Fran Samson, Consultant

04/2010

Your bank’s credit policy should already address what documentation is required to establish the current market value of real estate that is being pledged as collateral at loan origination. This should include both evaluations that may be completed in-house and appraisals being conducted by a third party. During the life of a commercial or retail mortgage loan, there are various circumstances that would prompt a reappraisal to be completed, and your bank’s policy should address that as well. Some banks are including this information in their existing credit policy; however, since this is considered a “hot topic” with the banking examiners, others are creating a separate policy to address reappraisals.

When Young & Associates, Inc. conducts third-party loan reviews, we often find banks carry appraisals forward when a loan is being refinanced or consolidated with other credits. This is generally done to save the borrower closing costs and often used as a selling feature in today’s competitive market. It would be appropriate that the bank’s policy address the maximum age that an appraisal is still considered valid. Even if the age is acceptable, the bank should require a review of the original appraisal and document that the assumptions made at origination are still appropriate. This would include the property use, condition of the property, and that the real estate market conditions are unchanged, therefore making the market value assigned still valid.

Another situation where the bank’s policy should prompt a reappraisal is when the condition of a loan deteriorates to the point where the bank does not feel comfortable with the borrower’s repayment ability (a highly-leveraged customer, a weak cash flow position, a serious past-due status, or a nonaccrual status). At this point, the collateral may be considered the primary source of repayment and the current market value will determine if there is a potential loss should liquidation be necessary. If the policy allows the use of the original appraisal, the bank should determine the current value based on the current real estate environment, establishing an appropriate discount to apply to the original amount in order to determine a more likely sale price. In addition to the discount due to the age of the appraisal, the bank should also include a discount for the cost to maintain the property until sale, as well as the cost to liquidate. While the bank may not want to include the actual discount percentages in the policy since they are subject to change, the policy should state what type of discounts are to be applied.

Most banks’ loan policies require periodic action plans to be completed on all watchlist credits to document the current status of the credit and to establish a plan to get the borrower off the watchlist. Part of this process includes a collateral evaluation to determine if the collateral pledged continues to be sufficient to assure the bank will suffer no losses should liquidation take place. In order to make that determination, the liquidation value has to be established. This is accomplished in the same manner described in the paragraph above, by applying appropriate discounts to the original market value of the property or obtaining a new liquidation value appraisal.

Young and Associates, Inc. has found that examiners are taking a very conservative approach when applying discounts to collateral values. Establishing a reasonable, current value and having it documented in the file will show that the bank is being diligent in assessing the true credit risk. The end result should be limited surprises in the asset quality assessment of the bank’s safety and soundness exam.

For more information on this article or on how Young & Associates, Inc. can assist your bank with its reappraisal needs, give us a call at 1.800.525.9775 or send an e-mail to lending@younginc.com.

Michael R. Metalonis, Associate Consultant

12/2009

While it is no secret that the majority of financial institutions are facing asset quality problems in today’s tough economic times, the key is how an institution deploys its resources to effectively and efficiently identify, measure, monitor, and control the asset quality issues in the loan port¬folio. For those institutions that have not had a recent examination and are expecting one in the near future, this article may provide additional insight. While it does not guarantee that your exam will go flawlessly, it will help executive management be aware of examiner expectations.

Identifying Problem Assets
One of the most important tools for executive management to iden¬tify potential problem assets quickly is having a proper credit risk rating methodology that is both objective and subjective in nature, in addition to having a meaningful annual review process. A successful risk rating methodology and annual review process will allow an institution to be proactive in tracking the credit risk of an asset (typically commercial credits) before it becomes problematic. This allows for modification or forbearance, if needed, before the credit deteriorates to a point where liquidation is the only way out. It is our opinion that monitoring a credit for payments and delinquency is a reactive approach. An institution’s credit policy should have clear and definitive criteria for its risk rating methodology, and the annual review process should be commensurate to the size and complexity of the loan portfolio. The implementation of this process should be driven from the board of directors to executive man¬agement to possibly a committee of individuals that are responsible for reviewing credits, and should assess that the credit risk remains valid on an ongoing basis.

Measuring Potential Impairment
Upon reviewing and identifying troubled assets, the next step would be to measure the potential impairment, if any. This step is absolutely critical in maintaining an appropriate Allowance of Loan and Lease Loss (ALLL). To be able to support your ALLL, an institution needs to be able to document that the value(s) used in the impairment analysis can be sup¬ported. There are two common ways this can be accomplished:

New Appraisals
An institution may elect to order new appraisals on all problem as¬sets; however, in most cases, it can be very expensive. If an institution decides to order new appraisals, it is imperative that the scope of the assignment be clearly communicated with the appraiser in the form of an engagement letter. Young & Associates, Inc. recommends that an institution obtain several values from the appraiser based on the length of time it will take to dispose the collateral. For example, the engage¬ment may include a “market” value of the collateral with a useful life up to 12 months, a “liquidation” value with a useful life between 60 and 180 days, and a “fire sale” value with the intent to sell the collateral within the next 30 days. These three values, when utilized among other things, will assist an institution in deciding which collateral is worth taking into Other Real Estate Owned (OREO) and which collateral is worth disposing and recording the loss at that point in time. Once the underlying value has been determined, an institution should apply a discounting factor for the cost to liquidate the collateral.

Discounting Factors
Another alternative is to perform market research to develop a ba¬sis for discounting factors. For example, an institution may determine through prior comparable sales data and general economic factors that single family residences in the local market on average are selling for 20% less than similar homes appraised a year ago. In addition to this, an institution may determine that the cost to liquidate similar properties (e.g., attorney fees, taxes, insurance, maintenance, etc.) is approximately 10%. With this information, an institution can apply a discounting meth¬odology to the original appraised values of similar properties that are not more than 12 months old (as the data above indicates homes are selling for 20% less than a year ago). For older appraised values, an institution may want to engage an appraiser or other independent, qualified person to perform a drive-by of the subject property to verify that the condition of the property remains satisfactory, then apply appropriate discounting factors based on the age of the appraised value, general economic fac¬tors, and cost to liquidate. If an institution is not comfortable with ap¬plying this method or the subject property is complex, it may be feasible to order a new appraisal.

In either case, an institution’s board of directors and executive man¬agement need to determine the most cost-effective and efficient method for measuring the potential impairment of problem assets that not only meets the risk appetite of an institution, but also meets the expectations of the examiners.

Monitoring Problem Assets
Once an asset has been identified as problematic and an impairment analysis has been performed, an institution should monitor the credit until the problem has been cured, the loan has been charged off, or the loan has been taken into OREO. Proper monitoring of troubled assets is critical in the eyes of the examiners. An institution that keeps track of their problem assets in the form of a detailed watchlist, classified asset report, or some other reporting form are far better off than those institutions that do not update collateral values, perform impairment analyses, or document what the current status of the credit is on at least a quarterly basis. The board of directors and executive management should decide whether or not these reports should be updated on a more frequent basis, provided that there are sufficient resources to do so. For example, an institution may decide that all problem credits over a certain dollar threshold are to be updated monthly, regardless if no material changes have occurred.

Controlling Problem Assets
The last phase of this process is controlling the number and dollar amount of problem credits. A number of different circumstances can con¬tribute to problem credits, such as culture, underwriting standards, mar¬ket conditions, etc. It is the duty of the board of directors and executive management to investigate the root of the troubled credits to determine if an institution’s policies and procedures need to be enhanced or to curtail from certain lending activities.

Conclusion
While this article only scratches the surface of the entire process, by be¬ing proactive versus reactive, the examiners will see that an institution is aware of the problems and is addressing them going forward. Throughout the course of the year, Young & Associates, Inc. has assisted many clients in preparing for upcoming examinations. If you would like to discuss this article or find out more about how we can help your bank with this process, please contact Rob Grope at 1.800.525.9775 orclick here to send an Email.

Debra L. Werschey, Associate Consultant

10/2009

Effective quality control is essential to properly manage mortgage loan risks. Additionally, effective quality control benefits everyone involved in the mortgage lending process by:

• Protecting lenders by ensuring the salability of the mortgages in their portfolios
• Protecting borrowers by keeping loans on manageable terms
• Protecting investors by lower¬ing the probability of defaults and foreclosures

Program Management
Quality control of the loan portfolio must be managed as an integral part of any institution’s business strategy. A bank’s board of directors and management must recognize the scope and implication of laws and regulations that apply to their institution. They must establish a quality control system that not only protects the institution, but also uses resources effectively. Senior management must assign well-qualified staff and resources to properly implement and administer the compliance program. Participation at all levels in the compliance management system is important to its success.

Procedures and Policy
An effective quality control program includes procedures and a policy that state the intent of the institution to meet the secondary market and investor expectations. The policy provides the framework for the institution’s procedures and a source of reference and training for the institution’s personnel.

Education
Education of the institution’s personnel is essential in order to maintain a sound quality control program. All personnel should be generally familiar with the requirements of Fannie Mae, Freddie Mac, FHA/VA, and FHLB consumer protection laws and should receive comprehensive education in laws directly affecting their jobs. They must also be trained in policies and procedures adopted by the institution to ensure compliance with those laws.

Tailored to Your Institution
An effective system will take into account the individual characteristics of your institution and be designed to recognize the:

• Size and structure of your institution
• Experience and expertise of your staff
• Geographic areas of your operations
• Number of your branch offices
• Demographic characteristics of your customer base
• Volume of mortgages originated
• Significant changes in your product line

Program Requirements
To be eligible to sell home mortgages to Fannie Mae, Freddie Mac, FHA/VA, and/or FHLB, a lender is required to operate a quality control system that must:

• Be in writing
• Provide standard operating procedures for all staff involved in the quality control process
• Operate independently of mortgage origination and underwriting
• Evaluate and monitor the overall quality of mortgage production
• Include procedures to ensure timely sample selection, mortgage file re¬view, and reporting to senior man¬agement of findings
• Comply with Fannie Mae, Freddie Mac, FHA/VA, FHLB, and other investor requirements, by address¬ing sample size and selection, re-verification, mortgage file review and reporting
• Ensure that findings affecting investment quality or eligibility of mortgages are thoroughly ana¬lyzed and corrective measures are implemented

Program Administration
An individual should be designated in your institution to have overall responsibility for implementing and coordinating the quality control function. Depending on the size of your institution, the quality control staff may have other responsibilities. However, this individual should not be responsible for mortgage origination, processing, or underwriting. Fannie Mae, Freddie Mac, FHA/VA, and FHLB require the quality control function to be established independently of production and underwriting.

The responsibilities of quality control staff include:

• Maintenance and dissemination of up-to-date information on company pol¬icy, mortgage insurer requirements, applicable government requirements, and Fannie Mae, Freddie Mac, FHA/VA, and FHLB guidelines
• Authority to modify the quality control program, as necessary, to meet the program objectives
• Dissemination of quality control findings to management
• Working with lending staff to develop corrective measures when quality control reviews contain de¬ficient findings
• Lending staff education and training
• Follow-up with management responses to quality control findings

Documentation
You must have clear written documentation of your quality control program management because these documents must be available to Fannie Mae, Freddie Mac, HUD (FHA/VA), or FHLB upon request. This system will enable you to document your policies and procedures for sample selection, information re-verification, mortgage file reviews, reports of findings, and follow-up measures.

In Conclusion Young & Associates, Inc. has a team of qualified lending consultants that can assist your bank in establishing and implementing a customized quality control system. This system is developed, written, and implemented inclusive of necessary staff training. An existing quality control system can also be evaluated for conformance with Freddie Mac and Fannie Mae guidelines, bank policies, insurer and guarantor requirements, and regulatory compliance. For more information, please contact me at 1.800.525.9775 or click here to send an Email.

Jackie Roesser, Senior Consultant

10/2009

The active management of credit risk has been receiving increasing regulator attention and strategic focus at many financial institutions. Regulators cite poor credit risk management at the portfolio level, weak credit standards for borrowers and counterparties, and insufficient attention to changes in economic and other circumstances affecting the capacity of borrowers and counterparties as the highest contributors to inadequate credit risk management. Regulators have changed capital charges to make financial institutions more responsive to actual credit exposure and have set new rules for how much capital banks must set aside to cover potential losses.

The basic principles for an effective credit risk management process were outlined in the consultative paper “Principles for the Management of Credit Risk,” issued by the Basle Committee on Banking Supervision. We consider it appropriate to underscore these principles in view of the current regulatory and credit market influences.

Definition of Credit Risk
Credit risk is the risk of loss arising from a borrower’s or counterparty’s inability to meet its obligations. The majority of a financial institution’s credit risk arises from its lending activities – outstanding loans and leases, trading account assets, derivative assets, and unfunded lending commitments that include loan commitments, letters of credit, and financial guarantees. It also exists in other activities such as acceptances, interbank transactions, trade finance, and retail and investment settlements.

Managing Credit Risk
It is important to formulate and implement a structured credit policy and related processes to manage credit risk. Strategies for credit risk management, including credit policy development and risk monitoring, is the responsibility of business unit and senior management, and the board of directors.

Financial institutions should establish credit limits to control the risk in all credit-related activity. Limits by industry sector, geographical region, product, customer, and country should be specified, along with the approaches to be used for calculating exposures against those limits, and made part of credit policy. Consideration should also be given to the spread across industries or regions as the default of one firm or industry may also affect others. Larger financial institutions might also consider multiple limits for each borrower or borrower group, by product, operational unit, and borrower member so that banking and trading activities of those borrowers or borrower groups creating credit risk can be more adequately monitored. While the trend has been that many financial institutions monitor total exposures in those categories, most have not set maximum limits on those exposures.

Commercial Portfolio Credit Risk Management
Credit risk in the commercial portfolio can be managed based on the risk profile of the borrower, repayment source, and the nature of underlying collateral given current events and conditions. Commercial credit risk management should begin with an assessment of the credit risk profile of an individual borrower or counterparty based on current analysis of the borrower’s financial position in conjunction with current industry, economic, and macro geopolitical trends. As part of the overall credit risk assessment of an obligor, each commercial credit exposure or transaction should be assigned a risk rating and be subject to approval based on approval standards defined in credit policy. Subsequent to loan origination, risk ratings should be adjusted on an ongoing basis as necessary to reflect changes in the obligor’s financial condition, cash flow, or ongoing financial viability. The regular monitoring of a borrower’s or counterparty’s ability to perform under its obligations allows for adjustments to be made that will affect the credit exposure measurement.

Risk rating aggregations should be considered for measurement and evaluation of concentrations within portfolios. Risk ratings are also a factor in determining the level of assigned economic capital and the allowance for credit losses.

To manage the relative risk within the commercial portfolio, many financial institutions utilize participation or syndication of exposure to other financial institutions or entities, loan sales and securitizations, and credit derivatives to manage the size of the loan portfolio and the relative associated credit risk. These activities can play an important role in reducing credit exposures for risk mitigation purposes or where it has been determined that credit risk concentrations are undesirable.

Consumer Portfolio Credit Risk Management
Credit risk management for consumer credit should begin with initial underwriting and continue throughout a borrower’s credit cycle. Consumer and other common attributes to evaluate credit risk. Statistical techniques may be used to establish product pricing, risk appetite, operating processes, and metrics to balance risks and rewards appropriately. Statistical models can be purchased or created that use detailed behavioral information from external sources such as credit bureaus, along with internal historical experience. These models should be validated periodically to assure they continue to be statistically valid and reflect performance of the institution’s customer base, particularly if used for credit scoring. When used, these models will form the foundation of an effective consumer credit risk management process and may be used in determining approve/decline credit decisions, collections management procedures, portfolio management decisions, adequacy of the allowance for loan and lease losses, and economic capital allocation for credit risk.

Accurate Calculations of Exposures
Assuring accurate calculations of exposures against limits is critical to managing credit risk. Methodologies will vary according to product types. For lending products and current accounts, the book balance is considered an appropriate measure, with related accruals included as part of the exposure as default of a counterparty on the primary exposure would also likely lead to loss of interest income. The current market value should be used for issuer exposures on bonds and equities, with replacement cost of the trade used as measure for any unsettled trades. For foreign exchange and derivatives, exposure should be measured at the replacement cost of the trades plus an add-on value based on the nominal value to reflect potential future adverse movements in the replacement cost.

Concentrations of Credit Risk
Portfolio credit risk should be evaluated to assure that concentrations of credit exposure do not result in undesirable levels of risk or in violations of regulatory requirements. Regular review and measure of concentrations of credit exposure against established limits by product, industry, geography, and customer relationship should be performed. For specialized industries, additional measurement categories may be appropriate, such as geographic location and property type for commercial real estate loans. When exposures exceed established limits, an escalation process should be triggered to avoid potential conflicts and to assure senior management is aware of all excesses. Periodic revalidation of established limits would be appropriate to assure that the limits continue to match the strategic risk appetite, provide for targeted asset mix, and recognize potential exposures as anticipated.

Examination of Credit Risk Management
Regulatory examination activities use a variety of techniques to assess a financial institution’s credit risk, including a sampling of loans and review of the institution’s credit management processes. Consideration is given to the complexity of the financial institution’s products and activities, and overall risk management practices. Designing, implementing, and adjusting processes and practices to effectively manage credit risk will limit unanticipated exposures.

Young & Associates, Inc. can assist you in your efforts toward managing credit risk. Through the combined efforts of our Loan Review and Internal Audit divisions, we offer services to assure risks are identified and managed: loan reviews focused on safety and soundness issues, documentation and appraisal reviews, reviews of the adequacy and appropriateness of loan loss reserves with consideration of credit concentrations, quality control reviews, control reviews of credit administration and portfolio management activities, and policy, processes and procedures reviews. For more information, contact Rob Grope or Jackie Roesser at 1.800.525.9775.

Linda Young, Consultant

05/2009

We only have to pick up a newspaper or “surf” the internet to know that the current credit and housing crisis had its start in the secondary mortgage market. Over the past several years, American homebuyers have enjoyed a loose credit climate and purchased the home of their dreams with little or no monetary investment with the assumption that property values would continue to climb. Interest rates were good and the number of loan programs available from secondary market investors, such as stated income, interest first and no doc, were at an all-time high. Credit card use was also at an all-time high, and job security was not an issue. Then the bubble burst and those same secondary market investors found themselves with massive numbers of delinquent loans, plummeting real estate values, and unemployed borrowers who could no longer afford their current lifestyle.

So how has the secondary mortgage market responded? While secondary market investors have tightened credit and increased down payment requirements (the requirements to have an acceptable credit history, monetary investment, and the capability to repay the debt are nothing new), mortgage money is available. Additionally, the investors have added increased fees for lower credit scores, loan-to-value, type of property, etc., making selling loans to them, while competitive from an interest rate perspective, more expensive for borrowers.

With all of the additional fees, the next question is, why sell on the secondary market? The answer is, not only are banks able to offer competitive interest rates and turn over their funds quicker, but they also reduce the possibility of loss should the loans default to almost zero. If the bank retains the servicing rights on a sold loan and the loan defaults, the bank is expected to handle collections and, if necessary, foreclosure and property maintenance, all of which is eventually reimbursed; but the bank sustains no loss on the mortgage itself. In today’s banking climate, what could be more important?

The national media would have the public believe that there is limited mortgage money available to purchase or refinance a home, despite the fact that interest rates are at an all-time low. Nothing could be further from the truth. While large national banks have sustained massive losses, community banks not only have money to lend but understand the economic dynamics of their communities. Originating loans with the intent to sell them on the secondary market is not only good risk management, but also allows the bank to remain competitive in their mortgage market.

S. Wayne Linder, Senior Consultant

11/2008

The economic news being reported is devastating. The news media states that banks are not willing to loan money and that borrowers cannot obtain loans. Our continued relationship with clients tells a different story. While it is certainly true that the economy has deteriorated significantly and is likely to continue to do so in the near future, our client banks continue to show the willingness to make loans to qualified borrowers. They are experiencing severe pressure on profits, minimal asset growth, and deteriorating trends in overall asset quality. But, they have the capital and liquidity to weather the storm.

These community banks followed more traditional underwriting for residential real estate loans (LTV = 85% and D/I ratio = 40%). They did not participate in the “instant” mortgage approvals and automated underwriting systems which relied heavily on credit scores and appraisals which could be qualified under Fannie Mae and Freddie Mac subprime lending programs. They did not allow their lenders to make senseless loans just because they could, and therefore earn large loan origination and closing fees. They instead showed the true community bank spirit of working with the borrower to find the best economic solution.

That being said, bank management and boards of directors will need to continue to monitor the economic meltdown and must be prepared for tough times. The devaluation of home values have left many homeowners owing more than their home is worth. Nearly 12 million of the 52 million Americans with a mortgage — that's 23% of them — are in that position, according to Moody's Economy.com. The USA Today (October 21, 2008) stated that as many as 2,600 new auto dealers, out of nearly 20,000, will close their doors within 18 months.

“The plight of car dealers is being watched closely by economic analysts because vehicle sales are a key indicator of the economy’s health. The auto industry overall supports one in ten U.S. jobs, according to the Alliance of Automobile Manufacturers. Dealers alone employ more than 1.1 million and generate nearly 20% of retail sales in most states.”

Things to Do
Here’s a list of actions bank management should take in these challenging times:

Monitor general economic conditions and industry conditions impacting your loan portfolio. The financial regulators continue to stress that each financial institution should monitor economic conditions within the institution’s primary market areas. The institution should determine how changes in economic conditions might impact credit quality within various portfolio segments, including consumer and retail lending.

Increase the number of visitations by commercial loan officers to your commercial customers. Kick the tires and observe.

Place major emphasis on obtaining current financial information on your commercial customers. Review and analyze these financial statements as they are received, looking for signs of deterioration.

Adjust credit risk grades on loans as appropriate. Do not wait until the loan becomes delinquent.

Stress test various portfolio segments identified as high-risk lending areas to determine potential impact on capital.

If you need help with any of these issues, call Young & Associates, Inc. and we will be glad to assist. You can contact us at 1.800.525.9775. For more information on this article, give me a call or click here to send an Email.

S. Wayne Linder, Senior Consultant

07/2008

With the continued weakening of the residential housing market, and now the commercial real estate market, FDIC issued a Financial Institution Letter (FIL), dated July 1, 2008, reminding financial institutions that they should be reviewing their procedures, policy, and the regulatory guidelines for “other real estate owned” (OREO). It is important that banks are aware of the options available when foreclosing on properties. An updated, thorough policy statement on OREO can assist financial institutions in making the right financial decision to protect the bank’s capital and shareholders.

Some of the fundamental concepts to consider include:

• Determine CERCLA Status of Property. The bank must determine the environmental status of the property before taking ownership. Failure to do so could result in environmental liability and potential clean-up costs.
• Taking Ownership of Property. There are several ways that a bank acquires OREO. This should be addressed in your policy.
• Documenting Current Valuation of Property. Once the bank has transferred the property into OREO, the parcel’s market value must be documented through an appraisal or an appropriate evaluation. These appraisals must be completed following certain guidelines.
• Monitoring Current Value. A new appraisal or a certification in letter form from an independent appraiser must be obtained annually. This can be waived depending on the book value of the property.
• Dollar Amount to Carry on Institution’s Books. OREO should be accounted for individually lower of “recorded investment in the loan satisfied” or its fair value on the date of transfer to that category.
• Allowable Holding Period. Basically, banks are permitted to hold onto OREO under certain circumstances for a period no longer than five years. An additional five-year period might be granted with the approval of your primary supervisory agency.
• Documentation of Efforts to Dispose of OREO Property. The bank will document its efforts to dispose of the OREO at the earliest time that prudent judgment dictates.
• Additional expenditures on OREO. Depending on the type of OREO, the bank may need supervisory approval to invest additional funds into the property. Normal repairs and maintenance costs fall outside of this approval process.
• Disposal of OREO Property. Banks may dispose of OREO property through sale, reuse the property for bank premises, or in some cases, obtain a coterminous sublease.
• Accounting Treatment. Generally accepted accounting principles (GAAP) will guide how your bank will account for OREO on your books while it is in your possession and when you sell it.
• Special Disclosures. Care needs to be taken if the bank sells an OREO property and finances the purchase. Regulation Z disclosures will need to be reviewed carefully to include the “Total Sales Price.”
• Flood Insurance Requirements. Your bank policy will need to state whether insurance will be placed on the property while in the bank’s possession if said property is located in a flood area.
• IRS Information Reporting for Financial Institutions. Make sure that you don’t slip up and not file the necessary IRS forms on OREO. Given today’s real estate market, it is essential that financial institutions maintain and review their OREO procedures and policy regularly. Young & Associates, Inc. has incorporated this guidance into our Off and Recovery Policy (#078). The policy is available for $325 and can be easily customized for your bank. For more information on the Collection, Charge-Off and Recovery Policy, or to order, call 1.800.525.9775 or visit www.younginc.com.

Tom Scudiere, Associate Consultant and Rob Grope, Consultant

07/2008

Stress testing in banking is a form of analysis that may be used to determine the stability of an individual loan or portfolio. It involves testing beyond normal operational capacity, often to a breaking point, in order to observe the results. This can assist management in determining the comfort level of risk, as well as bring to light capital adequacy issues.

Stress testing shows the sensitivity of a portfolio to a particular shock. It measures the change in value in response to changes in the underlying risk factors. The assumed changes are usually made large enough to impose some stress, but not so large as to be considered implausible.

Choosing Stress Factors

It is important early on to determine which factors are most critical in the credit assessment in order to understand what components are most likely to cause the biggest influence. Factors to consider can be interest rates, collateral value, and economic factors that affect debt service coverage (DSC). Many lenders employ their own models to rank potential and existing loan customers and then apply appropriate strategies.

Regulations, such as Basel II, reinforce the desire for more robust stress testing. However, regulators have tried not to over specify the type and nature of stress tests. Industry and regulatory dialogue have, thus far, failed to establish consensus on the best practice and policy.

Recent accounting discussions have improved disclosures about valuation, but public disclosures about liquidity are either insufficiently detailed or cannot be updated rapidly enough. You need to know early on which component is most vulnerable and requires close attention, and how a default could affect you.

Be Proactive in Your Approach

In designing stress testing, a financial institution should:

• Consider a full range of extreme outcomes
• Cover both full-loss as well as loss generating risk factors
• Use judgmental – as well as statistical– based methodologies

Testing individual loans can help identify problems before trouble happens. This can be employed during the initial underwriting, as well as the ongoing monitoring of credits. By decreasing sales or gross margins, discounting collateral values, or increasing interest rates, the impact can be shown in the deterioration of DSC, net worth, or even collateral coverage. Regulators consider this a reactive approach.

It is recommended by regulators that financial institutions shift to a portfolio view. They believe that institutions will be better able to identify, measure, monitor, and then report on credit risk. Regulators consider this to be a proactive approach that is important to the anticipation of problems.

In light of the current economic conditions, it is important to address the need for quick responses to problems when they arrive, so as not to be “blind sided” by changing conditions. The employment of what-ifs is critical for management to control downturns. One advantage of the advancement of information technology is it can assist in the rapid assembly of data to facilitate the stress-test calculations. The immediate focus in a down market is on minimizing risk and reducing losses. The of risk management is to ensure long-term earnings and build long-term value. If risk management processes were employed early, the events over the past year might have been controlled and the negative impact mitigated. The institutions that have invested in stress testing will be better prepared to act with greater confidence and exhibit flexibility and survivability.

Conclusion

While risk measurement has evolved rapidly, it is still common practice to apply stress tests in an isolated fashion. Although the practice is evolving quickly, the regulatory agencies have not provided consistent guidance around stress tests. It is, therefore, important for banks to begin to consolidate this information and work toward the implementation and reporting process for the entire financial institution.

For more information on how your institution can begin to stress test loans and portfolios, call 1.800.525.9775 or click here to send an Email.

Tom Scudiere, Associate Consultant

02/2008

The full-time loan review department at Yong & Associates, Inc. conducts third-party loan reviews for community banks throughout the country, with a concentration in the Midwest. The basic characteristics of our client banks in regards to portfolio composition and risk tolerance are fairly comparable. As a result, Young & Associates, Inc. can aggregate the total risk assessed in all of our client banks and use this as a specialized peer group for comparison purposes. From this, benchmarks in grade stratifications and overall risk are established fairly.

Our findings from the loan reviews performed in 2005, 2006, and 2007 are presented in the table to the right. A comparison of the risk from year to year, while fluctuating slightly, shows only a nominal change, and the overall grade increases from 3.15 to 3.33.

What’s this? If the distribution of grades is similar, how can the overall grade increase? Let’s look more closely at the pass grades (1-4) in order to better understand the reasons for the grade increase. The overall percentage of loans graded at the pass levels shows a migration from low risk to moderate risk. We believe this illustrates banks’ efforts to properly recognize and control the risk associated with market and economic influences.

This analysis demonstrates the benefits of a loan review system utilizing multiple pass grade levels. If only one pass grade had been used, the results would have been misleading. Shifting risk levels can influence forecasts of reserves and capital needs. The impact in today’s volatile economy can have wide swings in funds.

One of the primary purposes of a proper loan review program is to serve as an early warning system for increasing risks. We use our considerable knowledge and experience, as well as financial analysis software, to educate our clients’ staff and identify potential risks to the overall portfolio. We recommend that you take a proactive approach, which will improve your comfort, instead of waiting for unexpected delinquencies or regulatory pressures to occur.

If you have any questions about this article or would like to discuss your loan review system with us, please contact Rob Grope, Manager of Lending, at 1.800.525.9775 or click here to send an Email.