Key Elements of Effective Credit Underwriting

July 27, 2022

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

The focus of this article is to provide an overview of what Y&A Credit Services, LLC 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, LLC
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, LLC) to meet the needs of these organizations. Y&A Credit Services, LLC 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 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.

Get Our Insights

Connect with a consultant

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