Commercial and Industrial Lending:
Pitfalls and Risk Mitigants
Call the Fed Webinar - September 13, 2012
Kevin Cragholm, Senior Analyst
Dante Tosetti, Credit Risk Examination Specialist
Randy Santos, Senior Analyst
Adrienne Thompson, Examining Manager
Tim Marder, Examining Manager (Facilitator)
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
1
Portfolio Shifts to C&I Loans
“[T]o generate loan volume without increasing real estate
lending, many banks are now targeting growth in
commercial and industrial (C&I) loans,
. In fact, banks
have generally experienced higher loss rates on C&I loans
than on commercial real estate secured loans (excluding
construction loan losses), even through the crisis.
.”
Elizabeth A. Duke, Federal Reserve Board Governor
2012 Bank Presidents Seminar, CBA
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
2
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
3
1
• Market Dynamics
2
• Personnel Considerations
3
• Administration & Monitoring
4
• Remediation Framework
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
4
Competitive
Landscape
Borrower
Circumstances
Pricing
• How attractive is your C&I market?
• Are borrowers’ C&I needs underserved?
• How sensitive are borrowers to price?
Comparative
advantages
• Can you create (cross-sell) customers?
Success
Benchmarks
• How well is your C&I strategy working?
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
5
Personnel Considerations
Staff
Assessment
Resource
Allocation
Costs
• Skills
• Competencies
• Duration
• Training
• Recruiting
• Monetary
• Opportunity
• Transition
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
6
•
•
•
•
•
Risk analysis
Loan structuring
Documentation
Collateral perfection
Approval
Post-disbursement
•
•
•
•
•
Covenant compliance
Risk monitoring
Collateral verification
Loan review/audit
Reporting
Pre-disbursement
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
7
Detect
You want a robust capacity to detect problems early
Communicate
You want open, accurate communication with key decision-makers
Intervene
You want effective intervention to protect interests and minimize loss
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
8
Perspectives of C&I Underwriting
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
9
Perspectives of C&I Underwriting
Financial Analysis Isn’t
Enough to Bank on
Financial Analysis:
What is the number and is it good enough?
Credit Analysis:
Why is the number what it is?
ABA Banking Journal July 27, 2012
By Jeff Judy
www.JeffJudy.com
Is it a duck or a rabbit?
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
10
Perspectives of C&I Underwriting
Financial Analysis
•
Loan DSCR = 1.50x.
And
Credit Analysis
•
•
•
•
Young lady or old maid?
Does loan amortization match the
purpose?
Is a rate shock needed?
Will future capex become an issue?
Is subordinated debt included?
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
11
Perspectives of C&I Underwriting
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
12
Perspectives of C&I Underwriting
QUESTIONS ABOUT
EBITDA
Earnings
•
•
•
Are earnings seasonal like 70% of all businesses?
What is other income and will it be recurring?
If expenses have declined (amounts or margins),
why?
Interest
•
Are historical interest expenses similar to the
historical debt structure. If not, why not?
Taxes
•
Question: Which line is the longest?
Answer: They are all the same length.
Don’t add-back taxes. Use EBIDA.
Depreciation & Amortization
•
What are the economic lives of the assets?
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
13
Perspectives of C&I Underwriting
There are sources of
repayment within the balance
sheet.
UCA incorporates the
balance sheet.
Therefore…
Use UCA
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
14
Watch the Add Backs
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
15
Perspectives of C&I Underwriting
• Financial Analysis
versus Credit Analysis.
• Use UCA.
• Watch the add-backs.
Is it a vase or two faces?
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
16
Collateral Inspection Purpose
The field audit should be approached with the idea of
providing the lender with nonbiased, factual
information about custody, type, quantity, and
valuation of the collateral to make sound credit
decisions.
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
17
Collateral Inspection Staging
• New Relationship:
o Qualifying prospective borrower
• Existing Relationship:
o Assessing ongoing performance
• Exiting Relationship:
o Determining work-out strategy
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
18
Asset Based Lending Candidates
Categories
•
Profitable and Stable – Working Capital
•
Relationships with Cash Flow Problems
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
19
Asset Based Lending Candidates
(Continued)
Relationships with Cash Flow Problems
• Uncertain or unpredictable cash flow
• Inability to make agreed upon loan payments and past due trade creditor
payments
• Highly leveraged
• Unsustainable growth
• Diminishing sales without appropriate declines in costs
• Limited secondary sources of repayment
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
20
Collateral Audit Scope
•
Background
•
Shipping / performance test
•
Books & records
•
AR activity review
•
Key statistics
•
Cash application test
o
Turnover
•
Verifications
o
Dilution
•
Accounts payable
o
Past due
•
Payroll taxes
o
Concentrations
•
Borrowing base calculation
•
Inventory stages and locations
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
21
What to Look for in an Outsourced Report
•
Differences between auditor’s calculated values and those on the borrowing base
certificates submitted by the borrower.
•
The borrower should assist with the preparation of books and records. The auditor’s
function is to verify, not create, the information.
•
The worst field audits generate more questions than answers. Major issues should
always be brought to the attention of the borrower during the field examination.
•
If the major issue cannot be resolved on-site, it should be communicated to the lender.
This gives the lender the ability to terminate the transaction and avoid embarrassment as
well as incurring additional time and expense of a dead deal.
•
Completion time varies significantly based on the quality of the records, collateral, the
number of locations and companies involved. Nevertheless, a long delay can be
indicative of record keeping concerns with the borrower.
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
22
What to Look for in a Collateral Auditor
• The firm’s field auditors should all have solid accounting and audit backgrounds,
coupled with asset-based field exam experience in a multitude of industries.
Resumes are a good source for this information. Firm should be able to cite the
number of collateral audits they have performed by industry.
• Due diligence field audits should be the firm’s prominent source of business, not a
supplement to its core business or used as filler work.
• The firm must have staff at all levels with the proper interpersonal skills needed to
work effectively with the borrower.
• The firm should be viewed as an extension of your own bank/department.
• Solid references with sample audits and workpapers.
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
23
Collateral Auditor Search
•
Commercial Finance Association
•
The Secured Lender
•
The RMA Journal
•
CPA
•
Bankers
•
Appraisers
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
24
Credit Administration Highlights
C&I loans often have unique characteristics which require specialized
monitoring of financial performance, compliance with loan and financial
covenants, and processes to address findings from collateral audits or
inspections. Processing borrowing-base certificates and eligible
collateral can be labor intensive, and may require specialized skills to
ensure sound credit administration practices.
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
25
Ensure that all advance rates, sub-limits, financial covenants and
financial statements are accurately captured for on-going monitoring.
• Advance rates:
o Triggers: assuming advance rates are industry and borrower
appropriate at origination, under what circumstances could they be
decreased or increased (change in dilution, for example)
o Changes to advance rates: who is authorized to approve, who
monitors changes, and is there reporting of changes.
o Pitfalls: Loans or portfolios can take on additional risks and loans
may become more difficult (or impossible) to exit; management may
be unaware of increasing risk unless MIS is sufficient.
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
26
• Sub-limits:
o A/R and Inventory Structure: Ideally, A/R secures a larger portion of total
availability and loan amount, both through advance rates and dollar sublimits. (examples: advance rates of 80% for A/R, 40% of inventory; plus a
hard dollar or percentage limit on the amount of eligible inventory)
o Changes in sub-limits: Identifying who is authorized to make or approve
changes, or temporary “over-advances”.
o Systems capability: Systems may not be able to track sub-limits, and
compliance can be tracked only through the borrowing base. Manual
reporting or adjustments may be required.
o Pitfalls: Inadvertent overreliance on aging or obsolete inventory.
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
27
• Covenants (operating, financial or negative):
o Tracking: In accordance with loan documents, and in conjunction with
receipt of financial statements, may be tracked on a quarterly basis.
o Need a defined process to ensure that all covenants are initially identified
and tracked in a timely manner.
o Ensure compliance with any unique definitions or formulas as defined.
o May require a manual or custom form for tracking or documenting review.
o Tracking process should include periodic certification from the borrower that
they are in compliance with all covenants.
o Monitoring: Who monitors and ensures that internal covenant analysis is
current (tickler), that violations are cured within set time limits and noncompliance appropriately escalated.
o Waiver of covenants: If not enforcing or waiving a covenant, ensure rights
to enforce covenants are preserved (including written notification to
borrower)
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
28
The borrowing base needs to accurately reflect the loan terms:
• Accounts Receivable:
o Eligibility: Reconciles sales, credit memos, and payments/receipts, and
deducts ineligibles before applying advance rates. Common ineligibles:
o Delinquencies, as defined in loan documentation
o Contra-accounts/offsets
o Foreign accounts/government receivables
o Support: Define what you need to support each borrowing base; monthly
receivables output can be time consuming to process.
o Pitfalls:
o Delinquencies: ensure that loan terms specify due date or invoice date
eligibility, and that reporting from borrower matches
o Borrower Account List: Needs to be kept current; critical in a default.
o Reconciliation : Balance Sheet and Borrowing Base.
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
29
• Inventory:
o Sub-limits: common
o Define: Raw material, work-in-process vs. finished goods
o Ineligibles:
• Work-in-process (WIP)
• Raw material (or minimal advance rate)
• Obsolescence (reserves)
• Over-advances:
o Who approves and how are they reported to senior management.
o Policies and procedures need to define limits and approval authority.
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
30
Comments on administration of collateral audits, periodic valuations,
access to legal counsel and fraud.
• Administration of collateral audits:
o Policy/procedures: Define process and time frame for review and
corrective action by loan or relationship manager (how are the information
and exceptions handled and by whom.)
o Pitfalls: Failure to address identified deficiencies in a timely manner
(expiration of key man insurance, failure to pay taxes, other insurance,
additional debt, etc.)
• Collateral valuations (Orderly liquidation vs. forced liquidation values):
o Policy should define how often and under what circumstances
o Appraiser with relevant industry experience
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
31
• Legal counsel:
o May require specialized legal counsel with expertise in UCC laws, providing
guidance in securing assets and potentially work with lenders in Debtor-inPossession financing.
o My experience: need more readily available access to counsel for ABL issues
than I did with CRE. Processes may not be as well defined as CRE foreclosures,
for example.
o Most community banks do not have in-house counsel, which may slow processes if
problems arise.
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
32
• Fraud – beginning of a relationship and as borrower deteriorates
o Ensure financial statements and collateral are adequately validated at beginning of
relationship.
o Accounts Receivable: May quickly evaporate if borrower picks up checks directly
from customers as lender tries to notify customers and collect receivables
(diverting funds).
o Reporting non-existent receivables by creating false invoices
o Re-aging uncollected debts to increase eligibility
o Inventory: Overvaluing or double counting stock (“Empty box “ experiences,
equipment disappearing, risk from “routine” or predictable collateral inspections)
o ln contrast, land doesn’t move.
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
33
Contact the Speakers
• Kevin Cragholm, Senior Analyst
kevin.cragholm@sf.frb.org
• Dante Tosetti, Credit Risk Examination Specialist
dante.tosetti@sf.frb.org
• Randy Santos, Senior Analyst
randy.santos@sf.frb.org
• Adrienne Thompson, Examining Manager
adrienne.thompson@sf.frb.org
• Tim Marder, Examining Manager
tim.marder@sf.frb.org
The opinions expressed in this presentation are intended for
informational purposes, and are not formal opinions of, nor binding on,
the Federal Reserve Bank of San Francisco.
34