Assessing Management Skills in Agricultural Borrowers

By: Robert Viering, Senior Consultant & Lending Department Manager

In our loan review practice we have seen an overall deterioration in farm financial results. However, we have noted that there are borrowers that are still providing reasonable returns and acceptable debt service coverage ratios. Our anecdotal observations have been confirmed by data from farm financial databases from farms in the Midwest. In his blog post in the December 19, 2017 Corn + Soybean Digest, Dr. David Kohl observed, “Regardless of farm size or enterprise, the gap between the top one-third of economic performers and the bottom one-third is widening. Among the most profitable, common practices include strong production, a drive towards efficiency, and an executed marketing and risk management.” My interpretation of his comment can be simplified to: Management skills count.

In our loan review client banks, management skills may be a part of the bank’s risk rating model, but how management skills are determined varies widely. All too often most borrowers are rated as having good management skills even if their financial results put them in the bottom third of financial performance. Based on my 30+ years as a banker and now as a loan review professional, management skills are what separates the top and bottom producers. The question becomes, how do we assess the management skills of our borrowers? While there are no hard and fast rules, there are several attributes that can often help in making an assessment of management skills.

The following are items to consider when assessing management skills:

  • Production competency. On the production side, you will want to honestly assess how their level of production compares to others with similar operations. As an example, if they are consistently producing more bushels of corn per acre than similar farms in your market, then their skills should be rated higher than an operation with more variable results or certainly better than those that are consistently below their peers. You will want to consider if their equipment line/livestock production facilities are appropriate for the scale and sophistication of their operation.
  • Financial competency. Questions for you to consider to determine financial competency include: Are you provided accurate, thorough, and timely financial information? Are the cash-flow projections reasonable and based on sound assumptions (you will need to back test borrower’s cash flows to actual results to assess this attribute)? Does the producer understand the financial implications of their decisions?
  • Risk management. Risk management is about protecting what you have and limiting your downside. Among the items to assess include whether they are carrying adequate crop insurance. This can include whether they can cover the difference between what insurance pays and what they expected to produce. Other questions that are important to consider include: Does the borrower have a marketing plan? Do they make good use of hedging strategies? A good marketing plan can help pick up some additional income while limiting the downside of market volatility.
  • Intangible skills. There are a few other items that should be considered that are difficult to quantify but are important to consider. Among the items to ask are: Are they willing to make tough decisions? This is often about expenses and includes the ability to reduce family living, reduce labor costs (even if it means a family member may have to leave the operation), or any other decisions that may not be popular or easy but may be required to succeed. Do they have a long-term vision of where they want to go? Even if they are not considering doing anything different, that is still a strategy that has its risks. Are they realistic in their understanding of their operation’s strengths and weaknesses? Are they open to taking advice from outside experts to improve their operation? Do they have any trusted advisors that they use? If applicable, do they have a plan to transition to the next generation? If so, do they have an understanding of the next generation’s strengths/weaknesses and the risks in their transition plan?

Agriculture is like all other types of business: good management is critical to long-term success and especially to getting through more challenging times like today. As a bank, having a good understanding of the borrower’s management skills is an important aspect of knowing the level of risk in a borrower. We encourage banks to make a thorough assessment of a farm operator’s management skills, especially today as management skills can often be the difference between long-term success and just surviving, or even the difference between just surviving and having to quit farming.

For more information on this article, contact Bob Viering at bviering@younginc.com or 1.800.525.9775.

Changes to the Appraisal Threshold

By: Kyle Curtis, Senior Consultant

The OCC, Federal Reserve Board, and FDIC (collectively, the agencies) have adopted a final rule to amend the agencies’ regulations requiring appraisals of real estate for certain transactions. The final rule increases the threshold level at or below which appraisals are not required for commercial real estate
transactions from $250,000 to $500,000. The final rule defines commercial real estate transaction as a real estate-related financial transaction that is not secured by a single 1-to-4 family residential property. It excludes all transactions secured by a single 1-to-4 family residential property, and thus construction loans secured by a single 1-to-4 family residential property are excluded. For commercial real estate transactions exempted from the appraisal requirement as a result of the revised threshold, regulated institutions must obtain an evaluation of the real property collateral that is consistent with safe and sound banking practices.

The agencies have adopted a definition of commercial real estate transaction that excludes construction loans secured by single l-to-4 family residential properties. Specifically, the final rule defines commercial real estate transaction as a real estate-related financial transaction that is not secured by a single 1-to-4 family residential property. This definition eliminates the distinction between construction loans secured by a single l-to-4 family residential property that only finance construction and those that provide both construction and permanent financing. Under the definition in the final rule, neither of these types of loans will be commercial real estate transactions; they will both remain subject to the $250,000 threshold. However, a loan that is secured by multiple 1-to-4 family residential properties (for example, a loan to construct multiple properties in a residential neighborhood) would meet the definition of commercial real estate transaction and thus be subject to the higher threshold.

Evaluations

With the increase in the threshold, it is expected that many institutions will now utilize internal staff to prepare evaluations for commercial transactions that are less than $500,000, so it might be time to revisit the Interagency Appraisal and Evaluation Guidelines (Federal Register, Vol. 75, No. 237), as well as the Interagency Advisory on Use of Evaluations in Real Estate-Related Financial Transactions (FDIC, FIL 16-016). While the Guidelines state that an evaluation is not required to be completed by a state-licensed or state-certified appraiser or to comply with USPAP, the evaluation preparer should, however, be knowledgeable, competent, and independent of the transaction and the loan production function of the institution. Evaluations may be completed by a bank employee or by a third party. In smaller communities, bankers and third-party real estate professionals have access to local market information and may be qualified to prepare evaluations for an institution.

An evaluation should provide a reliable estimate of the market value of the property and, therefore, the approach or approaches used in an evaluation should be appropriate to the property being valued, and the intended use, so it may be appropriate to omit one or more of the three approaches to value. If the income approach is the primary approach for a tenant-occupied, income-producing property, it may be appropriate to omit the sales comparison approach and the cost approach. Similarly, if the sales comparison approach is the primary approach for a single family residence or an owner occupied commercial property, it may be appropriate to omit the cost approach and the income approach.

The Guidelines provide information regarding the minimum content that should be contained in an evaluation. Unlike an appraisal report that must be written in conformity with the requirements of USPAP, there is no standard format for documenting the information and analysis performed to reach a market value conclusion, but like an appraisal report, the evaluation should contain sufficient information to allow a reader to understand the analysis that was performed to support the value conclusion and the institution’s decision to engage in the transaction.

Young & Associates, Inc. offers a Third-party Appraisal Review service designed to provide financial institutions with a qualified, independent review of appraisals, consistent with the requirements listed in the 2010 Interagency Appraisal and Evaluation Guidelines. For more information on this article or the interpretation of the appraisal guidelines, contact Kyle Curtis at
kcurtis@younginc.com or 330.422.3445.

A Look to the Future

By: Jerry Sutherin, President & CEO, Young & Associates, Inc.

On January 31, 2018, I was fortunate to have the opportunity to purchase Young & Associates, Inc. from Mr. Gary Young, the company’s founder and current Chairman. Nearly 40 years ago, Gary created this organization with a vision of providing community banks with consulting services that were typically cost-prohibitive to perform internally. Since its inception in 1978, Young & Associates has evolved from a small start-up organization offering select outsourcing and educational services to one of the premier bank consulting firms with clients nationwide and overseas. We now offer consulting, education, and outsourcing services for nearly every aspect of banking.

From the outset of our acquisition discussions, Gary and I agreed that the greatest asset of the company is its employees. Over the years, not only has Gary developed unique servicing platforms for the industry but more importantly, he has assembled an employee base that is second to none. These employees provide a level of expertise and service to our clients that remains unparalleled in the community banking industry.

To quote Gary, “I founded Young & Associates with the goal of assisting community banks while maintaining a family atmosphere that valued and respected the people that I work with.” Going forward, it is my primary objective to carry on this legacy that Gary has created. I look forward to making this a seamless transition building on the solid foundation that Gary has built over the years. With the work of our employees and support of our clients, there is no doubt that Gary’s legacy will continue for years to come.

Although the ownership of Young & Associates, Inc. has changed, the company’s name, mission, personnel, quality of service, and structure will not change in any way. Gary now serves as Chairman of the Board and will remain actively involved with the business through January 2019, providing the same high-quality service while also assisting me with the transition. In addition to ensuring a smooth internal transition, Gary and I remain focused on making sure that the relationship with our clients remains strong. Existing and new clients are encouraged to contact me, Gary, or any of our consultants to discuss this transition and how we might be able to earn your business.

A Current Perspective on Concentrations of Credit

By: Tommy Troyer, Executive Vice President

Concentrations of credit are certainly not a new risk for community banks, but for many banks they are an increasing challenge. While effective concentration risk management involves much more than we have room to discuss here, we would like to use this article to highlight a few timely considerations related to concentration risk management.

Growing Concentrations
We all know that, though we can calculate statistical averages for various measures across community banks, there is no “average community bank” in the real world. Each bank has its own unique combination of characteristics. However, concentrations of certain types of credit do seem to be increasing across community banks as average loan-to-asset ratios have been increasing and banks are, for the most part, still trying to stick to in-market lending and to loan types with which they have experience.

Continued regulatory emphasis on prudent concentration risk management practices, especially related to CRE, has been one result of these trends. One of the ways some banks have experienced this attention is to have examiners note a greater interest in measures of total CRE exposure, including owner occupied loans, as opposed to the more traditional measures of non-owner occupied concentrations described in the well-known 2006 interagency guidance on CRE concentrations. (This emphasis has been driven in part by the growing realization that the industry’s loss history on these two types of CRE loans has not been that different over the last decade.)

As a simple example of the growth in credit concentrations for community banks, I collected some data on commercial banks and savings banks in four Midwestern states (Ohio, Michigan, Indiana, and Illinois) with less than $2 billion in total assets. While we work with community banks nationwide and with some banks larger than this threshold, I thought this would be a sample of banks of interest to many of the readers of this newsletter. Of these banks, 700 met these criteria as of 2017Q3. I compared selected concentration levels for these banks to their levels five years earlier, as of 2012Q3.

  • The number of banks with construction and land development loans totaling 100% or more of total capital doubled, though it certainly remains low at just 2% of the sample.
  • The number of banks with non-owner occupied loans totaling 300% or more of total capital increased from 29 to 42.
  • The number of banks with total CRE loans totaling 400% or more of total capital increased from 50 to 66.

None of the figures above total even 10% of the banks in the sample, but I have also chosen to test quite significant concentration levels. Our consulting work indicates that many more banks, which have chosen to set their internal concentration limits at more conservative levels than described above, are experiencing challenges as they near internal limits. This applies for both broad categories of concentrations, such as non-owner occupied CRE, and for more narrowly defined categories, such as hotels.

In some other cases, concentrations that banks have always understood were necessary given the community they serve have become more concerning. For example, many community banks operate in markets where agriculture is a dominant industry. Such banks have always accepted the risk associated with heightened ag concentrations, but continued challenging ag conditions have made such concentrations more of a concern in recent years.

Risk Management Considerations
The fundamentals of effective management of concentration risk are well-known, and can be found in a variety of regulatory sources. I will not rehash all of them here, though I do feel obliged to emphasize that concentration risk must be factored into capital planning and must be appropriately evaluated as a qualitative factor impacting the ALLL. I would also like to highlight a couple of trends in concentration risk management we have noted recently:

  • Incorporating concentration considerations into strategic planning. Yes, detailed analysis of concentration risk and recommendations for concentration limits will likely be provided to the board by management. However, such limits should reflect the board’s risk appetite and desired strategic direction for the bank. It has been encouraging to me to hear in several recent strategic planning retreats thoughtful, forward-looking discussion about what the bank should look like in the future and what that means for the bank’s approach to credit concentrations.
  • Incorporating a proactive approach to monitoring and managing relationship levels. We have seen an increasing number of clients take what can be described as a more proactive and sophisticated approach to monitoring and actively managing concentration levels. Instead of testing concentration levels quarterly and simply “turning off the spigot” when a limit has been reached, these banks incorporate a proposed loan’s impact on their concentration profile into their underwriting analysis. They also use their pipeline and runoff projections to forecast their various concentration levels in coming quarters, and then manage prospective and existing borrowers to maximize the quality and profitability of a given portfolio. This can help prevent, for example, a couple of marginally profitable and purely transactional deals that may be easy to “win” from crowding out prospective deals that can lead to profitable long-term banking relationships.
  • Utilizing portfolio stress testing. Portfolio stress testing has long been a tool for evaluating concentration risk, but more community banks seem to be making efforts to implement forms of portfolio stress testing than ever before.
  • Utilizing collateral valuation and collateral management. One important way of ensuring that downturns in an industry in which a bank has a concentration do not cause excessive losses is to have in place effective practices for both managing the initial valuation and assessment of the collateral (especially for real estate collateral) and for monitoring collateral on an ongoing basis. The ongoing monitoring of the status and value of collateral can be especially important for banks with ag concentrations. While we see plenty of good work done by banks in both of these areas, we would also note that these seem to be some of the most common areas about which we, and also often examiners, provide recommendations for improvements in practices.

Conclusion
Effectively managing concentrations of credit will remain important for as long as lending remains a primary source of income for banks (in other words, forever). Young & Associates, Inc. has assisted clients by providing portfolio stress testing services (both CRE and ag), loan reviews, and more targeted consulting focused on enhancing collateral valuation processes or credit policies. We also assist clients by facilitating strategic planning sessions that encourage the board and management to think about and plan for the future of the bank. This can result in a bank better defining its lending strategy and ensuring its lending approach is consistent with its overall strategy. To discuss this article or any of our services further, please contact Tommy Troyer at ttroyer@younginc.com or 330.422.3475.

CECL: What’s New, and What Some Community Banks are Doing

By: Tommy Troyer, Executive Vice President

I have been writing about CECL in this newsletter and providing CECL educational programs to community banks for several years. The overall theme I’ve tried to communicate in all of these settings has been: CECL is manageable for community banks, but it requires planning and preparation starting now.

I’m quite encouraged by the fact that the second part of that message, about the need to actively prepare for CECL now, seems to have been accepted by the majority of community bankers. In this article, I will provide a brief overview of a few noteworthy recent developments related to CECL, as well as some brief comments on what we are seeing from banks with respect to CECL preparation.

Regulatory FAQs Updated
On September 6, 2017, the federal financial regulators released an updated version of the interagency FAQs on CECL that were first issued in December 2016. All CECL FAQs are being consolidated into one document, so the most recent release includes both questions 1-23 from December and new questions 24-37. The information conveyed in the new questions is broadly consistent with the things I have tried to communicate in my articles and in my teaching about CECL and contains no surprises. This lack of surprises from the regulators is, of course, a good thing. I specifically recommend the expanded discussion in questions 28-33 regarding the definition of a Public Business Entity (PBE), as the PBE definition is a FASB concept that is fairly complex. The definition is important to understand because institutions can be PBEs without being “SEC Filers,” and PBE status determines the effective date of CECL for an institution. Questions 34-36 also include some helpful and fairly detailed examples of how the transition to CECL should work for call reporting purposes for institutions in various situations with respect to PBE status and whether or not an institution’s fiscal year lines up with a calendar year.

These are helpful clarifications since non-PBEs do not need to adopt CECL for interim periods, only for the year-end financials, in the first fiscal year of adoption and because call reports are completed on a calendar year basis irrespective of a bank’s fiscal year.

FASB TDR Decisions
The final CECL standard has been in place and has been public for over 15 months at this point. CECL is not going to magically disappear before implementation, and there will not be substantial changes to CECL’s requirements. However, there are still some decisions related to CECL that are being made by FASB, specifically through its Transition Resource Group (TRG), which exists to help identify potential challenges to implementing the standard as written. The TRG met in June and a number of issues were discussed, though many of the issues discussed are unlikely to have an impact on the average community bank. However, several issues related to Troubled Debt Restructurings (TDRs) were discussed and ultimately clarified by FASB in September. These issues are relevant to community banks and are worth noting.
The first decision that community banks should be aware of is one that will generally be viewed favorably by community banks. The issue at hand is that CECL requires estimating expected losses over the contractual term of loans and states that the contractual term does not include “expected extensions, renewals, and modifications unless [there is] a reasonable expectation” that a TDR will be executed. The issue FASB considered was just how expected TDRs should factor into an institution’s allowance.

The options presented were, essentially, to estimate losses associated with some level of overall TDRs that you expect to have in your portfolio even though you don’t know on what loans these TDRs might occur, or to only account for expected TDRs when you reasonably expect that a specific loan in your portfolio will result in a TDR being executed. FASB chose the latter option, which should prove to be much more manageable for community banks.

The second decision that FASB made is one that might generally be viewed less favorably by community banks. The CECL standard, when released, seemed to provide more flexibility around measuring expected losses on TDRs than current rules, which requires a discounted cash flow approach unless the practical expedients related to the fair market value of the collateral or the market price of the loan apply. The CECL rules essentially said that any approach to estimating losses on TDRs that was consistent with CECL’s principles was acceptable. However, FASB ultimately decided that the cumulative requirements in the CECL standard and in existing accounting rules for TDRs require that all concessions granted to a borrower in a TDR be accounted for through the allowance. The brief summary of FASB’s decision is that, in fact, a discounted cash flow approach to measuring the impact of TDRs will still be required under CECL in any circumstance where such an approach is the only way to measure the impact of the concession (the best example of such a concession is an interest rate concession). The TRG memo dated September 8 and available on FASB’s website is a good resource for a more detailed discussion of the above issues.

What Community Banks are Doing
What are some of your peer community banks doing to prepare for CECL? There does of course remain a wide range of preparation and some banks still haven’t gotten started in any serious way. However, many banks have at least informally assembled the team that will work on CECL, and while not as many have adopted simple project plans as we might wish, many do at least have informal steps and deadlines in mind. Many have started giving thought to data availability and needs, though again perhaps not enough have yet gotten very serious about fully evaluating the data they have, how they will store and use it on an ongoing basis, and what additional data they would like to begin capturing. Nearly all banks have undertaken at least some educational efforts around CECL, and this is an area of focus that should continue through implementation and even beyond. Options for third-party solutions are being explored by some banks, though in order to make sure that an informed decision is made, it is critical that banks go into these explorations with a good fundamental understanding of CECL as well as with an awareness of the regulatory position that such solutions are perfectly fine options but are neither required nor necessary for CECL implementation.

How We Can Help
We have presented and will continue to present webinars, seminars, and talks on CECL. Please visit our website or call or email me for an overview of these sessions, which are specifically designed for the community banker and which are not designed to try to sell any particular software solution.

Additionally, we are ready and willing to work with banks in a consultative role on CECL. Like everything else we do, there is no fee associated with an initial phone conversation or email exchange about CECL, and if we can help provide you with clarity about something related to CECL, then we are happy to do so. We are of course also happy to discuss various approaches in which we might provide consulting support in one or more capacities to assist your institution in preparing for CECL.

To discuss CECL further, contact Tommy Troyer at ttroyer@younginc.com or 330.422.3475.

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.