COMMERCIAL AND ORTGAGE LENDING INCLUDING HAMP LOANS · Within commercial real estate, what types predominate? Single family rentals, multi family ... Specify lending authorities for

June 19, 2012

Presented by:Robin D. Hoag, CPA, CMC Blair C. Svendsen, MBA

COMMERCIAL AND MORTGAGELENDING INCLUDING HAMP LOANS

Does your CU have a business loan portfolio? How long? How large?

Composition: C&I, Agricultural, Commercial Real Estate?

Within commercial real estate, what types predominate? Single family rentals, multi family rentals, retail, industrial, land development, office space, restaurants, owner occupied?

What does your CU consider to be a large business loan?

Audience Survey

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Do you use a Credit Union Service Organization (CUSO) or originate and underwrite loans in-house?

What is your role as internal auditors in reviewing the portfolio? Full loan review vs. oversee outside party?

How comfortable do you feel in assessing the risks in your business loan portfolio?

Audience Survey

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Objectives & Overview

Solid understanding of MBLs Risk management implications Quick update of basics Intermediate/Advanced underwriting criteria Develop ability to look behind the numbers

and assess risk MBL audit programs and approach

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Objectives & Overview

Risk rating commercial loans Internal controls Resources Internal audit roles Future developments (Basel II, HAMP Act)

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Mortgage characteristicsBorrowers are predominantly natural persons

Products are relatively standardized

Conforming mortgages can be readily sold on the secondary market

Portfolio can be monitored by watching payment stream

Highly regulated

Mortgages vs. Business Loans

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MBL characteristicsBroad range of borrowing entities

Each loan is a customized transaction

Difficult to sell to outside investors

Portfolio must be actively monitored

Relatively unregulated


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The hardest part of reviewing business loans is not in evaluating the information that is

available, but in spotting missing information.


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Preliminary assessment of loan portfolio Review Loan Policy Arrange work papers Examine loan files Discuss findings with management and

resolve open issues Issue report

Steps in Loan Review

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Loan policy forms the foundation for all lending and is the beginning point of any loan review.

MBL lending policy should contain the following attributes (next slides):

Review Loan Policy

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Board reviewed and approved at least annually.

Establish concentration limits by loan and collateral type.

Specify borrowing limits for individual members

Specify lending authorities for all lenders and review annually

Review Loan Policy Attributes

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Loan grading system with criteria Market area served Appraisal policy (when needed, how appraiser

is chosen, appraisal reviews) LTV ratios (real estate and non-real estate) Requirements to secure collateral Environmental review requirements Flood search policy


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Overdrafts ACH transactions Collateral release authorizations Stand-by Letters of Credit Criteria for unsecured loans TDR, non-accrual, and charge off criteria Authority to approve policy exceptions and

system of tracking and reporting them


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Desirable Loans = sets CU’s strategy Regulatory mandates

Discussion of Loan Policy

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Policy – Board reviewed and approved Experience in commercial lending (MBL) Loan limits Capital limitations Concentration risk Credit risk Insiders

Regulatory Considerations

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Prohibited transactions for MBLsCEO, COO, CFO, senior executives Family members of the above Loans in which the credit union will share profits

of the sale Loans to compensated directors


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Construction and development loans for commercial or residential property Limitation of 15% of net worth Single family residences by individual with 25%

equity interest are allowed


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Policies Written to manage risk and loan types granted;

Board approved and annually reviewed NCUA Supervisory Letter: 2009 Current Risks

in Business Lending and Sound Risk Management Practices – A Must Read

Underwriting and MBL experience required Two years minimum in the type of loans being

approved and underwritten


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Analyze and document borrower’s ability to repay the loan (underwriting) Financial statements, borrower history & creditCash flow, interest rates, maturity structure Tax returnsCollateral valuationOwnership Loan monitoring and servicing


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Minimums required Trade areas / geography – knowledge of value Types of business loans to be offered Limitations in terms of MBL to assets and net

worth; individual types and aggregate Individual member limits or concentrations

MBL Policy - Regulatory

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Maximum LTV is 80%, unless government guaranteed, insured or PMI type insurance, or subject to advance purchase by a federal or state agency.

With guarantee the maximum is 95% Must provided personal guarantee of the

borrower (except if Reg. flex qualified)

Collateral and Security

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Net member business loan maximumOne member or group of associated members Greater of these two values below 15% of net worth or

$100,000

Unsecured MBL limitationsMust be well capitalized Lesser of $100,000 or 2.5% of net worth

Maximum of all unsecured borrowers 10% of net worth

Maximum Loans – Reg. 723.7

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Lesser of 1.75 times CU’s net worth or

12.25% of CU’s total assets Aggregate limitation includes nonmember

loan participation balances outstanding

MBL Maximum Exposure

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See Examples

MBL Audit Work Papers

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Trace loan amount, date, payment, interest rate, and type from loan subsidiary system to loan note.

Examine current credit report. Examine documented approval within loan

policy limits. Examine business entity documentation and

determine if it’s appropriate and complete.

Existence Assertion Testing

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Trace loan amount, date payment, interest rate and type from loan subsidiary system to executed collateral documents

Trace loan covenant and financial statement requirements to executed business loan agreement

Trace guaranty amounts and type of guarantees from loan approval document to executed guaranty documents

Policy, Risk & Procedures Testing

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Review evidence of lien placement, such as UCC filing statements, a recorded mortgage, or final title policy

Review final title policy; verify (1st Mtg.) or title search verify (2nd Mtg.)

Review evidence that taxes are monitored and paid current


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Review evidence of hazard insurance naming lender as beneficiary for proper amount.

Examine approval/credit file to verify borrower's cash flow position is reviewed and analyzed from the most recent F/S.

Examine approval/credit file to verify borrower's leverage position is reviewed and analyzed from most recent F/S


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Examine approval/credit file to verify guarantor’s recent F/S are reviewed and analyzed

Verify DSC ratio was accurately calculated and within lender's policy guideline

Verify LTV ratio is within lender's policy and supported by acceptable invoice, sales receipt, or appraisal


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Examine credit file for f/s monitoring Examine credit file for covenant monitoring Examine approval for underwriter's

recommendation Examine approval for deal's strengths and

weaknesses Examine approval for deal's policy exceptions


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Examine appraisal; trace amount and valuation date to requirement in the approval, such as if a new appraisal ordered prior to funding

Examine environmental due diligence Verify loan is properly risk rated in accordance

to institution’s risk rating policy Assess loan loss reserve for loan if there is a

specific reserve


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To have an enforceable loan documentation package, you must use the appropriate

documentation for each type of borrower or guarantor.

Business Entity Types

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Sole Proprietor Individual; may do business under different name

(i.e. Edward Smith, d/b/a ABC Mechanical)Need copy of assumed name filing Loan is to the individualNeed Business Purpose Affidavit


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Limited Liability Company (LLC) Exists independently from its owners. Members

are not personally liable for its debts unless they sign a guarantee

Need Articles of OrganizationNeed Operating AgreementCertificate of Good StandingNeed borrowing resolution


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Corporation Independent entity governed by a Board of

Directors elected by shareholders. Members not responsible for entity’s debts.

Need Articles of IncorporationBylaws with any amendments. (Borrowing

restrictions?)Corporate resolution authorizing officers to

conduct financial transactions in corporate nameCorporate Certificate of Good Standing


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Non-Profit CorporationsUsually has elected Board and officers with staff.

Members not responsible for entity’s debts.Need Charter of AssociationNeed Bylaws and any amendmentsAssociation Certificate of Good StandingResolution specifying who can make agreements

and sign in the entity name.Make sure to update resolution as membership

changes.


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General Partnership Two or more general partners. Partners are individually responsible for the

partnership debts.May not have a partnership agreement. (Either

obtain agreement or obtain a letter stating one does not exist)

Need borrowing resolution or have all partners sign note as co-borrowers


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Limited PartnershipsComposed of one or more general partners and

one or more limited partners.General partners are liable for partnership debts,

limited are not (unless they sign a guarantee). Purpose is to allow some partners to put up capital without assuming liability for future debts.

Need Partnership Agreement, Partnership Certificate, Borrowing Resolution


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Guaranties Unlimited and General vs. Limited and Specific

UCC-1 used for following collateral typesAccounts EquipmentGeneral intangibles

Property taxes

Collateral

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COMMERCIAL LOAN UNDERWRITING

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Basics of Commercial Underwriting

Cash flow analysis Loan to value (LTV) Credit worthiness Property / collateral analysis Secondary guarantees Loan structure and covenants

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Five Cs of Credit Capacity

Capital

Collateral

Conditions

Character

Five Cs of Credit

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Capacity Revenues, earnings, and cash flow (primary

repayment source) Capital Entity’s ability to service the debt if earnings fall

short Collateral Specific assets pledged to support the debt

Five Cs of Credit

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Conditions Industry-wide characteristics that affect business;

firm’s unique strengths and weaknesses. Character Management’s ability and willingness to service

the debt.

Five Cs of Credit

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Please see example on second screen.

Underwriting Example

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Cash Flow Analysis

Most important component Debt service coverage (DSC) ratio Minimum requirements Riskier loan types

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Revenue stability & growth Margin protection: Gross Margin/Sales less COGS

(cost of goods sold) Cash flow Fixed charge coverageWhat is the hurdle?What is pro forma (forecast or projected) coverage? How much cushion is implied? Perform a sensitivity analysis

Capacity Components

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Quality of InformationOnly use recurring revenues and expenses in DSC

calculationAny projections used should be fully supported

and carefully examinedMust be forward-looking projection, upcoming

threats to revenues should be noted

Capacity Components

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Owner’s investment in the businessPaid in capital/other equityRetained earnings

Cushion to withstand disruption

Capital

Member’s “skin in the game”

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Minimum net worth (tangible NW): $ value Capital to capitalization: Equity / (funded debt

+ equity) Debt to capitalization: FD / (FD + equity) Debt to equity Debt to enterprise value: (FD / (FD + market

value equity) Debt to EBITDA

Capital Measurements

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Please review example provided

Example

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Composition of the capital is important. You cannot repossess or sell retained earnings.

Quality of information is critical. Most often working with unaudited statements.

If a capital item is critical to your credit decision, it should be verified.

Capital

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Secondary source of repayment Specify what secures the loan Identify any competing claims Summarize important aspects What is the primary collateral? Quality of collateral (specialized, single purpose, or

active market) Coverage rate Recovery costs and expectations

Collateral

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Collateral Summary

Collateral Analysis Example Company ($ in thousands)

Accounts Receivable 33,828$ - 33,828$ 75.0% 25,371$ Inventory - - - 30.0% -

ST Assets Collateral 33,828$ 33,828$ 25,371$

Property, Plant, & Equipment - NBV 20,885$ - 20,885$ 50.0% 10,443$ LT Asset Collateral 20,885$ 20,885$ 10,443$

Total ST Collateral 25,371$ Total LT Collateral 10,443$

Total Collateral 35,814$

Senior Debt Commitment OutstandingRevolving Credit ($55.0MM) 55,000$ 1,536$

Letters of Credit 17,226$ Senior Term Loan 60,450$ 60,450$

Total Long Term Debt 115,450$ 79,212$

Total Discounted Collateral 35,814$

Total Collateral Surplus/ (Deficit) - Outstanding (43,398)$ Airball Percentage - Outstanding 54.8%Collateral / Total Outstanding 0.45 x

Total Collateral Surplus / (Deficit) - Commitment (79,637)$ Airball Percentage - Outstanding 69.0%Collateral / Total Outstanding 0.31 x

Ineligible/ Foreign

Actual 12/31/10

Eligible Domestic

Advance Rate

Discounted Value

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Loan to Value (LTV)

Loan Amount / Appraised Value = LTV Key risk factor Valuation of property (appraisal vs. in-

house evaluation) Maximum LTV ratio Property types influence LTV

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Property / Collateral Analysis

Property or collateral analysis is the valuation of assets pledged against a loan

Fair market value Investment property collateral Non real estate collateral Forced sale of collateral

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General economyBusiness cycle

Specific industryAssess the industry

Market positionClient specific

Conditions

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State of overall economy Business cycle Early expansion Late expansion Early contraction Late contraction

Individual industries react differently to economic cycles

Conditions

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Definition and industryCyclical or Seasonal Where are they now?

Growth, mature, declining, consolidatingCompetitive threats Legislative or political threats

General Industry Conditions

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Median salary of a surgeon in Denver = $312,219

Median salary of an Internal Auditor in Denver = $73,670

Why aren’t we all surgeons?

Beyond the Numbers

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Assess the industry – SpecificBarriers to entryCompetition Substitute productsCustomer leverage Supplier leverage

Beyond the Numbers

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Market Position – Client SpecificMarket share Leader / followerRMA statistics (resource & reference in materials) SWOT analysisStrengthsWeaknessesOpportunitiesThreats

Market Position Conditions

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Where the case for making the loan is documented. It should be complete and comprehensive. A “stand alone” document that details the reason for granting the credit.

Loan Presentations

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Should at least contain the following: Proposed terms of the loanMay have alternative terms that will be presented

to borrower Loan policy should specify latitude given to loan

officers to make minor changes in loan before going back to get it re-approved.

Loan Presentation Requirements

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Opening description of borrower and proposed loan, covering at least:Purpose of the fundsNature of the businessHistory of the businessOwners, guarantors, and related entities are

discussed and their relationship to this credit made clear. Outside interest and contingent liabilities should be revealed.

Sources and uses of funds


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Sources of payment in order of preference Typically cash flows, guarantor support, and

liquidation of collateral Entity Cash FlowsAt lease 3 years of cash flows. Look for trends.

There should be verbal explanations for fluctuations


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Entity balance sheet At least 3 years of examples; unusual fluctuations

should be explained verbally. Fluctuations should be consistent with fluctuations in

the cash flow trends

Guarantor evaluation Type of guaranty: unlimited vs. limited At least 3 years of financial information for all

significant guarantors Compute personal DSC Evaluate credit report


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Presentation

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Global cash flowGlobal DSC of entity and all guarantors combined

should be computed Collateral evaluationDate of valuation: recent and still relevant Source of valuation: competent, independently

chosen Expected salvage value

Loan Presentation

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Strengths and weaknesses Policy exceptions and mitigating factors Contingencies Shock test proposed credit and see how it

performs under unfavorable market conditionsRate shock (for variable rate loans, demonstrate

how credit would perform under rate increases) Real Estate Loans: establish occupancy break-even

point(see example)

Loan Presentation

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RISK RATING COMMERCIAL LOANS

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Loan Risk Rating System

Primary indicator of credit exposure Used for a variety of purposes Approval requirements Portfolio management Identifying problem loans Loan pricing Loan loss reserve calculations

An important element No one correct rating system

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Structure of Rating System

Four minimum categories1. Pass2. Substandard3. Doubtful 4. Loss

Additional categories1. Watch list2. Special mention

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PassSub

Pass ratings (At Least 3 Categories)

1. Exception Risk Unquestioned primary source of loan

repayment; no apparent risk

2. Very Good or Good Quality Primary source of repayment very likely to be

sufficient, with secondary sources readily available; strong financial position; minimal risk; profitability, liquidity and capitalization are better than industry norms

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Pass ratings (At Least 3 Categories)

3. Acceptable or StandardPrimary source of loan repayment is

satisfactory, with secondary sources very likely to be realized if necessary; loan within normal credit standards; requires average amount of Loan Officer attention; company is of average size within its industry and may have difficulty accessing or does not have access to public markets for short term or capital needs

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Marginal Rating

Risk rating systems should have a transitory or marginal classification with at least one of the following categories: Watch List Loans having potential weaknesses deserving

management’s attention; they don’t go on the special mention list. Not adversely classified and don’t expose CU to significant risk.

Special Mention Commercial loans needing close operating attention or

action to mitigate possible weakness; have emerging identifiable problems.

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Adversely Classified Risk Ratings

Loans with some impairment Fall into three categories

1. Substandard (least severe) Defined weaknesses or negative trends meriting

close monitoring 2. Doubtful

Vital weaknesses exist where collection of principal is highly questionable

3. Loss (most severe) Uncollectible and of such little value the

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Substandard Definition

Asset inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any.

Assets so classified must have well-defined weakness or weaknesses that jeopardize the liquidation of the debt.

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

Non-interest accrual status has been attained.

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Doubtful Definition

An asset having all the weaknesses inherent in “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.

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Loss Definition

Asset is considered uncollectible and of such little value that its continuance on the books is not warranted.

Does not mean asset has absolutely no recovery or salvage value; rather it’s not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.

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Key Points

When are ratings assigned? How often are ratings reviewed? Segregation Examiners

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Loan structure depends on the nature of the member’s business

To properly structure a member relationship, the credit union must:Project how the company will perform in the

futureAnticipate challenges and problems that may ariseDevelop covenants that protect the credit union

Loan Structure

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Lines of Credit Seasonal or RevolvingPurpose is to fund short term cash flow shortages Collateral is generally short term assets, accounts

receivable or inventoryMaturity of no more than 12 months Funding percentages and “taint” rule

Credit Facilities

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Term Loans Single advance, declining balance loansPurpose is to fund permanent working capital or

refinance debt or equityCollateral is generally first liens on fixed or long

term assetsMaturity of 2 to 10 years

Credit Facilities

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Affirmative Covenants Timely delivery of financial information (default

rate penalty)Access to company’s booksRight to inspect collateral Timely notification of contingent liabilitiesMaintain operating accounts with the credit union

Full Disclosure Covenants

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Minimum tangible net worth Other financial ratios Key person life insurance Current settlement of tax liabilities

Protection of Net Worth: Affirmative Covenant

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Restrictions on additional borrowings Restrictions on distributions or stock buy-backs Minimum/maximum financial ratios Restrictions on sales of assets

Protection of Net Worth: Negative Covenant

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Affirmative CovenantMaintain minimum DSCMaintain minimum Current RatioMaintain property and casualty insurance

Negative CovenantRestriction of capital expenditures and leasesRestriction on investments

Protection of Cash Flow Covenants

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Case Study

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For pass graded credits; more frequently for criticized loans

Should include Current financials and analysis Physical inspection of business & collateral if applicable Credit report Estimate of current collateral value Payment history Adherence to loan covenants Revolving LOCs should be revolving Recommended loan grade

Monitoring – Annual Reviews

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Two-tier loan grading systemDefault grade Loss grade

Profitability analysis of loans

Future Trends

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Please review handout.

HAMP Act

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755 West Big Beaver RoadSuite 2300

Troy, Michigan 48084 Thank You!2603 Augusta Drive

Suite 1100Houston, Texas 77057

www.doeren.com

Blair Svendsen, MBALending Specialist

Office: (248) 244-3281Cell : (517) 230-6047

Email : [email protected]

Robin D. Hoag, CPA, CMCDirector, Financial Institutions Group

Phone: (248) 709-1270Email : [email protected]

6750 North Andrews AvenueSuite 200

Ft. Lauderdale, FL 33309

Services

Financial Institutions Group

Audit Mergers & consolidations IT assurance

Controls reviews Vulnerability assessments Penetration testing

Commercial loan review Loan loss & delinquency

control Regulatory compliance

services

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The Risk Management Association: Annual Statement Studies – Financial Ratio Bookmarks 2010/2011 (www.rmahq.org)

See reference materials at the back of the NCUA Letter to Credit Unions

Resources

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Documents

COMMERCIAL AND ORTGAGE LENDING INCLUDING HAMP LOANS · Within commercial real estate, what types predominate? Single family rentals, multi family ... Specify lending authorities for