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Transcript of 1 The opinions expressed in this presentation are intended for informational purposes, and are not...
1
The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Commercial and Industrial Lending: Pitfalls and Risk Mitigants
Kevin Cragholm, Senior AnalystDante Tosetti, Credit Risk Examination Specialist
Randy Santos, Senior AnalystAdrienne Thompson, Examining Manager
Tim Marder, Examining Manager (Facilitator)
Call the Fed Webinar - September 13, 2012
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Portfolio Shifts to C&I Loans
“[T]o generate loan volume without increasing real estate lending, many banks are now targeting growth in commercial and industrial (C&I) loans, a type of lending with which they may have less expertise. In fact, banks have generally experienced higher loss rates on C&I loans than on commercial real estate secured loans (excluding construction loan losses), even through the crisis. So this portfolio shift has the potential to increase rather than decrease expected losses.”
Elizabeth A. Duke, Federal Reserve Board Governor
2012 Bank Presidents Seminar, CBA
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
What are the critical factors a community bank’s senior management and board of directors should evaluate before expanding further into C&I lending?
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
FOUR CORNERSTONESOF C&I LENDING
1• Market Dynamics
2• Personnel Considerations
3• Administration & Monitoring
4• Remediation Framework
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
• How attractive is your C&I market?Competitive Landscape
• Are borrowers’ C&I needs underserved?Borrower Circumstances
• How sensitive are borrowers to price?Pricing
• Can you create (cross-sell) customers?Comparative advantages
• How well is your C&I strategy working?Success Benchmarks
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Personnel Considerations
Staff Assessment
Resource Allocation
Costs
• Skills• Competencies• Duration
• Training• Recruiting
• Monetary• Opportunity• Transition
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
• Risk analysis• Loan structuring• Documentation• Collateral perfection• Approval
Pre-disbursement
• Covenant compliance• Risk monitoring• Collateral verification• Loan review/audit• Reporting
Post-disbursement
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Remediation Framework
Intervene
You want effective intervention to protect interests and minimize loss
CommunicateYou want open, accurate communication with key decision-makers
DetectYou want a robust capacity to detect problems early
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Perspectives of C&I Underwriting
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Perspectives of C&I Underwriting
Financial Analysis Isn’t Enough to Bank on
Financial Analysis: What is the number and is it good enough?
Credit Analysis: Why is the number what it is?
ABA Banking Journal July 27, 2012By Jeff Judy
www.JeffJudy.com Is it a duck or a rabbit?
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Perspectives of C&I Underwriting
Financial Analysis• Loan DSCR = 1.50x.
And
Credit Analysis• Does loan amortization match the
purpose?• Is a rate shock needed?• Will future capex become an issue? • Is subordinated debt included?
Young lady or old maid?
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Perspectives of C&I Underwriting
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Perspectives of C&I Underwriting
QUESTIONS ABOUT
EBITDAEarnings• Are earnings seasonal like 70% of all businesses?• What is other income and will it be recurring?• If expenses have declined (amounts or margins),
why?
Interest• Are historical interest expenses similar to the
historical debt structure. If not, why not?
Taxes• Don’t add-back taxes. Use EBIDA.
Depreciation & Amortization • What are the economic lives of the assets?
Question: Which line is the longest?Answer: They are all the same length.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Perspectives of C&I Underwriting
There are sources of repayment within the balance sheet.
UCA incorporates the balance sheet.
Therefore…Use UCA
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Watch the Add Backs
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Perspectives of C&I Underwriting
• Financial Analysis versus Credit Analysis.
• Use UCA.
• Watch the add-backs. Is it a vase or two faces?
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Collateral Inspection Purpose
The field audit should be approached with the idea of providing the lender with nonbiased, factual
information about custody, type, quantity, and valuation of the collateral to make sound credit
decisions.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Collateral Inspection Staging
• New Relationship: o Qualifying prospective borrower
• Existing Relationship:o Assessing ongoing performance
• Exiting Relationship:o Determining work-out strategy
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Categories
• Profitable and Stable – Working Capital
• Relationships with Cash Flow Problems
Asset Based Lending Candidates
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Relationships with Cash Flow Problems
• Uncertain or unpredictable cash flow
• Inability to make agreed upon loan payments and past due trade creditor
payments
• Highly leveraged
• Unsustainable growth
• Diminishing sales without appropriate declines in costs
• Limited secondary sources of repayment
Asset Based Lending Candidates(Continued)
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
• Background
• Books & records
• Key statistics
o Turnover
o Dilution
o Past due
o Concentrations
• Borrowing base calculation
• Inventory stages and locations
• Shipping / performance test
• AR activity review
• Cash application test
• Verifications
• Accounts payable
• Payroll taxes
Collateral Audit Scope
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
What to Look for in an Outsourced Report• Differences between auditor’s calculated values and those on the borrowing base
certificates submitted by the borrower.
• The borrower should assist with the preparation of books and records. The auditor’s function is to verify, not create, the information.
• The worst field audits generate more questions than answers. Major issues should always be brought to the attention of the borrower during the field examination.
• If the major issue cannot be resolved on-site, it should be communicated to the lender. This gives the lender the ability to terminate the transaction and avoid embarrassment as well as incurring additional time and expense of a dead deal.
• Completion time varies significantly based on the quality of the records, collateral, the number of locations and companies involved. Nevertheless, a long delay can be indicative of record keeping concerns with the borrower.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
What to Look for in a Collateral Auditor• The firm’s field auditors should all have solid accounting and audit backgrounds,
coupled with asset-based field exam experience in a multitude of industries. Resumes are a good source for this information. Firm should be able to cite the number of collateral audits they have performed by industry.
• Due diligence field audits should be the firm’s prominent source of business, not a supplement to its core business or used as filler work.
• The firm must have staff at all levels with the proper interpersonal skills needed to work effectively with the borrower.
• The firm should be viewed as an extension of your own bank/department.
• Solid references with sample audits and workpapers.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Collateral Auditor Search• Commercial Finance Association
• The Secured Lender
• The RMA Journal
• CPA
• Bankers
• Appraisers
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Credit Administration Highlights
C&I loans often have unique characteristics which require specialized monitoring of financial performance, compliance with loan and financial covenants, and processes to address findings from collateral audits or
inspections. Processing borrowing-base certificates and eligible collateral can be labor intensive, and may require specialized skills to
ensure sound credit administration practices.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Ensure that all advance rates, sub-limits, financial covenants and financial statements are accurately captured for on-going monitoring.
• Advance rates: o Triggers: assuming advance rates are industry and borrower
appropriate at origination, under what circumstances could they be decreased or increased (change in dilution, for example)
o Changes to advance rates: who is authorized to approve, who monitors changes, and is there reporting of changes.
o Pitfalls: Loans or portfolios can take on additional risks and loans may become more difficult (or impossible) to exit; management may be unaware of increasing risk unless MIS is sufficient.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
• Sub-limits: o A/R and Inventory Structure: Ideally, A/R secures a larger portion of total
availability and loan amount, both through advance rates and dollar sub-limits. (examples: advance rates of 80% for A/R, 40% of inventory; plus a hard dollar or percentage limit on the amount of eligible inventory)
o Changes in sub-limits: Identifying who is authorized to make or approve changes, or temporary “over-advances”.
o Systems capability: Systems may not be able to track sub-limits, and compliance can be tracked only through the borrowing base. Manual reporting or adjustments may be required.
o Pitfalls: Inadvertent overreliance on aging or obsolete inventory.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
• Covenants (operating, financial or negative): o Tracking: In accordance with loan documents, and in conjunction with
receipt of financial statements, may be tracked on a quarterly basis. o Need a defined process to ensure that all covenants are initially identified and
tracked in a timely manner.o Ensure compliance with any unique definitions or formulas as defined. o May require a manual or custom form for tracking or documenting review.o Tracking process should include periodic certification from the borrower that
they are in compliance with all covenants.o Monitoring: Who monitors and ensures that internal covenant analysis is
current (tickler), that violations are cured within set time limits and non-compliance appropriately escalated.
o Waiver of covenants: If not enforcing or waiving a covenant, ensure rights to enforce covenants are preserved (including written notification to borrower)
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
The borrowing base needs to accurately reflect the loan terms:• Accounts Receivable:
o Eligibility: Reconciles sales, credit memos, and payments/receipts, and deducts ineligibles before applying advance rates. Common ineligibles:o Delinquencies, as defined in loan documentationo Contra-accounts/offsetso Foreign accounts/government receivables
o Support: Define what you need to support each borrowing base; monthly receivables output can be time consuming to process.
o Pitfalls: o Delinquencies: ensure that loan terms specify due date or invoice date
eligibility, and that reporting from borrower matcheso Borrower Account List: Needs to be kept current; critical in a default. o Reconciliation : Balance Sheet and Borrowing Base.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
• Inventory:o Sub-limits: commono Define: Raw material, work-in-process vs. finished goodso Ineligibles:
• Work-in-process (WIP)• Raw material (or minimal advance rate)• Obsolescence (reserves)
• Over-advances:o Who approves and how are they reported to senior management.o Policies and procedures need to define limits and approval authority.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Comments on administration of collateral audits, periodic valuations, access to legal counsel and fraud.
• Administration of collateral audits:o Policy/procedures: Define process and time frame for review and
corrective action by loan or relationship manager (how are the information and exceptions handled and by whom.)
o Pitfalls: Failure to address identified deficiencies in a timely manner (expiration of key man insurance, failure to pay taxes, other insurance, additional debt, etc.)
• Collateral valuations (Orderly liquidation vs. forced liquidation values):o Policy should define how often and under what circumstanceso Appraiser with relevant industry experience
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
• Legal counsel:
o May require specialized legal counsel with expertise in UCC laws, providing guidance in securing assets and potentially work with lenders in Debtor-in-Possession financing.
o My experience: need more readily available access to counsel for ABL issues than I did with CRE. Processes may not be as well defined as CRE foreclosures, for example.
o Most community banks do not have in-house counsel, which may slow processes if problems arise.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
• Fraud – beginning of a relationship and as borrower deteriorates
o Ensure financial statements and collateral are adequately validated at beginning of relationship.
o Accounts Receivable: May quickly evaporate if borrower picks up checks directly from customers as lender tries to notify customers and collect receivables (diverting funds).o Reporting non-existent receivables by creating false invoiceso Re-aging uncollected debts to increase eligibility
o Inventory: Overvaluing or double counting stock (“Empty box “ experiences, equipment disappearing, risk from “routine” or predictable collateral inspections)
o ln contrast, land doesn’t move.
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The opinions expressed in this presentation are intended for informational purposes, and are not formal opinions of, nor binding on, the Federal Reserve Bank of San Francisco.
Contact the Speakers• Kevin Cragholm, Senior Analyst
• Dante Tosetti, Credit Risk Examination [email protected]
• Randy Santos, Senior [email protected]
• Adrienne Thompson, Examining [email protected]
• Tim Marder, Examining Manager [email protected]