Where is the UCA/FAS 95 Analysis?

By: David Dalessandro, Senior Consultant

In the summer of 1987, the savings and loan I was working for at the time sent me to a “cash flow” seminar in Norman, OK. I had graduated from Penn State a few years before and had recently accepted my first of what would prove to be many positions in banking as a credit analyst. At that point, my experience at financial analysis was limited to what I had absorbed from two accounting firms I had worked for and studying for (and passing) the CPA exam. The seminar topic was “The Implications of FASB 95.”

FASB 95, for those of you asking, was issued in November 1987 and was to be utilized in all financial statements finalized in fiscal years ending after July 15, 1988. The requirement replaced the famous APB 19, Statement of Changes in Financial Position, which we all knew and loved as a pretty worthless financial statement at the time, because no one without a CPA attached to their name understood it, and most CPAs had difficulty explaining it.

The seminar turned out to be one of the most beneficial events in my life. As it was explained, the Statement of Cash Flows, as required by FASB 95, was a financial disclosure that would trace every dollar of cash through an accounting period. How awesome, I thought, because only cash pays back loans. So now if I have a tool to trace every dollar of cash, credit analysis would be a cinch.

Well, fast forward 30 years…and the Statement of Cash Flows is still not a household name in Credit Analysis. Most financial institutions, even the largest, still hang onto EBITDA for “cash flow” or multiples of EBITDA for “value.” The EBITDA analysis may approximate real cash flow for real estate rental properties, but for those thousands of enterprises that carry Accounts Receivable, Accounts Payable, Inventory, Other Assets, and Other Liabilities, pay distributions, report gains and losses on sales of assets, take charge downs on intangibles, write off bad debts, and enter into other “non-cash” transactions, the Statement of Cash Flows is the only real way to “follow the money.”

The question here is, why would any financial institution NOT at least include FASB 95/UCA in cash flow analysis when it was appropriate? EBITDA, or even EBITDA adjusted for one-time items, may give the analyst an estimate of total cash flow, but true operating cash flow can only be obtained from a properly and timely prepared Statement of Cash Flows. The Statement separates the movement of cash into three primary categories: Operations, Investment, and Financing. From a bank or financial institution standpoint, if there is positive cash flow from the Investing segment or from the Financing segment, then the enterprise is selling assets or obtaining more loans or selling stock in order to make its loan payments. Are those sources sustainable? Are those sources where you want your customer to come up with the funding to make your loan payments? Is the quality of cash flow from Investing or Financing equal to that of Operating Cash Flow? Probably not. But if the cash flow from operations is positive, and it has been positive for a number of years and it is sufficiently positive to fund all loan payments, then that should be a sustainable source of cash flow far into the future. If the Operating Cash Flow is positive enough to fund loan payments, pay distributions/dividends, AND fund capital expenditures, then that enterprise is more than likely to enjoy a very strong financial condition with relatively easy debt coverage.

If your underwriting protocols do not include UCA/FAS 95/Statement of Cash Flow analysis, then you risk being surprised when a borrower who had “good” EBITDA coverage shows up past due or comes to you needing more money. Use this tool in conjunction with your standard analysis and it will enable you to rethink loan structures where the expected cash flows do not match up.

If you would like to discuss incorporating UCA/FAS 95/Statement of Cash Flow analysis in your institution, please contact me at 330.422.3487 or ddalessandro@younginc.com.

Annual Reviews of Commercial Credits

By: David G. Dalessandro, Senior Consultant

What is the overall condition of your commercial loan portfolio? Do you focus on net charge-offs? Delinquencies? Financial statement exceptions to policy? Number and level of TDR’s and non-accruals? The percent of the ALLL to total loans? While all of these broad measures can be helpful, the number and nature of grade changes coming from internal annual reviews are likely to be more timely and accurate than all of the other measures combined.

Does your credit policy contain specific criteria describing relationships which must receive annual reviews? If so, have you recently evaluated whether that level remains appropriate for your portfolio today? The commercial annual review threshold should be set at a level where the required reviews will cover at least 50% of commercial exposures. Each bank should do a sort of the commercial portfolio and determine what level of exposure will yield the desired coverage ratio. Note that the annual review requirements should differ from the Watch List or Special Asset requirements as the annual reviews should be separate from those assets already identified with some level of weakness.

Now that you have set an annual review requirement, what elements of a credit analysis should be completed? Although the ultimate goal is to determine the accuracy of the risk rating, regulators will be looking for the robustness of the annual review in order to “sign off” or accept the annual review results. Note that in addition to providing executive management and the board with timely and accurate results, a solid and meaningful annual review process can help to build confidence in your systems with the regulators and potentially allow for a more efficient third-party loan review.

Minimum requirements for annual review activities should be built into the loan or credit policies so that management and the board can demonstrate to regulators that they are determined to ensure risk ratings and, therefore, that the ALLL and criticized and classified reporting is accurate.

The annual review procedures should include the following:

a) Detail of the relationship being reviewed including borrower, guarantors, SBA or other guarantees, and note numbers included.

b) Update of all borrower/co-borrower financial information used in the original approval or the latest renewal which would include spreads, debt coverage calculations, loan-to-value calculations, borrowing base analysis, etc.

c) Update of all guarantor financial information including a new complete and signed personal financial statement, most recent tax returns, and, for individuals, an updated credit report.

d) Statement of how the account has been handled since the previous annual review (or approval), including any delinquency of payment, financial information, or supporting information such as insurance, borrowing base reporting, etc.

e) In most cases, site visits by the loan officer or relationship manager or other representative of the company should have occurred since the previous annual review or approval. For CRE loans, the documentation of the visit should include perceptions by the representative of the condition of the property, occupancy trends, whether or not any deferred maintenance was noted, and if there were any changes in the neighborhood. For all credits, the representative should also use this visit to become updated on any material changes in the customer base, management, operating personnel, market conditions, condition of equipment or other fixed assets, and any other information that would help to understand the customer.

f) Update of any approval conditions and whether or not the borrower is maintaining those conditions, including any promises of deposit accounts, financial reporting, property improvements, and compliance with any financial or other covenants.

g) Confirmation that the existing risk rating is accurate or recommendations to change the risk rating up or down, and the factors that the change is based on.

The financial institution that is covering 50% of its commercial portfolio, every year, with robust and timely annual reviews should provide executive management and the board with sufficient information to understand the level and direction of credit risk and whether or not these are in accordance with the desired risk appetite.

For more information on this article or on how Young & Associates, Inc. can assist your institution in this area, please contact me at 330.422.3487 or ddalessandro@younginc.com.

Ag Lending in 2017

By: Bob Viering, Senior Consultant

In our loan review practice, we have an opportunity to work with ag banks throughout the Midwest. In general, our findings are similar to what you may have read from many ag economists. Working capital is dwindling quickly, and the debt to asset ratio is increasing as is short-term debt. Many banks have been refinancing intermediate- and long-term assets to fix working capital declines and carryover debt. Some borrowers have sold land to reduce debt. We have seen many instances where borrowers have been able to reduce input costs and, most importantly, cash rents to bring them back to the point where they are either producing positive debt service coverage or are coming much closer to positive debt service coverage than they were in 2014. But overall, balance sheets are weakening and repayment is a continuing challenge. Credits that were barely a pass credit in better times have, in many cases, dropped to Special Mention or Substandard. Solid pass credits from a couple of years ago are now one weak year from a criticized level.

For many bankers, having struggling ag borrowers is a relatively new experience. I have more recently been through the experience in working with struggling ag borrowers while working at a western bank that had many cattle ranches that were severely impacted by low cattle prices and drought conditions. Many of the lessons learned there are just as applicable to the situation many of us face here in the Midwest.

As you head into renewal season, here are a few items to consider:

1. Complete information is critical. There is an old Russian proverb, “Trust but verify.” This is good to keep in mind when analyzing your borrower. As things get tougher, there is a temptation by some borrowers to not include every liability or to see some liabilities as something not worth mentioning. When short-term borrowing gets tougher, some borrowers will turn to using the local co-op for some inputs, borrowing from family and friends, or using online lenders (FinTech has hit agriculture too) or credit cards. At renewal time at our bank, we would send out a renewal package that had not only financial statement requests but a complete debt schedule form and inquiry about other loans or bills from any source, including family. We ran a new credit bureau report and compared it to prior ones to see if any new credit card or other type of debt was taken out since the last renewal and looked for any significant increases in balances, especially on credit cards. We completed a new UCC search for the same reason. In the end, we wanted to be sure that all debts were accounted for and had a source of repayment.

2. Restructure only if it helps. Often we see banks terming out any carryover debt or being quick to term out short-term debt to improve working capital. Before you restructure debt, make sure the underlying problem is fixed. Carryover debt usually occurs because the farmer didn’t make enough from crop/livestock sales to pay all term debt, operating lines, and living expenses. Given that revenue isn’t likely to grow in the next few years, improving cash flow is about expense control. Has the operation cut input costs, cash rents (this is the big one), and living costs to a level they can produce enough profits to cover their debt payments and family living? If so, then they are a perfect candidate for a restructure. If those tough choices have not been made and the operation won’t operate profitably, then you are likely to find yourself with even more carryover, more debt, and far fewer options not far down the road.

3. Income taxes may become an issue. Section 179 deductions were very helpful to reduce/eliminate income taxes in the past. But with far fewer pieces of equipment being purchased, those deductions have decreased significantly. Prepaying expenses and holding over grain sales can put off taxes for a while but, at some point, the timing can get tougher and some operations will now show taxable income when their accrual earnings may be negative. Those tax payments are often not planned for and can create a significant cash outflow at exactly the wrong time. It’s important that you encourage your borrowers to work with their tax professionals to plan as far ahead as possible to minimize any tax consequences.

4. Be empathetic and be realistic. Many of your borrowers were on top of the world a few short years ago. Everything they did went well and equipment dealers (and friendly bankers) made expansion with few tax consequences a reality. With today’s reality of weak (if any) earnings and less ability to add debt, it has become a very stressful time for many farmers and their families. It’s a lot tougher to be a banker too. Good bankers help their customers succeed. It’s not always easy and it’s often stressful, but letting customers operate unprofitably and not trying to help them make tough decisions usually only makes the problem get worse. It’s so important to be empathetic with your borrowers and to have a thick skin when they get mad. They may seem like they’re mad at you when they are really frustrated about their current situation. However difficult the conversation may seem today, it’s a far easier conversation than to have to tell someone that they have to quit farming and start over.

Ag lending is a key part of many banks’ loan portfolios and is important to their local market. Even in these tough times, it’s critical to work with your customers and do all you can to help them succeed. At Young & Associates, Inc., we work with many banks with ag portfolios. If we can help you with your loan review, policy reviews, process/underwriting reviews, and improvement plans, give us a call at 1.800.525.9775 or send an email to bviering@younginc.com.

Regulatory Initiative Provides Good Reminder of Importance of Credit Policies

By: Tommy Troyer, Executive Vice President
A look back over recent issues of the 90-Day Note, or a more general scan of industry news and regulatory comments, would reveal the industry’s focus on underwriting standards and possible industry-wide changes in underwriting standards over the last several years. As we have noted previously, for any individual community bank, the important consideration is not simply how conservative or liberal underwriting standards are or whether underwriting standards are loosening or tightening. Instead, the question that is critical for the ultimate health and profitability of the bank focuses much more on whether underwriting standards, and any changes in underwriting standards, are accurately understood and monitored, consistent with an institution’s risk management capabilities, and regularly assessed to ensure that the risk/return calculus and the institution’s level of capital are appropriate for the loan portfolio’s characteristics.

The above considerations, as well as overall industry trends in risk appetite and underwriting standards, are quite naturally of interest to regulators as well. In addition to other regulatory tools (such as loan officer surveys) for measuring underwriting standards, the OCC has launched within the last year an initiative to try to standardize and collect assessments of underwriting practices during safety and soundness examinations. We have heard OCC leadership discuss this initiative at banking conventions and have heard from clients who have had OCC safety and soundness exams over the last year. While the OCC’s overall approach to assessing underwriting can be informative or, at the minimum, a great reminder of critical factors for controlling credit risk, our intention here is to highlight an aspect of controlling underwriting standards and credit risk that should not be, but sometimes is, overlooked: the role of credit policies.

The Important Role of Credit Policies
Credit policies represent perhaps the most important tool for the board of directors and bank management to define underwriting standards and credit risk appetite. While it can be appropriate for some details of underwriting criteria to be maintained outside of formal loan policy, it is not appropriate or effective to employ an overly generic credit policy that provides little specific detail about the characteristics of credits the institution desires to originate. The OCC’s assessment of an institution’s underwriting considers the range of important factors one might expect (for example, loan structure, presence of appropriate covenants, etc.). Importantly, this assessment also extends to whether loan policy provides enough detail and information to control these important characteristics of credit underwriting. Without a policy that defines the bank’s limits on factors such as amortization periods, collateral advance rates, etc., underwriting standards can loosen and credit risk can grow without the intention or even the knowledge of the board. An appropriately detailed policy sets limits on the extent of any loosening that might occur and, assuming exception tracking and reporting is effective, allows for the board to receive better information about any changes in underwriting quality.

Some institutions try to avoid having too much specificity in policy because they do not want to create too many policy exceptions or provide examiners or auditors with more opportunities to “catch” them in violation of their own policy. There certainly is such a thing as a policy that is too specific or detailed to be effective, as at a certain level of detail it is not possible for lenders and analysts to actually know or easily find all of the policy requirements. However, it is also important to recognize the risks that come with overly generic policies, primarily, the inability to effectively control the terms of credit extended and the possibility of regulatory concern about the bank’s effectiveness in defining risk appetite and controlling risk.

The amount of detail is certainly not the only factor that determines the effectiveness of a credit policy. The content of the actual details certainly matters (a well-defined minimum debt service coverage ratio of 0.75 and maximum collateral advance rate against work-in-process inventory of 150%, for two extreme examples, are specific but do not effectively control credit risk). The organization and consistency of policy also matter, as a credit policy can only be effective if it is a usable tool for lenders and credit personnel.

Many credit policies at community banks have been in place for a long time, with small or ad hoc updates put in place as needed. Young & Associates, Inc. offers a policy review service that takes advantage of our exposure to the credit policies of many community banks around the country to evaluate the adequacy of a bank’s policy and to make recommendations for enhancements. We will not tell you what your risk appetite should be, but we can and will assess the content of your policy against regulatory expectations, compare your specific risk limits to what is common across the industry so that you can have better information about where your risk appetite stands relative to peers, and evaluate the effectiveness of your policy’s layout, language, and internal consistency.

If you would like to discuss the importance of credit policies or believe your institution may benefit from a policy review, please contact Tommy Troyer at ttroyer@younginc.com or 1.800.525.9775.

Criteria for Determining Loan Defects on the Secondary Market

By: Debra Werschey, Consultant and Manager of Secondary Market Services

In determining whether there is a significant defect on a loan, the quality control reviewer must give due consideration to the severity of the defect. In addition, the defect must relate but not be limited to one of the following:

1. The underwriting of the borrower’s creditworthiness and capacity. This would entail the borrower’s income, credit, liabilities, and assets.
2. The borrower’s eligibility and qualification. Things to consider are the area median income, first time home-buyer status, and status as lawfully present in the United States.
3. The underwriting criteria related to property or project eligibility. Is the property for residential use or condo eligible?
4. The property appraisal or the physical condition of the property. A close examination of the property appraisal is required. Are the comparable sales similar to the subject?
5. The loan and product terms and criteria. Criteria such as LTV ratio, occupancy, credit score, and loan purpose must be reviewed. The terms for ineligible transaction types, products that may require special lender approval as a prerequisite for delivery, limitations on cash out to borrowers that determines the type of refinance, and any negotiated exception or variance must be considered.
6. The requirements applicable at the time of loan purchase. This would include making sure that there are no defaults, all taxes and insurance premiums have been paid or escrows established, and no modification, encumbrance, subordination, or release of mortgage has occurred.
7. The existence, sufficiency, or enforceability of any required insurance or guaranty. The property must have sufficient hazard insurance coverage in place.
8. The form and/or execution of required loan documents that without which made the loan ineligible for sale or limit the enforceability of the required loan terms. The file must contain the Uniform Residential Loan Application,
any power of attorney used, and any nonstandard and special purpose documents such as living trusts.

All of the above factors and more should be taken into consideration when a reviewer is completing a post-closing quality control review to identify defects. Young & Associates, Inc. is a trusted provider of mortgage quality control reviews and can assist your bank in this area. For more information on our quality control services, contact me at 1.800.525.9775 or click here to send an email.

Is Credit Risk Rising?

Loan Review Observations and Recommendations for Effective Risk Management

By: Tommy Troyer, Executive Vice President

Over the recent past, there have been a number of public assertions, warnings, or observations that credit risk is rising in the banking industry. These statements have come in many forms, and while we do not intend to present an exhaustive review of such statements here, it is easy to present a brief list showing the various forms and messengers: ƒƒ

  • Public Comments by Regulatory Officials: Thomas Curry, the Comptroller of the Currency, devoted his speech to the RMA Annual Risk Management Conference in November of last year to evidence that credit risk was rising and to the need for the industry to respond with appropriate risk management tools and ALLL decisions. Similarly, at the Ohio Bankers League’s CEO Symposium in May, Julie Blake, Assistant Deputy Comptroller, shared with attendees that credit risk had moved to the top of the OCC’s risk priorities and provided some evidence of increases in risk appetite over recent years.
  • Formal Regulatory Publications: This category includes issuances of regulatory guidance, such as the December 2015 CRE guidance (discussed in a previous 90-Day Note) that was issued not to provide new guidance to banks but simply to highlight what regulators believed to be increasing risk in the CRE space and to remind banks of risk management expectations. This category also includes more informational publications, such as the OCC’s Semiannual Risk Perspective, which has been highlighting some increases in credit risk recently.
  • Private Sector Commentary: Any bankers who may be inclined to brush off such regulatory comments as simply arising from regulatory conservatism should pay special attention to comments about credit risk originating from bankers themselves. The July-August edition of the Risk Management Association’s RMA Journal includes an article written by a banker and quoting numerous other private sector risk executives about their feelings that credit risk has likely increased and that heightened diligence on the part of banks is needed to appropriately manage that risk.

Ultimately, all of these comments are based on observations that underwriting standards have loosened and concentrations of credit may be increasing. Unlike typical asset quality measures that provide lagging indicators of credit risk (such as nonaccrual or charge-off rates), underwriting standards can provide a leading indicator of changes in credit risk.

Loan Review Observations
Given these industry-wide observations, what does the situation look like for community banks? Our contribution to this topic is primarily anecdotal, and is based on observations gleaned from the independent loan reviews we perform for community banks. While it must be acknowledged that the diversity of community bank practices and circumstances means that no generalization will apply to all community banks, our anecdotal observations would seem to support the belief that credit risk has risen in recent years. For our community bank clients, the loosening of credit standards is actually less evident in changes to formal underwriting standards (in part because community banks often do not employ as detailed of a set of underwriting standards as larger banks) and more evident in the decisions banks are making on what might be described as “borderline” credits. In other words, our clients have not slashed their required minimum debt service coverage ratios or FICO scores as much as they have begun saying “yes” a little more often on deals that could go either way. Healthy debate in credit committees is important and should be encouraged. One interesting piece of information for banks to consider is whether more deals have recently been approved in credit committee by a split vote rather than unanimously, which may indicate that banks are saying yes to a few more “on-the-fence” deals than they have historically.

Closely related to the concept of approving the borderline deal, and an issue commonly discussed by regulators, is the increase in loans approved with one or more exceptions to loan policy. Making commercial loans on a non-recourse basis is perhaps the classic community bank commercial credit policy exception, and these types of deals may well be increasing.

Other examples of increasing risk include an increased willingness to finance start-up ventures or significant expansions of current businesses and, in some cases, a reflection of the eased CRE terms referred to in the aforementioned 2015 regulatory guidance, such as longer interest-only payment periods. Especially in more urban markets or markets where larger banks are active, competition is undoubtedly a major factor in some of these developments, as banks unwilling to make any concessions on terms or price today can quite quickly find themselves with a shrinking loan portfolio.

What Should Community Banks Do?
Young & Associates recognizes, as do most community banks, that an increase in risk appetite is not necessarily a bad thing. However, an increase in risk appetite that is not matched by a corresponding increase in risk management is a bad thing. So how should community banks ensure that any loosening credit standards now do not result in major issues later? The following actions are a good start:

  • Monitor and report to the board forward-looking measures of asset quality. If a bank’s appetite for credit risk is increasing, it should be because of a conscious decision of the board. It should not be something the board discovers several years later when asset quality problems begin to manifest. Forward-looking measures are key to monitoring changes in credit risk before it is too late. Such measures include reporting on the rate of policy exceptions (including loans with multiple exceptions); tracking loan performance by vintage, which can provide an early warning when the performance of a recent vintage early in its time on book is notably weaker than that of previous vintages; and even a measure as simple as monitoring the rate of loan growth compared to peers.
  • Enhance risk management practices. At a time when credit risk may be increasing, banks should be sure that risk management practices are also heightened. In such a situation, it may be appropriate to increase the scope of independent loan review so that a greater percentage of credits, and especially new originations, are reviewed.  Steps to quantify risk, such as stress testing higher-risk portfolios or portfolios that represent concentrations, are even more important at times of increased risk. And personnel should not be overlooked: increased volumes of higher-risk loans without a corresponding increase in the credit staff’s capacity may be a recipe for trouble.
  • Ensure that capital planning factors in any increases in risk. As noted, a measured and controlled increase in the credit risk a bank is willing to accept can be a positive for its shareholders and community. For this to be true over the long term, however, the bank’s capital planning process must appropriately account for this increase in risk. Regulatory minimum capital ratios are but a small part of capital planning, and capital planning can only be effective when it is sensitive to changes in a bank’s risk profile. Banks must ensure that their capital planning process accounts for changes in risk across the bank and that they are able to effectively identify such changes.

Conclusion
We have not seen from our clients (nor do we expect to see) the type of extremely risky loans that people write books and movies about in the aftermath of a credit crisis.  However, there is anecdotal evidence to support the widely-held belief that credit risk in the banking sector is higher than it was a few years ago. It is crucial that banks effectively identify and manage any such increases.  Young & Associates, Inc. can assist banks in both identifying and managing credit risk. Contact Tommy Troyer at 1.800.525.9775 or click here to send an email to discuss loan review, stress testing, or capital planning services.

Outsourcing Quality Control

By: Debra L. Werschey, Consultant and Manager of Secondary Market Services

With the industry increasingly focusing on quality in the loan origination process, lenders’ quality control (QC) programs are more important than ever. Is your QC program effective in meeting Fannie Mae’s and Freddie Mac’s requirements and mitigating post-purchase risk?

Increasing Industry Regulation
The mortgage industry is struggling with the best ways to incorporate QC processes into a qualified mortgage (QM) world. It’s a difficult, ongoing challenge for many lenders, and new regulations make the process even more difficult. To be sure, the market is more regulated today than ever before and, as recent financial history has shown, the trend of increasing regulation is likely to continue.

Fannie Mae and Freddie Mac and other investors are demanding higher loan quality standards from lenders who want to sell loans to them and have announced their intention to get tougher on mortgage lenders regarding loan quality. The risks of non-compliance today are greater than ever. You can help control your risks by outsourcing your quality control.

Benefits of Outsourcing Your QC Reviews
QC reviews allow lenders to correct loan processes, help to mitigate loan file errors that may be discovered by examiners, and provide data upon which solutions can be based. But, maintaining the QC function in-house can be difficult for community banks given the time, staffing, and expertise needed.

Young & Associates, Inc. provides QC services that satisfy regulatory requirements:

  • Approved loan file reviews
  • ƒƒDenied file reviews
  • Defaulted file reviews

Our strong reputation has been developed through providing quality services, assuring our clients the highest level of professional service available today. We work diligently to keep apprised of the regulatory requirements and, by working with us, you will benefit from our comprehensive and extensive knowledge of the mortgage industry. Additionally, by outsourcing your quality control function, you can shift the QC workload to us and achieve high-quality results at a lower cost to the organization.

Organizations with a commitment to quality control recognize that quality begins before an application is taken and continues throughout the entire mortgage origination process. Young & Associates, Inc. has provided education, outsourcing, and a wide variety of consulting services to community financial institutions for over 37 years. We are committed to your bank’s future success and look forward to assisting you in order to ensure or enhance that success.

To learn more about outsourcing quality control, contact me directly at 1.800.525.9775 or click here to send an email.

CECL Nears Finalization (For Real This Time)

By: Tommy Troyer, Executive Vice President

Those who have been following the Financial Accounting Standards Board’s (FASB) nearly decade-long effort to revamp the accounting rules impacting the recognition of impairment on financial assets (and thus how community banks determine the level of their ALLL) have heard for years that the project was nearing completion. While the project has indeed been moving forward over all these years, the anticipated date of finalization has been repeatedly pushed back. However, this time really is different: on April 27, FASB voted to direct FASB staff to prepare the final draft of the proposed update for a vote by written ballot. FASB hopes for the standard to be formally approved by June 30, but any delays beyond that point should be minimal as FASB has clearly reached a level of comfort with the current draft language.

The new approach to loss recognition is known as the CECL, or Current Expected Credit Loss, model. It represents a significant change to current practices, with the heart of the change being that the ALLL should cover expected lifetime losses on held-to-maturity loans and most other financial assets, rather than simply covering “probable” losses that are deemed to have been “incurred” as of the balance sheet date. In simplified terms, this means that the foundation of the ALLL estimate for community banks will not be an estimate of losses over the next year but will instead be an estimate of all losses expected over the life of the loans held on the balance sheet as of the date of the ALLL calculation. Additionally, the standard requires a forward-looking aspect, as institutions must consider the impact of “reasonable and supportable forecasts” on their loss estimates.

FASB also decided on April 27 to delay the implementation date of CECL by one year from the implementation dates originally determined in November. This means that CECL will need to be implemented in the first fiscal year following December 15, 2019 (2020 for banks with January-December fiscal years) for banks that are “SEC-filers,” and in the first fiscal year following December 15, 2020 (2021 for January-December fiscal years) for banks that are not “SEC-filers.” Early adoption beginning in the first fiscal year following December 15, 2018 (2019 for January-December fiscal years) is permitted.

The Balancing Act: Prepare, but Don’t Panic
The proper approach for any community bank is to attempt to find a balance between complacency about CECL and panic about CECL. Complacency about CECL (including believing that the extra year FASB provided before implementation means an additional year before a bank needs to start preparing) will lead to issues down the road. The methodology and data used to estimate the allowance under CECL will need to be meaningfully different from what banks use today, and as such, preparation to collect data and develop a methodology should begin now. Banks should understand that nearly all community banks base their current ALLL methodology on data that measures net charge-off rates on a monthly, quarterly, or annual basis. Such data does not describe lifetime loss rates, however, which is what is needed to comply with CECL’s lifetime expected loss standard. Thus, some basic data collection and evaluation efforts should begin now, in part to allow some time to accumulate the data needed by the implementation date.

At the same time that banks recognize the need to begin preparing, they need to also recognize that CECL does not represent any reason to panic. CECL will require some additional work for an effective transition, but it is not an existential threat to any community bank. We believe that some of the most extreme concerns discussed publicly in recent years about CECL and the complexity of approach it might require were overstated, given comments from FASB, financial regulators, and the wording of the 2012 draft Accounting Standards Update. All of these sources emphasized that the approach used by an institution should be appropriate for that institution’s size and complexity. However, the most recent draft released by FASB does represent a notable improvement in the clarity with which this fact is communicated: community banks will not be expected to use unduly complex or expensive approaches. Further, it seems that in every opportunity financial regulators have to speak about CECL, they emphasize that they intend to tailor their expectations for approaches to the size and complexity of financial institutions. Regulators have also repeatedly noted that they do not believe that a community bank will need to purchase an expensive software solution or vendor model in order to comply with CECL.

The Path Forward
At this point in time, banks have all of the information about CECL that they could need to develop a project plan for the transition. Such a plan should incorporate all relevant areas of the bank (for example, in many community banks the IT area will need to provide support with data gathering and warehousing), and updates on progress should regularly be provided to the board or a committee thereof. Evaluating the adequacy of existing credit risk data and planning to improve its collection and storage should be a high priority. Data should be collected in a way that allows institutions to measure lifetime losses and to understand the most important drivers of risk that impact loss rates.

Young & Associates, Inc. is closely following CECL and what it means for community banks. We have presented and will continue to present educational offerings on CECL through various state banking associations. We are also prepared to provide consulting services to help assist community banks in the preparation process. This can include helping banks understand the types of methodologies that can be acceptable means of estimating lifetime losses under CECL and the types of data that will be needed to support such methodologies.

To discuss CECL further, contact Tommy Troyer at 1.800.525.9775 or click here to send an email.

Regulatory Attention on CRE Portfolios is Rising

By: Tommy Troyer, Senior Consultant and Loan Review Manager

Over the last several months, it has become increasingly difficult to miss the fact that the federal regulatory agencies (the FDIC, Federal Reserve, and OCC) believe that credit risk is on the rise across the banking industry and particularly within Commercial Real Estate (CRE) portfolios. While industry-wide developments are of course not necessarily reflective of the situation of any single bank, it is the case that regulatory concerns about building credit risk in CRE portfolios makes it more likely that your bank’s CRE policies, underwriting, and portfolio management will be closely scrutinized in your next safety and soundness exam. Note that in this context, CRE refers to what are sometimes called non-owner occupied commercial real estate loans: loans for which the sale of the property, take-out financing, or third-party rental/lease income are the primary sources of repayment.

Recent Comments on Increasing CRE Risk
On December 18, 2015, all three federal bank regulatory agencies issued the interagency Statement on Prudent Risk Management for Commercial Real Estate Lending, an existing guidance on CRE lending. In fact, the statement itself contains no new guidance or regulatory expectations. Its purposes, instead, appear to be to “remind financial institutions of existing regulatory guidance on prudent risk management practices” for CRE and, perhaps more importantly, to highlight the belief that credit risk in CRE portfolios is increasing and must be carefully monitored and managed. The guidance highlights several reasons to believe that CRE portfolios may experience some strain over the next several years. These include both market factors (historically low capitalization rates are cited) and findings from recent exams (easing of underwriting standards along several dimensions, increasing frequencies of underwriting policy exceptions, and insufficient monitoring of market conditions).

The new interagency statement is far from the only suggestion of increased concern regarding the CRE market. The OCC’s Semiannual Risk Perspective for Fall 2015 cites easing underwriting standards, increasing CRE concentrations (especially in multifamily), and for community banks, strong growth in CRE lending as possible risks. The December 2015 – January 2016 RMA Journal includes the final installment of the publication’s annual rundown of “Today’s Top Credit Risk Issues.” Multifamily lending makes the list, suggesting that the Risk Management Association, a respected industry group unaffiliated with any financial regulators, also sees notable risk in the CRE market.

The fact that the CRE market remains competitive in many areas, combined with low interest rates, has thus far meant that several traditional but lagging indicators of credit risk (for example, delinquency and non-accrual rates) have not yet shown signs of weakening. Nonetheless, as has been demonstrated in past credit cycles, the risk factors cited above can often lead to increases in credit risk that do eventually result in deteriorating asset quality and increasing charge-offs.

Prudent CRE Risk Management for Community Banks
The good news is that the keys to effectively managing risks in the CRE portfolio are not mysteries and are achievable for any disciplined and committed community bank. The recent interagency statement provides a good summary. It notes that, in part, banks that successfully manage CRE risk:

  • Establish and adhere to appropriate policies, underwriting standards, and concentration limits
  • Conduct accurate cash flow analysis on the project, borrower, and global levels at underwriting and on an ongoing basis
  • Effectively monitor market developments (supply and demand, vacancy and rental rates, etc.)
  • Implement appropriate appraisal review and collateral valuation processes

In addition to the factors described above, two additional critical features of CRE risk management, CRE Stress Testing and Independent Loan Review, are mentioned. These processes can be performed internally by community banks, but due to resource and other constraints may be both more efficient and more effective if outsourced.

Stress Testing the CRE Portfolio
The interagency statement notes that “market and scenario analyses” that “quantify the potential impact of changing economic conditions on asset quality, earnings, and capital” are an important aspect of CRE risk management. This is a reference to stress testing the CRE portfolio. Further, the 2006 interagency Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices states that any institution with a CRE concentration “should perform portfolio-level stress tests.” Even if your bank does not meet the concentration thresholds defined in the 2006 guidance for identifying institutions with “potentially…significant CRE concentration risk,” stress testing the CRE portfolio can have a number of important benefits. By quantifying the impact of several adverse scenarios on asset quality, earnings, and capital, a CRE stress test can inform your bank’s strategic and capital planning processes, your internally established credit concentration limits and practices, and your credit policy and underwriting requirements.

Young & Associates, Inc. offers a CRE Portfolio Stress Testing service that provides an insightful and efficient stress testing solution. Our service uses data specific to your bank’s portfolio to stress your CRE portfolio across several factors. Our report will assist in quantifying the possible impact to earnings and capital that could result from decreases in collateral value, property net operating incomes, or increases in interest rates. In the current environment in which interest rate increases are likely over the next several years and decreases in collateral values are at least a distinct possibility, understanding your bank’s possible exposure is key to maintaining a safe and sound bank and demonstrating effective risk management to your examiners. Our CRE Stress Testing service is performed remotely, meaning that no travel expenses are associated with the service. More importantly, once the project has been discussed and you have provided a response to our initial data request, bank management can remain free to work on the many other initiatives that require attention, while we make use of our existing systems and expertise, making the stress testing process an efficient one. Our service includes a detailed report documenting the results of the stress test and, if desired, a phone presentation of the findings to management or the board.

Independent Loan Review
An effective independent loan review function is critical to assessing asset quality in the CRE portfolio, determining the accuracy and effectiveness of both underwriting and the ongoing monitoring of CRE credits, and identifying whether exceptions to credit policies or underwriting standards are being appropriately identified and approved by the bank. Any issues identified by loan review can be proactively addressed by the bank, helping to ensure risk mitigation is in place before the issues are identified by examiners or are revealed by deteriorating asset quality.

Most community banks find that their size and the requirement that loan review be performed by a qualified, independent party means that outsourcing loan review is the best option. Young & Associates, Inc. has extensive experience providing loan reviews for community banks. Our loan review of a sample of your CRE portfolio may identify individual credits of concern, but more importantly, will provide perspective regarding whether your credit standards, credit analysis, and ongoing monitoring of existing credits are adequate for the nature of your CRE portfolio. In this way, our findings not only inform management and the board about existing risks in the portfolio, but provide recommendations for effectively managing that risk. We can perform loan reviews on-site or, if your technological capabilities allow, remotely, allowing you to reduce or eliminate the travel expenses associated with the loan review.

For information regarding Young & Associates, Inc.’s CRE Stress Testing service, please contact Kyle Curtis at 1.800.525.9775 or click here to send an email. For information regarding Young & Associates, Inc.’s Independent Loan Review service, please contact Tommy Troyer at 1.800.525.9775 or click here to send an email.

HELOC End-of-Draw Risk Remains Worthy of Attention

By: Tommy Troyer, Consultant and Loan Review Manager

In “Agencies Issue New HELOC Guidance,” published in the August 2014 issue of the 90 Day Note, we presented an overview of what was at that time brand new safety and soundness guidance for HELOC portfolios (Interagency Guidance on Home Equity Lines of Credit Nearing Their End-of-Draw Periods). We also presented a few practical steps for community banks to consider in order to address the issues raised in the guidance. As a brief reminder, the guidance was issued by the regulatory agen­cies to encourage financial institutions to properly manage the risk associated with HELOCs that were reaching the end of their contractual draw period. The draw pe­riod is the time during which the borrower has access to the line of credit feature of the HELOC. Minimum monthly payments during this time can be quite low, in many cases interest-only. When the draw period ends, HELOC structures either require a transition to payments that amortize the outstanding debt over a defined number of years or require a balloon payment to repay the outstanding balance in full. The risk associated with this transition is that the borrower will experience a “payment shock” because the terms after the draw period ends can require significantly higher minimum monthly payments than were required during the draw period. Higher monthly debt service, all else equal, increases the risk of delinquency and default.

It was the potential for payment shock risk associated with end-of-draw HELOCs, coupled with the fact that across the industry the peak of HELOCs reaching end-of-draw was expected to occur from 2014-2017, that prompted the interagency guid­ance. We are now about a year down the road from the issuance of the guidance, and the idea of elevated risk embedded in some HELOC portfolios continues to receive regulatory, media, and analyst attention. We wanted to briefly revisit the issue to point out two important facts for community banks with HELOC portfolios. First, the avail­able evidence is suggesting that regulators and bankers were right to worry about payment shock risk, as borrowers who have reached the end-of-draw period thus far have demonstrated, in the aggregate, the intuitively expected decline in timely pay­ments. Secondly, it is important to note that it is not too late to take important steps to help mitigate end-of-draw risk.

End-of-Draw Performance Thus Far
Aggregate data on HELOC and mortgage delinquencies does not demonstrate any notable increases that we can attribute to end-of-draw risk. However, one needs to dig deeper to measure the issue with any accuracy, primarily because end-of-draw HE­LOCs still represent a relatively small share of the overall mortgage market (and even the HELOC market), and any increases in delinquency due to end-of-draw payment shocks can easily be masked by the overall improvements in mortgage delinquency rates associated with continued economic improvement and continued progress in most states in working through foreclosure backlogs (which reduces the number of long-term, seriously delinquent loans and improves overall delinquency rates).

Several more specific pieces of data on end-of-draw risk are worth noting:

  • The OCC’s Semiannual Risk Perspective for Spring 2015, published June 30, 2015, shows that 30+-day delinquency rates for loans that have reached end-of-draw at the nine largest OCC-regulated banks have essentially doubled in the three-months following the end of the draw period, and have remained persis­tently high. The OCC also notes that, “many lenders have found the early stages more challenging than expected,” which should provide a wake-up call for any banks that still believe this issue will take care of itself without proactive man­agement on the part of the bank.
  • Data provided by Equifax, which was cited in a front-page Wall Street Journal article in June, indicated that just four months after reaching the end-of-draw pe­riod, HELOC borrowers from the 2004 vintage saw 30+-day delinquency rates increase by over 50% from the month prior to when they reached end-of-draw (2.7% to 4.3%). Similar increases are shown for vintages from 2000-2003 as well.
  • A study by Experian, reported on its website, showed that 90-day delinquency rates increased three-fold during the 12 months of 2014 for those borrowers that reached their end-of-draw period between December 2013 and March 2014.
  • Research published in the May 2015 RMA Journal by the other primary credit reporting agency, TransUnion, does not provide as directly comparable data as the previously mentioned studies, but does indicate that its data set of HELOCs showed overall 30+-day delinquencies of 2.2% while HELOCs 12 months after their payment shock showed a 60+-day delinquency rate of 3.1%.

The overall takeaway from all of this data is that the intuitive and expected impact of HELOC payment shock—increases in delinquency and eventually default and loss rates—does in fact appear to be occurring.

Impact on Community Banks and Risk Management Steps
The experience of any individual community bank will by no means mirror the overall industry experience. For one thing, the minimum payment required during the draw period does vary across banks, and banks that require significant principal reduction each month during the draw period may be less vulnerable to payment shock than those that required just interest-only payments. (Requiring principal reduction during the draw period certainly does not make a bank immune from payment shock, as it is important to keep in mind that the borrower also loses access to the line of credit as a source of funds when the draw period ends.) Further, community banks may have some advantages over larger lenders in terms of customer familiarity that may assist in working through end-of-draw issues with borrowers.

With that said, it is important to recognize that both the theory and the data are in line on this issue so far: all else equal, payment shock results in increased risk for the lender. In fact, the credit reporting agency research cited above also provides data indicating that the negative effects of payment shocks carry over to other credit facili­ties of borrowers, which presents an additional source of risk to relationship-minded community banks who may have multiple loans with a HELOC borrower. For these reasons, it is important that all community banks with HELOC exposures evaluate the interagency guidance’s recommendations and take the actions appropriate for their portfolio. We discussed these issues in more detail last year, but important steps include: 1) defining consistent and prudent options for borrowers approaching the end of their draw period that take into account the borrowers’ current financial and home value positions; 2) proactively initiating contact with borrowers who are ap­proaching the end of their draw periods; 3) ensuring that all relevant parties within the bank have a voice in the bank’s approach to mitigating risk and are well-versed in the steps to follow with end-of-draw borrowers; and 4) gathering and analyzing enough data specific to your bank to fully understand the nature of the risk your bank faces.

End-of-draw risk does not need to lead to a massive amount of charge-offs to ma­terially impact a community bank’s performance, especially given the low level of charge-offs many banks have been experiencing in that portfolio. Though there are very few, if any, banks for which end-of-draw concerns may represent an existential risk, a failure to properly manage end-of-draw risk could easily have a notable im­pact on earnings over the next several years, and could also result in weak regula­tory assessments of a bank’s risk management. The OCC has publicly noted that it is pursuing a review of HELOC practices, and while this targeted horizontal review is unlikely to directly affect community banks, it would be a good bet that HELOC end-of-draw practices will be a point of emphasis in many community banks’ next safety and soundness exam, regardless of the examining agency.

Conclusion
The evidence continues to suggest that proper risk management of end-of-draw HELOCs is important. One consideration not directly mentioned above is that some banks may also find it beneficial to use their end-of-draw experience to consider whether any changes to their existing HELOC product’s structure would be appro­priate. If you have questions or would like to discuss your end-of-draw risk manage­ment, please contact me at ttroyer@younginc.com or 1.800.525.9775.