Steve Brown, President & CEO, Pacific Coast Bankers' Bank/Bancshares Chairman, PCBB Capital Markets

02/2012

Note: This article is reprinted from the December 13, 2011 issue of Bank Investment Daily, published by Pacific Coast Capital Markets, a subsidiary of Pacific Coast Bankers’ Bancshares and an affiliate company of Pacific Coast Bankers’ Bank.

Community banks continue to be the backbone of small business lending and jobs opportunity in this country. If you were beginning to doubt that, or thought the bigger banks would eat your entire lunch box and all the food within it, consider a new survey by Biz2credit. Analysis of 1,000 loan applications found approval rates for small business financing requests were 45.1% for community banks, while rates for banks with assets above $10B were only 9.2%. Yes, you read that right – community banks approved 5x more small business loans than large banks on average. Since small businesses drive jobs growth, you can bet dollars-to-donuts that community banks are going to deliver the dough to make it that happen. Pat yourself on the back, high five around the branch and let customers know you are there for them, even when they get turned down by a larger bank. Community banks support small business and drive jobs growth – period.

That doesn’t mean you should rest on your laurels (by the way, this reference comes from ancient Greece, where laurel wreaths were symbols of victory worn around the heads of gods). Even if you don’t know what a laurel is, you know thumbing your nose at the largest banks for anything is about the same as thumbing your nose at your big brother – you might get away with it for awhile, but when they catch you alone you are in for a beating. The largest banks know community banks have a good business in small business and they have begun to ramp up their offerings. You only have to visit the websites of Wells Fargo, JP Morgan, Bank of America or others and you will find small business pitches are all the rage. Make no mistake, these larger banks are on the hunt in small business lending and they want to take the best customers from community banks. You might also want to take a look at all of the business you do with larger banks to see if you can move it somewhere else. Leaving money with them or doing business with them helps fuel your competition. Perhaps it is time to reconsider other options out there in 2012.

The large banks have really ramped up one area in particular and that is corporate mobile banking. These large banks are offering options to small business clients in this area to meet demand and because studies show small business owners want more time and convenience. Large banks see this as a relatively inexpensive way to capture these clients.

Take a look at JP Morgan for instance. They have a new iPhone/Android application that allows small business owners to view historical data on their accounts, view secure account information, project cash balances, get alerts when balance levels shift above or below certain levels and get detailed account information. This information is also available via an iPad or tablet, so it can truly go anywhere the customer goes. Next up, JP Morgan says they plan to add wire approvals, ACH item notification and multiple language navigation.

Wells Fargo on the other hand, seems to be trying to duplicate its online functions through these delivery channels. Business owners can key in wire transfers, ACH and other transactions, approve them and view pending transactions. Wells has also launched a mobile application that lets customers capture check and money order images and make remote deposits to their account. The Wells approach lets customers view a consolidated picture of all accounts; access transaction history for 18 months; track deposits; budget; have up to 25 people to view balances; get email alerts; set credit limits and download statements. Make no mistake; Wells Fargo and JP Morgan are chasing your small business customers and this is one area they are exploiting.

The good news is that you can still attack this large bank penetration point into your business. A study by Ponemon Institute finds that right now, only 21% of people feel protected from fraud when using mobile banking and 51% who have not yet used mobile banking say they don’t think it is safe enough. You can’t avoid this big bank push into your customers forever, but it is nice to know you still have time to explore options. Talk to your small business customers and let them know you too are open for business and ready to help.

For more information on this article, contact Steve Brown, President and CEO, Pacific Coast Bankers' Bank/Bancshares and Chairman, PCBB Capital Markets, at 1.877.777.0412.

Fran Samson, Consultant

06/2011

While there haven’t been recent changes in the Allowance for Loan and Lease Loss (ALLL) guidelines, the approach taken for the completion of the reserve analysis is taking a new face, prompted primarily by the added attention from banking regulators. This is true especially for those banks that have been experiencing an increase in problem credits.

Determining ALLL
Several years ago, the ALLL process was enhanced with the addition of environmental factors being used to determine the reasonableness of the bank’s potential losses. Historical losses were no longer the sole factor in establishing the required reserve for a portfolio. It would seem reasonable to take into account the effectiveness of the bank’s loan review system, the level of experience in the lending staff, and the local, state, and national economy (to name a few of the factors) to determine the appropriate levels of reserve.

With an analysis of the reserve calculation being carried out every quarter, the process appears to be improving in the majority of banks. However for the banks whose delinquency numbers are increasing along with the number of classified credits, the ALLL calculation has become more time-consuming with the completion of the FAS 114 calculation for impaired loans. In addition, these banks are also under a more watchful eye of the banking regulators. Accurate completion of the analysis is more important than ever. Banks are finding out how underestimating the reserve requirement can impact their capital position when examiners require the reserve to be amplified, with the additional funds coming directly from earnings immediately.

A loan is considered impaired when it is likely the lender will not collect the full value of the loan because the creditworthiness of a borrower has fallen. If the loan is considered impaired, the FAS 114 is completed on an individual basis.

To determine if a specific reserve is needed, the bank has three options to calculate whether the collateral coverage is sufficient:

• Present value of expected future cashflows
• Fair value of collateral (less cost to sell)
• Observable market price of the loan

In this writer’s banking experience, the observable market price is not typically used. Most small- and medium-sized community banks have opted to use the fair value of the collateral less the cost to maintain and liquidate the property. Recently however, banks are being asked by their regulator to calculate present value of expected future cashflows on some of their impaired credits; in the case of a loan classified as a Troubled Debt Restructure, the present value of expected future cashflows option is required to determine what the impact of the lower interest rate granted will have on the bank’s earnings.

It is likely the present value of expected future cashflows option was avoided, as the accounting calculation according to GAP looks very complicated. Therefore, banks opt to take a simpler approach by using the market value. However, if the market value is determined by discounting an older appraisal, it is likely that the examiner will require an updated appraisal.

If the loan is considered collateral dependent (the repayment of the loan is dependent on the liquidation of the collateral), the bank is required to use the fair value method in determining the adequacy of collateral coverage. Again, if the bank is using an older appraisal and applying a larger discount to the original value, it is likely to receive criticism from its regulator. The bank should obtain an updated appraisal to substantiate the collateral coverage assumptions.

Conclusion
The ALLL process is part of the bank’s risk management that requires the identification and monitoring of the level of risk in the credit portfolio. Reasonable assumptions, along with accurate processes, validate that the bank is being diligent in the assessment of potential losses. In addition, using a proper approach to ALLL will show that your bank is proactive in risk management.

Young & Associates, Inc. offers several products and services that address the ALLL. For more information on this article or on how we may assist you in this area, please contact us at 1.800.525.9775 or click here to send Fran an Email.

Mitchell Cohen, Esq., Loan Workout Consultant

03/2011

The fallout from the ongoing bank failures has continued into 2011. Facing mounting losses to its deposit insurance fund, the FDIC recently filed a series of lawsuits against bank officers and directors attempting to hold them personally liable for negligence and breach of duties that arguably led to the banks’ failure and resulting FDIC losses. In the last six months alone, the FDIC has initiated four so-called “Professional Liability Lawsuits” personally naming individual bank executives. These four suits are at the forefront of an expected wave of litigation coming on the heels of the recent financial crisis. With so many banks still in financial distress, bank executives can look to these cases as a roadmap on how they should conduct themselves to avoid being similarly named as a defendant in a future FDIC suit.

The cases demonstrate that the most dominant reason for the high number of bank failures are losses associated with commercial real estate (CRE) lending, particularly residential construction and land development. It should come as no surprise then that in determining which bank failures and which officers to pursue, FDIC is targeting banks that were overexposed to CRE lending concentrations without adequate measures to mitigate those risks. Examiners expect banking organizations to have in place effective policies, systems, and internal controls to monitor and manage concentration risk. Particularly with high CRE concentrations, where the principal source of repayment of the loan is collateral-dependent, an even greater level of scrutiny is required. The bank’s board of directors is responsible for evaluating the methods used by management to control and manage this risk. With collateral values a long way off from recovery and an estimated $1 trillion in CRE loans scheduled to mature over the next two years, boards of directors are scrambling to find ways to deal with underperforming and maturing loans. With so many options ranging from foreclosure, extend and pretend, forbearance, modification, troubled debt restructuring, re-capitalization, and more, it’s difficult to know which strategy to use when.

For those looking for ways to best protect themselves against future liability claims, be vigilant in your efforts to look for solutions to deal with problem CRE loan portfolios. Key lessons for bank executives are:

• Be proactive. Do not to wait until problems begin to spiral, but if and when they do, take aggressive action to mitigate risks.
• Be responsive. Respond to changes in market conditions and all regulatory criticisms.
• Be consistent. Have loan policies and administration procedures in place, and where exceptions are made, keep track.
• Document your efforts. Keep documentation of your efforts to deal with problem loan portfolios and your implementation of potential workout strategies.

Banks Fail: FDIC Losses Mount
The stock market over the past few quarters may be showing signs of an economic recovery, but the banking sector continues to face chal¬lenges in 2011. In the month of January alone, an additional eleven bank failures occurred, bringing the total number of failures since January 1, 2008, to 334 and counting. The FDIC reports that more than 800 other banks are listed as “problem institutions.” The financial impact of those failed institutions and anticipated additional losses to the FDIC are now estimated to exceed $50 billion dollars.

FDIC Goes On the Offensive
Facing critical Deposit Insurance Fund levels and exposures to losses, FDIC first attempted to stop the bleeding back in 2009 when it called upon the banks to prepay three years of FDIC insurance assessments totaling $46 billion. Now, with continued bank failures and exposures from loss share agreements, the FDIC is going on the offensive with aggressive pursuit of liability from individual bank directors and officers for failing to properly discharge their duties. In fact, according to FDIC records, as of January 18, 2011, the FDIC has already initiated lawsuits against 119 individuals for D&O liability with damage claims of approximately $2.5 billion.

More FDIC litigation is expected. With no end in sight to the bank failures, it’s certainly reasonable to expect the professional liability suits will continue. While many of those suits will settle before trial (frequently with proceeds funded from D&O insurance coverages) if the FDIC prevails, case precedent may send a chilling effect on directors’ and officers’ willingness to serve on bank boards and loan committees.

The Law
Under the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989, when a bank is closed, the FDIC immediately steps in the shoes of and acquires the rights of the failed institution as Receiver. Charged with the responsibility of recovering the losses suffered from the bank’s failure, the FDIC acquires a group of legal rights and privileges (sometimes called “Professional Liability Claims”), which includes claims for losses caused by the wrongful acts of directors and officers, among others, who provided service to the failed institution. Officers and directors serving on the bank’s board are subject to both federal and state statutory laws which impose certain duties such as the duty of care and loyalty. The federal statute 12 U.S.C. § 1821(k) permits the FDIC, as Receiver, to sue directors and officers for gross negligence, or for simple negligence if applicable state law allows. Variances in such state laws are beyond the scope of this article but it’s worth noting, under the common law, directors and officers are held to a higher common-law standard of care and loyalty than non-bank corporations on grounds that bank directors are in a trust or fiduciary relationship with bank depositors and shareholders.

Fortunately, there are defenses available and other steps that boards can take to shield themselves from liability. Bank directors are usually shielded from any personal liability by the “business judgment rule.” The business judgment rule generally requires directors to perform their duties in good faith, after reasonable inquiry and as an ordinarily prudent person in a like circumstance would. It provides that directors are entitled, as a matter of law, to rely on certain information prepared by others which may include reports from other bank officers, loan committees, or attorney opinions.

But there is a catch. While bank executives may rely on the recom¬mendations of others, such reliance is defensible only if that reliance was “reasonable.” In other words, it is not reasonable to rely on management after management has been severely criticized at prior exams and the board does nothing to make sure management has addressed the criticism. What is or may be reasonable is left to the courts and that takes time, sometimes years. The law provides that the FDIC, as Receiver, has up to three years to file for any tort claims and six years for breach of contract claims after a bank is closed. Waiting is not an option.

The Role of the Board in Problem Loan Workouts
Loan workouts have become an integral part of a bank’s ability to mitigate known risks. Countless numbers of financial institutions are currently undergoing the task of loan restructuring and determining how best to clean up their problem loans. How the bank’s board of directors deals with its distressed portfolios will impact both the banks survival and potentially the board members’ personal liability.

It no longer matters whether the decision to make the original loan was prudent. Discussing historical underwriting and blaming others for bad loans are time-consuming and counterproductive. Focusing on forward-looking corrective measures is what matters. The FDIC’s focus on the more serious mistakes shown by the four cases cited to glaring omissions and cover-ups that were made by bankers after the loans went into default. A bank’s failure to aggressively pursue various solutions will increase exposure to potential liabilities.

No two workout situations are alike, and no single strategy can be implemented for every workout situation. Every institution will have its own unique set of challenges when developing restructuring or workout plans: the culture and direction of the bank, the workload of individual officers, and the degree of supervision that a particular credit appropriately requires (which may be a product of the size of the credit, the nature of the default, and how the loan is classified on the bank’s books with its regulators). Every borrower will have its own unique factors at play, such as whether the borrower has a sustainable core business, the strength of management, cash flows, industry health, the value of collateral, and how any other credit guarantors or bankruptcies may affect the workout strategy.

Being a bank director is obviously much more than showing up for a monthly meeting. Typically, smaller community banks bring on directors because members bring a wide array of sophisticated business knowledge and insight. Some have extensive experience directly in the banking and financial services industry, others have their own businesses with particular industry knowledge, or may be close personal friends with knowledge of the borrower’s history and current financials. That kind of knowledge can be very valuable to identify problem loans early on in the process and to find solutions to offset risks from loan defaults. By using this information, a board member can and should take an active role in providing direction and leadership.

Hiring an Outside Consultant
Taking an active role, however, does not mean exerting any influence on the decision-making of borrower's business that may expose the bank to claims of lender liability. Finding the right balance can be tricky. It’s no surprise that lender liability claims only come in times of loan workouts. To avoid any such claims or assertions that could derail an otherwise possible successful workout, hiring an outside consultant is a worthwhile option for many banks, particularly where the bank may be understaffed, have conflicts of interest, or require expertise in evaluating and/or structuring the workout.

Hiring an outside consultant can maximize efficiency and success of the workout process. Many banks, particularly those without a special assets department, will often have the same originating loan officer continue to deal with the borrower even after major loan problems have been identified. This is problematic on two levels. First, this situation fails to provide much needed checks and balances. Consultants are objective and are able to avoid or neutralize prior “personal relationships.” Consultants also help existing loan officers avoid the embarrassment and the difficulty involved when a previously friendly relationship becomes adversarial. Secondly, the originating loan officer may not have the experience and knowledge necessary for the workout. Consultants add valuable depth to the negotiation strategies and skills in structuring the workout.

Experienced consultants are well-versed in the nuances of the October 2009 “Guidance on Prudent Loan Workouts,” which spelled out a variety of measures available to banks in structuring workouts, including troubled debt restructurings and A/B note structures. The Guidance also provided that, “Financial institutions that implement prudent loan workout arrangements after performing comprehensive reviews of borrowers’ financial conditions will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse credit classifications.” This is the reason for the absence of any failed workouts being the subject of the complaint allegations in the four professional liability cases discussed above. Bank boards can rely on the 2009 Guidance as a safe haven for exhausting efforts, including hiring outside consultants to assist with problem loan workouts. The role of the directors should be to act as advisors, set the policies, and direct the institution. When it comes to individual loan workouts, the directors should leave the detailed decision-making up to senior management. I frequently recommend establishing a minimum threshold dollar amount or risk exposure below which directors have only limited oversight, and anything above the threshold requires directors’ direct involvement. The key is to make sure loan policies and procedures are well-documented, reviewed at least annually, and remain flexible to adjust strategies to adapt to changes in market condition or other factors.

For those credits where the board is actively involved, directors should be vigilant in getting at least the minimum requirements needed for a workout, including full and comprehensive reports of borrowers, guarantors’ financials, current appraisals on collateral, and periodic reports on workout negotiations with the borrower. That is not to say that all information will always be available, as borrowers in distress frequently will refuse to provide current financials and reject a lender's attempts to obtain important project information. Loan workouts are only an option with a cooperative borrower and no concessions should be made where there is a refusal to cooperate. A lender’s only option in this scenario is simply to document all reasonable efforts attempted and then to pursue available remedies.

When negotiations are productive and it comes time for directors’ approval of any workouts, approval cannot be arbitrary and must demonstrate activity consistent with the banks goals and policies. Boards are well-advised to document all efforts to finding solutions, including notation in board minutes, correspondence, and communications with counsel or outside advisors.

Conclusion
These are difficult times for banks and lenders alike, particularly those that have a substantial market and history with concentrations in commercial real estate. Regulators are watching closely and as the cases demonstrate, they will pursue individual liability where bank directors and officers fail to take an active role in problem loan management. Loss mitigation efforts must be heavily documented, including needed updates to loan and workout policies and regular tracking efforts to workout problem loans. Banks with inadequate staffing levels, inexperienced lenders, and mounting regulatory pressures are well-advised to avail themselves of all available resources, including engaging independent and experienced advisors. Taking a proactive approach will afford banks the greatest chance for success in reducing losses, maximizing returns from problem loans, and afford directors and officers the greatest protection in defending future potential liability actions

03/2011

The Interagency Appraisal and Evaluation Guidelines was issued December 2010 and is now the working “framework” for appraisals and evaluations. The following guidance documents have been incorporated in the Guidelines and are now being rescinded: (1) the 1994 Interagency Appraisal and Evaluation Guidelines, (2) the 2003 Interagency Statement on Independent Appraisal and Evaluation Functions, and (3) the Interagency Statement on the 2006 Revisions to the Uniform Standards of Professional Appraisal Practice.

As part of this change, the Guidance has greatly enhanced the evaluation process and what is required for a bank to perform an internal evaluation. According to past guidance statements, banks were able to use tax cards or internal assumptions as part of their evaluation processes. While this appeared to be effective during times of stable and, in many cases, increasing real estate values, it is no longer an acceptable method of evaluating a property on its own merit. Banks are now required to perform a more in-depth analysis that helps to support the overall value of the evaluation. Based on the final Guidance, banks are required to go through a more extensive process in determining the value for their subject property.

Neighborhood Data
The beginning part of the evaluation process includes banks providing an overall description of the subject’s neighborhood and its local market conditions. This can include, but is not limited to, the local growth patterns, foreclosure rate, recent sales data, etc. The neighborhood support data should correlate and help support the final value conclusion (i.e., if the current market area shows a higher than normal foreclosure rate and/or a declining sales price, a higher than typical property value would not be warranted).

Property Inspection
Next in the overall evaluation process, the bank needs to perform an overall inspection of the property.

This is done by:

• Identifying the location of the property
• Providing a description of the property along with its current and projected use
• Showing an estimate of the property’s market value in its current condition

The evidence of a property inspection is to be completed by the preparer through the use of a detailed write-up combining the above points along with the identification of any limiting conditions that may have been used in determining the overall value. In addition, the preparer is to identify whether an internal or external inspection was used. The preparer will then support the overall type of inspection and condition of the property through the use of photographs of the subject property, taken on the date that the inspection was completed.

Supporting Data
The write-up, completed by the reviewer, should contain supporting documentation that includes a description of the type of analysis that was performed and any other information that was used by the preparer to determine the final value. This type of analysis can be, but is not limited to, the use of automated value models, additional analytical methods, or any other type of technological software. In addition, if the preparer uses any type of tax assessment data, comparable sales information, previous sales data, comparable sales, public tax records, etc., this needs to be identified and an explanation of how it was used and how it impacted the final value conclusion should be provided.

Signatures
All completed evaluations must include, at a minimum, information on the preparer when an evaluation is performed by a person, such as their name, contact information, and signature.

Conclusion
While banks have been using internal evaluations for a number of years, the requirements, as a result of the recent real estate crisis, have changed the way banks show their due diligence in evaluating real estate when using internal evaluations. This change in the requirements places additional responsibility on banks and their preparers to document and support what they feel is the most appropriate value of the subject real estate. Therefore, it is recommended that banks review and determine if their overall appraisal policy meets or exceeds the current regulatory requirements as described in final Guidelines issued December 2010.

For more information on this article, or to receive information on Young & Associates, Inc.’s customizable appraisal policy, please contact Young & Associates at 1.800.525.9775.

Wayne Linder, Senior Consultant

12/2010

According to a recent survey of community banks’ allowance methodologies for retail and commercial portfolios (“Allowance Best Practices Are Key in Troubled Credit Markets,” Kevin McLaughlin, The RMA Journal, February 2010), two concerns surfaced regarding perceived risk and expected loss as they related to reserves. Community bankers are concerned with how to convert perceived risks into percentages to use for reserve purposes. For example, is there a way to quantitatively put into the reserve the impact of unemployment rising from 8% to 9%? Would that automatically increase reserves by 5 basis points or 50 basis points? Regarding expected loss, how do you bring expected loss, versus realized loss, into a bank’s reserve setting? In this article, I hope to provide some insight into both of these issues.

Adjustments for Environmental Factors
The Interagency Policy Statement on Allowance for Loan and Lease Losses Methodology and Documentation (December 2006) allows either adjustment for environmental factors by each portfolio segment or the portfolio as a whole. Let’s establish a methodology using the portfolio as a whole instead of by each portfolio segment. After we feel comfortable with this approach, we can expand it by dividing the loan portfolio into segments and applying this approach to each segment.

Economic Indicators – Unemployment and Consumer Sentiment
The process of analyzing potential impairment in homogenous pools of loans should begin with the establishment of a base year for analyzing economic indicators, from which we will track changes from that time period forward to the present time. I have selected the year 2005 as a base year, as most community banks were operating in a fairly stable economic environment at that time. This was before the significant build-up of commercial real estate loans, spec homes, apartments, condos, etc.

Next, gather information which reflects economic conditions in your market. I suggest capturing historical information on two more common economic indicators, regional unemployment rate movements and consumer sentiment.

You can capture historical unemployment rates on a quarterly basis at the lowest level available on the internet. Since this is a lagging indicator, let’s also analyze a forward-looking indicator, consumer sentiment, utilizing the University of Michigan’s Consumer Sentiment Survey. The University of Michigan’s Consumer Sentiment Survey is used because it is free and can be obtained on the internet. This survey reflects near-time assessment of consumer attitudes on the business climate, personal finance and spending, and forecasts the economic expectations and the future spending behavior of the consumer. Again, capture the index numbers on a quarterly basis and save this information, along with the historical unemployment rates, in an Excel spreadsheet.

Historical Loan Information
The second step in the process is to capture historical loan information for your financial institution by using the institution’s Uniform Bank Performance Reports (UBPR). Capture the net losses as a percentage of average loans (historical loss rates), delinquency rates (30-89 days delinquency), and non-performing loan rates as a percentage of average loan volumes for the total loan portfolio. Again, save this information in an Excel spreadsheet.

Determining the Relationship Between Base Periods and Calendar Periods
Starting with the base year (2005), calculate the basis points change between the base period and calendar period (i.e., each calendar quarter) for each of the data points. Do this first for the two economic indicators. Then determine the average change using these two economic indicators. This will place equal weight on the lagging and forward projection indicators.

Next, calculate the basis points change between the base period and each calendar period for the total of delinquency rates and non-performing loan rates combined together as one number (delinquency).

The average change for the two economic indicators in the above example is 12.00. By dividing the change in delinquency by the average change of the economic indictors, we have a factor which we will use to adjust the ALLL environmental factor. In the example, this number is 0.94. In other words, the reserve portion for homogenous pools will be the historical loss percentage plus an adjustment of 94 basis points. This number will move in relation to the movement of the initial input data which is unemployment, consumer sentiment, delinquency, and non-performing loan rates. It is this relationship that the financial regulators want to see financial institutions utilize in the FAS 5 calculation.

Other Internal Indicators of Credit Risk Levels
There are several additional internal identifiers of credit risk that can become supporting documentation for the dollar amount assigned to the environmental factors. These internal risk indicators include trends in the stratification of assigned risk grades and/or credit scores, trends in the percentages of the dollar amount of loans originated with underwriting exceptions, trends in the aggregate dollar amount of unsecured loans, trends in the percentages of the dollar amount of HELOC loans extended compared to commitment, analysis of cure programs (extensions and renewals), etc.

The same process of starting from base-year position and comparing the change between that period and the current period will provide supporting documentation of the level of potential risk exposure, movement, and direction of change in risk levels. For example, start with the average weighted risk grade or percentage of outstanding loan balances with credit bureau score below 650 for the base year 2005. Compare the change between that period and the current period.

Bringing Expected Loss Versus Realized Loss into the Reserve
According to the Interagency Policy Statement (December 2006), the term "estimated credit losses" means an estimate of the current amount of loans that the institution will probably be unable to collect given facts and circumstances as of the evaluation date. Estimates of credit losses should reflect consideration of all significant factors that affect the collectability of the portfolio as of the evaluation date. (Under GAAP, the purpose of the ALLL is not to absorb all of the risk in the loan portfolio, but to cover probable credit losses that have already been incurred.) The dollar level of reserves includes an amount to cover loan losses normally associated with normal operating activities in normal economic times and an amount for potential losses as a result of changes in the institution’s risk profile, including losses and risks arising from highly volatile and concentrated portfolios. As the dollar volume of loans with thin debt service coverage, high LTV collateral coverage, low credit bureau scores, improperly structured loans, operating lines-of-credit which are not monitored and managed in a safe and sound banking manner, etc., increase or decrease, so should the dollar amount of loan reserves. In other words, reserves provide additional capital to cover potential levels of loan losses based on documented levels of credit risk in the institution’s loan portfolio. These levels of credit risk are to be identified by the internally assigned credit grade. This ties back to our previous discussion on internal indicators of credit risk levels.

Strong collateral values affect potential levels of losses but not the probability of default. Collateral values become a major factor in determining the level of impairment for individually analyzed loans, but not necessarily the amount of needed reserves for non-impaired loans in the homogeneous pools of loans. This is influenced more by the internal identifiers of credit risk and changes in economic indicators which can be associated with potential movements in the levels of credit risk.

Conclusion
For more information on this article, or to receive information on how Young & Associates, Inc. can assist your bank in evaluating your ALLL, please contact Rob Grope at 1.800.525.9775 or click here to send him an email.

Fran Samson, Consultant

04/2010

Your bank’s credit policy should already address what documentation is required to establish the current market value of real estate that is being pledged as collateral at loan origination. This should include both evaluations that may be completed in-house and appraisals being conducted by a third party. During the life of a commercial or retail mortgage loan, there are various circumstances that would prompt a reappraisal to be completed, and your bank’s policy should address that as well. Some banks are including this information in their existing credit policy; however, since this is considered a “hot topic” with the banking examiners, others are creating a separate policy to address reappraisals.

When Young & Associates, Inc. conducts third-party loan reviews, we often find banks carry appraisals forward when a loan is being refinanced or consolidated with other credits. This is generally done to save the borrower closing costs and often used as a selling feature in today’s competitive market. It would be appropriate that the bank’s policy address the maximum age that an appraisal is still considered valid. Even if the age is acceptable, the bank should require a review of the original appraisal and document that the assumptions made at origination are still appropriate. This would include the property use, condition of the property, and that the real estate market conditions are unchanged, therefore making the market value assigned still valid.

Another situation where the bank’s policy should prompt a reappraisal is when the condition of a loan deteriorates to the point where the bank does not feel comfortable with the borrower’s repayment ability (a highly-leveraged customer, a weak cash flow position, a serious past-due status, or a nonaccrual status). At this point, the collateral may be considered the primary source of repayment and the current market value will determine if there is a potential loss should liquidation be necessary. If the policy allows the use of the original appraisal, the bank should determine the current value based on the current real estate environment, establishing an appropriate discount to apply to the original amount in order to determine a more likely sale price. In addition to the discount due to the age of the appraisal, the bank should also include a discount for the cost to maintain the property until sale, as well as the cost to liquidate. While the bank may not want to include the actual discount percentages in the policy since they are subject to change, the policy should state what type of discounts are to be applied.

Most banks’ loan policies require periodic action plans to be completed on all watchlist credits to document the current status of the credit and to establish a plan to get the borrower off the watchlist. Part of this process includes a collateral evaluation to determine if the collateral pledged continues to be sufficient to assure the bank will suffer no losses should liquidation take place. In order to make that determination, the liquidation value has to be established. This is accomplished in the same manner described in the paragraph above, by applying appropriate discounts to the original market value of the property or obtaining a new liquidation value appraisal.

Young and Associates, Inc. has found that examiners are taking a very conservative approach when applying discounts to collateral values. Establishing a reasonable, current value and having it documented in the file will show that the bank is being diligent in assessing the true credit risk. The end result should be limited surprises in the asset quality assessment of the bank’s safety and soundness exam.

For more information on this article or on how Young & Associates, Inc. can assist your bank with its reappraisal needs, give us a call at 1.800.525.9775 or send an e-mail to lending@younginc.com.

Debra L. Werschey,Consultant/Manager of Secondary Market Services

Effective quality control is essential to properly manage mortgage loan risks. Additionally, effective quality control benefits everyone involved in the mortgage lending process by:

• Protecting lenders by ensuring the salability of the mortgages in their portfolios
• Protecting borrowers by keeping loans on manageable terms
• Protecting investors by lower¬ing the probability of defaults and foreclosures

Program Management
Quality control of the loan portfolio must be managed as an integral part of any institution’s business strategy. A bank’s board of directors and management must recognize the scope and implication of laws and regulations that apply to their institution. They must establish a quality control system that not only protects the institution, but also uses resources effectively. Senior management must assign well-qualified staff and resources to properly implement and administer the compliance program. Participation at all levels in the compliance management system is important to its success.

Procedures and Policy
An effective quality control program includes procedures and a policy that state the intent of the institution to meet the secondary market and investor expectations. The policy provides the framework for the institution’s procedures and a source of reference and training for the institution’s personnel.

Education
Education of the institution’s personnel is essential in order to maintain a sound quality control program. All personnel should be generally familiar with the requirements of Fannie Mae, Freddie Mac, FHA/VA, and FHLB consumer protection laws and should receive comprehensive education in laws directly affecting their jobs. They must also be trained in policies and procedures adopted by the institution to ensure compliance with those laws.

Tailored to Your Institution
An effective system will take into account the individual characteristics of your institution and be designed to recognize the:

• Size and structure of your institution
• Experience and expertise of your staff
• Geographic areas of your operations
• Number of your branch offices
• Demographic characteristics of your customer base
• Volume of mortgages originated
• Significant changes in your product line

Program Requirements
To be eligible to sell home mortgages to Fannie Mae, Freddie Mac, FHA/VA, and/or FHLB, a lender is required to operate a quality control system that must:

• Be in writing
• Provide standard operating procedures for all staff involved in the quality control process
• Operate independently of mortgage origination and underwriting
• Evaluate and monitor the overall quality of mortgage production
• Include procedures to ensure timely sample selection, mortgage file re¬view, and reporting to senior man¬agement of findings
• Comply with Fannie Mae, Freddie Mac, FHA/VA, FHLB, and other investor requirements, by address¬ing sample size and selection, re-verification, mortgage file review and reporting
• Ensure that findings affecting investment quality or eligibility of mortgages are thoroughly ana¬lyzed and corrective measures are implemented

Program Administration
An individual should be designated in your institution to have overall responsibility for implementing and coordinating the quality control function. Depending on the size of your institution, the quality control staff may have other responsibilities. However, this individual should not be responsible for mortgage origination, processing, or underwriting. Fannie Mae, Freddie Mac, FHA/VA, and FHLB require the quality control function to be established independently of production and underwriting.

The responsibilities of quality control staff include:

• Maintenance and dissemination of up-to-date information on company pol¬icy, mortgage insurer requirements, applicable government requirements, and Fannie Mae, Freddie Mac, FHA/VA, and FHLB guidelines
• Authority to modify the quality control program, as necessary, to meet the program objectives
• Dissemination of quality control findings to management
• Working with lending staff to develop corrective measures when quality control reviews contain de¬ficient findings
• Lending staff education and training
• Follow-up with management responses to quality control findings

Documentation
You must have clear written documentation of your quality control program management because these documents must be available to Fannie Mae, Freddie Mac, HUD (FHA/VA), or FHLB upon request. This system will enable you to document your policies and procedures for sample selection, information re-verification, mortgage file reviews, reports of findings, and follow-up measures.

In Conclusion In Conclusion Young & Associates, Inc. has a team of qualified lending consultants that can assist your bank with a quality control plan. An existing quality control system can also be evaluated for conformance with Freddie Mac and Fannie Mae guidelines, bank policies, insurer and guarantor requirements, and regulatory compliance. For more information, please contact me at 1.800.525.9775 or click here to send an Email.

Jackie Roesser, Senior Consultant and Manager of Internal Audit Services

The active management of credit risk has been receiving increasing regulator attention and strategic focus at many financial institutions. Regulators cite poor credit risk management at the portfolio level, weak credit standards for borrowers and counterparties, and insufficient attention to changes in economic and other circumstances affecting the capacity of borrowers and counterparties as the highest contributors to inadequate credit risk management. Regulators have changed capital charges to make financial institutions more responsive to actual credit exposure and have set new rules for how much capital banks must set aside to cover potential losses.

The basic principles for an effective credit risk management process were outlined in the consultative paper “Principles for the Management of Credit Risk,” issued by the Basle Committee on Banking Supervision. We consider it appropriate to underscore these principles in view of the current regulatory and credit market influences.

Definition of Credit Risk
Credit risk is the risk of loss arising from a borrower’s or counterparty’s inability to meet its obligations. The majority of a financial institution’s credit risk arises from its lending activities – outstanding loans and leases, trading account assets, derivative assets, and unfunded lending commitments that include loan commitments, letters of credit, and financial guarantees. It also exists in other activities such as acceptances, interbank transactions, trade finance, and retail and investment settlements.

Managing Credit Risk
It is important to formulate and implement a structured credit policy and related processes to manage credit risk. Strategies for credit risk management, including credit policy development and risk monitoring, is the responsibility of business unit and senior management, and the board of directors.

Financial institutions should establish credit limits to control the risk in all credit-related activity. Limits by industry sector, geographical region, product, customer, and country should be specified, along with the approaches to be used for calculating exposures against those limits, and made part of credit policy. Consideration should also be given to the spread across industries or regions as the default of one firm or industry may also affect others. Larger financial institutions might also consider multiple limits for each borrower or borrower group, by product, operational unit, and borrower member so that banking and trading activities of those borrowers or borrower groups creating credit risk can be more adequately monitored. While the trend has been that many financial institutions monitor total exposures in those categories, most have not set maximum limits on those exposures.

Commercial Portfolio Credit Risk Management
Credit risk in the commercial portfolio can be managed based on the risk profile of the borrower, repayment source, and the nature of underlying collateral given current events and conditions. Commercial credit risk management should begin with an assessment of the credit risk profile of an individual borrower or counterparty based on current analysis of the borrower’s financial position in conjunction with current industry, economic, and macro geopolitical trends. As part of the overall credit risk assessment of an obligor, each commercial credit exposure or transaction should be assigned a risk rating and be subject to approval based on approval standards defined in credit policy. Subsequent to loan origination, risk ratings should be adjusted on an ongoing basis as necessary to reflect changes in the obligor’s financial condition, cash flow, or ongoing financial viability. The regular monitoring of a borrower’s or counterparty’s ability to perform under its obligations allows for adjustments to be made that will affect the credit exposure measurement.

Risk rating aggregations should be considered for measurement and evaluation of concentrations within portfolios. Risk ratings are also a factor in determining the level of assigned economic capital and the allowance for credit losses.

To manage the relative risk within the commercial portfolio, many financial institutions utilize participation or syndication of exposure to other financial institutions or entities, loan sales and securitizations, and credit derivatives to manage the size of the loan portfolio and the relative associated credit risk. These activities can play an important role in reducing credit exposures for risk mitigation purposes or where it has been determined that credit risk concentrations are undesirable.

Consumer Portfolio Credit Risk Management
Credit risk management for consumer credit should begin with initial underwriting and continue throughout a borrower’s credit cycle. Consumer and other common attributes to evaluate credit risk. Statistical techniques may be used to establish product pricing, risk appetite, operating processes, and metrics to balance risks and rewards appropriately. Statistical models can be purchased or created that use detailed behavioral information from external sources such as credit bureaus, along with internal historical experience. These models should be validated periodically to assure they continue to be statistically valid and reflect performance of the institution’s customer base, particularly if used for credit scoring. When used, these models will form the foundation of an effective consumer credit risk management process and may be used in determining approve/decline credit decisions, collections management procedures, portfolio management decisions, adequacy of the allowance for loan and lease losses, and economic capital allocation for credit risk.

Accurate Calculations of Exposures
Assuring accurate calculations of exposures against limits is critical to managing credit risk. Methodologies will vary according to product types. For lending products and current accounts, the book balance is considered an appropriate measure, with related accruals included as part of the exposure as default of a counterparty on the primary exposure would also likely lead to loss of interest income. The current market value should be used for issuer exposures on bonds and equities, with replacement cost of the trade used as measure for any unsettled trades. For foreign exchange and derivatives, exposure should be measured at the replacement cost of the trades plus an add-on value based on the nominal value to reflect potential future adverse movements in the replacement cost.

Concentrations of Credit Risk
Portfolio credit risk should be evaluated to assure that concentrations of credit exposure do not result in undesirable levels of risk or in violations of regulatory requirements. Regular review and measure of concentrations of credit exposure against established limits by product, industry, geography, and customer relationship should be performed. For specialized industries, additional measurement categories may be appropriate, such as geographic location and property type for commercial real estate loans. When exposures exceed established limits, an escalation process should be triggered to avoid potential conflicts and to assure senior management is aware of all excesses. Periodic revalidation of established limits would be appropriate to assure that the limits continue to match the strategic risk appetite, provide for targeted asset mix, and recognize potential exposures as anticipated.

Examination of Credit Risk Management
Regulatory examination activities use a variety of techniques to assess a financial institution’s credit risk, including a sampling of loans and review of the institution’s credit management processes. Consideration is given to the complexity of the financial institution’s products and activities, and overall risk management practices. Designing, implementing, and adjusting processes and practices to effectively manage credit risk will limit unanticipated exposures.

Young & Associates, Inc. can assist you in your efforts toward managing credit risk. Through the combined efforts of our Loan Review and Internal Audit divisions, we offer services to assure risks are identified and managed: loan reviews focused on safety and soundness issues, documentation and appraisal reviews, reviews of the adequacy and appropriateness of loan loss reserves with consideration of credit concentrations, quality control reviews, control reviews of credit administration and portfolio management activities, and policy, processes and procedures reviews. For more information, contact Fran Samson or Jackie Roesser at 1.800.525.9775.

We only have to pick up a newspaper or “surf” the internet to know that the current credit and housing crisis had its start in the secondary mortgage market. Over the past several years, American homebuyers have enjoyed a loose credit climate and purchased the home of their dreams with little or no monetary investment with the assumption that property values would continue to climb. Interest rates were good and the number of loan programs available from secondary market investors, such as stated income, interest first and no doc, were at an all-time high. Credit card use was also at an all-time high, and job security was not an issue. Then the bubble burst and those same secondary market investors found themselves with massive numbers of delinquent loans, plummeting real estate values, and unemployed borrowers who could no longer afford their current lifestyle.

So how has the secondary mortgage market responded? While secondary market investors have tightened credit and increased down payment requirements (the requirements to have an acceptable credit history, monetary investment, and the capability to repay the debt are nothing new), mortgage money is available. Additionally, the investors have added increased fees for lower credit scores, loan-to-value, type of property, etc., making selling loans to them, while competitive from an interest rate perspective, more expensive for borrowers.

With all of the additional fees, the next question is, why sell on the secondary market? The answer is, not only are banks able to offer competitive interest rates and turn over their funds quicker, but they also reduce the possibility of loss should the loans default to almost zero. If the bank retains the servicing rights on a sold loan and the loan defaults, the bank is expected to handle collections and, if necessary, foreclosure and property maintenance, all of which is eventually reimbursed; but the bank sustains no loss on the mortgage itself. In today’s banking climate, what could be more important?

The national media would have the public believe that there is limited mortgage money available to purchase or refinance a home, despite the fact that interest rates are at an all-time low. Nothing could be further from the truth. While large national banks have sustained massive losses, community banks not only have money to lend but understand the economic dynamics of their communities. Originating loans with the intent to sell them on the secondary market is not only good risk management, but also allows the bank to remain competitive in their mortgage market.

S. Wayne Linder, Senior Consultant

07/2008

With the continued weakening of the residential housing market, and now the commercial real estate market, FDIC issued a Financial Institution Letter (FIL), dated July 1, 2008, reminding financial institutions that they should be reviewing their procedures, policy, and the regulatory guidelines for “other real estate owned” (OREO). It is important that banks are aware of the options available when foreclosing on properties. An updated, thorough policy statement on OREO can assist financial institutions in making the right financial decision to protect the bank’s capital and shareholders.

Some of the fundamental concepts to consider include:

• Determine CERCLA Status of Property. The bank must determine the environmental status of the property before taking ownership. Failure to do so could result in environmental liability and potential clean-up costs.
• Taking Ownership of Property. There are several ways that a bank acquires OREO. This should be addressed in your policy.
• Documenting Current Valuation of Property. Once the bank has transferred the property into OREO, the parcel’s market value must be documented through an appraisal or an appropriate evaluation. These appraisals must be completed following certain guidelines.
• Monitoring Current Value. A new appraisal or a certification in letter form from an independent appraiser must be obtained annually. This can be waived depending on the book value of the property.
• Dollar Amount to Carry on Institution’s Books. OREO should be accounted for individually lower of “recorded investment in the loan satisfied” or its fair value on the date of transfer to that category.
• Allowable Holding Period. Basically, banks are permitted to hold onto OREO under certain circumstances for a period no longer than five years. An additional five-year period might be granted with the approval of your primary supervisory agency.
• Documentation of Efforts to Dispose of OREO Property. The bank will document its efforts to dispose of the OREO at the earliest time that prudent judgment dictates.
• Additional expenditures on OREO. Depending on the type of OREO, the bank may need supervisory approval to invest additional funds into the property. Normal repairs and maintenance costs fall outside of this approval process.
• Disposal of OREO Property. Banks may dispose of OREO property through sale, reuse the property for bank premises, or in some cases, obtain a coterminous sublease.
• Accounting Treatment. Generally accepted accounting principles (GAAP) will guide how your bank will account for OREO on your books while it is in your possession and when you sell it.
• Special Disclosures. Care needs to be taken if the bank sells an OREO property and finances the purchase. Regulation Z disclosures will need to be reviewed carefully to include the “Total Sales Price.”
• Flood Insurance Requirements. Your bank policy will need to state whether insurance will be placed on the property while in the bank’s possession if said property is located in a flood area.
• IRS Information Reporting for Financial Institutions. Make sure that you don’t slip up and not file the necessary IRS forms on OREO. Given today’s real estate market, it is essential that financial institutions maintain and review their OREO procedures and policy regularly. Young & Associates, Inc. has incorporated this guidance into our Off and Recovery Policy (#078). The policy is available for $325 and can be easily customized for your bank. For more information on the Collection, Charge-Off and Recovery Policy, or to order, call 1.800.525.9775 or visit www.younginc.com.

Rob Grope, Consultant

07/2008

Stress testing in banking is a form of analysis that may be used to determine the stability of an individual loan or portfolio. It involves testing beyond normal operational capacity, often to a breaking point, in order to observe the results. This can assist management in determining the comfort level of risk, as well as bring to light capital adequacy issues.

Stress testing shows the sensitivity of a portfolio to a particular shock. It measures the change in value in response to changes in the underlying risk factors. The assumed changes are usually made large enough to impose some stress, but not so large as to be considered implausible.

Choosing Stress Factors

It is important early on to determine which factors are most critical in the credit assessment in order to understand what components are most likely to cause the biggest influence. Factors to consider can be interest rates, collateral value, and economic factors that affect debt service coverage (DSC). Many lenders employ their own models to rank potential and existing loan customers and then apply appropriate strategies.

Regulations, such as Basel II, reinforce the desire for more robust stress testing. However, regulators have tried not to over specify the type and nature of stress tests. Industry and regulatory dialogue have, thus far, failed to establish consensus on the best practice and policy.

Recent accounting discussions have improved disclosures about valuation, but public disclosures about liquidity are either insufficiently detailed or cannot be updated rapidly enough. You need to know early on which component is most vulnerable and requires close attention, and how a default could affect you.

Be Proactive in Your Approach

In designing stress testing, a financial institution should:

• Consider a full range of extreme outcomes
• Cover both full-loss as well as loss generating risk factors
• Use judgmental – as well as statistical– based methodologies

Testing individual loans can help identify problems before trouble happens. This can be employed during the initial underwriting, as well as the ongoing monitoring of credits. By decreasing sales or gross margins, discounting collateral values, or increasing interest rates, the impact can be shown in the deterioration of DSC, net worth, or even collateral coverage. Regulators consider this a reactive approach.

It is recommended by regulators that financial institutions shift to a portfolio view. They believe that institutions will be better able to identify, measure, monitor, and then report on credit risk. Regulators consider this to be a proactive approach that is important to the anticipation of problems.

In light of the current economic conditions, it is important to address the need for quick responses to problems when they arrive, so as not to be “blind sided” by changing conditions. The employment of what-ifs is critical for management to control downturns. One advantage of the advancement of information technology is it can assist in the rapid assembly of data to facilitate the stress-test calculations. The immediate focus in a down market is on minimizing risk and reducing losses. The of risk management is to ensure long-term earnings and build long-term value. If risk management processes were employed early, the events over the past year might have been controlled and the negative impact mitigated. The institutions that have invested in stress testing will be better prepared to act with greater confidence and exhibit flexibility and survivability.

Conclusion

While risk measurement has evolved rapidly, it is still common practice to apply stress tests in an isolated fashion. Although the practice is evolving quickly, the regulatory agencies have not provided consistent guidance around stress tests. It is, therefore, important for banks to begin to consolidate this information and work toward the implementation and reporting process for the entire financial institution.

For more information on how your institution can begin to stress test loans and portfolios, call 1.800.525.9775 or click here to send an Email.