Stress Testing the Loan Portfolio

Mike Lubansky, Director of Consulting Services

Sageworks

The Leader in the Financial Analysis of Privately Held Companies

O - (919) 851-7474 | F - (919) 851-6718

info@sageworks.com

www.sageworks.com

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About Sageworks & Our Speaker

Financial information company that provides credit and risk management

solutions to financial institutions

Data and applications used by thousands of financial institutions and

accounting firms across North America

Mike Lubansky

Mike is a director of consulting services at Sageworks, where he oversees

product development and implementation in the financial institutions market. He

serves as the in-house stress testing expert at Sageworks and has been a

featured speaker for audiences of both financial institutions and regulatory

agencies on matters pertaining to the banking industry. Most recently, he spoke

before federal examiners at the FFIEC, on the subject of stress testing

approaches and challenges.

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1. About Sageworks and Our Speaker

2. Poll

3. Regulatory Requirements: Who, What and When

4. Stress Testing Objective

5. Why Stress Testing’s Important

6. Types of Community Bank Stress Testing

7. Biggest Challenge: Data

8. Scenario Selection

9. Maximizing Value of Reports

10. Sample Stress Tests

11. Common Mistakes

12. Q & A

Agenda

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Quick Polls

1. Types of Stress Testing Performed

2. Obstacles to Stress Testing

Regulatory Update: Who, What and When

2006 Interagency Guidance on CRE Concentrations

Banks with 100% of total capital in construction, development and land-related

loans

Banks with CRE representing 300% of risk-based capital.

Primarily “bottom up” analysis

2009 CCAR

Requirements for 19 largest U.S. banks

“Top down” annual analysis

2010 Dodd-Frank Wall Street Reform and Consumer Protection Act

Banks >$10 billion in assets

“Top down” annual analysis like under CCAR

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Regulatory Update: Who, What and When

2011 OCC Comptroller’s Handbook “Concentrations of Credit”

“Banks of all sizes will benefit by supplementing stress testing of significant

individual loans with portfolio and firm-wide stress testing”

Prescribes “top down” and “bottom up” analyses

2012 Interagency Expectations for Stress Testing by Community Banks

Recommends some type of sensitivity analysis to assess potential impact of adverse

outcomes on the bank’s finances

Prescribes “top down” and “bottom up” analyses

2012 FDIC “Stress Testing Credit Risk at Community Banks”

Defines stress testing for community banks and provides example methodology

2012 OCC “Community Bank Stress Testing: Supervisory Guidance”

Recommends at least top down stress testing for banks <$10 billion in assets

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Stress Testing Objective

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Thesis from Regulatory Bodies:

Every bank should stress test their loan portfolio.

Objective?

Assess risk by loan and concentration

Evaluate impact of policy changes in the bank

Assess needs for the allowance and capital adequacy

How much?

Determined by size, complexity of a bank’s loan portfolio and risk appetite

Why Stress Testing’s Important

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Best practice for banks that

demonstrates proactive and progressive

improvement

Identify pockets of portfolio that are

vulnerable to a variety of outside factors:

e.g. changes in short term interest rates

or deteriorating real estate market

conditions

Recognize overexposures in

concentrations, geographies, industries

or types of real estate

Why Stress Testing’s Important

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Increase banks’ ability to mitigate risk by targeting potentially problematic

loans for additional scrutiny, such as more frequent rent-roll reviews or

owner-income updates

Provide bank management with clues on how to amend credit policies,

pricing or business strategy based on desired risk profile

Why Stress Testing’s Important

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ALLL Provisions

Capital Adequacy

Types of Community Bank Stress Testing

Borrower/ Relationship Sensitivity Analysis

Bottom Up Scenario Analysis

Loan Migration Analysis

Reverse Stress Testing

Enterprise Level Stress Testing

Stressed Loss Rates (Simple Capital Stress Test)

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Typical Bank: Disconnected Systems

Current Appraisal

Values

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Rent Rolls

Core Processing

System

Biggest Challenge: Data

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Accumulate and examine data for largest real estate exposures or the

segment with higher dollar/ higher risk—should be the first priority

Develop a process for accumulating the necessary data on ongoing basis

and account for different data sources

Help identify data weaknesses within the institution for that and other segments

Expand stress testing coverage to include other portfolio segments over time

Review processes over time to ensure the right data is included

Sample Portfolio Analysis, Coverage

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334 Loans in sample as of 1/31/2012

54% of Pass-rated CRE, Multifamily

& Construction

C&I loans with real estate collateral

treated as CRE

Includes loans reviewed between

12/2010 and 3/2012

Coverage increases every quarter

Income properties (263 loans, 84%

of exposure):

174 Multifamily (53% of exposure)

38 Retail (11%)

17 Industrial (10%)

34 Office & Other (9%)

Bottom Up Stress Test: Identify concentrations

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High risk

concentration

Examples of Data Elements Needed

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Bottom Up Stress Test: Determine Scenarios

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Determine Scenario

Scenarios range from

moderate to severe

Use current market data or

bank’s historical data to

validate scenario variables

Combine scenarios to

evaluate total exposure in

some cases

Larger institutions can use

loan migration analysis

Bottom Up Stress Test: Results

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Estimate Rating Migration

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Loan-by-loan post-stress DSCR and LTV used to estimate potential

migration to criticized and classified ratings

Rating Migration Change based on NOI Stress

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Interest Rate Sensitivity: Potential Grade Migration

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Selected Peer Comparisons

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Sample Top Down Approach

“For most community banks, a simple stressed loss-rate analysis based on

call report categories may provide an acceptable foundation to determine if

additional analysis is necessary.”

OCC Supervisory Guidance– Community Bank Stress Testing– 10/18/2012

Segment the portfolio into pools with similar risk characteristics

Develop “stressed” loss rates for each segment; consider:

Bank’s historical loss rates over several stress periods

Peer/ market loss rates over several stress periods

Results of any “bottom up” stress testing

Calculate Stress Period Loss amounts (2 year timeframe)

Estimate Earnings impact, apply to Tier 1 Capital ratios

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FDIC Supervisory Insights Example

1. Estimate Portfolio Losses Over the Stress-Test Horizon

Stress Period Loss Rates, Two Yrs Stress Period Losses, Two Yrs

Est. Portfolio

Balances, in $

Moderate Case

Stress

Severe Case

Stress

Moderate Case

Stress, in $

Severe Case

Stress, in $

Construction & Development 124 14.0% 25.0% 17 31

Commercial Real Estate 22 2.5% 5.0% 1 1

Residential Mortgage 372 2.9% 6.5% 11 24

Other Loans 125 5.0% 10.0% 6 13

Totals 643 35 69

2. Estimate Revenues and Impact of Stress on Earnings

Moderate Case

Stress, in $

Severe Case

Stress, in $

Pre-provision net revenue (over two years) 31 25

Less Provisions 35 69

Less Tax Expense (Benefit) -1 -13

Net After-Tax Income -3 -31

3. Estimate Impact of Stress on Capital

Moderate Case

Stress, in $

Severe Case

Stress, in $

Beginning Tier 1 Capital 88 88

Net Change in Tier 1 Capital -3 -31

Ending Tier 1 Capital 85 57

Estimated Average Assets 850 816

Estimated Tier 1 Leverage Ratio 10% 7%

One Bank’s Approach: Top Down Stress

“Base Case” is calibrated to the latest default and loss data (December 2012)

“Q1-2010: Severe Recession” is the stress scenario replicating Bank’s default and

loss experience from April 2009 to March 2010. This was the longest (18 months)

and deepest recession since the Great Depression. During the period:

National Unemployment Rate peaked ~10%

Home Prices decreased 30% peak to trough

Bank had the highest level of nonaccrual/delinquent loans at March 2010

Bank recorded $108 million in realized losses

CDR Severity

Mar-10 Dec-12 Mar-10 Dec-12

Commercial Loans 12.4% 9.5% 52% 37%

Commercial Real Estate 6.5% 1.8% 44% 26%

Community Association 1.3% 4.6% 47% 37%

Cooperative Real Estate 3.3% 0.8% 49% 40%

Share /Single Family

(Consumer) 4.8% 3.1% 51% 44%

5.7% 4.0% 48% 37% 26

Portfolio Stress Losses: Results Overview

($000) Base Severe Recession

UPB

Cumulative

Loss

Annual

Loss

Cumulative

Loss

Annual

Loss

Commercial 809,588 (76,911) (28,457) (100,389) (52,202)

CRE 641,869 (11,554) (3,004) (41,721) (18,357)

CMA 138,431 (6,368) (2,356) (1,800) (846)

Coop 780,096 (6,241) (2,496) (25,743) (12,614)

Consumer 1,195,513 (37,061) (16,307) (57,385) (29,266)

3,565,498 (138,134) (52,620) (227,038) (113,286)

Bank’s reality check of the above summary:

Approximates Bank’s Loan Loss

Allowance at Dec 2012 of $52.6

million. (Including FAS 114 and FAS 5

Allowances).

Approximates the $108 million of

losses experienced during the

period April 2009 through March

2010. The “high-water” mark of

Bank’s losses during the Great

Recession.

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Sample Segment Top Down Stress Setup

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Commercial Real Estate

I. Scenario Parameters

No Default Base Q1-2010

CDR 0.00% 1.20% 6.00%

Loss Severity 0% 25% 42%

Recovery Lag (Months) 24 24 24

Prepay Multiplier 100% 100% 100%

II. Fair Value & WAL

Fair Value 210,486,568 208,850,747 199,027,155

UPB 214,165,722 214,165,722 214,165,722

Price 98.3 97.5 92.9

WAL 2.5 2.4 2.1

III. Projected Losses

Cumulative ($) $ - (1,635,822) (11,459,413)

Cumulative (%) 0.00% -0.80% -5.40%

Annual Loss ($) $ - (678,439) (5,386,358)

Annual Loss (%) 0.00% -0.30% -2.50%

+ Qualitative Adj. 0.00% 0.00% 0.00%

Adj. Annual Loss (%) 0.00% -0.30% -2.50%

Other Types of Stress Testing

Loan Migration Analysis

Looking at how loans migrate under stressed scenarios and how it would impact

asset quality and capital

Reverse Stress Testing

Running various stress tests to determine a “break point” that would cause the

bank’s capital levels to fall below satisfactory levels

“Enterprise Level” Stress Testing

Combining results from the various credit risk stresses with results from interest

rate risk and liquidity risk stress tests

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Is the Bank Getting the Most from the Process?

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Aside from organizing the different data sources, banks should identify the

best, most useful types of reports

What loans/borrowers are struggling? What industries are struggling? Is the bank

stressing these industries to predict future issues?

Frequency of running the reports and sharing results with board

Can the bank demonstrate what kind of potential losses it might have if a

certain stress occurred? How would that stress affect earnings/ capital?

Verify accuracy, timeliness of the data used for the stress testing

Quick Polls

1. Stress testing solution from Sageworks

2. Stress testing resources from Sageworks

Questions?

Mike Lubansky

866.603.7029 ext. 651

Mike.Lubansky@sageworks.com

Additional whitepapers and archived webinars available at www.sageworksanalyst.com.

Featured whitepaper – Stress Testing: The Who, What, When and Why

Featured resource – Stress Testing Template by Sageworks

Selected References

FDIC Supervisory Insights 2012

OCC Community Bank Stress Testing, October 2012

CEIS Review Methodology for Stress Testing; Peer Stress Results

Sample bank’s Top Down Stress Test

Sageworks Clarity Stress testing sample data and results

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