Credit Evaluation School - May 2023

Credit Evaluation School

May 15-19, 2023 Chicago, IL

@ www.csbs.org ε @csbsnews

CONFERENCE OF STATE BANK SUPERVISORS 1 , Street NW / 6XLWH / Washington, DC 20 / (202) 296-2840

Credit Evaluation School Chicago, Illinois May 15 - 19, 2023

Hyatt Regency Chicago Meeting Room: Roosevelt 3B

Monday, May 15, 2023 7:30 am – 8:30 am 8:30 am – 9:00 am 9:00 am – 9:30 am 9:30 am – 10:15 am 10:15 am – 10:30 am 10:30 am – 12:00 pm 12:00 pm – 1:15 pm 1:15 pm – 2:15 pm 2:15 pm – 2:30 pm 2:30 pm – 3:00 pm 3:00 pm – 3:30 pm 3:30 pm – 4:30 pm 5:00 pm – 7:00 pm 8:30 am – 8:45 am 8:45 am – 9:30 am 9:30 am – 10:00 am 10:00 am – 10:15 am 10:15 am – 10:45 am 10:45 am – 12:00 pm 12:00 pm – 1:15 pm 1:15 pm – 4:00 pm 4:00 pm – 4:30 pm Tuesday, May 16, 2023 7:30 am – 8:30 am

Registration and Breakfast Plaza Foyer and Plaza A

Introduction and Goals for the Week

Pre-Course Recap

Examiner Roles & Loan Scoping

Break

Primary Loan Documents

Lunch on your own

6 P’s Review

Break

Nonaccrual

6 P’s Review Exercise Hand Out Line Deck #1 Networking Reception Plaza A

Breakfast Plaza A

Monday Recap

Decision Strategies & Loan Classification

Mock Discussions

Break

Quick Hitters

Loan Discussion Prep Lunch on your own

Loan Discussions

Loan Discussion #1 Materials Due Students must turn in classification grid, self-evaluation, and bullet-point writeup on a classified line.

Wednesday, May 17, 2023 ; 7:30 am – 8:30 am 8:30 am – 8:45 am 8:45 am – 9:00 am 9:00 am – 9:30 am 9:30 am – 10:00 am 10:00 am – 10:15 am 10:15 am – 10:45 am 10:45 am – 11:15 am 11:15 am – 12:00 pm 12:00 pm – 1:15 pm 1:15 pm – 4:30 pm Thursday, May 18, 2023 7:30 am - 8:30 am

Breakfast Plaza A Icebreaker

Tuesday Recap Quick Hitters

Red Flags

Break

Red Flags (continued)

Loan Writeups

Hand Out Line Deck #2 Lunch on your own Loan Discussion Prep

Breakfast Plaza A

Wednesday Recap

8:30 am – 8:45 am 8:45 am – 9:15 am 9:15 am – 10:15 am 10:15 am – 10:30 am 10:30 am – 12:00 pm 12:00 pm – 1:15 pm 1:15 pm – 4:00 pm 4:00 pm – 4:30 pm

Quick Hitters

Loan Discussion Prep

Break

Loan Discussions Lunch on your own Loan Discussions

Loan Discussion #2 Materials Due Students must turn in classification grid, self-evaluation and full writeup on a classified line.

Friday, May 19, 2023 7:30 am – 8:30 am

Breakfast Plaza A

Thursday Recap

8:30 am – 8:45 am 8:45 am – 9:30 am 9:30 am – 10:00 am 10:00 am – 10:15 am 10:15 am – 11:00 am

Asset Quality Discussion & Grading

AQ Quick Hitters

Break

Learning Assessment

11:00 am

Adjourn

Credit Evaluation School May 15-19, 2023

Instructors

Kelley Jones

Roberto Chavez

Senior Financial Institutions Examiner California Department of Financial Protection & Innovation

Consumer Finance Team Supervisor North Carolina Office of the Commissioner of Banks

Zac Smith

Senior Bank Examiner Iowa Division of Banking

Introductions

SOMETHING YOU HOPE TO LEARN DURING THIS CLASS

NAME AGENCY AND STATE

YEARS OF EXPERIENCE AS EXAMINER AND LENGTH OF TIME WORKING CREDIT FILES

FUN FACT ABOUT YOURSELF

Class Demographics - States

Goals for the Week

Discuss with you the 6 Ps method of credit evaluation 1

Give you the tools and tips to assist you in arriving at the appropriate classification decision 2

Improve your comfort level in the discussion setting 3

Provide guidance for clear and concise writeups 4

Questions?

Internal Use Only

Examiner Roles & Loan Scoping

Internal Use Only

Asset Manager and/or Examiner-In-Charge

Obtains the loan download and various reports from management. • Watch List • Past Due report • Concentration reports • Other miscellaneous reports Uses the ETS program to generate the loan scope, identifying loans to review based on items such as:

• Previously Classified Loans • Large Lending Relationships

• New Loans • Loan Type • Insider Loans

Internal Use Only

Asset Manager (Examiner-In-Charge in ETS)

Manages the loan review process between bank and examiners

Tracks noted trends, violations, policy and technical exceptions, etc.

Generates portfolio classification data, compares to bank identified information, etc.

Collects completed linesheetsfrom examiners

Internal Use Only

Loan Scoping

Internal Use Only

Loan Selection • Which loans do we look at and why? • Which loans generally have more risk? • Which loans tend to have less risk? • Why is it important to look at insider loans?

Internal Use Only

Loan Selection Condition of the bank • Previous Examination Reports • Uniform Bank Performance Report • Correspondence

Risk Focus

• Commercial loans • Real Estate • Consumer

Internal Use Only

Loan Selection

Coverage • Loan volume or particular area of the loan trial • History can dictate how much to review • Confidence in management also lends to coverage Resources • Number of employees assigned to examination • Length of time allowed on site/scheduling

Internal Use Only

Standard Review Items

 Loans above the “cut”  Letters of credit

 Previously Classified  Internal Watch List  External Loan Review  Past Dues • Delinquency Threshold  Nonaccrual  Restructured  Insider and Related-Interest  Participations • Files worked or discussed only

 Unfunded Loan Commitments  Financed Sales of Other Real Estate  Unusual Loans • Capitalized Interest • Out-of-Territory • Long-term Unsecured • Evergreen  New Loan Sampling  New Loan Officer Sample

Internal Use Only

Additional Line Sheets Info • Charge Off Amounts • Overdrafts • Rejects/ Insufficient Items • Unadvanced funds to which bank is committed

Internal Use Only

Individual Loan Reviewer • Obtains the ETS Distribution package from the Asset Manager (or EIC).

• Gains familiarity with loan products, policies and procedures.

• Reviews assigned files. • Examine loan and credit files for necessary documents • Completes 6 P and Financial Analysis • Completes a writeup on sizable downgrades or when management does not agree • Discusses lines with loan officer and/or management designee as needed.

• Communicates findings with Asset Manager.

Internal Use Only

Primary Loan Documents

Internal Use Only

Primary Loan Documents for Commercial, Real Estate, Consumer & Ag Credits

Internal Use Only

Overview • Ability to collect on a loan can depend on the accuracy & completeness of the loan documents. • Ability to understand the purpose & effect of each loan document is crucial.

Internal Use Only

Questions to Ask • What are the appropriate documents? • Are the documents properly executed? • Have they been properly filed?

• Are there any pertinent documents omitted? • Have the authorized signer(s) correctly signed?

Internal Use Only

Things to Consider • Different types of loan transactions • Primary & supporting loan documents • Documents necessary to attach, perfect, protect, & gain access to collateral in secured transactions • Who is authorized to sign on behalf of various types of businesses?

Internal Use Only

In this session we will: • Identify documents required for various types of commercial, real estate, consumer, & agricultural loans • Identify the purpose & effect of common loan documents, including promissory notes, credit reports, borrowing resolutions, articles of incorporation, appraisals/inspections, collateral filings, financial documents, & insurance • Security agreements, security interest in collateral, financing statements/UCCs, title commitment & title insurance • Review primary documents including documents within basic line sheets

Internal Use Only

Primary Documents Application: States the requested amount, purpose, borrower, and security.

Internal Use Only

Primary Documents Promissory Note: Is a document that contains a written promise by the borrower to pay the bank. It is enforceable against the borrower. Review of each section for content, purpose, rights of all parties and terms.

Internal Use Only

Primary Documents Security Agreement: A document that provides a lender a security interest in a specified asset or property that is pledged as collateral (may be included within the promissory note).

Internal Use Only

Primary Documents Borrowing Resolution: A corporate resolution that authorizes borrowing is often referred to a borrowing resolution. This resolution indicates that the members (LLC) or Board of Directors (Corporation) have held a meeting and conducted a vote allowing the company to borrow a specific loan amount.

Internal Use Only

Primary Documents Articles of Incorporation: A set of formal documents filed with a government body

to legally document the creation of a corporation.

Internal Use Only

Primary Documents Credit Report: Has information about a borrower/principal/guarantor's credit activity and current credit situation such as loan paying history and score.

Internal Use Only

Primary Documents Appraisal: A fair market valuation of real estate property (or other collateral) conducted by an authorized person.

Internal Use Only

Primary Documents Appraisal Review: An evaluation of a real estate appraisal that comments on the completeness and apparent accuracy and compliance of an appraisal report.

Internal Use Only

Primary Documents Title Commitment & Title Policy: Commitment for Title Insurance is issued once the title search is complete, describing everything that was uncovered during the search. It is also a binder promising to issue a title policy once the requirements laid out in the commitment are met. Title insurance will provide the bank for defending against any lawsuit against the bank’s insured title & will either clear up the title problems or pay the insured’s (bank’s) loss.

Internal Use Only

Primary Documents Mortgage (Deed of Trust): The mortgage conveys the security interest from the borrower to the bank. Also called a Deed of Trust, gives the lender the right to foreclose on the property being used to secure the loan. The mortgage document must be recorded at the county records office to ensure that the bank’s security interest is protected.

Internal Use Only

Primary Documents Assignment of Leases & Rents: Is a document that gives a mortgage lender (bank) the right to any future profits that may come from leases and rents when a property owner defaults on their loan. This document can be attached to a mortgage loan agreement or separate.

Internal Use Only

Primary Documents Commercial Lease Agreement: Outlines a landlord's and tenant's rights and obligations when the landlord rents out commercial property to a tenant. (look for sections: “title” and “subordination”) .

Internal Use Only

Primary Documents Agreement to Provide Insurance: A legal document that requires the borrower to maintain insurance coverage on the collateral securing the loan and to show evidence of the coverage (list bank as lien holder, forced place).

Internal Use Only

Uniform Commercial Code (UCC)

Internal Use Only

UCC Set of rules that help govern U.S. business laws on commercial transactions •Start with UCC search for previous lienholders UCC – 1 filings typically happen when loan is originated •Includes creditor’s name & address, debtor’s name & address, and collateral description

Internal Use Only

UCC UCC liens against specific collateral or blanket lien – 5-year terms •After, lender must renew the lien if loan is still active

UCC – 1: UCC is filed with the state & the county where property is located

Internal Use Only

Types of Guarantees

Unlimited • Full-recourse

Limited • Simple form • Puts a limit on

Joint & Several

• If multiple

guarantees - aka unconditional guarantee • Guarantors pay all amounts due until note paid • Guarantor liable for any debt owed

guarantors, lenders have few options to distribute risk guarantor is fully responsible for entire loan

amount guarantor responsible for • Usually, an agreed upon dollar amount or percentage of total debt

• Each individual

Internal Use Only

Types of Guarantees

Performance • Guaranty that may not be based on payment • Based on certain conditions or milestones • In CRE, based on specific actions

Carve Out • Aka “bad boy” guaranty • Ties liability to bad acts

• Usually found on non-recourse loans & includes borrower’s promise to abstain from certain acts • Gives lenders control to recoup payment quickly during legal process

Internal Use Only

Financial Information

Paystubs

PFS

Credit Reports

Financial Statements

Tax Returns

Internal Use Only

Examples of Loan Documents (redacted)

5-Appraisal Review Form PDF File

2-Redacted Resolution

1-Redacted Promissory Note

4-Redacted Appraisal

3-Mortgage Document PDF File

7-Agreement to Provide Insurance

9-Assignment of Leases and Rents

8-Redacted Commercial Lease Agreement

6-Title Commitment and Policy

Internal Use Only

Loan Types & Primary Documents Required Consumer Loans •Motor Vehicles • Residential Home • Residential Construction Commercial Loans •Working Capital & Equipment •Commercial Real Estate (CRE) Agricultural Loans •Working Capital & Equipment •Real Estate

Internal Use Only

Consumer Loans – Motor Vehicles

What is it: A consumer loan to an individual for personal reasons. Typically, to purchase automobiles, boats, trucks, truck tractors, trailers, semi-trailers, motorcycles, motor scooters, buses, or recreational vehicles.

Internal Use Only

Consumer Loans – Motor Vehicles

Primary Documents Required: • Signed Consumer Credit Application • Promissory Note

• Credit Report • Security Agreement • Certificate of Title or Certificate of Origin • Income Information

• Financing Statement • Evidence of Insurance

Internal Use Only

Consumer Loans – Residential Home

What is it: A consumer loan to an individual for personal reasons. Typically, to purchase real property such as a residential home, undeveloped land, lots, free-standing dwellings, duplexes, fourplexes, apartments, or condominiums.

Internal Use Only

Consumer Loans – Residential Home Primary Documents Required: • Signed Residential Mortgage Credit Application (Form 1003) • Promissory Note • Appraisal or Evaluation • Title Insurance Commitment/ Preliminary Lien Search • Agreement to Provide Homeowner’s Insurance/Flood Insurance • Credit Report • Mortgage or Deed of Trust • Appraisal Review • Title Insurance Policy/Title Opinion • Income Information

Internal Use Only

Consumer Loans – Residential Construction

What is it: A consumer loan to an individual for personal reasons. Typically, to purchase and construct a residential home.

Internal Use Only

Consumer Loans – Residential Construction

Primary Documents Required: • Signed Residential Mortgage Credit Application (Form 1003) • Promissory Note/Construction Draw Note • Appraisal or Evaluation • Title Insurance Commitment/ Preliminary Lien Search • Agreement to Furnish Homeowner’s Insurance

• Credit Report • Warranty Deed/

Mortgage Deed of Trust

• Appraisal Review • Builder’s Risk Hazard Insurance • Income Information • Master Construction

Inspection Draw Report

Internal Use Only

Commercial Loans – Working Capital & Equipment

What is it: A loan to a commercial business for business purposes. Typically, for operating purposes (working capital line of credit) or for the purchase of equipment to be used in the business.

Internal Use Only

Commercial Loans – Working Capital & Equipment

Primary Documents Required: • Promissory Note • Articles of Incorporation • UCC Lien Search/UCC-1 Financing Statement • Guarantees

• Borrowing Resolution • Security Agreement • Agreement to Provide Insurance • Financial Statements

Internal Use Only

Commercial Loans – Commercial Real Estate

What is it: A loan to a commercial business for business purposes secured by real estate for the purpose of purchasing, acquiring, developing, or constructing an income producing property. Typical loans within this category are business and industrial properties, apartment or condominium buildings, hotels, hospitals, golf courses, nursing homes, mini-storage warehouses, etc.

Internal Use Only

Commercial Loans – Commercial Real Estate

Primary Documents Required: • Promissory Note • Articles of Incorporation • Assignment of Leases & Rents • Appraisal & Appraisal Review • Title Insurance Commitment/ Preliminary Lien Search • Agreement to Provide Insurance

• Borrowing Resolution • Mortgage/Deed of Trust • Commercial Lease Agmt. • Title Insurance Policy/ Title Opinion • Guarantees • Financial Statements

Internal Use Only

Agricultural Loans – Working Capital & Equipment

What is it: Loans for the purpose of financing agricultural production and equipment. Typical loans within this category are for: growing, storing, or marketing of crops, breeding, raising, fattening, or marketing of livestock, financing fisheries, forestry's, and commercial fishermen, and purchase or maintenance of farm machinery, equipment, and implements.

Internal Use Only

Agricultural Loans – Working Capital & Equipment

Primary Documents Required: • Promissory Note • UCC Lien Search/UCC-1 Financing Statement • Farm/Livestock Inspection • Appraisal/Valuation of Collateral/Bill of Sale

• Security Agreement • Agreement to Provide Insurance • Financial Statements

Internal Use Only

Agricultural Loans – Real Estate

What is it: A loan which is secured by farmland and known to be used or usable for agriculture purposes, such as crop and livestock production. Farmland includes grazing or pastureland, whether tillable or note and whether wooded or not.

Internal Use Only

Agricultural Loans – Real Estate

Primary Documents Required: • Promissory Note • Appraisal • Title Insurance Commitment/ Preliminary Lien Search • Title Insurance Policy/Title Opinion

• Mortgage/Deed of Trust • Appraisal Review • Agreement to Provide Insurance • Farm/Livestock Inspection • Financial Statements

Internal Use Only

Examples of Documents Within Basic Line Sheets

Sample Equipment Loan Files

Sample Ag credit

Internal Use Only

Questions?

Internal Use Only

Credit Evaluation School 6 P’s

Internal Use Only

6 P Format

Internal Use Only

Person / People • Who is the borrower? • Borrower’s primary business? • Owners of the business? • Borrower’s background & experience? • Guarantors? • Any related businesses?

Internal Use Only

Purpose • How are loan proceeds being used? • Structure of financing appropriate for loan purpose? • Repayment terms appropriate - frequency & source of repayment?

Internal Use Only

Protection • What is the collateral? • Condition & value of the collateral? • How is lender’s interest secured?

Internal Use Only

Payment

• Primary source of repayment? • Repayment source adequate? • Secondary source of repayment? • Adequate to repay the loan? • Tertiary source of repayment? • Adequate to repay the loan?

Internal Use Only

Problem

• Do any weaknesses exist which are jeopardizing repayment? • Any potential weaknesses which have emerged?

Internal Use Only

Prospects

• What actions are being taken to address weaknesses?

Internal Use Only

Criticized & Classified Loan Rating Definitions

Internal Use Only

Special Mention A Special Mention asset has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Special Mention assets are not adversely classified and do not expose the institution sufficient risk to warrant adverse classification.

Internal Use Only

Special Mention

Key characteristics: • Improper loan structure

• Inadequate loan agreements or covenants • Incomplete or inadequate documentation to adequately monitor the loan • Lack of control over collateral

Internal Use Only

Substandard Loans classified Substandard are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

Internal Use Only

Substandard

Key characteristics: • Negative trends • Significant deviation from original repayment source • Numerous extensions and/or renewals • Diversion of repayment funds • Delinquency • Failure to clean up operating line • Whenever debt is carried over without sufficient reason

Internal Use Only

Doubtful Loans classified Doubtful have all of the weaknesses inherent in those 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. Loans classified Loss are uncollectible and of such highly questionable and improbable.

Internal Use Only

Doubtful

Key characteristics: • Weaknesses noted for loans classified Substandard & not readily identified Loss • Undetermined value of collateral

Internal Use Only

Loss Loans classified Loss are uncollectible and of such little value that their continuance as a bankable asset is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather that it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future.

Internal Use Only

Doubtful

Key characteristics: • No readily identifiable source of repayment • Not well secured & not in process of collection • Severe delinquency

Internal Use Only

Questions?

Internal Use Only

Credit Evaluation School Nonaccrual

Internal Use Only

What is Nonaccrual?

• Accounting term • Describes the accounting treatment of a loan • NOTA LOAN RATING • NOTA LOAN CLASSIFICATION

Internal Use Only

What does it mean when a loan is placed on nonaccrual? • Loan becomes a nonearning asset • Loan must be reported as nonaccrual • Accrued interest is charged off • Future payments are applied to principal • Customer is typically NOT notified • Bank maintains two accounting records for the account

Internal Use Only

Loan should be reported as nonaccrual if… Loan is maintained on a cash basis because of deterioration in the financial condition of the borrower. OR When payment in full of principal or interest is not expected. OR When principal or interest has been in default for a period of 90 days or more unless the asset is both well secured and in the process of collection.

Internal Use Only

Well Secured? An asset is “well secured” if it is secured by collateral in the form or liens or pledges or real or personal property, including securities, that have a reliable value sufficient to discharge the debt (including accrued interest) in full or by the guarantee of a financially responsible party.

Internal Use Only

In process of collection? An asset is “in the process of collection” if collection of the asset is proceeding in due course either through legal action, including judgment enforcement procedures or, in appropriate circumstances, through collection efforts not involving legal action which are reasonably expected to result in repayment of the debt or in its restoration to a current status in the near future.

Internal Use Only

Nonaccrual Decision Tree N O IS THE LOAN 90 OR MORE DAYS PAST DUE?

Y E S

Is the loan well-secured AND In the process of collection?

Is full repayment reasonably assured?

YES

Y E S

N O

NONACCRUAL STATUS

ACCRUAL STATUS

Internal Use Only

Returning to accrual None of the loan’s principal and interest is due and unpaid, AND the bank expects repayment of the remaining contractual principal and interest

OR

When it otherwise becomes well secured AND in the process of collection.

Internal Use Only

Reviewing and Classifying Loans

INDIVIDUAL LOAN FILE REVIEW As we work through the files and identify the 6 P’s of credit, we are looking for:

•Problem credits (may not yet be identified) •Past due loans (is management manipulating) •Credit documentation exceptions •Violations of laws/regulations/policies •Concentrations of credit •Evidence of self-dealing loan transactions

ASSET MANAGER DUTIES • Collect data from examiners working files to aid in identifying trends • Compare examiner classification to internal classification • Determine if adequate risk controls exist • Adequacy of policies, practices, controls, procedures, servicing, etc. • Nonaccrual guidelines • Risk rating system-early identification of risk

LOAN CLASSIFICATION DEFINITIONS

Substandard Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

LOAN CLASSIFICATION DEFINITIONS

Doubtful Loans classified Doubtful have all the weaknesses inherent in those 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.

LOAN CLASSIFICATION DEFINITIONS Loss Loans classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future.

LOAN CLASSIFICATION DEFINITIONS

Listed for Special Mention A asset listed for Special Mention has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution's credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

UNACCEPTABLE OR HIGH RISK LOANS

• Illegal or illegal purpose • Speculative

• Finance changing business ownership • Construction loans without firm takeout • Loans for new business ventures/venture capital loans • Nonamortizing term loans • Loan where source of repayment is not firmly committed • Loans on unmarketable securities • Unsecured loans for real estate purposes

UNACCEPTABLE OR HIGH RISK LOANS

Other Considerations • Loans where management has no expertise • Loans that require special handling or controls • Abnormal amount of loans involving out of territory borrowers • Loans involving brokered deposits or link financing

ITEMS NEEDED TO REVIEW FILE

• Credit File Information • Financial Analysis

• Review and consideration of six “Ps” • Historical financial data and trends • Nature and degree of collateral • Capacity to retire debt in accordance with specified terms • Financial responsibility • Credit reports

ITEMS NEEDED TO REVIEW PORTFOLIO • External Credit File Information • Aware of bank’s service area and regional economy • Trend in the business’ industry • Bank management • Previous reports of examination • Prior examination loan decks • Loan committee minutes • Board reports and management information systems

COMMON RISKS IN LOAN PORTFOLIO

• Self dealing loans • Anxiety for income or growth • Weak servicing • Incomplete credit information • Poor supervision • Complacency • Poor risk evaluation • Concentrations of credit • Subprime Lending

SOURCES OF REPAYMENT

• Conversion of current assets to cash • Sale of non-current assets • Replacing debt with debt - refinancing • Equity injection

SOURCES OF REPAYMENT

CASH IS KING!

QUESTIONS?

Mock Discussions

Introductions

Introductions

Organization

Organization

Asking Questions

Asking Questions

Listening

Listening

Concluding the Discussion

Concluding the Discussion

Bad Habits

Eye Contact

Disinterested

Banker Admits to Fraud

Examiner classifies loan over something small

Banker doesn’t take examiner comments seriously

Credit Evaluation School

RED

FLAGS

What is a…

RED

FLAG

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

• A review of the previous ROE lists appraisal violations on multiple credits and during the current loan review, newly originated loans have similar violations. • During pre-planning of the loan scope, examiners discover several loans over the state’s legal lending limit. Management dismisses concern by saying the loans are to “good customers.”

Lack of a Structured Lending Format

• Bank makes all of its commercial real estate loans with fixed interest rates and for fully amortizing 30-year periods. • Monthly interest and annual principal payment on loan when borrower’s income is monthly.

Poor Oversight of Lending

Numerous Federal and State Violations Pertaining to Lending

• Several lenders made loans which exceed their loan authority. • Concentrations in Commercial Real Estate were found to exceed internal policy, but management was unaware.

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

• A review of the previous ROE lists appraisal violations on multiple credits and during the current loan review, newly originated loans have similar violations. • During pre-planning of the loan scope, examiners discover several loans over the state’s legal lending limit. Management dismisses concern by saying the loans are to “good customers.”

Lack of a Structured Lending Format

• Bank makes all of its commercial real estate loans with fixed interest rates and for fully amortizing 30-year periods. • Monthly interest and annual principal payment on loan when borrower’s income is monthly.

Poor Oversight of Lending

Numerous Federal and State Violations Pertaining to Lending

• Several lenders made loans which exceed their loan authority. • Concentrations in Commercial Real Estate were found to exceed internal policy, but management was unaware.

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

• Several loans on the bank’s internal watchlist lacked annual reviews, even though updated financials were in the credit file. • Construction loans are made without any inspection requirement. • Bank has multiple pieces of OREO, and some properties have not been visited in over 12 months. • Several loans were approved with DSCR below bank’s loan policy, no exception approvals were noted. • Several loans were missing environmental due diligence required by bank’s loan policy. • Repayment analyses of individuals do not include a deduction for personal living expenses. • Non-recurring capital gains were included in the global cash flow analysis. • Repayment analysis of a strip mall included no allocation for vacancy or reserves.

Non-Compliance With Loan Policies and Procedures

Inadequate Credit Analysis

Failure to Detect Existing and Emerging Loan Problems

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

Collection Difficulties Reduces Quality Time in Servicing Remaining Loan Portfolio

• Substandard loan has been identified to have an impairment, but the impairment amount has not been charged off.

• Large problem loan client has been granted four short-term renewals in order to provide a current rent roll and personal financial statement. • Annual review dated November 2019 provided an analysis of 2017 financial performance.

Failure of Early Recognition of Losses

Borrower Delays in Providing Financial Information

• Lenders spend most of their time with problem loan clients and there is little time to service other existing clients or solicit new business. • We do not have a collections or past due department. Lenders are responsible for their own collections.

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

Unauthorized Capitalization of Accrued Interest

• Smalltown Bank, a small community bank located in the southeastern United States, financed the construction of seven multi-family properties located on the west coast. The loans total 92 percent of Total Capital.

• John knows his builder/developer borrower Susan is a good person; she’s just fallen on hard times and can’t catch a break. John wants to help. John approves an advance off the line of credit to pay the past due accrued interest so the line of credit can be renewed. His credit officer is on vacation, but John is sure his credit officer won’t mind.

Loan Concentrations

• Midtown Bank’s ADC portfolio has historically hovered around 90 percent of Total Capital; however, the ADC portfolio has increased over the last three quarters and is now 114 percent of Total Capital.

Excessive Out of Territory Loans

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

• Smalltown Bank has a large portfolio of unsecured evergreen letters of credit related to its ADC portfolio. The economy and local development has been slowing. Smalltown Bank’s liquidity rating changed from a 2 to 3 at the most recent examination. • Smalltown Bank approved funding the construction of a high-end hotel. The hotel will be located across the street from a local amusement park. Projections based upon surrounding hotel performance is reassuring. However, the company which owns the amusement park was sued late last year. One local reporter claims the amusement park is going to close.

High Loan Growth

Excess Off-Balance Sheet Items, i.e. Loan Commitments and Letters of Credit

• Smalltown Bank increased its loan portfolio by 100 percent due to an 18-month lucrative incentive program which rewarded its lenders to produce.

Trends in Local and Regional Economies

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

• Since the Cycles R Us line of credit has been fully advanced for the last 11 months, John allows Cycles R Us to overdraw their checking account for a short period of time each month. A deposit on the 20 th of the month usually covers the negative balance. • Smalltown Bank does not complete a global debt service coverage analysis on its complex commercial relationships because it always lacks complete financial information. • Smalltown Bank President Smith is also a lender, performs his own underwriting, and gets approval from the Board for larger loans. Some larger loans have been made to friends of President Smith. Details in underwriting of loans to friends are vague and President Smith is defensive and uncooperative when asked about these loans.

Ineffective or Lax Credit Underwriting on New or Existing Loans

Borrower is Frequently Overdrawn or Experiencing Cash Flow Difficulties

Evergreen Loans

Insider Transactions

• Midtown Bank issues a letter of credit on behalf of Better Boat Sales. There is no expiration date on the letter of credit.

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

Over-Lending To Individuals And Industries

• “Since hiring Felicia and giving her loan authority, our loan growth has skyrocketed. Despite this economy, Felicia has been able to increase our loan portfolio 40 percent! She has the highest loan production of anyone and customers are lining up to meet with her. Go Felicia!”

Inexperienced Loan Officers

• “Cashy McCash-Face has total exposure of 28 percent of Total Capital, but this is not of concern due to high levels of liquidity Cashy has in a trust. We’ve always leant him money and he’s always paid.”

Inadequate Staffing

• Smalltown Bank performs a document review of all newly originated loans within tweleve months of their origination.

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

• The person who was supposed to be filing the UCCs was not aware they needed to be submitted for recordation. Going forward, this will be corrected.

Loan Pricing May Not Reflect Risk

Incomplete Loan Documentation

• Borrower signed the note, but there was no security agreement, guaranty agreement, or borrowing resolution.

Numerous Instances of Lien Imperfections

• “Great news! Felicia just closed a $9 million loan to construct a new cruise ship! Although the borrowers have limited experience, the projections are amazing. She was even able to offer them a rate 200 basis points lower than their best offer!!”

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

• Chuck, a longtime lender at Midtown Bank, did not understand why I asked about three missing annual reviews related to his clients. Chuck insisted it was not required by their policy and provided his well-read and worn copy of the loan manual he relies upon to support his claim. Chuck told me I should read the policy. The printed policy Chuck provided clearly stated an Annual Review was not required.

Loan Officer Unfamiliar With Lending Policies and Procedures

Lending Staff Do Not Understand Loan

• Can be any type of loan, but these are often: Participations, SBA, USDA, and HUD.

• Our loan officers choose which loans they would like to review annually. However, if the loan performing as agreed, it is not reviewed unless it becomes past due.

Inadequate Loan Review Process

MATCH THE RED FLAGS TO THE EXAMPLES PROVIDED

New Loan Products

• “Could you send someone out to the house your bank is financing? There isn’t a door on it any longer, and I think animals are living in it.”

Lack of Collateral Inspections

• Smalltown Bank has agreed to be the primary provider of chicken house financing for a regional chicken integrator. Smalltown has no previous agriculture lending experience and lacks knowledgeable staff.

Annual Clean-up of Operating Lines of Credit

• Cycles R Us has a $100M operating line of credit which has been fully advanced for four years.

QUESTIONS?

Internal Use Only

Credit Evaluation School Loan Writeups

Internal Use Only

Criticized Vs. Classified Loans • All four categories are considered - Criticized • All but Special Mention are considered - Classified •Special Mention • Substandard •Doubtful •Loss

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Internal Use Only

Loan Writeups Rules for including a loan writeup in an examination report vary among regulators, states and agencies: •Management disagrees with examiner •Dollar amount represents a significant percentage of assets or capital •EIC discretion •Others (concentrations, economic impact - COVID)

Internal Use Only

Loan Writeups The writeup format should cover the 6 Ps: •Person

•Purpose •Payment • Protection •Problem • Prospects

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Internal Use Only

Types of Writeups • Agencies have different formats for loan writeups • May vary depending on the examination • Full: detail of the credit relationship & 6 Ps • Abbreviated: summary (usually one paragraph) • Bullet points: highlight each area

Internal Use Only

Contents of a Writeup All write-ups should include the following: • Identification of Borrower • Description of Debt • Description of Collateral • Borrower’s Financial Status • Classification • Management’s comments, plan, and/or prospects

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Internal Use Only

Identification of Borrower • Name and/or title of borrower – note insiders • Nature of borrower • Nature of business or employment • Capacity • Identify Cosigners, Endorsers & Guarantors Note: The identification of the obligor can be in the heading of the write-up or in the written comments. It is also standard procedure to include the total balance of the debt above the heading, in thousands of dollars.

Internal Use Only

Identification of Borrower

Examples:

1,200 ABC Corporation End: Alfred B. Cook, President/Owner Textile Manufacturer

1,200 ABC Corporation

• The corporation is in manufacturing and operated by the owner. All notes are signed and endorsed by Mr. Alfred B. Cook, president and owner.

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Internal Use Only

Description of Debt

• Original Amount Borrowed • Original Date • Original Due Date/Terms • Purpose of Loan • Repayment Source • Present Balance

Internal Use Only

Description of Debt Note: If any portion of the debt was previously charged-off or paid from liquidation of the collateral, this should be noted. •Past due status is applicable

•Tie-ins: related debt/related interests •Note any specific reserve balances

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Internal Use Only

Description of Debt

Example:

Debt consists of a $150,000 note originating 1-20-x8 at the same amount due 1-20-x9. The purpose of the loan was to purchase the collateral to be repaid from maker’s income.

Internal Use Only

Description of Debt

Example: Debt consists of two installment notes totaling $100M, due $500 each monthly, past due two payments each. The notes originated at $50M and $75M respectively. The purpose of both loans was for working capital and repayment was to come from income. The secondary source of repayment was from the guarantor, Mr. Johnson who has a NW of $1,300M as reflected in 6-30-x8 financial statement.

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Internal Use Only

Description of Collateral

• Type of Collateral • Examples: Real Estate, Inventory, Accounts Receivable, Automobiles, etc. • Location of Collateral (out of trade area) • Appraised value or estimated value

Internal Use Only

Description of Collateral •Note if estimates of the value higher or lower than appraised value •Note if internal or external appraisal & date of valuation if pertinent to classification •Specialized collateral or work in progress may need special consideration •Appraisal violations should be noted only

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Internal Use Only

Description of Collateral Example: Appraisal Violation Noted Within Writeup The appraisal does not meet the requirements for a Certified Appraisal. Refer to Schedule of Violations of Laws and Regulations elsewhere in this report of examination.

Internal Use Only

Description of Collateral

Example: Collateral Description

Collateral consists of 2 AL valued at $100M (internal evaluation). The property is unimproved and zoned commercial.

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Internal Use Only

Description of Collateral

Example: Collateral Description

Collateral is listed as inventory and AR valued at $125M on the makers audited 12-31-x8 financial statement. Management indicated that the liquidation value would probably be $100M.

Internal Use Only

Financial Exhibits Preparer - Internal, CPA (type), Other Term •Annual (Fiscal Year) •Interim List major categories only Note: Depreciation and amortization should be footnoted on the operating statement

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Internal Use Only

Financial Exhibits

Note Abbreviations:

Balance Sheet

AP -Accounts Payable CA - Current Assets CPLTD - Current Portion of

AP -Accounts Receivable CL - Current Liabilities CSVLI - Cash Surrender

Long-Term Debt

Value Life Insurance

FA - Fixed Assets

LTD - Long-Term Debt

NR - Notes Receivable TL - Total Liabilities

NW - Net Worth

UP/RE- Undivided Profits

Internal Use Only

Financial Exhibits

Note Abbreviations:

Income Statement

COGS - Cost of Goods Sold

GP - Gross Profit NP – Net Profit

NI - Net Income

NIAT - Net Income After Taxes

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Internal Use Only

Classification Point out all the reasons for classification

•Marginal or insufficient collateral •Poor or weak financial condition •Lack of a repayment plan •Past due status •Others?

Internal Use Only

Classification Example: Poor or Weak Financial Condition

ABC Corporation’s 12-31-x9 audited financial statements reflected TA of $1,200M, TL of $2,000M, and negative NW of $800M. Also reflected was GP of $2,000M, COGS of $1,000M, Operating Expenses of $1,200M, and Net Loss of $200M.

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Internal Use Only

Classification • Clear & concise reasons for classification • Accurate • Include management's response including any commitments • If debt was classified at the previous exam, include the information - how classified & what amount

Internal Use Only

Classification

Example: Previously Classified

Debt classified Substandard at the previous examination in the amount of $150,000. Collateral remains the same.

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Internal Use Only

Classification

Amounts secured by cash collateral not classified IF completely documented: •Assigned Certificates of Deposit •Assigned savings accounts with holds •Listed securities with adequate documentation

Internal Use Only

Classification Example: Cash Collateral Excluded

The $10,000 CD (certificate of deposit) assigned as collateral is deleted from classification, with the remaining balance classified Substandard.

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Internal Use Only

Classification Government guaranties are also removed from classification •Small Business Administration (SBA) •Farm Service Agency (FSA) •Some states have loan guaranty programs •Others?

Internal Use Only

Classification Example: Government Guarantees Excluded

The $200M note is 90% guaranteed by the Small Business Administration. The guaranty is deleted from classification and the remaining $20M is classified Loss.

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Internal Use Only

Classification As was noted in the Collateral section:

Add a notation if any violations or contravention of regulatory guidance are noted & refer to that section of the report of examination.

Internal Use Only

Classification Example: Violation Cited Elsewhere

This line is in excess of the bank’s legal lending limit. Refer to Violations of Law and Regulations section of this report.

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Internal Use Only

Management’s Comments, Plans and/or Prospects • This can be in the write-up before classification or included in classification comments • Include management comments regarding the problem with the credit and/or borrower • Include any plan’s management has to remedy the problem or work with the borrower • Include management’s response to the classification – agree/disagree

Internal Use Only

Management’s Comments, Plans, and/or Prospects

Example: During loan discussion, bank management stated the company is experiencing cash flow difficulties stemming from an increase in the price of materials. They have requested updated financial information to determine current cash flow and may temporarily restructure notes.

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Internal Use Only

Management’s Comments, Plans and/or Prospects

Example: Bank management stated that the cause of the current past due status was a temporary cash flow deficiency due to delays in the company’s supply chain that should be resolved in the next six months. They further stated they plan to work with the borrower until they can return to positive cash flow.

Internal Use Only

Management’s Comments, Plans and/or Prospects

Example –Management Disagrees: This relationship is downgraded to Substandard based on apparent insufficient capacity to repay debt, collateral shortfall, no outside sources of income, and lack of meaningful guarantor support. Bank Management disagreed with the classification and stated that all payments have been made as agreed since returning to amortization last month. Management plans to continue to work with the borrowers until they return to profitability.

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