CREDIT AND COUNTERPARTY RISK:

1
CREDIT AND COUNTERPARTY RISKRISK ASSET REVIEW

• February 22, 2000
• David Dudley
• Federal Reserve Bank of New York

2
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

3
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

4
CREDIT RISK MANAGEMENT EVALUATION FACTORS

• ORIGINATION ADMINISTRATION COLLECTION
• Strategy 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

5
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 ELEMENT

• A 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

13
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 REQUIREMENTS

• Legal - 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 REQUIREMENTS

• Credit
• 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 CS OR 5 PS OF CREDIT

• Character
• Capacity
• Capital
• Collateral
• Conditions

• People
• Payment
• Purpose
• Protection
• Prospects

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PEOPLE OR CHARACTER

• Measures borrowers willingness to pay
• Payment History
• Credit Report
• Information from Other Lenders
• Information from Loan Discussion

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PAYMENT OR CAPACITY

• Measures borrowers 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 COLLATERAL

• What are Banks options if the loan is not paid?
• What is pledged collateral?
• Lien position? Perfected?
• What is market value?
• Easily marketed?
• Borrowers Financial Strength
• Analyze Net Worth
• Adjust for Changes in Debt and Assets Value
• Review Encumbered Assets

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PROSPECTS OR CONDITIONS

• Borrowers Circumstances
• Within the Industry
• Cyclical Trends
• New Developments
• New Laws and Regulations
• (e.g., EPA Cleanup)

22
THE 5 CS OF BAD CREDIT

• Complacency
• Carelessness
• Communication
• Contingencies
• Competition

23
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
• Borrowers 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 managements 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 LOANS

• FINANCIAL
• 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 LOANS

• NON-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 LOANS

• LOAN 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 managements close attention. If left
  uncorrected, these potential weaknesses may
  result in the deterioration of the repayment
  prospects for the asset or the institutions
  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
• 20SS50DL Weighted Classification Ratio
• Tier 1 Capital LLR
• Delinquency statistics
• 90 days past due/Total loans
• Nonaccrual loans/Total loans
• Nonperforming loans (NPLs)/Total loans
• NPLsforeclosed assets/Total loansforeclosed
  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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WHATS 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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WHATS 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-15SS-50D- L-
• (3 yr. net loss
  raterest 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 !
• Its a model --- evaluate the assumptions
• --- review the performance
• Watch the short-run and the long-run !

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The End