CREDIT AND COUNTERPARTY RISK:“RISK ASSET” REVIEW

February 22, 2000

David Dudley

Federal Reserve Bank of New York

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CREDIT RISK ANALYTICAL FACTORS

• Level, trend, and types of risk in asset portfolios

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

• Volume of classifications:– Weighted classification ratio– Total classification ratio– Level and trend of ratios and dollar amounts– Composition of these assets

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CREDIT RISK ANALYTICAL FACTORS

• Level, trend, and composition of nonperforming, nonaccrual, and renegotiated loans, and foreclosed assets

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

• Volume and character of insider and intercompany transactions

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CREDIT RISK MANAGEMENT EVALUATION FACTORS

ORIGINATION ADMINISTRATION COLLECTIONStrategy Portfolio Assessment Payment Processing

Expertise Concentration Management Collection Thresholds

Disclosure Performance to Terms Workout/Restructuring

Credit Analysis Asset Review Term Changes

Credit Decision Risk Management and Control Write-off Management

Pricing/Structuring Loan Loss Reserve Management Recovery Management

Products/”Add-ons”

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CREDIT RISK PROBLEMS

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

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WHY HAVE LOAN ADMINISTRATION?

Risk management versus risk avoidance!– Loan Portfolio: significant contributor or drag on

earnings.– Lending function requires active management.– Loan quality impacts capital adequacy.– A definition: “The establishment and

implementation of policies and procedures that optimize the lending function by maintaining proper credit standards.”

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CREDIT CULTURE

POLICY, PROCESS and REVIEW

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

• Requires enforcement and commitment by management at all levels!

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THE FIVE ELEMENTS OF LOAN ADMINISTRATION

• Loan Policy - sets forth clear policies and specific procedures.

• Loan Approval Process - uniform and consistent with accountability.

• Loan Monitoring - from day one throughout life of loan.

• Loan Review - objective evaluation of individual loans and portfolio.

• Problem Loans - deteriorated situations that threaten repayment.

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LOAN POLICY - FIRST ELEMENTA comprehensive Loan Policy includes:• Objectives

• Performance Objectives: growth, earnings, liquidity, leverage.• Compliance and Law Regulations - also non-discrimination.• Lending Authorities

• Board and senior management responsibilities• Delegation to loan committees or individuals• Maximum amounts to be extended

• General Approval Criteria: the criteria used in evaluation of loan requests.

• Defined Trade Area• General Fields of Lending - commercial, consumer,

secured, unsecured, etc.

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LOAN POLICY - FIRST ELEMENT• Desirable Loans - legitimate, economically productive

enterprises in the area.• Undesirable Loans - specific prohibitions as to purpose or

borrower.• Collateral and Appraisal policies• Loan Administration - broadly define credit administration

process and responsibilities- origination - administration and collection

- credit analysis - review

• Miscellaneous Credit Exposure - contingent liabilities, settlement risk, etc.

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LOAN POLICY - FIRST ELEMENT• Insider Loan Policy• Adherence to Loan Policy - responsibilities for

compliance.• Nonaccrual Loans

– Eligibility following past due interest and/or principal

– Conditions necessary for exemption

• Allowance for Loan Losses Allocation - a risk assessment judgment.– To specific commercial credits

– To identified sub-portfolios

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LOAN APPROVAL PROCESS-THE SECOND ELEMENT

• Loan Committees– Best lenders

– Good Learning experience

– Uniformity

• Signature System– Timely responses

– Clear responsibility

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LOAN APPROVAL PROCESS-THE SECOND ELEMENT

• Standardized Presentation for All Credit– Purpose– Repayment sources– Financial analysis– Collateral evaluation– Structure and terms, Pricing– Loan documentation

• Field Examinations for Secured Loans– Adequacy of controls– Collateral evaluation– Performance trends

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GENERAL LOAN DOCUMENTATION REQUIREMENTSLegal - U.S. Business Law

1. Note.

2. Security agreement.

3. UCC Filing (financing statement).

4. Guaranty (collateralized or not).

5. Subordination agreement.

6. Corporate resolution.

7. Participation agreement.

8. Form U-1.

9. Stock powers.

10. Assignment of insurance.

11. Title (car, boat).

12. Mortgage/Deed of trust.

13. Copy of deed.

14. Assignment of leases

15. Title insurance policy

16. Loan agreement

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GENERAL LOAN DOCUMENTATION REQUIREMENTSCredit

1. Loan application.

2. Commitment letter.

3. Tax returns.

4. Personal financial statements.

5. Business financial statements.

6. Evidence of insurance.

7. Key-man insurance

8. Appraisal.

9. Credit bureau report.

10. Credit memorandum.

11. Correspondence.

12. Loan review.

13. Inspections.

14. Other

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THE 5 C’S OR 5 P’S OF CREDIT

Character

Capacity

Capital

Collateral

Conditions

People

Payment

Purpose

Protection

Prospects

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PEOPLE OR CHARACTER

Measures borrower’s “willingness to pay”

Payment History

Credit Report

Information from Other Lenders

Information from Loan Discussion

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PAYMENT OR CAPACITY

Measures borrower’s “ability to pay”

Payment Source

Income to Debt Service

Cash Flow to Debt Service

Living Costs and Other Income

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PURPOSE OR CAPITAL

How was the money used?

Purchase Asset?

Working Capital?

Debt Refinance?

What is the Leverage Position?

Debt to Worth

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PROTECTION OR COLLATERALWhat are Bank’s options if the loan is not paid?

What is pledged collateral?Lien position? Perfected?What is market value?Easily marketed?

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

Review Encumbered Assets

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PROSPECTS OR CONDITIONS

Borrower’s Circumstances:

Within the Industry

Cyclical Trends

New Developments

New Laws and Regulations

(e.g., EPA Cleanup)

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THE 5 C’S OF BAD CREDIT

Complacency

Carelessness

Communication

Contingencies

Competition

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LOAN MONITORING -THE THIRD ELEMENT

• Tracking - Key Elements– Interim results– Agings of receivable and payables– Inventory levels– Borrowing levels– Actual vs. plan– Credit file maintenance

• Risk Rating Determines Degree of Monitoring– Responsibility of loan officer– Rating consistently reflects risk– Degree of risk relates frequency of monitoring– Risk ratings influence loan pricing

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LOAN REVIEW - THE FOURTH ELEMENT

• Review of Individual Credit by Objective Third Party– Confirm risk ratings

– Identify deteriorating situations

– Monitor remedial action

• Review of total portfolio– Industry concentrations

– Identification of economically weak industries

– Aggregate findings to be reported to the Board

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PROBLEM LOAN ADMINISTRATION - THE FIFTH ELEMENT

• Performance - One of Three Ways

• There Will Always Be Problem Loans

• Cost of Problem Loans– Lost interest and principal– Absorption of loan officer time– Legal costs– Morale

• Early Identification is Critical!

• Three Lines of Defense– Loan Officer– Loan Review– Outside Examiners

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STAGES OF A PROBLEM LOAN

• Salvageable - where deterioration first occurs– Financials deteriorate– Loan not performing as expected– Borrower’s attitude changes– Situation requires action

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

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STAGES OF A PROBLEM LOAN

• Workout - The Twilight Zone - problem worsens– More loans critical– Question business servicing– Setting of conditions prior to new funding

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

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STEPS IN PROBLEM LOAN ADMINISTRATION

• Workout Specialists– Efficient and objective– Technical expertise and experience– Establish an agreed upon workout plan– Separate from origination function– Manage lender liability

• Strategy for Recovery– Obtain additional collateral– Reduce outstandings

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STEPS IN PROBLEM LOAN ADMINISTRATION

• Borrower Has To Do The Restructure– Obtain management’s cooperation

– Show the risk of liquidation

• Additional Funds?– Documentation and legal preference are critical

• Strategy for Recovery– Obtain additional collateral– Reduce outstandings

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STEPS IN PROBLEM LOAN ADMINISTRATION

• Role of Attorneys in Liquidation– Bankers must retain control of business decision

– Lawyers are expensive

• Charge Off Administration– Continue collection efforts

– Borrower should be unaware of charge-off

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SYMPTOMS OF TROUBLED LOANSFINANCIAL

Leverage– Trend – Industry norm

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

Liquidity– Working Capital

• Current ratio• Quick ratio• Receivable, inventory, payable turns

– Cash Flow

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SYMPTOMS OF TROUBLED LOANSNON-FINANCIAL

Financial Data– Timeliness of receipt

– Adequacy of content

Changes in Management Style– Turnover of key people

– Quality of forecasts

– Inability to meet budget

– Detailed knowledge of operations

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SYMPTOMS OF TROUBLED LOANS

NON-FINANCIAL

Changes in Industry, Market or Product– Awareness of changes– Management plans in anticipation

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

Adverse News from Public Services, Suppliers

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SYMPTOMS OF TROUBLED LOANSLOAN OFFICER

– Ignorance• lack of training or inexperience

– Workload• excessive workload impacts problem detection

– Procrastination• Hoping problem will go away• Avoiding the unpleasant• Ego; admission of failure• External forces; problem beyond control• Fear of management retribution• Reaction to the community• Lender liability potential !!

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SUBSTANDARD

An asset that is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

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CHARACTERISTICS OF A SUBSTANDARD ASSET

• Significant deviation from the original source of repayment• Diversion of repayment funds• Delinquency• Carry-over debt• Failure to clean-up a short-term operating line• Numerous extensions and/or renewals without identified sources of

repayment• Significant negative trends in financial statements

– deterioration in accounts receivable, decrease in net worth, decrease in profitability, cash flow, working capital

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DOUBTFUL

An asset that is classified Doubtful has all the weaknesses inherent in one classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently known facts, conditions, and values highly questionable and improbable.

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CHARACTERISTICS OF A DOUBTFUL ASSET

• All of the Substandard characteristics plus a loss exposure that cannot be readily defined with present circumstances and conditions

• Undetermined value of collateral• The possibility of loss is extremely high, but because of certain

important and reasonably specific pending factors that may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans.

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LOSS

An asset that is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted

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

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CHARACTERISTICS OF A LOSS ASSET

• Severe delinquency

• Unsecured

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

• Not well secured and not in the process of collection

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SPECIAL MENTION

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

Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

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EXAMINATION RATIOS• Total Classifications = Total Classification Ratio Tier 1 Capital + LLR

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

• Delinquency statistics– 90+ days past due/Total loans– Nonaccrual loans/Total loans– Nonperforming loans (NPLs)/Total loans– NPLs+foreclosed assets/Total loans+foreclosed assets– Total past due loans/Total loans

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LOAN LOSS RESERVE METHODOLOGY AND ADEQUACY General Rules:

• Loan loss reserves must always cover known and potential losses

• US accounting rules and the FFIEC's Interagency Policy Statement on Loan Loss Reserves (12/93) govern the booking and maintaining of loan loss reserves

• Provisioning is general and expensed against current earnings; specific provisions are equivalent to charge-offs

• ICERC-mandated (minimum) reserves against sovereign exposure are specific

• Reserve methodologies are unique to each institution but the fundamental techniques can be generalized

• General philosophy: Provision and charge-off now; recover later

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LOAN LOSS RESERVE METHODOLOGY AND ADEQUACY What is not clearly defined:• What asset exposures can be charged-off against the LLR?

– Loans-yes, securities-no, ORE-no, derivatives-not so clear

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

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

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

• The "Art" vs. The Science

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LOAN LOSS RESERVE ACCOUNTING• Beg. Balance LLR

+ Provisions earnings impact

- Charge-Offs no direct impact to earnings

+ Recoveries no direct impact to earnings

+/- Adjustments mergers, sales, acquisitions, etc.

End. Balance LLR

• Provisioning expenses reduce current taxes, if tax authorities have evidence that estimated losses and actual cash losses are "close;" otherwise, actual losses are charged against income (for tax purposes)

• An observation: Consumer loan losses are generally absorbed through current provisioning while commercial loans require longer-term provisioning

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LOAN LOSS RESERVE GENERALIZED METHODOLOGY

• Known and potential losses = expected losses + unexpected losses

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

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

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

• Local, national, and international economic conditions

• Portfolio composition and growth; concentrations

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LOAN LOSS RESERVE ENHANCED METHODOLOGY

• Increased granularity of bank-specific loan data– portfolio type, product type, risk rating - regulatory or internal, loan officer,

branch, vintage– bond proxy data used as sanity check

• Correlations between industries, geographies, and portfolios

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

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

• Tax adjustment factors

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WHAT’S THE LOSS?

• $500 million commercial real estate loan $625 million appraised value “when completed”

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

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

• What are the considerations for loss potential?

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WHAT’S THE LOSS?

What are the considerations for loss potential?

• Appraised Value– function of completion

• Completion costs?• Maintenance costs

– landscaping, security, weather, deterioration• Taxes• Legal fees• Sales costs

– brokerage, advertising, leasing concessions?• Time

– foreclosure to sale• Funding cost of carry, “Return?”

Result? Interest reversal, charge-off of ?

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A SIMPLE TOOL FORLOAN LOSS RESERVE ADEQUACY

• Using (admittedly) rough loss estimates for classified assets and a generalized loss rate for the rest of the portfolio, examiners can test loan loss reserve adequacy

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

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

• Bottom line: We expect better bank-specific methodologies !!!

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FINAL THOUGHTS

• Beware the fallacy of precision !

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

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

The End