Problem Loans and Workouts
This is the second installment of a four-part series on problem loans and
workouts. The RMA Journal hopes you find value in these articles.
Somebody Keep Score!
Is it a ball, a strike, or
by John Barrickman
what?
© 2006 by RMA. John Barrickman is president of New Horizons Financial Group, a firm specializing in training and risk management consulting.
A frequent contributor to The RMA Journal, Barrickman was recently recognized as a winner of RMA’s Journalistic Excellence Award.
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The RMA Journal December 2006–January 2007
P r o b l e m L o a n s a n d Wo r k o u t s
H
ow do you know who
is winning or losing if
you don’t keep score?
The same logic applies in
monitoring portfolio credit
quality. Unfortunately, many
banks assess portfolio credit
quality through a “scorecard”
of past-due, criticized/classified, and nonperforming loans,
as well as loan losses. This is
like declaring a winner or loser
long after the game is over
because those factors measure
the quality of lending decisions made three, four, or five
years ago—not a very good
way to keep score.
A much better indicator
of portfolio credit quality and
the potential for large levels of
past-due and other problem loans and losses is a
granular asset-quality-rating (AQR) framework. To
be an effective measure of portfolio credit quality,
AQRs must be timely and accurately assigned, and
this responsibility must reside with the lenders.
Lenders must be provided with guidance and training in assigning AQRs, and they must be incented
to assign accurate AQRs and to make timely adjustments as needed.
Guidance
The responsibility for providing guidance rests
with the senior credit officer. He or she must develop a granular (at least six pass categories) AQR
framework that ideally assigns a rating to the borrower (probability of default) and to the transaction
(loss given default). To simplify tracking the distribution of AQRs, the bank may develop a composite
rating of the borrower and the facility. The AQR
framework should provide a narrative description of
each borrower rating.
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Figure 1
C&I Borrower Rating Matrix
4
Risk-Rating
1
2
3
Acceptable
Description Minimal Risk Modest Risk Average Risk
Risk
5
6
Marginally Management
Acceptable Attention
Debt/Tangible
Net Worth1
.50 or less
0.51 to 1.25
1.26 to 2.25
2.26 to 3.00
3.01 to 3.75 3.76 or greater
EBITDA/
(Principal +
Interest)
Greater than
2.0
1.75 to 2.0
1.5 to 1.74
1.25 to 1.49
1.0 to 1.24
Less than 1.0
Operating
Breakeven or
Profit Before Profitable the Profitable the Profitable the Profitable the Profitable the unprofitable
in
Extraordinary past 10 years past 7 years past 5 years past 3 years
past year
most recent
Items and
year
Taxes
Current Ratio
Greater than
1.75
1.50 to 1.74
1.25 to 1.49
1.0 to 1.24
.75 to .99
less than .75
Repayment
History
Ahead of
Schedule
Original Terms
Usually by
Terms
Restructured
Slow
Collection
Problem
Quality of
Financial
Information
Audited/
Unqualified
Audited/
Unqualified
Reviewed
Compiled or
tax returns
Borrower
prepared
financials or
tax returns
Anything less
than in previous column
Customer
and/or Vendor
Concentration
(% of sales)
<=10%
<=15%
<=20%
<=25%
<=35%
<=35%+
Industry Risk2
Low 1.0 –
2.99
Low Moderate
3.0 – 4.99
Moderate
5.0 – 6.99
High
Moderate
7.0 – 8.99
High
9.0 – 10.99
Very High
> 11.00
Financial
Trends
Very Positive
Generally
Positive
Stable
Erratic
Generally
Negative
Very Negative
FICO Score of
Principal with
Highest
Percentage
Ownership
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Training
To effectively use the guidance, lenders need to be 1)
schooled in the methodology and
2) have the opportunity to apply
the methodology to “test” cases
(cases with existing AQRs
assigned by experienced senior
lenders and credit personnel using
the bank’s methodology).
Methodology training may be provided in person or through an
Internet-based medium, such as
WebExTM or Miscrosoft威 Live
Meeting. A follow-up training session allows the lenders to score
themselves and ask questions.
Incentives
760+
730 – 759
700 – 729
670 – 699
640 – 669
Less than 640
1 Includes properly subordinated debt in the calculation of tangible net worth and deducts the subordinated debt from
the total debt.
2 Industry risk will be evaluated relative to the probability of default statistics published by RMA.
•
• The loan to value, e.g.
B=50% LTV.
• Control exercised over the
collateral, e.g., C (above
average) = asset-based
lending arrangement.
The lender integrates the borrower rating and a facility rating by
using the Composite Risk Rating
Framework (Figure 3).
The lender assigns the initial
borrower rating using a narrative description for each rating
and then refines the rating by
using specific matrices (see
Figure 1, columns 1-6) for each
type of lending—for example,
C&I, CRE, A&D/construction,
and Agriculture. The matrices
use objective factors, such as
leverage and liquidity, to deterThe RMA Journal December 2006–January 2007
•
mine the borrower’s AQR. The
lender further refines the rating on a “best fit” basis.
The lender then assigns a
final facility rating (Figure 2).
The rating considers three
factors:
• Quality of the collateral—
e.g., A (Excellent) = cash,
the loan to value, e.g.,
B = 50% LTV.
To ensure timely and accurate
assignment of AQRs, lenders must
be incented to “do the right thing.”
A portion of the lender’s performance appraisal and incentive compensation should be the risk posed
by loan mis-grades. I use the term
“mis-grades” rather than downgrades, because banks often penalize lenders for downgrades that
were not initiated by the lender,
which incents lenders to assign a
rating lower than the credit fundamentals warrant in the belief that it
lowers the potential for an undetected downgrade. Overstating
portfolio credit risk can be as damaging as failing to recognize a
potential or actual problem in a
Somebody Keep Score! Is it a ball, a strike, or what?
Figure 2
Composite Risk-Rating Matrix
Class
Description
A–Excellent
Cash held at bank.
Letters of credit or bond issuance from issuer with “AA” or better investment grade.
Government securities at policy advance rates.
Credits 100% guaranteed by the full faith and credit of the U.S. government.
B–Superior
Cash held at other banks.
Letters of credit or bond issuance from issuer with “A”or better investment grade or non-rated financial institution.
Cash equivalents, such as cash value of whole life insurance.
Marketable securities including federal agency, municipal, and corporate securities margined at policy advance rates.
The portion of facilities guaranteed 80% or more by the U.S. government or an agency.
Commercial, ag, or owner-occupied real estate with less than 50% LTV.
C–Above Average
Senior/subordinated debt tranches vis-à-vis other debt positions.
Asset-based lending with dominion and control of collateral (e.g., periodic borrowing base, lockbox, controlled account, field audits).
Commercial, ag, or owner-occupied real estate with 50-65% LTV.
An abundance of other collateral (130% of policy advance rate) or exceptional collateral.
Operating ag—crop lien with borrowing base/joint checks and reporting/covenants.
D–Average
E–Below Average
F–Weak
Collateral meeting policy standards for quality and coverage.
Commercial, ag, or owner-occupied real estate with 65-75% LTV.
Controlled receivables and inventory at policy advance rates, e.g., borrowing base.
Crop lien plus other collateral, e.g., equipment and MPCI assignment.
Fixed assets including equipment at advance rates against approved appraised value.
Facilities guaranteed 70% by the U.S. government or agency.
Second lien position combined with first lien is less than 50% LTV.
Blanket lien or mixed collateral.
Loan to value (LTV) fails to meet policy standards.
Uncontrolled accounts receivable and inventory.
Crop lien.
Unsecured guarantee (where guarantee is the primary collateral).*
Intellectual property.
Second lien with combination first and second lien 60-80% LTV.
Second lien position combined with first lien is greater than 80% LTV.
Springing lien.
Negative pledge.
Assignment of partnership interest.
Comfort letters from controlling affiliated entities.
*The class ascribed to a secured guaranty is determined by the quality of the collateral securing the guaranty.
Figure 3
Facility-Rating Matrix
Borrower Rating
A
Excellent
B
Superior
C
Above Average
D
Average
E
Below Average
F
Weak
1–Minimum Risk
1
1
1
1
2
3
2–Modest Risk
1
1
1
2
3
4
3–Average Risk
1
2
2
3
4
5
4–Acceptable Risk
2
2
3
4
5
6
5–Manageable Risk
2
3
4
5
6
7
6–Watch
3
4
5
6
7
8
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Somebody Keep Score! Is it a ball, a strike, or what?
timely manner and then downgrading the credit. The bank will be
forced to make larger provisions
than warranted, which impacts
bank earnings and stock price.
A double downgrade (AQR 5
to Special Mention AQR 7 or AQR
6 to Substandard AQR 8) that was
not initiated by the lender should
result in the loss of the lender’s
incentive compensation. It suggests the lender is not adequately
monitoring his or her portfolio
and/or is not being intellectually
honest in assigning AQRs.
Using the AQR to Manage Portfolio
Risk
As lenders adjust a borrower’s
AQR downward, they should
intensify credit monitoring and
adjust the borrower’s interest
rate upward. These actions
reflect the incremental risk in
the credit and provide incentive
to the borrower to “clean up
their act” or “find a greater
fool.” When lenders downgrade
the credit to 6 (Marginally
Acceptable or the lowest pass
category in the bank‘s AQR
framework), they should be
required to develop a plan to
upgrade the credit or to exit the
credit within six to nine months.
The senior credit officer
(SCO) should monitor AQR distribution for both the bank’s
entire loan portfolio and the individual lines of business, such as
C&I or CRE. A shift in the distribution (migration) to the lower
pass categories (4-6) should
prompt the SCO to investigate
further whether the deterioration
is in one line of business, one
market, one branch or department, or one small group of
lenders’ portfolios. The SCO
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The RMA Journal December 2006–January 2007
may recommend tightening
underwriting guidelines, requiring
additional lender training, or
reducing exposure to—or exiting—the line of business.
An effective granular AQR
framework—in which users are
assured AQRs have been assigned
accurately and in a timely manner—becomes a powerful tool for
proactively managing portfolio
credit risk. Lenders will identify
potential problem borrowers more
quickly and take steps to compel
the borrower to 1) improve financial performance and allow an
upgrade of the credit or 2) find
another bank. At that point in
time, the borrower usually is reasonably cooperative and has a
viable core business, and the bank
has reasonably strong collateral
position and retains the option to
“pass the trash.”
The SCO can analyze AQR
migration—on a portfolio basis or
by line of business, market, or
lender—to identify potential portfolio deterioration and then take
steps to minimize the potential
for significant numbers of problem loans. In short, the SCO is
the scorekeeper and ultimately
determines whether the bank
wins or loses the credit quality
game. ❐
Contact John Barrickman by e-mail at
[email protected].