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June 15, 2011
Presented by:Robin D. Hoag, CPA, CMC
Robert M. Parks, CPA
COMMERCIAL LOAN AUDITING FOR INTERNAL AUDITORS
Objectives & Overview
Solid Understanding of MBL’s Trends in Commercial Lending - MBL’s Regulatory Consideration Risk Management Implications Basic Underwriting Criteria MBL Audit Programs
2
Objectives & Overview
Commercial loan workout arrangements Risk rating commercial loans Internal controls Resources Internal Audit Roles
3
2006 2007 2008 2009 2010 BUSINESS LOANSMember Business Loans (NMBLB) 1 18,891,446,077 21,459,363,443 25,531,770,716 28,279,415,320 30,413,271,788 Purchased Business Loans or Participations to Nonmembers (NMBLB) 1 3,915,871,018 4,929,242,985 6,360,143,424 6,789,563,211 6,765,768,251
Total Business Loans (NMBLB) 1 Total MBL's 22,807,317,095 26,388,606,428 31,891,914,140 35,068,978,531 37,179,040,039 Unfunded Commitments 1 1,938,867,620 1,852,703,145 1,701,806,459 1,612,294,689 1,593,523,144 TOTAL BUSINESS LOANS (NMBLB) LESS UNFUNDED COMMITMENTS 1 20,868,449,475 24,535,903,283 30,190,107,681 33,456,683,842 35,585,516,895 %(Total Business Loans (NMBLB) Less Unfunded Commitments/ Total Assets) 1 2.93 3.25 3.72 3.78 3.89
DELINQUENCY - MEMBER BUSINESS LOANS1 to < 2 Months Delinquent 129,438,460 207,709,817 387,226,608 537,092,843 579,835,938 2 to < 6 Months Delinquent 71,522,982 229,183,178 409,178,047 596,008,756 592,237,431 6 to 12 Months Delinquent 25,771,636 179,446,067 149,168,321 363,045,974 383,528,489 12 Months & Over Delinquent 12,602,739 49,100,897 125,981,018 292,012,289 420,137,828
Total Del Loans - All Types (2 or more Mo) MBL Delinquency 109,897,357 457,730,142 684,327,386 1,251,067,019 1,395,903,748
MBL CHARGE-OFFS AND RECOVERIES:*Total MBL Charge Offs MBL Charge-offs 25,269,178 37,922,077 131,876,705 223,995,934 289,271,389
*Total MBL Recoveries 4,709,215 3,482,536 7,065,554 6,544,607 7,394,203
Data for GraphicBillionsTotal MBL's 22.81 26.39 31.89 35.07 37.18 MBL Delinqucny % 0.48% 1.73% 2.15% 3.57% 3.75%MBL Charge-off % 0.11% 0.14% 0.41% 0.64% 0.78%
Policy – Board Reviewed and Approved Experience in commercial lending - MBL Loan Limits Capital Limitations Concentration risk Credit Risk Insiders
Regulatory Considerations
Proceeds used for commercial, corporate, investment, agricultural purposes
Balances aggregated to member exceed $50,000
Participation loans, or purchased loans with the same origin from another credit union
Member Business Loans
Prohibited transactions for MBL’s CEO, 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
Regulatory Considerations
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
Regulatory Considerations
Policies – Written to manage the 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 (2) years experience by your commercial lender at a minimum in the type of loans being approved and underwritten
Regulatory Considerations
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
Analyze and Document borrowers ability to repay the loan; Underwriting Financial Statements, borrower history & credit Cash flow, interest rates, maturity structure Tax returns Collateral valuation Ownership Loan monitoring and servicing
Regulatory Considerations
Maximum LTV is 80%, unless a 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 is Reg flex qualified)
Collateral and Security - Reg
Net member business loan maximum One member or group of associated members
Greater of these two values below 15% of net worth or $100,000
Unsecured MBL limitations Must be Well Capitalized Lesser of $100,000 or 2.5% of net worth
Maximum of all unsecured borrowers 10% of net worth; non-natural person credit card members for routine purchasing????
Maximum Loans – Reg. 723.7
Lesser of 1.75 times credit union net worth or 12.25% of credit union total assets Aggregate limitation will include nonmember
loan participation balances outstanding
MBL Maximum Exposure
Ten states have approved MBL regulations.
State MBL Regualtions
COMMERCIAL LOAN UNDERWRITING
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Credit Worthiness
Credit worthiness for the business and sponsor/guarantors is heavily scrutinized
Loans get paid somehow Start-up businesses
Risk, collateral, management Owner-occupied property
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Character Purpose Capacity Conditions Capital Collateral
Include Five Cs of Credit (P)
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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Character Identify participants
Purpose Reasons for transaction & client benefit
CapacityRevenues, earning & cash flow – primary source of repayment
ConditionsIndustry trend & analysis, market position, SWOT analysis
Capital Equity, sub-debt & retained earnings
CollateralType, quality, & coverage (value) – secondary source of repayment
Essential Component Details
Perhaps the most important issue Explain:
What is borrower’s capacity to bear burden of proposed debt while still making necessary investments to remain competitive and or viable?
Capacity Section Overview
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 coverage
What is the hurdle? What is pro forma (forecast or projected)coverage? How much cushion is implied Perform a sensitivity analysis
Capacity Components
Fixed Charge Coverage Ratio (FCCR)EBITDA / P+I+T+C+D
Forward looking analysis Can they repay the proposed debt? NOT a historical review of the performance, cash
flows or loan structure covenants
Cash Flow/Fixed Charge Analysis
General Define the industry
Specific Assess the industry
Market position Client specific
Conditions
Define and industry – General Cyclical or Seasonal
Where are they now? Growth, mature, declining, consolidating Competitive threats Legislative or political threats
General Industry Conditions
Assess the industry – Specific Barriers to entry Competition Customers Suppliers Substitutes
Specific Industry Conditions
Market Position – Client Specific Market share Leader / follower RMA statistics (resource & reference in materials) SWOT analysis
StrengthsWeaknessesOpportunitiesThreats
Market Position Conditions
Owner’s investment in the business Paid in capital/Other equity Retained earnings
Cushion to withstand disruption
Capital
Member’s “skin in the game”
Minimum net worth (tangible NW) Dollar 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
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, sing purpose, or
active market) Coverage rate or air ball percentage Recovery costs and expectations
Collateral
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
Loan to Value (LTV)
LTV ratioLoan Amount / Appraised Value = LTV
Key risk factor Valuation of property Maximum LTV ratio Property types influence LTV
34
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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Separation of functions is critical Credit and Underwriting Approval Process Sales and Relationship Management Collections and Workout Actions
Internal Controls
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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Pass ratings
At least three categories1. 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 three categories3. Acceptable or Standard
Primary 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 risk rating classification
A credit union should have at least one of the following categories: Watch List
Loans having potential weaknesses that deserve management’s attention; these loans don’t go on the special mention list. Not adversely classified and don’t expose an institution to significant risk.
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Marginal Rating
A credit union should have at least one of the following categories: Special Mention
Special mention loans are commercial loans needing close operating attention or action to mitigate possible weakness. These commercial loans 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 continuance
as an asset is not warranted 44
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 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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Loss Definition
Asset is considered uncollectible and of such little value that its continuance on the books is not warranted.
This classification does not mean the asset has absolutely no recovery or salvage value; rather it is 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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Resource MBL Risk Rating Example Document
Risk Rating Example
Key Points
When are ratings assigned? How often are ratings reviewed? Segregation Examiners
49
See Handout Materials
MBL AUDIT PROGRAMS & SCOPE CONSIDERATIONS FOR INTERNAL AUDIT
MBL Audit Workpapers
LOAN O/S PRESENT INT. LOAN COLL. CREDIT LOAN LOAN
ACCT # DATE BALANCE COMMITMENT PMT RATE TERM TYPE TYPE SCORE DSC LTV CU DM INSIDER OFFICER CLOSER
Member Business Loans
1234-1 Company A 10/28/2009 675,000.00 - 675,000.00 5,233.27 7.00% 60 CREM Apartments 795/767 1.39x 69.6% 2 2 N RDH Title Co.
1234-2 Company B 06/10/2009 945,485.53 - 945,485.53 8,362.63 6.50% 60 CREM Restaurant 784/744 1.40x 59.1% 2 2 N RDH Title Co.
1234-3 Company C 06/17/2009 1,042,071.30 - 1,042,071.30 7,891.63 6.50% 60 CREM Retail 753 1.55x 56.9% 2 2 N RDH Title Co.
1234-4 Company D 12/10/2008 937,275.44 - 937,275.44 6,563.66 6.75% 84 CREM Church n/a 2.88x 30.1% 2 2 N RDH Title Co.
1234-5 Company E 02/04/2009 803,074.93 - 803,074.93 7,141.36 6.40% 84 CREM Retail 808/791 2.46x 38.1% 1 1 N RDH Title Co.
1234-6 Company F 08/06/2009 889,345.84 - 889,345.84 10,377.62 6.75% 60 CREM Grocery Store 798/640 1.59x 66.1% 2 2 N RDH Title Co.
1234-7 Company G 09/11/2009 2,650,000.00 - 2,650,000.00 20,545.42 7.00% 120 CREM Retail 716/755 2.13x 48.2% 1 1 N RDH Title Co.
1234-8 Company H 03/27/2009 2,097,862.03 - 2,097,862.03 14,424.11 6.50% 60 CREM Apartments 677 1.35x 79.2% 2 2 N RDH CUSO
1234-9 Company I 10/19/2009 120,000.00 - 120,000.00 1,051.76 6.50% 60 CREM Apartments 772/772 1.59x 40.3% 2 2 N RDH Title Co.
1234-10 Company J 08/20/2009 4,034,489.30 - 4,034,489.30 28,234.08 6.75% 60 CREM Retail 735/727 1.25x 73.6% 2 2 N RDH Title Co.
1234-11 Company K 05/13/2009 145,438.21 - 145,438.21 1,747.05 7.00% 60 CREM Office 672/700 2.45x 55.9% 3 3 N RDH CU
1234-12 Company L 09/21/2009 - 100,000 100,000.00 Int. Only 6.75% 12 LOC Gas Station 751/786 1.70x 52.8% 3 3 N RDH CU
1234-13 Company M 04/27/2009 708,239.22 - 708,239.22 4,751.44 6.25% 180 CREM Restaurant 591/598 1.45x 79.2% 3 3 N RDH CU
1234-14 Company N 09/02/2009 45,000.00 305,000 350,000.00 Int. Only 7.00% 12 LOC All Assets 787/704 14.09x n/a 2 2 N RDH CU
1234-15 Company O 08/12/2009 142,277.05 - 142,277.05 1,137.82 7.25% 120 CREM Bar/Tavern 672/795 3.12x 79.2% 2 2 N RDH Title Co.
RISK RATINGMEMBER NAME
UN-FUNDED
Note
Cre
dit
Report
Appro
val
Colla
tera
l/Mort
gage A
gre
em
ent
Com
merc
ial L
oan A
gre
em
ent
Guara
nte
es
Evid
ence o
f Lie
n P
lacem
ent
Titl
e P
olic
y / S
earc
h
Monito
ring o
f R
eal E
sta
te T
axes
Evid
ence o
f In
sura
nce
Revie
w a
nd A
naly
sis
of B
orr
ow
er's C
ash F
low
Revie
w a
nd A
naly
sis
of B
orr
ow
er's L
evera
ge
Revie
w a
nd A
naly
sis
of G
uara
nto
rs' F
/S
Debt S
erv
ice R
atio
Calc
ula
tion
Loan-t
o-V
alu
e (
LT
V)
Fin
ancia
l Sta
tem
ent M
onito
ring
Loan C
ovenant M
onito
ring
Underw
rite
r's R
ecom
mendatio
n
Str
ength
s a
nd W
eaknesses Identif
ied
Polic
y E
xceptio
n Indentif
ied
Appra
isal/C
olla
tera
l Valu
atio
n
Environm
enta
l Quest. / P
hase 1
Ris
k R
atin
g
Specifi
c L
oan L
oss R
eserv
es
ACCT # 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Member Business Loans
1234-1 x x x x na x t t na x x x x x x x x x x na x x x na
1234-2 x x x x na x x x na x x x x x x x x x x na x x x na
1234-3 x x x x x x x x na x x x x x x x x x x na x x x na
1234-4 x na x x na na x x na x x x na x x x x x x na x x x na
1234-5 x x x x na x x x na x x x x x x x x x x na x x x na
1234-6 x x x x x x x e1 na x x x x x x x x x x na x x x na
1234-7 x x x x na x x x na x x x x x x x x x x na x x x na
1234-8 x x x x x x x x na x x na x x x x x x x na x x x na
1234-9 x x x x x x t t na x x x x x x x x x x na x x x na
1234-10 x x x x x x e1 e1 na x x na x x x x x x x na x x x na
1234-11 x x x x x x x x x x x x x x x x x x x na x x x na
1234-12 x x x x x na t t na x x x na x x x x x x na x x x na
1234-13 x x x x x x x x x x x x x x x x x x x na x x x na
1234-14 x x x x x x x na na na x x x x na x na x x na x na x na
1234-15 x x x x x x x e1 na x x x x x x x x x x na x x x na
EXISTENCE POLICY, RISK, & PROCEDURES
Legendx Tested without exceptione1 Procedure and Process Exceptione2 Best Practice Exceptionew Exception waived by authorized personnelna Not applicable
ACCT #
Member Business Loans
1234-1 1.20x DSC Covenant
1234-2 1.20x DSC Covenant
1234-3 1.20x DSC Covenant
1234-4 1.20x DSC Covenant
1234-5 1.20x DSC Covenant; 15 yr amort - DSC = 3.19x with 25 yr amort
1234-6 1.20x DSC Covenant; no final title policy
1234-7 1.20x DSC Covenant; 100% Occupancy
1234-8 1.20x DSC Covenant; 100% Occupancy
1234-9 1.20x DSC Covenant; 100% Occupancy
1234-10 1.25x DSC Covenant; 100% Occupancy - a 5% vacancy factor was included; no recorded mortgage and final title policy
1234-11 1.20x DSC Covenant; two quarterly loan reviews in file.
1234-12 1.20x DSC Covenant (for CREM)
1234-13 1.20x DSC Covenant; two quarterly loan reviews in file.
1234-14 Partically secured by securites at broker/dealer ($285thd @5/31/09)
1234-15 1.20x DSC Covenant; no final title policy; LTV includes a $104thd SBA loan, without SBS LTV is under 50%
COMMENTS
Trace loan amount, date, payment, interest rate, and type from loan subsidiary system to loan note.
Examine current credit report. If lender uses risk-based underwriting and/or pricing system, vouch credit score/grade to credit report.
Examine documented approval within loan policy limits.
Existence Assertion Testing
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
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
Policy, Risk & Procedures Testing
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
Examined 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
Policy, Risk & Procedures Testing
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 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
Policy, Risk & Procedures Testing
COMMERCIAL LOAN WORKOUT ARRANGEMENTS
58
Elements for Loan Workouts
Manage workout activity Document financial condition Identify and track performance and risk Regulatory reporting Loan collection procedures Adherence to lending limits
59
Loan Workout Arrangements
Workouts can take many forms Should improve lender’s prospects for
repayment Need to analyze repayment capacity and
collateral Maximize recovery Credit unions should not be criticized
Concessions require ALLL recognition
60
Analyzing Repayment Capacity
Primary focus of examiner’s
Borrower character Nature and degree of
protection Market conditions that
influence repayment Prospects for guarantor
support61
Evaluating Guarantees
Guarantees may improve the prospects for repayment
Financially responsible guarantor Financial capacity Adequate support for repayment Legally enforceable
Guarantor’s global financial condition Willingness to fulfill all current and previous
obligations62
Assessing Collateral
Ongoing procedure for monitoring value A new or updated appraisal or evaluation Market Value vs. Fair Value Current “as is” condition Use the market value conclusion What examiners will look at
63
See Handout Materials
FORECLOSED AND OREO MBL ASSETS
Cash Flow Analysis
Cash Flow Analysis
Cash Flow Analysis
Cash Flow Analysis
Cash Flow Analysis
755 West Big Beaver Road Suite 2300
Troy, Michigan 48084
Thank You!2603 Augusta DriveSuite 1100
Houston, Texas 77057
www.doeren.com
Robert Parks, CPADirector, Financial Institutions Group
Office: (248) 244-3049Cell : (248) 709-1046
Email : [email protected]
Robin D. Hoag, CPA, CMCDirector, Financial Institutions Group
Phone: (248) 709-1270Email : [email protected]
Services
71
Financial Institutions Group
Audit Mergers & consolidations IT assurance
Controls reviews Vulnerability assessments Penetration testing
Commercial loan review Loan loss & delinquency
control Regulatory compliance
services
The Risk Management Association: Annual Statement Studies – Financial Ratio Bookmarks 2010/2011 (www.rmahq.org)
Also: See reference materials at the back of the NCUA Letter to Credit Unions
Resources
