CREDIT ISSUES 2012

Credit issues continue to evolve as our industry’s credit quality improves. We are transitioning from workouts and non-performing asset management to other, sometimes equally difficult, issues.

1. What is a TDR?

The answer depends on who you ask. Most investors equate TDRs to NPAs, even if they are current and have been so since day one. The regulators prefer to use a somewhat amorphous definition – a loans turns into a troubled debt with the first sign of possible loss. The accountants are harsher in their definition, focusing on two indicators: market rate and financial distress.

The problem with the accountants’ focus is the largely judgmental nature of their indicators. For example, how can you prove that your borrower received market rate when there is no market for their loan, i.e. they can’t refinance elsewhere? Current rules indicate one must prove that the customer couldn’t get a better rate even at the time of renewal, a tricky projection at best.

Plus, if you raise the borrowing rate to market rate, it could still be considered a concession, which immediately turns the loan into a TDR.

One answer is to develop a clear and precise definition of TDRs that you will apply to your entire portfolio. This, in turn, will mean that some performing loans will be classified as TDRs…

The second important TDR indicator is financial distress. Substandard loans are, by definition, in financial distress, and therefore all substandard loans need to be tested for TDR status. A good benchmark rate for “market rate” for substandard loans tested for TDR status is the average borrowing rate of all your substandard loans. There is simple logic in this methodology.

Last, if the present value of the remaining cash flow on the loan is less than the original note, then the note is permanently impaired and the loan classified as a TDR.

2. Global cash flow

Calculating global cash flow (GCF) correctly is essential for a clean regulatory exam, yet many a commercial banker is confused by the correct calculation, and many a borrower can’t or won’t produce the data necessary for such a calculation.

Whose cash flow should you calculate? The borrowers’ as well as all obligated entities, including guarantors, on whose cash flow you are relying as a source of repayment. All unrelated debt service must be included in the calculation, as well as realistic living expenses (25% of the income is a good minimum). It is also important to study clauses on other projects and debt obligations of the cash flowing entities since they do impact their ability to repay the loan.

One portfolio that presents particular challenges for GCF calculations is franchisees, a growing borrowing segment for many banks. They typically have multiple entities and management companies, and the examiners are concerned about the weak sisters in their portfolio of loans and franchises.

3. New production pressure.

The pressure to grow loans is intensifying as rates remain painfully low and extending the maturity of the investment portfolio present unacceptable interest rate risk. Some considerations as loan growth picks up include:

·     Impact on allowance for loan losses

·     Pressure on relaxing concentration limits or hold levels for individual customers that should be resisted, since concentrations were at the root of many banks’ credit woes. Concentration limits should be set across several variables:

o By state

o By industry (e.g. wholesale, manufacturing, construction etc.)

o By originator (set limits on broker-sourced deals for each portfolio and on participations, including shared national credits)

o By market (only in footprint?)

o By type (to ensure a balanced portfolio)

o By both percent of capital and percent of total loans

o By growth rate per loan type (e.g. growth over 5% annually raises a yellow flag, over 10% a red flag)

o By percent of each asset class in special mention or worse category

o By related risk to other industries if appropriate (e.g. exposure to gas prices)

o By development anchor (e.g. Wal-Mart, Starbucks etc.)

Concentration limits compel your relationship managers to diversify themselves and look beyond their current portfolio.

Link your concentration limits to your risk appetite statement and your corporate strategy.

·     Remember: What grows like a weed must be a weed.

·     Incentives are shifting back from deposits to loans. Make sure past mistakes are not repeated by:

o Including cross-sell expectations

o Requiring portfolio granularity (no elephant hunting)

o Managing the loan-to-deposit ratio of the entire portfolio

o Extending payouts over a 2-3 year period

Loan growth is a cornerstone of community banking and will continue to be for the foreseeable future. Unfortunately, we have today too many dollars chasing too few credit-worthy loans, resulting in rate wars and covenant concessions all too reminiscent of 2007. Using credit policy and approach to ensure strong balance sheet growth and a diversified income stream is a difficult but worthwhile goal.