Credit Evaluation School - October 2023

Credit Evaluation School

October 3-12 , 2023 Live Virtual

@ www.csbs.org ε @csbsnews

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

Credit Evaluation School Live Virtual October 3-12, 2023

Week 1 Tuesday, October 3, 2023 1:00 pm – 1:30 pm

Introduction & Goals for the Week

Pre-Course Recap

1:30 pm – 1:45 pm

Break

1:45 pm –2:00 pm

Credit Evaluation Examiner Roles & Responsibilities: Asset Manager and Loan Reviewer

2:00 pm – 2:45 pm

Identifying the 6Ps & Their Documents

2:45 pm – 3:30 pm

Classified Definitions Loan Ratings and Special Mention

3:30 pm – 3:45 pm

Hand Out Line Decks & Review

3:45 pm – 4:00 pm

Wednesday, October 4, 2023 1:00 pm – 1:15 pm

What I Learned Yesterday

Decision Strategies & Loan Classification

1:15 pm – 2:15 pm 2:15 pm – 2:30 pm 2:30 pm – 2:45 pm 2:45 pm – 3:15 pm 3:15 pm – 3:45 pm 3:45 pm – 4:00 pm 1:20 pm – 1:45 pm 1:45 pm – 2:15 pm 2:15 pm – 2:30 pm 2:30 pm – 2:45 pm 2:45 pm – 3:20 pm 3:20 pm – 4:00 pm

Break

Quick Hitters

Loan Writeups Quick Hitters End of Day Q&A

Thursday, October 5, 2023 1:00 pm – 1:20 pm

What I Learned Yesterday

Quick Hitters

Red Flags

Break

Quick Hitters

Mock Discussions Instructor Q&A

Internal Use Only

Week 2 Tuesday, October 10, 2023 1:00 pm – 1:20 pm

Best Thing I Learned Last Week

Week 1 Recap Instructor Q&A

1:20 pm – 1:45 pm 1:45 pm – 2:00 pm 2:00 pm – 2:15 pm 2:15 pm – 3:00 pm

Break

Red Flags

Small Group Loan Discussion Planning

3:00 pm – 4:00 pm

Wednesday, October 11, 2023 1:00 pm – 1:10 pm

What I Learned Yesterday

Instructor Q&A

1:10 pm – 1:25 pm 1:25 pm – 4:00 pm

Small Group Loan Discussions

Thursday, October 12, 2023 1:00 pm – 1:15 pm

Best Thing I Learned

Review & Discuss Line Decks Asset Quality Discussion

1:15 pm – 1:45 pm 1:45 pm – 2:15 pm 2:15 pm – 2:30 pm 2:30 pm – 2:50 pm 2:50 pm – 3:30 pm 3:30 pm – 4:00 pm

Break

AQ Quick Hitters Instructor Q&A

Final Quiz & End of Class

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Credit Evaluation School October 3-12, 2023

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Instructors

Marcus Andrews

Zac Smith

Bank Examinations Coordinator Alabama State Banking Department

Senior Bank Examiner Iowa Division of Banking

Curtis Larsen

Senior Financial Institutions Examiner California Department of Financial Protection & Innovation Roberto Chavez

Bank Examinations Specialist, Sr. Alabama State Banking Department

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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

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Class Demographics - States

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Goals for the School

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

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Questions?

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Credit Evaluation Examiner Roles & Responsibilities Asset Manager vs Loan Reviewer

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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

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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 line sheets from examiners

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Loan Selection

Loan Scoping

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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?

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Loan Selection Condition of the bank • Previous Examination Reports • Uniform Bank Performance Report • Correspondence Risk Focus • Commercial loans

• Real Estate • Consumer

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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

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

 Loans above the “cut”  Letters of credit  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

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

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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.

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Let’s take a swing at Identifying the 6 P’s

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What are the 6 P’s?

Method of evaluating the asset quality of a loan.

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Take a moment and review the Sample Writeup included in your eBook.

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The 6 P’s Are…. 1. Person (People) • Borrower • Co-Borrower • Guarantor • Related Entity 2. Purpose • What, why, and how? 3. Payment

4. Protection

• Collateral

5. Problem

• What went wrong?

6. Prospects

• Potential remedies?

• Primary, Secondary, Tertiary

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Person

The 19 TH Hole, INC. • By: Tiger Woods, President • Gty: Tiger Woods Business operates as a local bar/restaurant/indoor golf simulation.

Person

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Indebtedness is the balance of a 1,100M note originated 10-5-16 with principal and interest payable at $7,567 per month for 20 years. Purpose of the loan was to purchase an existing restaurant and add an indoor golf simulation bay. Source of repayment is from the operation of the bar. Loan was 78 days past due and payments have been extended five times since origination. A payment was made during the examination bringing the note current.

Purpose

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Paym ent

The business continues to struggle financially. CPA-compiled financials as of 12-31-18 indicate a highly leveraged operation and reflect TA of 1,490M, TL of 1,610M, for a deficit NW of 120M. Assets are concentrated in net FA of 1,395M including various F&F and M&E. Liquidity is tight and was (14M). Operating income for 2018 shows a net loss of 100M on gross sales of 750M. Cash flow from operations available to service debt totals (35M). An unsigned and stale personal statement on the guarantor dated 11-15-17 adds minimal support and little liquidity with TA of 542M and NW of 145M. Cash was only 2M.

Payment

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Protection

Collateral consists of a first REM on the commercial building located in Iowa City, Iowa along with a blanket security agreement covering general business assets. An appraisal performed on 9-2-16 indicates an “as is” value of 950M and an “as completed” value of 1,350M.

Protection

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78 Days PD

The business was a new venture for Mr. Woods, who previously worked as a semi-professional golfer. The golf simulation bay closed last winter as Mr. Woods lost his contract with operator/servicer of the golf simulator. The entity struggles with employee turnover, unreliable suppliers, and pressure from existing competition. The operation continues to be unprofitable on a monthly basis and some suppliers are demanding cash upon delivery further limiting liquidity. President Mickelson now estimates the value of the property at 1,200M based on sales of similar properties. Due the to the apparent cash flow and liquidity issues, unprofitable operations, leveraged position, and marginal collateral coverage, the loan is classified Substandard. This is a downgrade from management’s internal Pass rating.

Problem

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Reviewing and Classifying Loans

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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

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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

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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.

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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.

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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.

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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.

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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 • Non-amortizing term loans • Loan where source of repayment is not firmly committed • Loans on unmarketable securities • Unsecured loans for real estate purposes

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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

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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

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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

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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

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SOURCES OF REPAYMENT

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

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SOURCES OF REPAYMENT

CASH IS KING!

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Loan Write-ups

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SPECIAL MENTION VS. CLASSIFIED LOANS: • Special Mention are loans of questionable quality, but involving insufficient risk to warrant Classification.

• The following are Classified designations: • Substandard • Doubtful • Loss

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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 (credit concentrations, economic impact ex: COVID)

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LOAN WRITEUPS The writeup format should cover the 6 Ps: • Person

• Purpose • Payment • Protection • Problem • Prospects

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Types of a Write-ups Agencies have different formats for loan write-ups, and they may vary depending on the examination:

• Full – detail of the credit relationship and 6 Ps. • Abbreviated – summary usually one paragraph • Bullet points – highlight each area

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Contents of a Write-up 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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IDENTIFICATION OF BORROWER • Name and/or title of borrower - Note if the borrower is an insider or related interest of an insider as defined by Regulation O, or state code if appropriate • Nature of borrower (Individual, partnership, corporation, etc.)

• Nature of business or employment • Capacity in which individuals sign • Identify Cosigners, Endorsers, and 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.

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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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DESCRIPTION OF DEBT • Original amount borrowed (per note or with notation of total original if renewals with reductions or combination of various notes) • Original Date (of note or line if renewals involved) • Original Due date/terms • Purpose of loan • Repayment source • Present balance

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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, if applicable

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DESCRIPTION OF DEBT EXAMPLES:

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.

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DESCRIPTION OF DEBT

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

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DESCRIPTION OF COLLATERAL • Note if loan officer estimates the value higher or lower than the appraised value • Note if internal or external appraisal and date of valuation if it is pertinent to the classification • Specialized collateral or work in progress may need special consideration • Appraisal violations should be noted only, not restated

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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.

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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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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.

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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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FINANCIAL EXHIBITS Note Abbreviations: (CHECK INSIDE OF REPORT COVER OR BACK PAGE) BALANCE SHEET AR - Accounts Receivable AP - Accounts Payable CA - Current Assets

CPLTD - Current Portion of Long-Term Debt

FA - Fixed Assets

CL - Current Liabilities LTD - Long-term debt TL - Total Liabilities UP/RE- Undivided Profits NW - Net Worth

NR - Notes Receivable CSVLI-Cash surrender value life insurance

INCOME STATEMENT

GP - Gross Profit NP – Net Profit

COGS - Cost of Goods Sold

NI - Net Income

NIAT - Net Income After Taxes

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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?

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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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CLASSIFICATION • Clear and concise reasons for classification • Accurate • Include management's response including any commitments (see Management’s Comments, Plans and/or Prospects section) • If the debt was classified at the previous examination, include the information - how classified, and at what amount

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

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

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CLASSIFICATION EXAMPLE – GOVERNMENT GUARNATYS 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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CLASSIFICATION Just as was noted in the Collateral section:

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

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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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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 or disagree).

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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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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.

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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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GENERAL WRITEUP TIPS • Use the 6 P’s as a guide

• Detailed vs. short form vs. bullet point • Outline key points – keep it simple • Break up paragraphs (not one huge one) • Include management’s comments and any commitments made • See Guide Sheet handout

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Mock Discussions

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Introductions

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Introductions

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Organization

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Organization

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Asking Questions

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Asking Questions

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Listening

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Listening

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Concluding the Discussion

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Concluding the Discussion

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Bad Habits

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Eye Contact

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Disinterested

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Banker Admits to Fraud

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Examiner classifies loan over something small

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Banker doesn’t take examiner comments seriously

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Asset Quality Analyzing and Rating Asset Quality

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C A M E L S Asset quality (AQ) is one of the most critical areas in determining the overall condition of a bank. • The primary factor affecting overall asset quality is the quality of the loan portfolio and the credit administration program. • Loans typically comprise a majority of a bank’s assets and carry the greatest amount of risk to capital. • Securities, OREO, and other earning (or non) assets the institution may have on their books can also greatly affect AQ. Examiners should be diligent and focused when reviewing a bank’s assets, as they can significantly impact most other facts of bank operations.

*FDIC RMS Manual of Examination Policies

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Why is AQ important? • Core earnings are reliant on the quality and earning ability of assets (i.e., accrual vs. nonaccrual; classifications’ impact on the loan loss provisions; impairment of securities). • Strong capital levels are excellent; however, quality assets are needed to ensure retained earnings are augmenting capital and that capital is being used as intended. • Poor asset quality continues to be a primary contributor in bank failures.

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Analyze AQ Questions to keep in mind when analyzing the overall AQ: • What are the loan reviewers' findings? • Was credit risk identification practices appropriate (examiner downgrades of credits)? • Were credit underwriting and administration weaknesses noted? • Amount and severity of technical exceptions. • Are the issues isolated or do they indicate a systemic issue? • What are the reasons for the issues? • Weak policies/procedures • Inadequate loan officer or credit administration staff training • Weak underwriting

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Analyze AQ - Credit Administration • Level and severity of weaknesses identified. • Promptness of identification, correction, and taking measures for future prevention. • Accuracy of internal risk ratings. • Identifying and taking losses in a timely manner. • Accurate and timely reporting to senior management and Board.

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Analyze AQ – Key Ratios • Adversely Classified Items Coverage Ratio (Total adversely classified items to Tier 1 Capital & ACL). • Total LN&LS-90+ Days Past Due and Nonaccrual – UBPR Summary Ratios Page • ACL to Total LN&LS – Summary Ratios Page • Concentrations – Concentrations of Credit Page • Problems Assets – Analysis of Past Due, Nonaccrual, and RTD Pages • Net Loans & Leases to Assets – UBPR Summary Ratios Page • Net Loans & Leases Growth Rate – UBPR Summary Ratios Page • Loan portfolio composition – Balance Sheet and Loan Mix Pages

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Analyze AQ – Other areas to consider • Portfolio composition • Strategic and succession plans

• Policies and procedures • Overall bank credit culture • Allowance for Credit Losses (ACL) • Concentrations • OREO/OA • Securities portfolio

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Considerations for AQ Rating – FDIC Manual • The adequacy of underwriting standards, soundness of credit administration practices, and appropriateness of risk identification practices. • The level, distribution, severity, and trend of problem, classified, nonaccrual, restructured, delinquent, and nonperforming assets for both on- and off-balance sheet transactions. • The adequacy of the ACL and other asset valuation reserves. • The credit risk arising from or reduced by off-balance sheet transactions, such as unfunded commitments, credit derivatives, commercial and standby letters of credit, and lines of credit.

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Considerations for AQ Rating cont. • The diversification and quality of the loan and investment portfolios. • The extent of securities underwriting activities and exposure to counter parties in trading activities. • The existence of asset concentrations. • The adequacy of loan and investment policies, procedures, and practices. • The ability of management to properly administer its assets, including the timely identification and collection of problem assets. • The adequacy of internal controls and management information systems. • The volume and nature of credit documentation exceptions.

*FDIC RMS Manual of Examination Policies

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Rating the asset quality factor • Like other components, the AQ rating is based on a 1 through 5 scale. • The asset quality rating definitions are applied following a thorough evaluation of existing and potential risks and the mitigation of those risks. The definition of each rating is as follows:

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Asset Quality Rating - 1 A rating of 1 indicates strong asset quality and credit administration practices. Identified weaknesses are minor in nature and risk exposure is modest in relation to capital protection and management’s abilities. Asset quality in such institutions is of minimal supervisory concern.

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Asset Quality Rating - 2 A rating of 2 indicates satisfactory asset quality and credit administration practices. The level and severity of classifications and other weaknesses warrant a limited level of supervisory attention. Risk exposure is commensurate with capital protection and management’s abilities.

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Asset Quality Rating - 3 A rating of 3 is assigned when asset quality or credit administration practices are less than satisfactory. Trends may be stable or indicate deterioration in asset quality or an increase in risk exposure. The level and severity of classified assets, other weaknesses, and risks require an elevated level of supervisory concern. There is generally a need to improve credit administration and risk management practices.

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Asset Quality Rating - 4 A rating of 4 is assigned to financial institutions with deficient asset quality or credit administration practices. The levels of risk and problem assets are significant, inadequately controlled, and subject the financial institution to potential losses that, if left unchecked, may threaten its viability.

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Asset Quality Rating - 5 A rating of 5 represents critically deficient asset quality or credit administration practices that present an imminent threat to the institution’s viability.

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Suggested AQ Comment This is a sample format and can be utilized as framework for an AQ comment. However, each examination is different and therefore, each AQ comment should be different. Utilize your state’s guidelines when writing AQ comments.

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First Paragraph: • Translate the numerical rating to a qualitative statement of AQ (i.e., Asset quality is strong). • Adversely classified items ratio, comparisons to prior periods or exams as appropriate. • Narrate the major findings (underwriting weaknesses). • Composition of classified/criticized assets (loans, securities, OREO, etc.) and the respective classifications (Substandard, Doubtful, etc.). • Internal classification/Watch List numbers, if necessary (ex: “few downgrades from management’s internal ratings”). • Level and trend of nonaccrual and past dues, if necessary.

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Second Paragraph (Risk Rating Accuracy/Risk Identification Practices):

• Level and amount of examiner downgrades • Adequacy of internal loan grading system • Adequacy of independent loan review

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Third Paragraph Address major findings. If none identified, then address acceptability of credit and loan administration practices.

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Fourth Paragraph The level and trend of the Allowance for Credit Losses (ACL) as well as the methodology associated with it. • New accounting standard introduces the current expected credit losses methodology (CECL) for estimating allowances for credit losses (effective January 1, 2023). • CECL requires financial institutions and other covered entities to recognize lifetime expected credit losses for a wide range of financial assets based not only on past events and current conditions, but also on reasonable and supportable forecasts.

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Subsequent Items to Consider • Concentrations • OREO • Investment portfolio • Off-balance sheet items

• Internal controls and management information systems • Adequacy of loan and investment policies, procedures, and practices

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AM Duties – Quick Overview • Scope loans/OREO for examiner review • Follow-up on prior examination findings/recommendations/violations/contraventions. • Review Loan Committee Minutes • Review Loan/Lending Policy and other lending policies, if needed. • Review UBPR/Call Report information related to AQ • Review completed linesheets from credit examiners. • Compile and review AQ related findings/recommendations/violations/contraventions. • Participate in individual loan discussions. • Conduct small loan (Discuss Only) discussions. • Review/edit loan write-ups • Update management on exam related AQ findings. • Prepare AQ comment and report pages. (for ECC, RMA, Concentrations)

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Examinations Data and Ratios Page (EDR) Exercise – Asset Quality Rating

Each of the following is a copy of an EDR page pulled from actual Reports of Examination. With the limited information given, identify an AQ rating for each of the following examples.

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Credit Evaluation School Loan Discussion Instructions

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Objectives

1. Determine which loans should/should not be discussed with the loan officer.

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Objectives

2. Choose pertinent questions (based on 6Ps) to ask the loan officer regarding each loan to be discussed.

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Objectives

3. Rate loans properly based on discussion and evaluation of loan quality.

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Objectives

4. Evaluate communication skills.

* The accuracy of your ratings decisions and communication skills will be evaluated by the instructors .

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Introduction and Overview • Line Deck consists of of 20 lines. • Students should plan on spending up to 8 hours outside of class time between now and the beginning of next Tuesday’s session reviewing these lines. • On Tuesday, 10/7, we will break into your groups for review as a group. • On Wednesday, 10/8, students in the group setting will be discussing the lines with instructors, • Instructors will act as the loan officer responsible for the credit. • Students will assign a rating to each line on the Loan Classification Recap. • Students will write a bullet point writeup in the 6P format for one classified line. • Students will complete a self-evaluation of their loan discussion

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Schedule • Tuesday, October 3: Hand out Line Deck • Tuesday, October 10: Loan Discussion Prep • Wednesday, October 11: Loan Discussions • Thursday, October 12: Materials due - students must turn in loan classifications, self-evaluation, and bullet-point writeup on a classified line by 10 AM Eastern .

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Preparation 1. Look through all lines individually and identify the 6Ps for each line 2. Review the lines together with your group and determine which lines need to be discussed with the loan officers 3. As a group, formulate questions for those lines which need clarification and discussion with the loan officers 4. Students should be prepared to discuss any of the loans in the line deck

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Discussion Guidelines • Instructors will act as loan officers, responsible for specific lines • Students should be prepared to discuss any of the loans in the line deck • Each group member must discuss at least one loan before any member can discuss a second loan • The group must agree on the loans to be discussed

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Discussion & Loan Rating Process

• The group will have 20 minutes with each loan officer to discuss their lines • The discussion is followed by a 10 minute debrief with your group to finalize notes • This is repeated for three rounds, allowing each group time with each instructor/loan officer

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Loan Rating Decisions • Immediately following your group’s completion of all three rounds of discussion, each student will complete the Loan Classification Recap • Assign a rating to each line in the deck (Pass, Special Mention, Substandard, Doubtful, or Loss) • Support each rating decision with 2-3 bullet points

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• The loan rating decisions are made individually • Each group may hear different explanations/ comments regarding the lines discussed • Discussion with other groups should be avoided when making a final rating decision

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• Each student will complete a bullet point writeup using the 6P format • Only classified lines are to be written up • Substandard, Doubtful, or Loss • Examiners do not write up Pass lines Bullet Point Writeups

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• Each student will complete a Loan Discussion Self-Evaluation Self-Evaluation

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Questions?

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Loan Classifications – Discussion STUDENT INSTRUCTIONS

INTRODUCTION AND OVERVIEW OF EXERCISE The Line Deck consists of 20 lines. Students should plan on spending up to 8 hours outside of class time between now and the beginning of next Tuesday’s session reviewing these lines. On Tuesday, 10/10, we will break into your groups for review as a group. On Wednesday, 10/11, students, in the group setting, will be discussing the lines with instructors. The instructors will be playing the part of the loan officer responsible for the credit. 1. A rating (Pass, Special Mention, Substandard, Doubtful, or Loss) will be assigned to each line on the Loan Classifications link. 2. Each student will then write a bullet points writeup using the Loan Write-Up Bullet Points link for one classified line. 3. Lastly, students will complete the Self-Evaluation link. 4. All three of the above links are to be completed no later than 10 AM Eastern on Thursday, 10/12. OBJECTIVES 1. Determine which loans should/should not be discussed with the loan officer. 2. Choose pertinent questions (based on 6Ps) to ask the loan officer regarding each loan to be discussed. 3. Rate loans properly based on discussion and evaluation of loan quality. 4. Evaluate communication skills. * The accuracy of your ratings decisions and communication skills will be evaluated by the instructors. PREPARATION Students will first look through all 20 lines individually and identify the 6Ps for each line. Once students are placed into groups on Tuesday 10/10, the group should use the time to briefly review the lines together and determine which lines need to be discussed with the loan officers. The students will then, as a group, formulate questions for those lines which need clarification and discussion with the loan officers. Students should be prepared to discuss any of the loans in the line deck. GUIDELINES FOR DISCUSSION • Each instructor will act as a loan officer, responsible for specific lines in the deck. The instructors will inform the students which loans are handled by each of the loan officers. • Students should be prepared to discuss any of the loans in the deck. • Each group member must discuss at least one loan before any group member can discuss a second loan. • The group must agree on the loans to be discussed. If a group member wants to discuss a loan that the rest of the group does not want to discuss, that loan may be discussed only if time allows. DISCUSSION AND LOAN RATING MECHANICS The group will have 20 minutes with each loan officer to discuss that loan officer’s lines, followed by a 10-minute break, part of which should be used to finalize any notes taken during the discussion. This will be repeated for four rounds (each group with each loan officer).

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Loan Classifications – Discussion STUDENT INSTRUCTIONS

LOAN RATING DECISIONS Immediately following your group’s completion of all four rounds of discussion, you as an individual should complete the Loan Classifications link. Assign a rating (Pass, Special Mention, Substandard, Doubtful, or Loss) to each line in the deck. Justify/support each decision made using 2-3 bullet points. Remember, these are individual rating decisions. Each group may also hear different explanations/comments regarding the lines discussed, so discussion with other groups should be avoided when making a final rating decision. BULLET POINT WRITEUP FOR A CLASSIFIED LINE Each student should choose one loan to complete a bullet point writeup using the Loan Write-Up Bullet Points link. Remember that only classified lines (Substandard, Doubtful, Loss) are to be

written up (examiners do not write up Pass lines). LOAN DISCUSSION SELF-EVALUATION Each student should complete the Loan Discussion Self-Evaluation link.

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SPECIAL MENTION and CLASSIFIED LOAN RATING DEFINITIONS

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. Key Characteristics: • Loans of questionable quality, but involving insufficient risk to warrant Classification • Weak underwriting, administration, and/or imprudent lending practices (improper loan structure, inadequate loan agreements or covenants, incomplete or inadequate documentation to adequately monitor the loan) • Borrowers with adverse operating trends (declining revenues or margins) • Borrowers with ill-proportioned balance sheet (e.g., increasing inventory without an increase in sales, high leverage, tight liquidity) • Collateral concerns • *(Special Mention assets may or may not have characteristics that management action would remedy) 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. Key Characteristics:

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• Negative trends in – Cash Flow; Profitability; Net Worth; Liquidity; Leverage • Significant deviation from the original repayment source • Numerous extensions and/or renewals • Diversion of repayment funds • Delinquency • Failure to clean up a short-term operating line • Whenever debt is carried over without sufficient reason 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. Key Characteristics: • Weaknesses noted for loans classified Substandard and not readily identified Loss • Undetermined value of collateral 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 occur in the future. Key Characteristics: • No readily identifiable source of repayment (cash flow or liquidation of collateral) • Not well secured and not in process of collection • Severe delinquency

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6 P Format

Person/People Who is the borrower? What is the borrower’s primary business? Who are the owners of the business? What is the borrower’s background and experience? Are there guarantors? Are there any related businesses which need to be discussed? Purpose How are the loan proceeds being used? Is the structure of the financing appropriate for the loan purpose? Are the repayment terms appropriate considering the frequency and source of repayment? Protection What is the collateral? What is condition and value of the collateral? How is the lender’s interest in the collateral secured? Payment What is the primary source of repayment? Is this repayment source adequate to repay the loan? What is the secondary source of repayment? Is this repayment source adequate to repay the loan? Is there a tertiary source of repayment? Is this repayment source adequate to repay the loan? Problem Do any weaknesses exist which are jeopardizing repayment of the loan? Are there any potential weaknesses which have emerged? Prospects What actions are being taken by the borrower or the bank to address the weaknesses related to the loan?

ABBREVIATIONS USED IN LINECARDS OR LOAN COMMITTEE MEMORANDUMS:

AL

Acres of Land

LS Livestock M&E Machinery & Equipment M/M Mr. and Mrs. MI Monthly Interest Mo. Monthly Mtg Mortgage P Prime Rate P&L Profit & Loss Statement PATL Pledged against total liability (collateral listed is pledged against all debt) RE Real Estate Rec. Recorded date S/S Shares of Stock SA Security Agreement SBA Small Business Administration

AR Accounts Receivable ARM Adjustable Rate Mortgage Assign Assignment AV Appraised Value Brand Brand Filing CD Certificate of Deposit CFD Contract for Deed CRP Crop Reduction Program D/T Deed of Trust (similar to Security Deed) End Endorser F&F Furniture & Fixtures F&G Feed & Grain FmHA Farmers Home Administration FS Financial Statement GTY Guaranty Int Interest INS Insurance Inv Inventory JM Joint Maker LC Letter of Credit LOC Line of Credit

T/C

Title Certificate

TI Title Insurance UCC Uniform Commercial Code W/C Working Capital

Loan Write-up Guide Sheet

A. Identification of Obligor

1. Amount of Current Debt 2. Delinquency/Nonaccrual State Associated with the Debt 3. Name of Borrower a. Individual b. Corporation 1. Executive officers Signing c. Partnership 1. General and Limited Partners 4. Occupation

5. Previously Classified 6. Internally Identified

B. Description of Debt

1. Describe Individually or Collectively 2. Terms Associated with Debt 3. Performance to Date

C. Description of Collateral 1. Describe individually along with dated valuation and source

a. Describe if management discounts collateral for liquidation purposes b. Describe if collateral is crossed to all loans

D. Financial Statements and Analysis 1. Describe basic elements of statements, financial and income 2. Indicate any discrepancies between past and current statements a. Increase in liabilities without a corresponding increase in assets b. Disproportionate increases in liabilities over capital support 3. Indicate projections based upon pro forma provided by borrower or historical review

E. Reasons for Classification/Management’s Response 1. Describe, in your opinion, the flaws in the credit a. Underwriting

b. Nonperformance c. Collateral shortfall d. Lack of capacity 2. Management’s Response

a. Efforts to correct deficiencies noted b. Disagrees with classification