in its external environments, the lender must monitor the fluctuating quality of

a given credit as a result of those changes. This imposes on the lender the responsibility of

staying abreast of changes – economic, legislative, technological, competitive, and

demographic – and their implications on the borrower.”

Relationship Manager's Monitoring Responsibilities:

The key to success in relationship monitoring: quality communication between the client and the

bank.

Relationship manager is primarily responsible for:

Maintaining regular communication with the client

Anticipating problems

Working effectively in problem resolution

Maintaining accurate and current credit files

Understanding the effects of economic and regulatory changes on the client’s risk

profile

Forms of Communication:

Visits

Phone calls

Letters

Social Events

Objectives of these contacts:

Monitor the success of the business.

Maintain open lines of communication.

Strengthen and extend the relationship.

Company visits:

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The key to good customer relations.

One of the ways to uncover organizational or operational changes.

On-site inspections can reveal changes in the company’s physical assets well before

they are disclosed in financial statements.

Other sources of Information

Borrower’s:

attorney, accountant or other consultants providing services.

competitors,

suppliers,

customers and

regulators.

Information from all possible sources can help you to put together a viable evaluation of

the company’s current position and future opportunities.

Inspections of public records including newspapers, magazines, and trade publications can

provide information on:

Filed liens on the company’s assets.

Plant closings.

Contracts received or terminated.

Maintenance of Credit Files:

Credit files:

are the written record of the relationship between the bank and the borrower;

are critical in effectively monitoring credit relationships.

outline the history of the relationship.

provide a snapshot of the entire client relationship, including all products and services.

provide financial data for an evaluation of the entire portfolio.

Properly maintained files can help improve credit quality and minimize losses, they must be:

Complete

Accurate

Well organized

Suggested content of Credit Files:

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Financial information

Credit write-ups and financial analysis

Credit inquiries and reports

Correspondence and memos

Miscellaneous materials

Copies of loan documents

In all bank-generated information - It is important for the writer to be clear, concise, simple,

objective, factual, truthful and well organized. Any written information should:

Supply adequate information for decision-making.

Interpret facts for the reader.

Indicate all sides of an issue.

Differentiate between fact and opinion.

State where the information came from, and evaluate the reliability of the source.

Admit errors of judgment and action on the part of the client, and explain why they

occurred and what needs to be done.

Word of Caution - Be careful in what is written and contained in the file, ask this question:

Is there information that might expose the bank to lender liability? (Keep the judge in

mind!)

Covenants

Loan covenants are:

a key element for monitoring loans;

designed to protect the bank’s interest;

a part of the formal loan agreement;

an outline for certain acts that the borrower must

perform (affirmative covenants)

must refrain from doing (negative covenants).

Creating loan covenants is a key to achieving the bank’s objectives.

Full Disclosure of Information

Protection of Net Worth

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Protection of Cash Flow

Protection of Asset Quality

Control Growth

Maintenance of Key Management

Assurance of Legitimacy and the Company as a Going Concern

Profitability for the Bank

Bring the borrower back to the table

Covenants must:

Be those that the bank expects to enforce.

Be set to provide timely warning signs.

Covenants do not:

Repay loans.

In crafting a covenant package, it is important to determine your key objectives to ensure

effective monitoring and management of the exposure and to assure the bank of the optimal

chance of repayment.

Monitoring covenants is an important function for the following reasons:

Provides a current set of financial statements

Facilitates awareness of the financial condition of the borrower(s) and guarantor(s)

Allows for periodic contact with the borrower

Minimizes risk through regular monitoring

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Affirmative Covenants (Financial)

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Financial ratios: You should require the company to maintain certain minimum or maximum levels for various ratios. These are triggers; if the borrower fails to comply, company performance is outside the expected range. Frequently used ratios are:

Current ratio – minimum X

Quick ratio – minimum X X

Sales / assets – minimum X X

Profits / assets – minimum X X

Return on equity or profits / tangible net worth – minimum X

Debt / equity – maximum X X

ARDOH – maximum X X

Inventory DOH – maximum X X

APDOH – maximum X X

Times interest earned – minimum X X

Fixed charges coverage – minimum X X

Working capital: You should require a minimum dollar amount of working capital to be maintained during the course of the loan based on the projections of future performance

X X X

Net worth: You should require the company to maintain a certain minimum level of net worth. This amount may increase for each year of the loan to correspond to the projected net worth levels

X X X X

Negative Covenants

Additional loans: You should place an upper limit on additional borrowing in terms of a dollar amount or a ratio. Limit should permit normal operations and other expected and acceptable needs.

X X X

Sale of assets: Limit the borrower’s ability to sell assets to a maximum dollar amount. (The exception to this is assets sold in the normal course of the company’s business – inventory, for example.)

X X X X

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HIGHLY EFFECTIVE HABIT #7

PROBLEM LOAN MANAGEMENT AND ACCOUNTING

Good Credit Administration requires effective management and oversight of problem loans. In

doing so, quick and accurate identification of problem loans are required. Routine and meaningful

problem loan reporting must be:

Frequent

Meaningful

Action plans

Specific

Actionable

Date-certain

The financial regulators recognize that financial institutions face significant challenges

with borrowers secured by commercial real estate (CRE) caused by:

◦ Diminishing operating cash flow

◦ Depreciated collateral values

◦ Prolonged sales and rental absorption periods

On October 30, 2009, the financial regulators issue a Policy Statement on Prudent Commercial

Real Estate Loan Workouts

Replaces the Interagency Policy Statements on

◦ “Review and Classification of Commercial Real Estate Loans” (November 1991)

◦ “Review and Classification of Commercial Real Estate Loans” (June 1993)

Prudent CRE loan workouts are often in the best interest of Bank and Borrower

Examiners are expected to take a balanced approach in assessing an institution’s risk

management practices for loan workouts

Examiners will not criticize banks implementing prudent CRE loan workout arrangements after

a comprehensive review of a borrower’s financial condition

Renewed or Restructured loans to paying borrowers will not be subject to adverse

classification solely because the value of the underlying collateral has declined to an amount

that is less than the loan balance

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Purpose of Guidance

Addresses supervisory expectations for an institution’s risk management elements for

loan workout programs including:

◦ Loan workout arrangements

◦ Classification of

loans

◦ Regulatory reporting and accounting considerations

Risk Management Elements

• Should be appropriate for the complexity and nature of lending activity

Should be consistent with safe and sound lending practices

• Should be consistent with regulatory reporting requirements and should address:

◦ Management infrastructure to identify, control and manage the volume

and complexity of the workout activity

◦ Documentation standards to verify the borrower’s financial condition and collateral

values

◦ Adequacy of MIS and internal controls to identify and track loan performance

and risk, including concentration risk

◦ Management’s responsibility to ensure that the regulatory reports of the institution

are consistent with regulatory reporting requirements (including GAAP) and

supervisory guidance

◦ Effectiveness of loan collections procedures

◦ Adherence to statutory, regulatory and internal lending limits

◦ Collateral administration to ensure proper lien perfection of the institution’s collateral

interests for both real and personal property

◦ An ongoing credit review function

Loan Workout Arrangements

• Banks should consider loan workouts after:

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1. Analyzing a borrower’s repayment capacity

2. Evaluating support provided by guarantors

3. Assessing the value of the collateral pledged

• If institutions enter into restructuring with borrowers that result in an adverse

classification, those institutions will not be criticized for engaging in loan

workout arrangements so long as management has:

1. Prudent workout policy establishing loan terms and amortization schedules

2. A well-conceived and prudent workout plan for an individual credit that

analyzes the financial information of borrower or guarantor. Key elements of a

workout plan include:

• Updated and comprehensive financial information on the borrower,

real estate project and any guarantor

• Current valuations of the collateral supporting the loan and the

workout plan

• Analysis and determination of appropriate loan structure (e.g. term

and amortization schedule) curtailment, covenants or re-margining

requirements

• Appropriate legal documentation for any changes to loan terms

3. An analysis of the borrower’s global debt service that reflects a

realistic projection of the borrower’s and guarantor’s expenses

4. The ability to monitor the ongoing performance of the borrower and

guarantor under the terms of the workout

5. An internal loan grading system that accurately and consistently reflects the

risk in the workout arrangement

6. An ALLL methodology that covers estimated credit losses in the restructured

loan, measured in accordance with GAAP, and recognizes credit losses in a

timely manner through provisions and charge-offs, as appropriate

How to Analyze Repayment Capacity

• Character, overall financial condition, resources, and payment record of

the borrower

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• Degree of protection provided by cash flow or collateral on a global basis that

considers the borrower’s total debt obligations

• Market conditions that may influence repayment prospects and the cash

flow potential of the business operations or underlying collateral

• Prospects for repayment support from any financially responsible guarantors

How to Evaluate Guarantees

Existence of a guarantee from a financially responsible guarantor may improve the

prospects for repayment and may be sufficient to preclude classification or reduce

the severity of classification

Be sure to determine number and amount of guarantees currently extended by guarantor

Consider if guarantor has significant investment in project

Consider whether past call on guarantee have been honored voluntary or as a the result

of legal actions

Attributes of a Sound Guarantor

o Financial capacity and willingness to support the credit through

payments, curtailments or re-margining

o Adequate to provide support for repayment of the indebtedness in whole or

in part, during the remaining loan term

o Guarantee is written and legally enforceable

Assessing Collateral Values

A new or updated appraisal or evaluation, as appropriate, should address current

project plans and market conditions

Consideration should include:

◦ Performance of project

◦ Conditions for geographic market and property type

◦ Variances between actual conditions and original appraisal assumptions

◦ Changes in project specifications

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◦ Loss of a significant lease or a take-out commitment

◦ Increase in pre-sales fallout

A new appraisal may not be necessary in instances where an internal evaluation

updates the original assumptions to reflect current market conditions and provides an

estimate of the collateral’s fair value for impairment analysis

A new appraisal may not be necessary in instances where an internal evaluation

updates the original assumptions to reflect current market conditions and provides an

estimate of the collateral’s fair value for impairment analysis

If weaknesses are found in assessing proper collateral value, examiners will direct

banks to address the weaknesses

It may require the bank to obtain a new collateral valuation

If a bank refuses, examiners will assess the degree of protection that the collateral

affords in analyzing an classifying a credit

Classification of Loans Based Upon:

Loan Performance Assessment for Classification Purposes

o Examiners should not adversely classify or require the recognition of a partial

charge-off on a performing commercial loan solely because the value of the

underlying collateral has declined to an amount that is less than the loan

balance

o It is appropriate to classify a performing loan when well-defined weaknesses

exist that will jeopardize repayment

Classification of Renewals or Restructurings of Maturing Loans

o Renewals or restructuring of maturing loans to commercial borrowers who

have the ability to repay on reasonable terms will not be subject to adverse

classification, but should be identified in the internal credit grading system

requiring close monitoring

o Adverse classification or a restructured loan would be appropriate if after

restructuring, well defined weaknesses exist that jeopardize the orderly

repayment of the loan in accordance with reasonable modified terms

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Classification of Troubled CRE Loans Dependent on the Sale of Collateral for

Repayment

o Amount of Loan in excess of Fair Value of Collateral (minus cost to sell)

should be classified as “Loss”

o Portion of loan balance that is adequately secured by the fair value of real

estate (less selling cost) should be classified no worse that “substandard”

o Portion of loan balance in excess of the fair value of real estate (less selling

cost) should be classified as “Doubtful” when the potential for full loss may

be mitigated by the outcomes of pending events or when loss is expected but

the amount cannot be reasonable determined

Effective problem loan management requires a full understanding of terms such as:

Impaired Loans as defined by ASC 310-10-35-2 through 30(fka FAS 114)

Impairment Analysis

o Present Value of Future Cash Payments

o Observable Market Price

o Fair Value of Collateral

Trouble Debt Restructure

Non-Accrual Loans

Recorded Amount of the Loan

Effective Interest Rate

Defining Impaired FAS No. 114 considers a loan to be impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amount due (that is, both the contractual interest payments and the contractual interest payment and the contractual principal payments of the loan) according to the contractual terms of the loan agreement. In short all loans classified Doubtful and certain loans classified Substandard, as currently defined for supervisory purposes, will meet this impairment criterion. A loan whose terms are modified in a troubled debt restructuring would be identified as an impaired loan.

FAS No. 114 clarifies that an insignificant delay in collection of an insignificant shortfall in the amount does not constitute impairment. It states that a loan is not impaired during a period of delay in payment if the creditor expects to collect all of the amount due including interest accrued at the contractual interest rate during the period the loan is outstanding.

Measuring Impairment

Once impairment is determined, FAS No. 114 requires that the impairment be measured in one

of three ways:

1. The “present value” of expected future cash flows, discounted at the loan’s effective

interest rate

2. The “market value” for the loan where an observable market price exists

3. The “fair value of the collateral” where the loan is collateral dependent