Skip to main content

Managing commercial real estate credit risk amid market shifts

Written by admin on . Posted in Advice, Consultation, CRE & AG Stress Testing, Lending & Loan Review, Liquidity Review, Management & Planning, Regulatory Enforcement.

By: Jerry Sutherin, President & CEO of Young & Associates

The landscape of commercial real estate (CRE) lending is shifting due to current economic events, presenting both challenges and opportunities for community financial institutions deeply entrenched in this sector. The challenges range from the profound impact of remote work trends and the uncertain future of office spaces to growing concerns about inflation and higher interest rates bringing CRE risk into the spotlight. This volatility has garnered increased attention from internal and external stakeholders, as well as regulatory authorities. Consequently, identifying the most pressing threats among these challenges and proactively mitigating risk has become a top priority for financial institutions with CRE exposure.

In the face of rising interest rates and delinquencies, many financial institutions are preparing to confront these economic stressors. In fact, some were already scaling back lending before the recent collapses of Silicon Valley Bank and Signature Bank. We have all witnessed the tightening of lending standards resulting from that event, and many analysts anticipate further tightening among all community financial institutions. This constriction is also impacted by limited deposits and liquidity forcing financial institutions to be selective in how they deploy their capital. These facts leave many analysts predicting when credit problems will emerge in the CRE sector.

Current CRE landscape at a glance

The evidence speaks for itself. According to S&P Global Market Intelligence, the delinquency rate for all CRE loans held in U.S. banks has increased by five basis points year over year. Moreover, within a single quarter earlier this year, the delinquency rate for nonowner-occupied nonresidential property loans spiked by a significant 24 basis points. This has led to tighter lending standards at origination, reflecting the concerns of institutions. Further, financial institutions are taking proactive measures to mitigate CRE risk after origination. Some have set aside high-single-digit percentage allowances for office loans. Others have reduced exposure through portfolio sales. Overall, loan originations have fallen, CRE sales have slumped, and forecasts indicate a drop in CRE prices.

The tightening of lending standards, the slowdown in the growth of CRE loans, and the impact on loan originations have emerged as central concerns in the financial sector. What unifies these factors is their inherent risk and whether they act as warning signals or responses. Managing CRE credit risk is undeniably intricate, but leveraging available strategies and tools empowers community banks, credit unions, and financial institutions to effectively navigate the ever-changing CRE lending sector. This enables them to proactively assess and plan for risk mitigation, rather than merely react to these changes.

Understanding commercial real estate risk

As CRE loans represent a substantial part of many banks’ loan portfolios and higher yielding assets, especially within community financial institutions, understanding the significance of CRE credit risk is paramount. Community banks and credit unions often operate in areas experiencing job and population growth, leading to a high demand for CRE lending and, in turn, a high concentration of CRE loans. This growth and its corresponding effects on loan portfolio concentration pose new challenges for banks in terms of risk monitoring and control.

While larger financial institutions commonly maintain experienced staff and even entire departments to manage these risks, it is generally not cost effective for smaller financial institutions to hire and maintain qualified resources to help mitigate the inherent risks. In the absence of an internal CRE risk management team, it is imperative for financial institutions to rely on independent third-party resources to assist in this crucial process.

Historical context and lessons from past experiences

A retrospective examination underscores the importance of proactive risk management. Many significant historical banking failures were largely attributed to overinvestment in CRE loans and the lack of an effective risk management process. Weak underwriting standards and poor portfolio management led to an oversupply of CRE properties and borrower defaults. Over time, regulatory improvements, such as stricter underwriting and risk management requirements, have been implemented. Nevertheless, predicting the future remains uncertain. We can only analyze past patterns and the shortcomings to properly assess future risks.

In 2023, community and regional financial institutions comprise approximately 72% of the CRE loan market, taking on an above-average amount of CRE credit exposure. Recognizing such circumstances is vital, as you should be alert to potential red flags. Identifying and managing CRE credit risk is critical.

Identifying emerging commercial real estate risk

A comprehensive understanding of CRE credit risk highlights the increasing complexity of its landscape. CRE credit risk is multifaceted, with numerous risk categories affecting CRE lending, including market risk, asset risk, liquidity risk, and credit risk, among others. To construct a robust risk management strategy, all these variables must be explored and considered.

To assess your financial institution’s CRE loan segment’s health, a systematic approach is needed. When determining if your CRE portfolio exceeds your institution’s risk appetite and how to quantify that risk and respond effectively, the answers lie in developing a comprehensive, tailored framework for assessing and analyzing your CRE loan market. The most recent regulatory interagency Statement on Prudent Risk Management for Commercial Real Estate Lending notes that institutions that successfully monitored risk have:

  • Established appropriate loan policies, underwriting standards, and concentration limits.
  • Conducted cash flow analyses based on realistic rates and expenses to ensure repayment ability and assessed borrowers’ ability to repay during interest rate fluctuations and loan structure changes.
  • Analyzed the impact of economic changes on the loan portfolio’s quality, earnings, and capital.
  • Provided boards and management with information to adapt lending strategies in changing market conditions.
  • Maintained information systems to manage concentration risk effectively.
  • Implemented appropriate appraisal review and collateral valuation processes.

With the many challenges faced by community financial institutions, the need to effectively identify, measure, and manage these risks has become paramount. While established best practices exist to address these risks, financial institutions must transition from assessing each risk in isolation to recognizing the interconnectedness and synergy between them. A more holistic approach to risk management is required, allowing institutions to confidently inform their capital planning, risk tolerance, and overarching strategy.

Strengthening commercial real estate risk management in community financial institutions

A comprehensive risk management strategy empowers financial institutions to adapt to market dynamics, instilling confidence among stakeholders and regulators. Alongside the factors discussed in the previous section, regulatory guidelines highlight two critical facets of CRE risk management: stress testing and portfolio reviews. While community financial institutions can execute these internally, outsourcing can offer efficiency and effectiveness.

Commercial real estate portfolio stress testing

Stress testing and sensitivity analyses are indispensable tools for evaluating CRE risk and gauging the impact of economic fluctuations on asset quality, earnings, and capital. These assessments should align with the portfolio’s size and risk profile. CRE stress tests inform strategic and capital planning, credit concentration limits, policy, and underwriting. Integrating stress testing into risk management and strategic planning is essential to anticipate and mitigate risks, especially given current market uncertainties.

Although loan-level stress testing serves a purpose on a transactional level at origination, financial institutions should also regularly perform portfolio-level stress testing that encompasses a bottoms-up and a top-down approach. The bottom-up approach allows financial institutions to gauge the risks of individual, seasoned loans by stressing each transaction through interest rate changes, collateral values, and other market factors. Implying moderate and high stress scenarios to each transaction allows for early identification of potential losses and their impact on the capital of your organization. The top-down approach takes the remaining portfolio not identified on a loan-level analysis and uses the same stressors to further identify any possible impact to capital.

Independent loan reviews for commercial real estate risk mitigation

Thorough loan reviews are pivotal for identifying and mitigating potential CRE portfolio risks. They enable banks to assess loan quality, maintain compliance with regulations, and make necessary adjustments on a loan and portfolio level. An effective loan review function is crucial for assessing asset quality, evaluating underwriting and ongoing monitoring, and identifying exceptions to policies. Proactive issue resolution ensures risk mitigation before regulatory scrutiny or asset quality deterioration.

To further safeguard against future losses, it is critical that a loan review be independent. If maintained internally at the organization, it should report directly to the audit committee of the board of directors or the full board of directors. If a third-party firm is contracted to perform this work, it too should report all findings to the board of directors or a committee thereof.

Tactical approaches to limit commercial real estate risk in an unpredictable market

To minimize exposure to CRE credit risk, institutions should enhance communication with borrowers, allocate additional resources for portfolio management, understand collateral, and manage interest rate risk. Effective market area monitoring, adaptable to the institution’s unique risk exposure and appetite, is essential. Clear communication of risk tolerance from the board down to lending staff fosters alignment and clarity.

Community financial institutions must not become complacent in their approach to risk management. It is critical to remain agile and continually adapt to changing environments and emerging risks, especially in the currently volatile realm of CRE lending. By staying proactive and employing a comprehensive risk assessment and management approach, banks and credit unions can successfully address CRE credit risk, safeguard their portfolios, and maintain their success.

Optimize your risk management strategies with Young & Associates

With over four decades of experience, Y&A specializes in helping community financial institutions manage risk. Our enduring presence in the industry reflects our ability to adapt to evolving financial landscapes. Our seasoned consultants, who have backgrounds in banking, bring firsthand experience of market fluctuations.

Outsourcing commercial real estate risk stress testing

Young & Associates offers a CRE portfolio stress testing service that efficiently and insightfully assesses your portfolio. Using data specific to your bank, we stress your CRE portfolio across various factors. Our report quantifies potential impacts on earnings and capital resulting from collateral value decreases, changes in property net operating incomes, or increases in interest rates. What sets us apart is our ability to handle the stress testing process efficiently, allowing your institution’s management to focus on other important initiatives.

Outsourcing loan review

For most community financial institutions, outsourced loan review is the best choice due to size and the need for an independent party. Our loan review service, applied to your CRE portfolio, uncovers individual credit assessments. It also evaluates the alignment of your credit standards, analysis, and continuous credit monitoring with the specific characteristics of your CRE portfolio. Our findings not only inform you about existing portfolio risks but also provide recommendations for effective risk management.

Contact us to explore how we can support your journey in addressing CRE credit risk effectively.

The art of safe lending: How to mitigate commercial loan underwriting risks

Written by admin on . Posted in Advice, Commercial Underwriting, Consultation, Lending & Loan Review.

By: Ollie Sutherin, Principal of Y&A Credit Services

Community financial institutions have long been known for their agility and personalized service, excelling at creating unique lending solutions and facilitating distinct transactions. However, the very attributes that have set them apart may now present fresh challenges as they seek to expand. Community banks and credit unions find themselves navigating a delicate equilibrium: effectively managing underwriting risk, diversifying their loan portfolios, and growing to better serve their communities. 

Additionally, the world of commercial loan underwriting presents its own distinctive challenges that further complicate finding this equilibrium. Commercial loan underwriting standards, in particular, are designed to foster relationship banking rather than transactional interactions. Loans are underwritten based on the borrower’s anticipated ability to operate their business profitably and service the debt being requested. However, the actual cash flows of borrowers can often deviate from expectations, and the value of collateral securing these loans may fluctuate. Most commercial loans are secured by the assets they finance, along with other business assets such as accounts receivable or inventory, and sometimes entail personal guarantees. Loans secured by accounts receivable heavily rely on the borrower’s ability to collect due amounts from customers. These complexities create a web of considerations for underwriters. 

Effective management of a community financial institution’s loan portfolio necessitates a strategic approach guided by skilled underwriters who play a pivotal role in mitigating underwriting risks in commercial lending. 

The aftereffects of the SVB collapse 

A little over six months have passed since the financial world experienced a seismic shift when a prominent regional bank collapsed. This event sent shockwaves throughout the banking sector, triggering a chain reaction that affected numerous other financial institutions, both regional and local. These far-reaching consequences have also left their mark on various aspects of community bank and credit union operations. 

Risk management has always held a pivotal role in credit underwriting, and its significance has become more pronounced in today’s ever-volatile environment. As we navigate an era of monetary tightening, global inflationary pressures, and increasing interest rates, underwriters find themselves under increased scrutiny. In the past, cheap funding was abundant, but now, risk-appropriate pricing is paramount for funding new deals. Underwriters must balance a new interest rate environment with the heightened lending and refinancing risks, necessitating increased diligence in risk assessments when extending credit and negotiating terms. 

To shed light on this matter, we will explore effective strategies for community financial institutions to limit underwriting risk in commercial lending, ensuring they can thrive while maintaining a prudent approach to lending.  

Comprehensive credit analysis 

The cornerstone of any sound underwriting process is conducting a comprehensive credit analysis. This involves digging deep into the current financial health of the borrower, their business, and the industry they operate in. By meticulously assessing factors like cash flow, collateral, and credit history, you can gain a clearer picture of the borrower’s ability to repay the loan. 

Moreover, consider working with an experienced outsourced credit underwriting service like Y&A Credit Services to ensure you have access to the latest data, analytical tools, and expertise in evaluating commercial loans. Our team of experts can assist from reviewing your analysis to completely underwriting the transaction, ensuring you have all the information to help you make informed lending decisions. 

Diversification of loan portfolios 

Diversification is a risk management principle that rings true in commercial lending as well. By diversifying your loan portfolios across various industries and business types, you can reduce your exposure to sector-specific risks. A balanced mix of loans in manufacturing, real estate, healthcare, and other sectors can help buffer your institution against economic downturns that may affect a particular industry. 

Loan covenants and monitoring 

Establishing clear and enforceable loan covenants is another key step in limiting underwriting risk. These covenants set out the terms and conditions under which the borrower must operate and repay the loan. Regularly monitoring the borrower’s compliance with these covenants and requesting the most current information from your borrower is equally important. It allows you to detect early warning signs of financial distress and take corrective action sooner when you have more options for a successful outcome for both your borrower and your institution. 

Loan portfolio stress testing 

Stress testing is an invaluable tool for gauging how your loan portfolio would perform under adverse conditions. By modeling various scenarios against your portfolio, you can assess your institution’s vulnerability to economic shocks and make proactive adjustments to your lending practices. 

Ongoing training and education 

Staying up to date with the latest industry trends, regulations, and best practices is essential. Encourage your staff to engage in ongoing training and education programs related to commercial lending and underwriting. This ensures that your institution’s underwriting processes remain current and effective. 

Regular commercial loan underwriting reviews 

To maintain the health of your loan portfolio, it’s crucial to conduct regular reviews of your commercial loan underwriting practices. This ensures that your institution’s standards and processes align with the evolving landscape of commercial lending. It also allows you to make necessary adjustments and refinements to minimize underwriting risks continuously. 

Outsourcing commercial credit underwriting 

Third party assistance for commercial credit underwriting can help to ensure the accuracy and effectiveness of your underwriting processes. It can relieve your institution of the need to maintain an up-to-date full-time staff.  Professional outsourced services, like Y&A Credit Services, offer expertise, access to advanced analytical tools, and an impartial perspective. We help your institution make sound lending decisions and maintain high underwriting standards.  These services can be implemented from fully outsourced to fractional, helping assist during peaks in volume.  

Y&A Credit Services’ guidance in commercial underwriting 

Mitigating underwriting risk in commercial lending is pivotal for upholding financial health and stability of community banks and credit unions. Especially in the wake of the industry upheaval earlier this year. By implementing comprehensive credit analysis, diversifying loan portfolios, enforcing loan covenants, conducting stress tests, and investing in ongoing training, regular reviews, and outsourcing, you can confidently navigate the complexities of commercial lending while minimizing risks and enhance your institution’s lending capabilities. 

At Y&A Credit Services, we understand the importance of risk management in commercial lending. We’re here to guide you through the process. Our outsourced credit underwriting services are designed to offer the expertise and resources needed to make sound lending decisions. Together, we can build a more secure lending future for your institution, helping our communities one loan at a time. 

Contact us today to learn how we can help. 

Key elements of effective credit underwriting

Written by admin on . Posted in Lending & Loan Review.

By Ollie Sutherin, chief financial officer, Young & Associates

The focus of this article is to provide an overview of what Y&A Credit Services views as key elements during the underwriting process. While there are many variables needed to effectively underwrite credits, below are the primary focal points of any quality credit presentation that we underwrite or review.

Cash is king

“Cash is king” is a saying that we use often as it translates to, “if you don’t have the cash to repay, you shouldn’t have the loan.” So often we are presented with transactions that aren’t the strongest, don’t show cash flow, and the underlying organization has no business being lent money. Lenders often try to form complex explanations regarding the guarantor’s wherewithal, global cash flow, etc., and they lose sight of the actual company, its financial condition, and its ability to service the debt on a stand-alone basis.

Every analysis should begin with the subject company and its ability to service debt. If it is a real estate holding company and the note is secured by a specific property, what is the cash flow of that property? If the most recent tax return statement, compiled, audited, etc., does not evidence the ability to service debt, what is the trend of the company? What are they doing to improve from the previous year and what is the YTD revenue/expenses compared to the prior year?

Eventually, we take into consideration the guarantor’s wherewithal and how it impacts the cash flow; however, the primary focus should always be on the company itself (the primary repayment source). If a transaction is being presented where repayment is heavily reliant on the guarantor, then the following questions must be asked: What is their character like? Have all of the assets and liabilities been verified on their personal financial statement(s)? Are other contingent liabilities factored in as well? So often, mistakes are caught when analysts simply say, “John Doe has $1,000,000 in cash and is clearly able to service the subject note should it be needed” without doing the proper due diligence verifying the source of the cash.

Quality of information

If the cash flow of the company is the backbone of the transaction, then the quality of information is the legs, providing the necessary base for everything. We are always looking at the reliability of this information as it minimizes the risks of inaccuracy and subsequently the risk of default. For example, if borrowers only give internal statements that are hastily prepared and communicate lease details in one-two sentences in an email, this poses a much greater risk than detailed property information in the actual tax return and actual signed lease agreements provided for review. Furthermore, as it pertains to C&I transactions, internally prepared statements rarely reconcile, which makes performing a UCA Cash Flow analysis much more difficult. Tax returns and audited or compiled statements always reconcile, providing an accurate analysis.

Collateral values

As it relates to the property or equipment securing an obligation, an appraisal is always going to be the safest way to measure the value. Too often, internal evaluations or estimates are utilized to justify a request during underwriting. To meet regulatory standards, the collateral securing an obligation must support the amount being considered and obtaining the appraisal during the underwriting phase can potentially save a significant amount of work if the value is insufficient to support the debt. For existing credits that are being refinanced, another important aspect of collateral valuations includes site visits by the account officers. Having photos and notes from the site visit will provide added support to the collateral pledged for the transactions.

Stress testing

Stress testing individual loans during underwriting is becoming increasingly necessary, especially in today’s rising rate environment. This was a regulatory focus back in the late 2010s as there was a rising interest rate environment. Variable rate notes, property values, vacancy rates and ultimately cash flow for debt service were adversely impacted. At the beginning of the pandemic in March 2020, rates dropped markedly and remained flat until just recently. To curb inflation, the Federal Reserve began increasing rates and the extent of the impact on variable rate loans has yet to be determined.

Stressing individual loans at origination provides the institution with a tool to better understand the impact of rate increases on cash flow, property values, and vacancy rates in different scenarios. The result is a more informed credit decision during the underwriting phase. Ultimately, these variables help determine the breakeven point of a business’s cash flow and provide great insight to the actual strength of the primary borrower.

Projections / proformas

These are something that all lenders should request from a borrower/potential borrower to justify the strength of a transaction. However, often these projections will paint an excellent picture of the company and a stellar cash flow that is more than adequate to service the underlying transaction. The intent of requesting and analyzing projections is to compare them to historical results, in many instances where the projected cash flow is higher than historical results. This is typically due to the borrower understating expenses which leads to overstated cash flow and debt service coverage. Given all of this, it is still important to obtain projections and to compare them to actual statements when available. Should they vary significantly, it will open the door to questions and force a deeper look into smaller details such as management of the company.

Y&A Credit Services

Over the past few years, a defined need has developed in the community financial institution industry. Specifically, it has been difficult for financial institutions to hire and retain quality credit professionals, especially in rural areas, to underwrite loans and perform other necessary tasks necessary for adequate credit administration. This need has led Young & Associates, Inc. to create a wholly-owned subsidiary (Y&A Credit Services) to meet the needs of these organizations. Y&A Credit Services has the mission of filling the voids of clients who have limited or even no credit staff to perform these necessary tasks. If your organization has a need for credit underwriting services, please feel free to contact us at 330.422.3482. Our services include spread sheet analyses, annual reviews, full credit underwriting and review of prepared presentations along with a full complement of other credit-related services through Young & Associates, Inc.

Annual reviews of commercial credits

Written by admin on . Posted in Lending & Loan Review.

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 TDRs 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 timelier and more accurate than all of the other measures combined.

Questions to consider

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 percent 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. 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. 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:

  • Detail of the relationship being reviewed including borrower, guarantors, SBA or other guarantees, and note numbers included.
  • 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.
  • 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.
  • A 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.
  • 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.
  • An update of any approval conditions and whether the borrower is maintaining those conditions, including any promises of deposit accounts, financial reporting, property improvements, and compliance with any financial or other covenants.
  • A 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 percent of its commercial portfolio with robust and timely annual reviews every year should provide executive management and the board with sufficient information to understand the level and direction of credit risk and whether these are in accordance with the desired risk appetite.

For more information on how Young & Associates, Inc. can assist your institution in this area, please contact Dave Reno. Reno is the Director of Lending and Business Development, at 330.422.3455 or dreno@younginc.com.

SAFE Act a decade on

Written by admin on . Posted in Compliance & Regulations, Lending & Loan Review.

By: William J. Showalter, CRCM, CRP, Senior Consultant

We have been dealing with the Secure and Fair Enforcement for Mortgage Licensing Act (SAFE Act) since 2010, and yet questions surface or confusion still exists over SAFE Act requirements.

“A loan clerk quotes loan rates from a non-public rate schedule, along with payment amounts for inquiring consumers. Should she be registered?” (Maybe, she is performing a function of a mortgage loan originator, MLO.)

“Our head of lending is our SAFE Act Officer. He also handles some mortgage loans, with his name on loan documents. However, his background is in commercial lending and he has never been registered with the NMLSR. Do we have a problem?” (Yes, if he is involved in more than five mortgage loans per year, he must be registered.)

“How often do we have to get criminal background checks for our MLOs? How about when their fingerprints expire?” (Criminal background checks are required only on initial registration. The fingerprint expiration date is only relevant for existing MLOs who are coming into the bank as new employees. No updating of fingerprints for ongoing MLOs is required.)

These queries reveal that confusion still exists over what the requirements are and how they impact banks and thrifts.

A little background

Congress enacted the SAFE Act in July 2008 to require states to establish minimum standards for the licensing and registration of state-licensed mortgage loan originators, and to provide for the establishment of a nationwide mortgage licensing system and registry for the residential mortgage industry.

The SAFE Act required all states to provide for a licensing and registration regime for mortgage loan originators who are not employed by federal agency-regulated institutions within one year of enactment (or two years for states whose legislatures meet biennially).

In addition, the SAFE Act required the federal banking agencies, through the Federal Financial Institutions Examination Council (FFIEC), and the Farm Credit Administration (FCA) to develop and maintain a system for registering mortgage loan originators employed by agency-regulated institutions.

The Dodd-Frank Act moved responsibility for the SAFE Act rules to the Consumer Financial Protection Bureau (CFPB), which rolled these rules into its Regulation G (12 CFR 1007).

Licensing vs. registration

Most of the confusion at the outset seemed to center on the issue of licensing versus registration of mortgage loan originators (MLOs). The issue is really deceptively simple.

  • MLOs that work for federally supervised banks, thrifts, and credit unions (as well as FCA lenders) must register with the national registry (NMLSR).
  • MLOs employed by other mortgage lenders (mortgage companies, etc.) must navigate the state licensing and registry system, a much more time consuming, expensive, and burdensome process which also carries a continuing education requirement.

Coverage

A “mortgage loan originator” is an individual who both takes residential mortgage loan applications and offers or negotiates terms of a residential mortgage loan for compensation or gain.

The term “mortgage loan originator” does not include individuals that perform purely “administrative or clerical tasks” (the receipt, collection, and distribution of information common for the processing or underwriting of a loan in the mortgage industry) and communication with a consumer to obtain information necessary for the processing or underwriting of a residential mortgage loan. Also excluded are individuals that perform only real estate brokerage activities and are duly licensed, individuals or entities solely involved in extensions of credit related to timeshare plans, employees engaged in loan modifications or assumptions, and employees engaged in mortgage loan servicing.

“Compensation or gain” includes salaries, commissions, other incentives, or any combination of these types of payments.

MLO registration

An MLO must be federally registered if the individual is an employee of a depository institution, an employee of any subsidiary owned and controlled by a depository institution and regulated by a federal banking agency, or an employee of an institution regulated by the FCA.

The final rule, as required by the SAFE Act, prohibits an individual who is an employee of an agency-regulated institution from engaging in the business of a loan originator without registering as a loan originator with the national registry, maintaining that registration annually, and obtaining a unique identifier through the registry. Employer financial institutions must require adherence to this rule by their employee MLOs.

MLOs may submit their registration information individually or their employer institution may do it for them (by a non-MLO employee). The decision of which approach to take should be made by management to ensure consistency within the institution, especially since there is prescribed institution information that also must be submitted to the registry.

This MLO information must include financial services-related employment history for the 10 years before the date of registration or renewal, including the date the employee became an employee of the bank – not just the time they have worked for their current employer.

MLOs and their employers need to remember that registrations have to be renewed annually for as long as an individual operates as an MLO. The renewal period opens on November 1 and ends on December 31 each year. If an MLO or bank registration lapses, it may be reinstated during a reinstatement period that opens on January 2 and closes on February 28 each year.

Other requirements

Bank and thrift managers also should remember that there are specific requirements in this rule for the institution to have policies and procedures to implement SAFE Act requirements, as well as regarding the use of a unique identifier (NMLS number) by MLOs.

At a minimum, the bank’s SAFE Act policies and procedures must:

  • Establish a process for identifying which employees have to be registered MLOs
  • Require that all employees who are MLOs are informed of the SAFE Act registration requirements and be instructed on how to comply with those requirements and procedures
  • Establish procedures to comply with the unique identifier requirements
  • Establish reasonable procedures for confirming the adequacy and accuracy of employee registrations, including updates and renewals, by comparisons with its own records
  • Establish reasonable procedures and tracking systems for monitoring compliance with registration and renewal requirements and procedures
  • Provide for independent testing for compliance with this part to be conducted at least annually by covered financial institution personnel or by an outside party
  • Provide for appropriate action in the case of any employee who fails to comply with SAFE Act registration requirements or the bank’s related policies and procedures, including prohibiting such employees from acting as MLOs or other appropriate disciplinary action
  • Establish a process for reviewing SAFE Act employee criminal history background reports, taking appropriate action consistent with applicable federal law, and maintaining records of these reports and actions taken with respect to applicable employees, and
  • Establish procedures designed to ensure that any third party with which the bank has arrangements related to mortgage loan origination has policies and procedures to comply with the SAFE Act, including appropriate licensing and/or registration of individuals acting as MLOs

The bank or thrift also must make the unique identifiers (NMLS numbers) of its registered MLOs available to consumers “in a manner and method practicable to the institution.” The bank has latitude in implementing this requirement.

It may choose to make the identifiers available in one or more of the following ways:

  • Directing consumers to a listing of registered MLOs and their unique identifiers on its website
  • Posting this information prominently in a publicly accessible place, such as a branch office lobby or lending office reception area, and/or
  • Establishing a process to ensure that bank personnel provide the unique identifier of a registered MLO to consumers who request it from employees other than the MLO

In addition, a registered MLO must provide his or her unique identifier to a consumer:

  • Upon request
  • Before acting as a mortgage loan originator, and
  • Through the MLO’s initial written communication with a consumer, if any, whether on paper or electronically (often by incorporating it into the signature information for standard letter and e-mail formats)

Banks, thrifts, and their registered MLOs often also make their NMLS numbers available in other ways – such as including them in advertising or on business cards.

As with any compliance rule, banks and thrifts need to make sure that they have systems in place to ensure compliance with SAFE Act requirements, including appropriate training for employees involved in the mortgage origination process.

For information on how Young & Associates can assist your bank with the SAFE Act requirements, contact Dave Reno at 330.422.3455 and dreno@younginc.com.

Regulation B Interpretive Rule on Sexual Orientation and Gender Identity

Written by admin on . Posted in Compliance & Regulations, Lending & Loan Review, News.

March 2021

The Bureau of Consumer Financial Protection (Bureau) issued an interpretive rule to clarify that, with respect to any aspect of a credit transaction, the prohibition against sex discrimination in the Equal Credit Opportunity Act (ECOA) and Regulation B, which implements ECOA, encompasses sexual orientation discrimination and gender identity discrimination, including discrimination based on actual or perceived nonconformity with sex-based or gender-based stereotypes and discrimination based on an applicant’s associations.

The interpretive rule became effective upon publication in the <i>Federal Register</i>.

At Young &amp; Associates, we have been teaching for years that this is the correct approach. The reality is that an applicant’s sexual orientation or gender identity has absolutely nothing to do with whether they will be able to repay the loan. The focus of all bankers should be on the same things that are important in all credit decisions – cash, collateral, and credit. Nothing else really matters.

The Equal Credit Opportunity Act (ECOA) makes it “unlawful for any creditor to discriminate against any applicant, with respect to any aspect of a credit transaction,” on several enumerated bases, including “on the basis of … sex …” Likewise, Regulation B prohibits a creditor from discriminating against an applicant on a prohibited basis (including “sex” ) “regarding any aspect of a credit transaction,” and from making “any oral or written statement to applicants or prospective applicants that would discourage on a prohibited basis a reasonable person from making or pursuing an application.”

Before this interpretive rule, twenty states and the District of Columbia prohibited discrimination on the bases of sexual orientation and/or gender identity either in all credit transactions or in certain (e.g., housing-related) credit transactions. This interpretive rule now makes this the new national standard. So financial institutions must recognize sexual orientation and/or gender identity to be protected classes and must incorporate practices that prohibit discrimination on these bases.

This interpretive rule addresses any regulatory uncertainty that may still exist under ECOA and Regulation B as to the term “sex” to ensure the fair, equitable, and nondiscriminatory access to credit for both individuals and communities and to ensure that consumers are protected from discrimination. It serves a stated purpose of Regulation B, which is to “promote the availability of credit to all creditworthy applicants without regard to … sex …”

As an interpretive rule, it is exempt from the notice-and-comment rulemaking requirements of the Administrative Procedure Act.

To learn more about how we can assist your organization with your compliance efforts, contact Dave Reno, Director – Lending and Business Development, at dreno@younginc.com or 330.422.3455.

www.younginc.com
Email: dreno@younginc.com
Phone: 330.422. 3455

Handle ARM Adjustments with Care

Written by admin on . Posted in Compliance & Regulations, Lending & Loan Review.

By William J. Showalter, CRCM, CRP, Senior Consultant

Adjustable-rate mortgages (ARM) have not been much of an issue for many banks and thrifts in recent years since fixed rates have been so low. But they are still an important tool for serving those customers who cannot meet the secondary market qualifications applied to most fixed-rate loans. And, many institutions have a portfolio of existing ARM loans that they service. One potential complication for some lenders is the impending discontinuance of the LIBOR index, requiring them to find another comparable index for their ARMs.

ARMs were in the spotlight over 10 years ago because of problems in the subprime market. Many subprime products have variable interest rates, which shift the interest rate risk from lender to borrower. Besides the issues raised then over putting borrowers into inappropriate products, there also are concerns over errors in ARM rate changes.

Do an internet search for “ARM errors” or similar terms and you will come up with numerous firms offering loan audit and information services to borrowers. These firms tell borrowers that their companies can correct ARM errors, bring loans into compliance, and get the borrower a mortgage refund.

Background

The initial furor over these mistakes arose over a report on ARM adjustment errors prepared by a former Federal Savings and Loan Insurance Corporation employee in 1989. His assertions sent a tremor through the mortgage industry. The report concluded that miscalculations in periodic adjustments to rates on ARM instruments resulted in significant overcharges. He found ARM adjustment errors in about 50 percent of the loans he sampled. From these results, he estimated the potential overcharges to be up to $15 billion for ARMs nationwide at the time. This figure has been estimated as high as $50-60 billion in recent years.

The controversy was further stoked by a study from the Government Accountability Office (GAO) released in September 1991 which found between 20 and 25 percent of the ARM loans at the time contained interest rate errors. Such errors occurred when the related mortgage servicer selected the incorrect index date, used an incorrect margin, or ignored interest rate change caps.

The damaging studies kept coming. In July 1994, Consumer Loan Advocates, a non-profit mortgage auditing firm announced that as many as 18 percent of ARMs had errors costing the borrower more than $5,000 in interest overcharges. And, another government study in December 1995 concluded that 50 to 60
percent of all ARMs contained an error regarding the variable interest rate charged to the homeowner. The study estimated the total amount of interest overcharged to borrowers was in excess of $8 billion. Inadequate computer programs, incorrect completion of documents, and calculation errors were cited as the major causes of interest rate overcharges.

Even though no other government studies have been conducted into ARM interest overcharges to date, the potential issue continues to simmer below the surface and lenders need to be vigilant so that it does not erupt into a veritable supervolcano of enforcement actions and lawsuits.

Types of Errors

The kinds of errors lenders are said to make in implementing ARM rate and payment adjustments run the gamut from calculation mistakes to carelessness, including:

  • Mistakes in original loan set up/data input
  • Miscalculation of payment amount
  • Improper allocation of payments between interest and principal (amortization)
  • Use of the wrong index
  • Selection of incorrect index value
  • Application of incorrect interest rate caps
  • Failure to adjust in some years
  • Use of incorrect margins
  • Improper rounding methods (e.g., rounding up instead of rounding to the nearest 1/8th of 1 percent)
  • Math mistakes causing an incorrect rate
  • Use of incorrect loan balance

Banking regulators point out that these errors may be considered breaches of contract and could expose the financial institution to legal action.

Extent of Errors

Since ARMs involve changing index values periodically and oftentimes complex computer calculations, they seem to attract human and software errors. Mortgage audit firms point out that leading publications such as The Wall Street Journal, MONEY, Forbes, and Newsweek have warned borrowers about miscalculations occurring in up to 50 percent of ARMs.

  • The firms get borrowers’ attention by pointing to figures of lender overcharges and borrower refunds like these:
  • Average borrower refund of over $1,500
  • 21 percent of refunds ranging from $3,500 to $10,000
  • 13 percent of errors exceeding $10,000

Reasons for Errors

The calculation of ARM rate changes is a complex process and errors can occur in a variety of ways. Add to this the fact that many lenders offer, and servicers support, a variety of ARM products with different rate adjustment intervals, indices, margins, and other terms. Another potential complicating factor is the widespread practice of transferring loan servicing, presenting another opportunity for human mistakes and software mismatches to cause errors.

In addition, some of the mortgage audit firms assert that ARM rate and payment adjustment errors have been linked to:

  • Lack of training, supervision, and experience of loan servicing personnel
  • Simple human error
  • Computer data entry or software errors
  • Clerical or calculation errors
  • Fraud
  • Sale or transfer of the loan to a different company
  • Rider, handwritten changes, or other irregularities in the note
  • Very complex calculations, use of an unusual index, or interest rate
  • Dissolution or merger of the original loan institution

How to Avoid These Problems

The federal banking supervisors began encouraging financial institutions back in 1991 to perform reviews of their adjustable-rate loan systems to ensure that interest rate information is correctly ascertained and administered, and that rates are adjusted properly.

Banks and thrifts should have effective internal controls and procedures in place to ensure that all adjustments are made according to the terms of the underlying contracts and that complete, timely, and accurate adjustment notices are provided to borrowers. Also, a system for the ongoing testing of adjustments should be in place to ensure that adjustments continue to be made correctly.

A critical component of any successful loan servicing program, including correctly implementing rate and payment adjustments, is a thorough training regime for lending personnel involved in the process. Those involved must be given the appropriate tools – including knowledge – to succeed in their jobs.

Any review of ARM adjustments should include documentation indicating the basis for interest rate adjustments made to a lender’s ARM loans, showing whether changes have been made consistent with the underlying contracts.

If a lender finds that it has made errors in the adjustments for interest rates which have resulted in interest overcharges on ARMs, the supervisory agencies expect that you will have in place a system to correct the overcharges and properly credit the borrower’s account for any interest overcharges. In general, undercharges cannot be collected from borrowers.

Young & Associates, Inc. offers a variety of compliance management and review services that are proven effective for institutions of all types and sizes. For more information on this topic or how Young & Associates, Inc. can assist your institution, contact Bill Showalter at wshowalter@younginc.com or 330.422.3473.

Off-Site Reviews, Virtual/Teleconference Training, and Management Consulting Support

Written by admin on . Posted in Compliance & Regulations, Information Technology, Lending & Loan Review, Management & Planning.

Young & Associates, Inc. remains committed to keeping our employees, clients, and partners safe and healthy during the COVID-19 pandemic. During this difficult and unprecedented time, we have continued to successfully leverage technology to fulfill our commitments to our clients and partners through secure remote access for reviews, virtual/teleconference training, and other management consulting support.

Young &Associates’ commitment to virtual/teleconference training and remote access reviews date back well over five years. We see this ability as a win-win for everyone – the review and training get completed in a timely manner and the bank avoids paying any travel expenses. Concerned about security, please be assured that we use the latest secure technology.

We remain committed to helping our clients with all areas of their operations through off-site reviews and providing the most current regulatory updates through our virtual/teleconferencing training.

Contact one of our consultants today for more information about our off-site reviews or virtual/teleconferencing training:

Bill Elliott, Director of Compliance Education:
bille@younginc.com or 330.422.3450

Karen Clower, Director of Compliance:
kclower@younginc.com or 330.422.3444

Martina Dowidchuk, Director of Management Services:
mdowidchuk@younginc.com or 330.422.3449

Bob Viering, Director of Lending:
bviering@younginc.com or 330.422.3476

Kyle Curtis, Director of Lending Services:
kcurtis@younginc.com or 330.422.3445

Aaron Lewis, Director of Lending Education:
alewis@younginc.com or 330.422.3466

Dave Reno, Director – Lending and Business Development:
dreno@younginc.com or 330.422.3455

Ollie Sutherin, Manager of Secondary Market QC Services:
osutherin@younginc.com or 330.422.3453

Jeanette McKeever, Director of Internal Audit:
jmckeever@younginc.com or 330.422.3468

Mike Detrow: Director of Information Technology Audit/Information Technology:
mdetrow@younginc.com or 330.422.3447

Young & Associates, Inc.’s consultants provide a level of expertise gathered over 42 years. In our consulting engagements, we closely monitor the regulatory environment and best practices in the industry, develop customized solutions for our clients’ needs, and prepare detailed and timely audit reports to ease implementation moving forward. With backgrounds and experience in virtually all areas of the financial services industry, our consultants bring a broad knowledge base to each client relationship. Many of our consultants and trainers have come to the company directly from positions in financial institutions or regulatory agencies where they worked to resolve many of the issues that our clients face daily.

We look forward to working with you as you work to obtain your goals in 2021 and beyond.

Loan Modifications: A Proactive Approach for Working with Borrowers Impacted by Coronavirus (COVID-19), Guided by Recently Issued Interagency Statement

Written by admin on . Posted in Lending & Loan Review.

By: Bob Viering, Director of Lending, and Aaron Lewis, Director of Lending Education, Young & Associates, Inc., March 25, 2020

On March 22, 2020, the federal banking regulators issued an interagency statement on loan modifications for customers affected by the Coronavirus Disease 2019 (also referred to as COVID-19). In a number of ways, it resembled historical statements issued in the wake of natural disasters. In keeping with previously issued statements following natural disasters the federal regulators recognize that there can be an impact on borrowers and encourages banks “to work prudently” with those borrowers. However, given the sudden and significant impact of the rapidly spreading coronavirus pandemic that has had a nationwide impact, the breadth of the statement was far more reaching than previous statements issued following natural disasters which historically have been isolated to specific geographic regions. In the statement the federal regulators included the following provisions:

    1. The federal regulators confirmed with the Financial Accounting Standards Board (FASB) that “…short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not troubled debt restructurings (TDRs).”
    2. “…short term (e.g., six months)…”modifications can include: payment deferrals, fee waivers, extension of payment terms or other delays in payments that are “insignificant.”
    3.“Current” is defined as less than 30 days past due. If the credit is current at the time of the modification the borrower is deemed to not be experiencing financial difficulties.
    4. Banks can choose to work with individual borrowers or as “part of a program.”
    5. Borrowers granted a modification will not be “automatically adversely risk rated” by agencies’ examiners. In fact, it is stated that agency examiners will use judgment in reviewing credits modified and “regardless of whether modifications result in loans that are considered TDRs or are adversely classified, agency examiners will not criticize prudent efforts to modify the terms on existing loans to affected customers.”
    6. Loans granted modifications will not be classified as past due if modified, unless they become past due per the terms of the modification.
    7.During the temporary short-term arrangements (as provided in the Interagency Statement), loans should not be reported as “non-accrual.”
    8. As information is gathered, if an adverse classification, non-accrual, or charge-off is warranted, bank actions should follow existing guidance on the topics.

The best way to interpret the Interagency Statement is to consider it as providing banks breathing room while more information is developed that allows the bank to accurately assess the borrower’s financial strength. It is clear throughout the statement that any modifications must be temporary and short-term to not be classified as TDR. This guidance is in keeping with previous statements regarding TDR and relative impact to the credit. While there is no specific definition of what constitutes short-term or temporary, the mention of six months in the Interagency Statement should be a reasonable maximum to consider.

The statement mentions that working with either individual borrowers or as part of a program is acceptable. The term “individual borrowers” is fairly self-explanatory. A “program” for working with borrowers will require a bank to determine criteria to allow for a more automatic deferral decision. This would need to include checking that the borrower was not past due for reasons other than the impact of COVID-19, that the deferral meets the criteria as outlined in the Interagency Statement, and that the bank believes the borrower has been impacted by the Coronavirus. In the case of a program, the decision on granting deferrals may be made by a lender or manager close to the front lines.

Once the deferral decision has been made, the real work begins. As mentioned above, this statement really provides banks with a near-term way to deal with an unknown impact while providing time to fully assess the actual impact on the borrower. Here are the steps we would recommend that banks take in response to the impact of COVID-19:

    1. Make a list of borrowers most likely impacted by COVID-19. Hotels, restaurants, non-essential retailers, ‘Main Street business,’ some manufacturers, distributors, and especially non-owner occupied commercial real estate owners with tenants impacted by COVID-19 are examples of customers that are most vulnerable to the current health crisis.
    2. Reach out to those borrowers to see how they are doing, how they have been impacted, and what they see as next steps for their business. Let your borrowers know you are here to work with them as they navigate through the downturn, including taking pro-active steps to ensure the viability of their business. Let them know what you are doing in the community to help. This is the most important time to keep up communications with your customers. They may well be concerned about what might happen to them and a few kind words of support from their bank can go a long way to letting them know they are not alone.
    3. Based on your initial analysis and conversations with potentially impacted borrowers, you should derive a shorter list of borrowers for which deeper analysis is warranted. As you develop a forward-looking analysis the following considerations should be made:
    • a. Last year’s tax return or financial statement may well be meaningless as a source of cash flow analysis if they have been significantly impacted by recent events.
    • b. This is the time to work with these borrowers to develop honest, meaningful projections to help determine their ability to overcome any short-term cash flow impact.
    • c. For CRE borrowers, a current rent roll with any concessions the owner has made to help tenants or identify tenants that may be at highest risk of defaulting on their lease should be included as part of the bank’s analysis.
    • d. It’s also important to have a current balance sheet for any C&I borrowers. This can provide you with another method of assessing the borrower’s financial strength and ability to withstand a downturn. Cash flow analysis alone cannot tell the whole story of a borrower’s repayment ability. A strong balance sheet will include substantial liquidity and limited leverage beyond minimum policy requirements.
    • e. Your analysis should be in writing and reviewed by the bank’s loan committee and especially its board of directors to keep them informed about the level of risk to the bank.
    • f. For those borrowers where your analysis shows limited long-term problems, great news! Keep in touch to assure that things are actually going as expected.
    • g. The overall thrust of the analysis should be on a forward-looking basis in terms of the borrower’s repayment ability, including a defined expectation for receiving frequent and timely financial information. Relying on a tax return, with financial information that could be aged up to 10 months following the borrower’s year-end date could result in a false calculation of future repayment ability.
    4. It is imperative that a pro-active approach is taken by the institution in response to the impact of COVID-19. Sufficient human resources should be dedicated to the bank’s response and outreach to impacted customers. If human resources are limited at the institution, the aforementioned list of borrowers should be prioritized based on factors developed by management, i.e., size of credit, borrower sensitivity to the impact of a downturn, and those businesses considered critical to the well-being of the community (large employers).

In addition to the bottom-up (customer level) analysis discussed above, we would recommend that the bank perform a comprehensive stress test of its loan portfolio to determine the level of impact, if any, on capital which should be addressed by the board and senior management. (This is a great time to update your capital plan as well.)

The next few months are likely to be a difficult period for many banks and their borrowers. As of today, we don’t really know the actual impact on the economy from COVID-19. But, we can be sure it won’t just be a quick blip and a return to normal for all borrowers. Take the time allowed by this unprecedented Interagency Statement and be proactive.

IRR and Liquidity Risk Review – Model Back-Testing / Validation of Measurements

Written by admin on . Posted in Lending & Loan Review, Management & Planning.

Effective risk control requires conducting periodic independent reviews of the risk management process and validation of the risk measurement systems to ensure their integrity, accuracy, and reasonableness. To meet the requirements of the Joint Policy Statement on Interest Rate Risk (IRR), as well as the Interagency Guidance on Funding and Liquidity Risk Management and the subsequent regulatory guidance, Young & Associates, Inc. can assist you in assessing the following:

  • The adequacy of the bank’s internal control system
  • Personnel’s compliance with the bank’s internal control system
  • The appropriateness of the bank’s risk measurement system
  • The accuracy and completeness of the data inputs
  • The reasonableness and validity of scenarios used in the risk measurement system
  • The reasonableness and validity of assumptions
  • The validity of the risk measurement calculations within the risk measurement system, including back-testing of the actual results versus forecasted results and an analysis of various variance sources

Our detailed interest rate risk review reports and liquidity risk review reports assess each of the above, describe the findings, provide suggestions for any corrective actions, and include recommendations for improving the quality of the bank’s risk management systems, and their compliance with the regulatory guidance. We are happy to customize the review scope to your bank’s specific needs.

For more information, contact Martina Dowidchuk at mdowidchuk@younginc.com or 330-422-3449.

CRE Portfolio Stress Testing

Written by admin on . Posted in Lending & Loan Review, Management & Planning.

CRE Stress Testing is widely viewed by bankers and bank regulators as a valuable risk management tool that will assist management and the board of directors with its efforts to effectively identify, measure, monitor, and control risk. The information provided by this exercise should be considered in the bank’s strategic and capital planning efforts, concentration risk monitoring and limit setting, and in decisions about the bank’s loan product design and underwriting standards.

Young & Associates, Inc. offers CRE Portfolio Stress Testing that provides an insightful and efficient stress testing solution that doesn’t just simply arrive at an estimate of potential credit losses under stressed scenarios, but provides a multiple page report with a discussion and summary of the bank’s level and direction of credit risk, to be used for strategic and capital planning exercises and credit risk management activities.
Our CRE Stress Testing service is performed remotely with your data, allowing for management to remain free to work on the many other initiatives that require attention, while we make use of our existing systems and expertise.

For more information, contact Kyle Curtis, Director of Lending Services, at kcurtis@younginc.com or 330.422.3445.

Ag Lending Considerations in 2020

Written by admin on . Posted in Lending & Loan Review.

By: Robert Viering, Director of Lending

On January 28, 2020, the FDIC published Financial Institution Letter (FIL-5-2020) Advisory: Prudent Management of Agricultural Lending During Economic Cycles. It’s a good summary of many items to consider in the management of your ag portfolio and I recommend you taking a few minutes to read it.

In our loan review practice we have many clients that have a reasonable exposure to agriculture, including agribusiness. We’ve seen a decline in the cash flow generated by these borrowers as the ag sector declined from the historic highs of a few years ago. Over the last two years, we have seen this sector stabilize as most producers have been able to make adjustments to their operation and, while not back to the same levels of profitability, reach a level of acceptable cash flow. For many it has been a case of reducing expenses not only for crop inputs, but also cutting family living. For some that were over-leveraged, we have seen the sale of land (or sale-leaseback) that has brought debt service in line with today’s cash flow or a slowing of capital expenditures. We’ve seen many instances where debt was refinanced to a longer term to bring payments in line with cash flow. However, even with the vast majority of borrowers making adjustments, we have seen more classified ag credits and increased non-performing loans. This has typically been due to high leverage or not being able to make the tough decisions needed to operate successfully today. Management skills are near the top of the list for success in agriculture today.
Based on what we have seen in our reviews of our ag clients and our own experience managing ag portfolios, the following is our list of “best practices” for 2020:

  • Have all the information needed to make an informed credit decision at renewal, including:
    • A complete financial statement with detailed schedules. Take the time to review this with your borrower and ask if they have any other bills, such as payables to input providers or loans from family or friends.
      • For more complex borrowers that may have various partnerships or corporate entities that make up the farming operation, make sure you have financial information for each of the entities, not just the one you may be financing. You need a global financial statement, as well as a global cash flow.
      • Ask about actual ownership of assets. Some assets may be owned by a trust; if so, consider making the trust a co-borrower or guarantor.
      • Have your borrower complete the financial statement as of 12/31 each year. You’ll need this to make accurate accrual adjustments when used with the tax return.
    • A credit report on all individuals that sign personally. Use this report to check for levels of personal debt and compare this report to past years to see if personal debt is increasing or decreasing.
    • A new UCC search. Use this to see if there are other secured lenders.
    • Estimated Costs. If you are getting a cash flow from the borrower to support an operating line, compare the estimated costs to historical costs. We see a lot of borrowers that underestimate their actual costs.
      • Government payments have been a big part of some farms’ cash flow. It is important to understand the impact of those payments on an operation. Consider what happens if the Market Facilitation Program is not extended in 2020.
      • Obtain a basic stress test on the borrower’s cash flow. If small changes in revenue or expenses will bring cash flow below break-even, do understand the level of crop insurance, any hedging program, and have a “Plan B” discussed with those in the operation regarding how they will get through if things are tough. It’s a lot easier to have that conversation about selling some land now than when payments are due in the fall if things don’t go as planned.
    • Cash Flow for New Debt Structure. If you’re going to restructure debt, make sure the operation can cash flow the new debt structure. If it can, great; you probably have a pass loan (or will be soon). If not, then you probably have a classified loan.
    • Trends. Trends matter. What direction are leverage, liquidity, and cash flow going?
    • Working Capital. Working capital is your real secondary source of repayment. If working capital is strong, that will cover an off year and not require a restructure or asset sale.
    • Future Plans. Ask about the plans for 2020, including any capital expenditures (for your good borrowers, don’t forget to pre-approve them for these loans); their marketing plans; and any changes in expenses from the prior year.
  • Know your portfolio:
    • Track risk rating changes for the portfolio. What is the direction of your average risk rating?
    • Stress test your portfolio. Develop moderate and high stress scenarios. Stress revenue, expenses, and collateral values. Understand the impact of moderate and high stress on your capital. (Young & Associates, Inc. can work with you to provide a stress test of your ag or CRE portfolio.)
  • Be proactive:
    • Don’t put off those farm visits. You’ll learn far more about your borrowers’ operation, their concerns, and what they most enjoy by spending a few hours with them at the farm than you ever will just talking in your office, making phone calls, and sending emails or text messages. Document those visits and take pictures for the file. Some banks list all farms they need to visit, estimate when the visit will take place, and track their progress each month.
    • Ask your borrower what information they monitor to manage the farm. You’d be surprised how many operators have a lot more information than they share with you. It’s almost never that they are holding information back as much as it is we haven’t asked.
    • Develop an exit plan if needed. If you have a struggling operation and there doesn’t appear to be a good way to turn it around, you need to have that tough conversation with the borrower about how you will get repaid sooner rather than later. Having a well-planned, cooperative exit plan is almost always in everyone’s best interest.
  • Know that best practices are not for every borrower:
    • Having more information than less is always best, but sometimes we have those very strong, long-time borrowers that provide minimal information. If every indication says the operation is strong, then sometimes you can get by with more limited information. But, in those cases, spell out in your loan presentation what you are not getting and why that does not pose a risk to the bank.

Need Assistance?
Please feel free to reach out to us if we can help you with your loan review, stress testing, or other aspects of your lending operation that you’d like to improve. Our lending team is made up of well-experienced bankers that provide you with realistic solutions. For more information, you can contact me at bviering@younginc.com or 330.422.3476.

Connect with a Consultant

Contact us to learn more about our consulting services and how we can add value to your financial institution

Ask a Question