COMMERCIAL LOAN AUDITING
FOR INTERNAL AUDITORS
June 15, 2011
Presented by:
Robin D. Hoag, CPA, CMC
Robert M. Parks, CPA
Objectives & Overview
Solid Understanding of MBL’s
 Trends in Commercial Lending - MBL’s
 Regulatory Consideration
 Risk Management Implications
 Basic Underwriting Criteria
 MBL Audit Programs

2
Objectives & Overview
Commercial loan workout arrangements
 Risk rating commercial loans
 Internal controls
 Resources
 Internal Audit Roles

3
Total Business Loans (NMBLB) 1
Total Del Loans - All Types (2 or more Mo)
*Total MBL Charge Offs
BUSINESS LOANS
Member Business Loans (NMBLB) 1
Purchased Business Loans or Participations to
Nonmembers (NMBLB) 1
Total MBL's
Unfunded Commitments 1
TOTAL BUSINESS LOANS (NMBLB) LESS
UNFUNDED COMMITMENTS 1
%(Total Business Loans (NMBLB) Less Unfunded
Commitments/ Total Assets) 1
DELINQUENCY - MEMBER BUSINESS LOANS
1 to < 2 Months Delinquent
2 to < 6 Months Delinquent
6 to 12 Months Delinquent
12 Months & Over Delinquent
MBL Delinquency
MBL CHARGE-OFFS AND RECOVERIES:
MBL Charge-offs
*Total MBL Recoveries
Data for Graphic
Billions
Total MBL's
MBL Delinqucny %
MBL Charge-off %
2006
2007
2008
2009
2010
18,891,446,077
21,459,363,443
25,531,770,716
28,279,415,320
30,413,271,788
3,915,871,018
22,807,317,095
1,938,867,620
4,929,242,985
26,388,606,428
1,852,703,145
6,360,143,424
31,891,914,140
1,701,806,459
6,789,563,211
35,068,978,531
1,612,294,689
6,765,768,251
37,179,040,039
1,593,523,144
20,868,449,475
24,535,903,283
30,190,107,681
33,456,683,842
35,585,516,895
2.93
3.25
3.72
3.78
3.89
129,438,460
71,522,982
25,771,636
12,602,739
109,897,357
207,709,817
229,183,178
179,446,067
49,100,897
457,730,142
387,226,608
409,178,047
149,168,321
125,981,018
684,327,386
537,092,843
596,008,756
363,045,974
292,012,289
1,251,067,019
579,835,938
592,237,431
383,528,489
420,137,828
1,395,903,748
25,269,178
4,709,215
37,922,077
3,482,536
131,876,705
7,065,554
223,995,934
6,544,607
289,271,389
7,394,203
22.81
0.48%
0.11%
26.39
1.73%
0.14%
31.89
2.15%
0.41%
35.07
3.57%
0.64%
37.18
3.75%
0.78%
Regulatory Considerations
Policy – Board Reviewed and Approved
 Experience in commercial lending - MBL
 Loan Limits
 Capital Limitations
 Concentration risk
 Credit Risk
 Insiders

Member Business Loans
Proceeds used for commercial, corporate,
investment, agricultural purposes
 Balances aggregated to member exceed
$50,000
 Participation loans, or purchased loans with
the same origin from another credit union

Regulatory Considerations

Prohibited transactions for MBL’s
 CEO,
COO, CFO, senior executives
 Family members of the above
 Loans in which the credit union will share profits
of the sale
 Loans to compensated directors
Regulatory Considerations

Construction and Development Loans for
Commercial or Residential Property
 Limitation
of 15% of net worth
 Single family residences by individual with 25%
equity interest are allowed
Regulatory Considerations



Policies – Written to manage the risk and loan
types granted, board approved and annually
reviewed
NCUA Supervisory Letter: 2009 Current Risks in
Business Lending and Sound Risk Management
Practices – A Must Read
Underwriting and MBL experience required -Two
(2) years experience by your commercial lender
at a minimum in the type of loans being
approved and underwritten
MBL Policy - Regulatory

Minimums Required
 Trade
areas, geography – knowledge of value
 Types of business loans to be offered
 Limitations in terms of MBL to assets and net
worth; individual types and aggregate
 Individual member limits or concentrations
Regulatory Considerations

Analyze and Document borrowers ability to
repay the loan; Underwriting
 Financial
Statements, borrower history & credit
 Cash flow, interest rates, maturity structure
 Tax returns
 Collateral valuation
 Ownership
 Loan monitoring and servicing
Collateral and Security - Reg
Maximum LTV is 80%, unless a government
guaranteed, insured or PMI type insurance, or
subject to advance purchase by a federal or
state agency.
 With guarantee the maximum is 95%
 Must provided personal guarantee of the
borrower (except is Reg flex qualified)

Maximum Loans – Reg. 723.7

Net member business loan maximum
 One
member or group of associated members
Greater of these two values below
 15% of net worth or
 $100,000


Unsecured MBL limitations
 Must
be Well Capitalized
 Lesser of $100,000 or 2.5% of net worth

Maximum of all unsecured borrowers 10% of net
worth; non-natural person credit card members
for routine purchasing????
MBL Maximum Exposure
Lesser of 1.75 times credit union net worth or
 12.25% of credit union total assets
 Aggregate limitation will include nonmember
loan participation balances outstanding

State MBL Regualtions

Ten states have approved MBL regulations.
COMMERCIAL LOAN UNDERWRITING
17
Credit Worthiness
Credit worthiness for the business and
sponsor/guarantors is heavily scrutinized
 Loans get paid somehow
 Start-up businesses

 Risk,

collateral, management
Owner-occupied property
18
Include Five Cs of Credit (P)
Character
 Purpose
 Capacity
 Conditions
 Capital
 Collateral

Basics of Commercial
Underwriting
Cash flow analysis
 Loan to value (LTV)
 Credit worthiness
 Property / collateral analysis
 Secondary guarantees
 Loan structure and covenants

20
Essential Component Details
Character
Purpose
Capacity
Conditions
Capital
Collateral
Identify participants
Reasons for transaction & client benefit
Revenues, earning & cash flow – primary
source of repayment
Industry trend & analysis, market position,
SWOT analysis
Equity, sub-debt & retained earnings
Type, quality, & coverage (value) –
secondary source of repayment
Capacity Section Overview
Perhaps the most important issue
 Explain:

 What
is borrower’s capacity to bear burden of
proposed debt while still making necessary
investments to remain competitive and or viable?
Cash Flow Analysis
Most important component
 Debt service coverage (DSC) ratio
 Minimum requirements
 Riskier loan types

23
Capacity Components




Revenue stability & growth
Margin protection – Gross Margin/Sales Less:
COGS Cost of Goods Sold
Cash flow
Fixed charge coverage
 What
is the hurdle?
 What is pro forma (forecast or projected)coverage?
 How much cushion is implied
 Perform a sensitivity analysis
Cash Flow/Fixed Charge
Analysis
Fixed Charge Coverage Ratio (FCCR)
EBITDA / P+I+T+C+D
 Forward looking analysis

 Can
they repay the proposed debt?
 NOT a historical review of the performance, cash
flows or loan structure covenants
Conditions

General
 Define

Specific
 Assess

the industry
the industry
Market position
 Client
specific
General Industry Conditions

Define and industry – General
 Cyclical
or Seasonal
 Where are they now?
 Growth,
mature, declining, consolidating
 Competitive threats
 Legislative or political threats
Specific Industry Conditions

Assess the industry – Specific
 Barriers
to entry
 Competition
 Customers
 Suppliers
 Substitutes
Market Position Conditions

Market Position – Client Specific
 Market
share
 Leader / follower
 RMA statistics (resource & reference in materials)
 SWOT analysis
 Strengths
 Weaknesses
 Opportunities
 Threats
Capital
Member’s “skin in the game”

Owner’s investment in the business
 Paid
in capital/Other equity
 Retained earnings

Cushion to withstand disruption
Capital Measurements

Minimum net worth (tangible NW)
 Dollar

Capital to capitalization
 Equity


/ (FD + equity)
Debt to equity
Debt to enterprise value
 (FD

/ (funded debt + equity)
Debt to capitalization
 FD

value
/ (FD + market value equity)
Debt to EBITDA
Collateral
Secondary source of repayment
 Specify what secures the loan
 Identify any competing claims
 Summarize important aspects

What is the primary collateral?
 Quality of collateral (specialized, sing purpose, or
active market)
 Coverage rate or air ball percentage
 Recovery costs and expectations

Collateral Summary
Collateral Analysis
Example Company
($ in thousands)
Actual
12/31/10
Accounts Receivable
Inventory
ST Assets Collateral
$ 33,828
$ 33,828
-
Property, Plant, & Equipment - NBV
LT Asset Collateral
$ 20,885
$ 20,885
-
Ineligible/
Foreign
Eligible
Domestic
$
75.0%
30.0%
$
33,828
33,828
$
$
20,885
20,885
50.0%
Total ST Collateral
Total LT Collateral
Total Collateral
Senior Debt
Revolving Credit ($55.0MM)
Letters of Credit
Senior Term Loan
Total Long Term Debt
Advance
Rate
Commitment
$
55,000
$
$
60,450
115,450
Discounted
Value
$
$
25,371
25,371
$
$
10,443
10,443
$
$
$
25,371
10,443
35,814
Outstanding
$
1,536
$
17,226
$
60,450
$
79,212
Total Discounted Collateral
$
35,814
Total Collateral Surplus/ (Deficit) - Outstanding
Airball Percentage - Outstanding
Collateral / Total Outstanding
$
(43,398)
54.8%
0.45 x
Total Collateral Surplus / (Deficit) - Commitment
Airball Percentage - Outstanding
Collateral / Total Outstanding
$
(79,637)
69.0%
0.31 x
Loan to Value (LTV)
LTV ratio
Loan Amount / Appraised Value = LTV
 Key risk factor
 Valuation of property
 Maximum LTV ratio
 Property types influence LTV

34
Property / Collateral Analysis





Property or collateral analysis is the valuation of
assets pledged against a loan
Fair market value
Investment property collateral
Non real estate collateral
Forced sale of collateral
35
Internal Controls

Separation of functions is critical
 Credit
and Underwriting
 Approval Process
 Sales and Relationship Management
 Collections and Workout Actions
RISK RATING COMMERCIAL LOANS
37
Loan Risk Rating System




Primary indicator of credit exposure
Used for a variety of purposes
 Approval requirements
 Portfolio management
 Identifying problem loans
 Loan pricing
 Loan loss reserve calculations
An important element
No one correct rating system
38
Structure of Rating System
Four minimum categories
1. Pass
2. Substandard
3. Doubtful
4. Loss
 Additional categories
1. Watch list
2. Special mention

39
Pass ratings

At least three categories
1. Exception Risk
 Unquestioned primary source of loan repayment; no
apparent risk
2. Very Good or Good Quality
 Primary source of repayment very likely to be
sufficient, with secondary sources readily available;
strong financial position; minimal risk; profitability,
liquidity and capitalization are better than industry
norms
40
Pass ratings

At least three categories
3. Acceptable or Standard
 Primary source of loan repayment is satisfactory,
with secondary sources very likely to be realized if
necessary; loan within normal credit standards;
requires average amount of Loan Officer attention;
company is of average size within its industry and
may have difficulty accessing or does not have
access to public markets for short term or capital
needs
41
Marginal Rating


Risk rating systems should have a transitory or
marginal risk rating classification
A credit union should have at least one of the
following categories:
 Watch List

Loans having potential weaknesses that deserve
management’s attention; these loans don’t go on
the special mention list. Not adversely classified
and don’t expose an institution to significant risk.
42
Marginal Rating

A credit union should have at least one of the
following categories:
 Special Mention

Special mention loans are commercial loans
needing close operating attention or action to
mitigate possible weakness. These commercial
loans have emerging identifiable problems.
43
Adversely Classified
Risk Ratings
Loans with some impairment
 Fall into three categories

1. Substandard (least severe)

Defined weaknesses or negative trends meriting close
monitoring
2. Doubtful

Vital weaknesses exist where collection of principal is
highly questionable
3. Loss (most severe)

Uncollectible and of such little value the continuance
as an asset is not warranted
44
Substandard Definition




Asset inadequately protected by the current sound
worth and paying capacity of the obligor or by the
collateral pledged, if any.
Assets so classified must have well-defined
weakness or weaknesses that jeopardize the
liquidation of the debt.
Categorized by the distinct possibility that the
institution will sustain some loss if the deficiencies
are not corrected.
Non-Interest accrual status has been attained
45
Doubtful Definition

An asset having all the weaknesses inherent in one
classified substandard with the added characteristic
that the weaknesses make collection or liquidation
in full, on the basis of currently known facts,
conditions, and values, highly questionable and
improbable.
46
Loss Definition


Asset is considered uncollectible and of such little
value that its continuance on the books is not
warranted.
This classification does not mean the asset has
absolutely no recovery or salvage value; rather it is
not practical or desirable to defer writing off this
basically worthless asset even though partial
recovery may be affected in the future.
47
Risk Rating Example

Resource MBL Risk Rating Example Document
Key Points
When are ratings assigned?
 How often are ratings reviewed?
 Segregation
 Examiners

49
MBL AUDIT PROGRAMS & SCOPE
CONSIDERATIONS FOR INTERNAL AUDIT
See Handout Materials
MBL Audit Workpapers
ACCT #
MEMBER
NAME
LOAN
O/S
DATE
BALANCE
UNFUNDED
PRESENT
COMMITMENT
INT.
PMT
RATE
TERM
LOAN
COLL.
CREDIT
TYPE
TYPE
SCORE
DSC
RISK RATING
LTV
CU
DM
LOAN
LOAN
INSIDER OFFICER CLOSER
Member Business Loans
1234-1
Company A
10/28/2009
675,000.00
-
675,000.00
5,233.27
7.00%
60 CREM
Apartments
795/767
1.39x 69.6%
2
2
N
RDH
Title Co.
1234-2
Company B
06/10/2009
945,485.53
-
945,485.53
8,362.63
6.50%
60 CREM
Restaurant
784/744
1.40x 59.1%
2
2
N
RDH
Title Co.
1234-3
Company C
06/17/2009
1,042,071.30
-
1,042,071.30
7,891.63
6.50%
60 CREM
Retail
753
1.55x 56.9%
2
2
N
RDH
Title Co.
1234-4
Company D
12/10/2008
937,275.44
-
937,275.44
6,563.66
6.75%
84 CREM
Church
n/a
2.88x 30.1%
2
2
N
RDH
Title Co.
1234-5
Company E
02/04/2009
803,074.93
-
803,074.93
7,141.36
6.40%
84 CREM
Retail
808/791
2.46x 38.1%
1
1
N
RDH
Title Co.
1234-6
Company F
08/06/2009
889,345.84
-
889,345.84
10,377.62
6.75%
60 CREM Grocery Store
798/640
1.59x 66.1%
2
2
N
RDH
Title Co.
1234-7
Company G
09/11/2009
2,650,000.00
-
2,650,000.00
20,545.42
7.00%
120 CREM
Retail
716/755
2.13x 48.2%
1
1
N
RDH
Title Co.
1234-8
Company H
03/27/2009
2,097,862.03
-
2,097,862.03
14,424.11
6.50%
60 CREM
Apartments
677
1.35x 79.2%
2
2
N
RDH
CUSO
1234-9
Company I
10/19/2009
120,000.00
-
120,000.00
1,051.76
6.50%
60 CREM
Apartments
772/772
1.59x 40.3%
2
2
N
RDH
Title Co.
1234-10
Company J
08/20/2009
4,034,489.30
-
4,034,489.30
28,234.08
6.75%
60 CREM
Retail
735/727
1.25x 73.6%
2
2
N
RDH
Title Co.
1234-11
Company K
05/13/2009
145,438.21
-
145,438.21
1,747.05
7.00%
60 CREM
Office
672/700
2.45x 55.9%
3
3
N
RDH
CU
1234-12
Company L
09/21/2009
100,000.00
Int. Only
6.75%
12
Gas Station
751/786
1.70x 52.8%
3
3
N
RDH
CU
1234-13
Company M
04/27/2009
708,239.22
708,239.22
4,751.44
6.25%
Restaurant
591/598
1.45x 79.2%
3
3
N
RDH
CU
1234-14
Company N
09/02/2009
45,000.00
350,000.00
Int. Only
7.00%
All Assets
787/704
n/a
2
2
N
RDH
CU
1234-15
Company O
08/12/2009
142,277.05
142,277.05
1,137.82
7.25%
Bar/Tavern
672/795
3.12x 79.2%
2
2
N
RDH
Title Co.
-
100,000
305,000
-
LOC
180 CREM
12
LOC
120 CREM
14.09x
Credit Report
Approval
Collateral/Mortgage Agreement
Commercial Loan Agreement
Guarantees
Evidence of Lien Placement
Title Policy / Search
Monitoring of Real Estate Taxes
Evidence of Insurance
Review and Analysis of Borrower's Cash Flow
Review and Analysis of Borrower's Leverage
Review and Analysis of Guarantors' F/S
Debt Service Ratio Calculation
Loan-to-Value (LTV)
Financial Statement Monitoring
Loan Covenant Monitoring
Underwriter's Recommendation
Strengths and Weaknesses Identified
Policy Exception Indentified
Appraisal/Collateral Valuation
Environmental Quest. / Phase 1
Risk Rating
Specific Loan Loss Reserves
ACCT #
POLICY, RISK, & PROCEDURES
Note
EXISTENCE
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
Member Business Loans
1234-1
x
x
x
x na
x
t
t
na
x
x
x
x
x
x
x
x
x
x
na
x
x
x
na
1234-2
x
x
x
x na
x
x
x
na
x
x
x
x
x
x
x
x
x
x
na
x
x
x
na
1234-3
x
x
x
x
x
x
x
na
x
x
x
x
x
x
x
x
x
x
na
x
x
x
na
1234-4
x
na
x
x na
na
x
x
na
x
x
x
na
x
x
x
x
x
x
na
x
x
x
na
1234-5
x
x
x
x na
x
x
x
na
x
x
x
x
x
x
x
x
x
x
na
x
x
x
na
1234-6
x
x
x
x
x
x
e1
na
x
x
x
x
x
x
x
x
x
x
na
x
x
x
na
1234-7
x
x
x
x na
x
x
x
na
x
x
x
x
x
x
x
x
x
x
na
x
x
x
na
1234-8
x
x
x
x
x
x
x
x
na
x
x
na
x
x
x
x
x
x
x
na
x
x
x
na
1234-9
x
x
x
x
x
x
t
t
na
x
x
x
x
x
x
x
x
x
x
na
x
x
x
na
1234-10
x
x
x
x
x
x
e1
e1
na
x
x
na
x
x
x
x
x
x
x
na
x
x
x
na
1234-11
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
na
x
x
x
na
1234-12
x
x
x
x
x
na
t
t
na
x
x
x
na
x
x
x
x
x
x
na
x
x
x
na
1234-13
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
na
x
x
x
na
1234-14
x
x
x
x
x
x
x
na
na
na
x
x
x
x
na
x
na
x
x
na
x
na
x
na
1234-15
x
x
x
x
x
x
x
e1
na
x
x
x
x
x
x
x
x
x
x
na
x
x
x
na
x
x
Legend
x
e1
e2
ew
na
Tested without exception
Procedure and Process Exception
Best Practice Exception
Exception waived by authorized personnel
Not applicable
ACCT #
COMMENTS
Member Business Loans
1234-1
1.20x DSC Covenant
1234-2
1.20x DSC Covenant
1234-3
1.20x DSC Covenant
1234-4
1.20x DSC Covenant
1234-5
1.20x DSC Covenant; 15 yr amort - DSC = 3.19x with 25 yr amort
1234-6
1.20x DSC Covenant; no final title policy
1234-7
1.20x DSC Covenant; 100% Occupancy
1234-8
1.20x DSC Covenant; 100% Occupancy
1234-9
1.20x DSC Covenant; 100% Occupancy
1234-10
1.25x DSC Covenant; 100% Occupancy - a 5% vacancy factor was included; no recorded mortgage and final title policy
1234-11
1.20x DSC Covenant; two quarterly loan reviews in file.
1234-12
1.20x DSC Covenant (for CREM)
1234-13
1.20x DSC Covenant; two quarterly loan reviews in file.
1234-14
Partically secured by securites at brok er/dealer ($285thd @5/31/09)
1234-15
1.20x DSC Covenant; no final title policy; LTV includes a $104thd SBA loan, without SBS LTV is under 50%
Existence Assertion Testing
Trace loan amount, date, payment, interest
rate, and type from loan subsidiary system to
loan note.
 Examine current credit report. If lender uses
risk-based underwriting and/or pricing
system, vouch credit score/grade to credit
report.
 Examine documented approval within loan
policy limits.

Policy, Risk & Procedures Testing

Trace loan amount, date payment, interest rate and type from
loan subsidiary system to executed collateral documents

Trace loan covenant and financial statement requirements to
executed business loan agreement
Trace guaranty amounts and type of guarantees from loan
approval document to executed guaranty documents


Review evidence of lien placement, such as UCC filing
statements, a recorded mortgage, or final title policy

Review final title policy; verify (1st Mtg.) or title search verify
(2nd Mtg.)

Review evidence that taxes are monitored and paid current
Policy, Risk & Procedures Testing

Review evidence of hazard insurance naming lender as beneficiary
for proper amount.

Examine approval/credit file to verify borrower's cash flow position
is reviewed and analyzed from the most recent F/S.

Examine approval/credit file to verify borrower's leverage position
is reviewed and analyzed from most recent F/S

Examined approval/credit file to verify guarantor’s recent F/S are
reviewed and analyzed

Verify DSC ratio was accurately calculated and within lender's
policy guideline

Verify LTV ratio is within lender's policy and supported by
acceptable invoice, sales receipt, or appraisal
Policy, Risk & Procedures Testing

Examine credit file for f/s monitoring

Examine credit file for covenant monitoring

Examine approval for underwriter's recommendation

Examine approval for deal's strengths and weaknesses

Examine approval for deal's policy exceptions

Examine appraisal; trace amount and valuation date to requirement
in the approval, such as if a new appraisal ordered prior to funding

Examine environmental due diligence

Verify loan is properly risk rated in accordance to institution’s risk
rating policy

Assess loan loss reserve for loan if there is a specific reserve
COMMERCIAL LOAN WORKOUT
ARRANGEMENTS
58
Elements for Loan Workouts
Manage workout activity
 Document financial condition
 Identify and track performance and risk
 Regulatory reporting
 Loan collection procedures
 Adherence to lending limits

59
Loan Workout Arrangements
Workouts can take many forms
 Should improve lender’s prospects for
repayment
 Need to analyze repayment capacity and
collateral
 Maximize recovery
 Credit unions should not be criticized

 Concessions
require ALLL recognition
60
Analyzing Repayment
Capacity
Primary focus of
examiner’s
 Borrower character
 Nature and degree of
protection
 Market conditions that
influence repayment
 Prospects for guarantor
support

61
Evaluating Guarantees




Guarantees may improve the prospects for
repayment
Financially responsible guarantor
 Financial capacity
 Adequate support for repayment
 Legally enforceable
Guarantor’s global financial condition
Willingness to fulfill all current and previous
obligations
62
Assessing Collateral
Ongoing procedure for monitoring value
 A new or updated appraisal or evaluation
 Market Value vs. Fair Value
 Current “as is” condition
 Use the market value conclusion
 What examiners will look at

63
FORECLOSED AND OREO MBL ASSETS
See Handout Materials
Cash Flow Analysis
Cash Flow Analysis
Cash Flow Analysis
Cash Flow Analysis
Cash Flow Analysis
2603 Augusta Drive
Suite 1100
Houston, Texas 77057
www.doeren.com
755 West Big Beaver Road
Suite 2300
Troy, Michigan 48084
Thank You!
Robin D. Hoag, CPA, CMC
Director, Financial Institutions Group
Phone: (248) 709-1270
Email : hoag@doeren.com
Robert Parks, CPA
Director, Financial Institutions Group
Office: (248) 244-3049
Cell : (248) 709-1046
Email : parks@doeren.com
Financial Institutions Group
Services



Audit
Mergers & consolidations
IT assurance

Controls reviews
 Vulnerability assessments
 Penetration testing



Commercial loan review
Loan loss & delinquency
control
Regulatory compliance
services
71
Resources
The Risk Management Association: Annual
Statement Studies – Financial Ratio
Bookmarks 2010/2011 (www.rmahq.org)
 Also: See reference materials at the back of
the NCUA Letter to Credit Unions
