June 15, 2011 Presented by: - PowerPoint Presentation

1. June 15, 2011Presented by:Robin D. Hoag, CPA, CMC Robert M. Parks, CPACommercial Loan Auditing For Internal Auditors

2. Objectives & OverviewSolid Understanding of MBL’sTrends in Commercial Lending - MBL’sRegulatory ConsiderationRisk Management ImplicationsBasic Underwriting CriteriaMBL Audit Programs 2

3. Objectives & OverviewCommercial loan workout arrangementsRisk rating commercial loansInternal controlsResourcesInternal Audit Roles 3

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6. Policy – Board Reviewed and ApprovedExperience in commercial lending - MBLLoan LimitsCapital LimitationsConcentration riskCredit RiskInsidersRegulatory Considerations

7. Proceeds used for commercial, corporate, investment, agricultural purposesBalances aggregated to member exceed $50,000Participation loans, or purchased loans with the same origin from another credit unionMember Business Loans

8. Prohibited transactions for MBL’sCEO, COO, CFO, senior executivesFamily members of the aboveLoans in which the credit union will share profits of the saleLoans to compensated directorsRegulatory Considerations

9. Construction and Development Loans for Commercial or Residential PropertyLimitation of 15% of net worthSingle family residences by individual with 25% equity interest are allowedRegulatory Considerations

10. Policies – Written to manage the risk and loan types granted, board approved and annually reviewedNCUA Supervisory Letter: 2009 Current Risks in Business Lending and Sound Risk Management Practices – A Must ReadUnderwriting and MBL experience required -Two (2) years experience by your commercial lender at a minimum in the type of loans being approved and underwrittenRegulatory Considerations

11. Minimums RequiredTrade areas, geography – knowledge of valueTypes of business loans to be offeredLimitations in terms of MBL to assets and net worth; individual types and aggregateIndividual member limits or concentrationsMBL Policy - Regulatory

12. Analyze and Document borrowers ability to repay the loan; UnderwritingFinancial Statements, borrower history & creditCash flow, interest rates, maturity structureTax returnsCollateral valuationOwnershipLoan monitoring and servicingRegulatory Considerations

13. Maximum LTV is 80%, unless a government guaranteed, insured or PMI type insurance, or subject to advance purchase by a federal or state agency.With guarantee the maximum is 95%Must provided personal guarantee of the borrower (except is Reg flex qualified)Collateral and Security - Reg

14. Net member business loan maximumOne member or group of associated membersGreater of these two values below15% of net worth or$100,000Unsecured MBL limitationsMust be Well CapitalizedLesser of $100,000 or 2.5% of net worthMaximum of all unsecured borrowers 10% of net worth; non-natural person credit card members for routine purchasing???? Maximum Loans – Reg. 723.7

15. Lesser of 1.75 times credit union net worth or12.25% of credit union total assetsAggregate limitation will include nonmember loan participation balances outstandingMBL Maximum Exposure

16. Ten states have approved MBL regulations.State MBL Regualtions

17. Commercial Loan Underwriting 17

18. Credit WorthinessCredit worthiness for the business and sponsor/guarantors is heavily scrutinizedLoans get paid somehowStart-up businessesRisk, collateral, managementOwner-occupied property 18

19. CharacterPurposeCapacityConditionsCapitalCollateralInclude Five Cs of Credit (P)

20. Basics of Commercial UnderwritingCash flow analysisLoan to value (LTV)Credit worthinessProperty / collateral analysisSecondary guaranteesLoan structure and covenants 20

21. CharacterIdentify participantsPurposeReasons for transaction & client benefitCapacityRevenues, earning & cash flow – primary source of repaymentConditionsIndustry trend & analysis, market position, SWOT analysisCapitalEquity, sub-debt & retained earnings CollateralType, quality, & coverage (value) – secondary source of repaymentEssential Component Details

22. Perhaps the most important issueExplain:What is borrower’s capacity to bear burden of proposed debt while still making necessary investments to remain competitive and or viable?Capacity Section Overview

23. Cash Flow AnalysisMost important component Debt service coverage (DSC) ratioMinimum requirementsRiskier loan types 23

24. Revenue stability & growthMargin protection – Gross Margin/Sales Less: COGS Cost of Goods SoldCash flowFixed charge coverageWhat is the hurdle?What is pro forma (forecast or projected)coverage?How much cushion is impliedPerform a sensitivity analysisCapacity Components

25. Fixed Charge Coverage Ratio (FCCR) EBITDA / P+I+T+C+DForward looking analysisCan they repay the proposed debt?NOT a historical review of the performance, cash flows or loan structure covenantsCash Flow/Fixed Charge Analysis

26. GeneralDefine the industrySpecificAssess the industryMarket positionClient specificConditions

27. Define and industry – GeneralCyclical or SeasonalWhere are they now?Growth, mature, declining, consolidatingCompetitive threatsLegislative or political threatsGeneral Industry Conditions

28. Assess the industry – SpecificBarriers to entryCompetitionCustomersSuppliersSubstitutesSpecific Industry Conditions

29. Market Position – Client SpecificMarket shareLeader / followerRMA statistics (resource & reference in materials)SWOT analysisStrengthsWeaknessesOpportunitiesThreats Market Position Conditions

30. Owner’s investment in the businessPaid in capital/Other equityRetained earnings Cushion to withstand disruptionCapitalMember’s “skin in the game”

31. Minimum net worth (tangible NW)Dollar valueCapital to capitalizationEquity / (funded debt + equity)Debt to capitalizationFD / (FD + equity)Debt to equityDebt to enterprise value(FD / (FD + market value equity)Debt to EBITDACapital Measurements

32. Secondary source of repaymentSpecify what secures the loanIdentify any competing claims Summarize important aspectsWhat is the primary collateral?Quality of collateral (specialized, sing purpose, or active market)Coverage rate or air ball percentageRecovery costs and expectationsCollateral

33. Collateral Summary

34. Loan to Value (LTV)LTV ratioLoan Amount / Appraised Value = LTVKey risk factorValuation of propertyMaximum LTV ratioProperty types influence LTV 34

35. Property / Collateral AnalysisProperty or collateral analysis is the valuation of assets pledged against a loanFair market valueInvestment property collateralNon real estate collateralForced sale of collateral 35

36. Separation of functions is criticalCredit and UnderwritingApproval ProcessSales and Relationship ManagementCollections and Workout ActionsInternal Controls

37. Risk Rating Commercial Loans 37

38. Loan Risk Rating SystemPrimary indicator of credit exposure Used for a variety of purposesApproval requirementsPortfolio managementIdentifying problem loansLoan pricingLoan loss reserve calculationsAn important elementNo one correct rating system 38

39. Structure of Rating SystemFour minimum categoriesPassSubstandardDoubtful LossAdditional categoriesWatch listSpecial mention 39

40. Pass ratingsAt least three categoriesException Risk Unquestioned primary source of loan repayment; no apparent risk Very Good or Good Quality Primary source of repayment very likely to be sufficient, with secondary sources readily available; strong financial position; minimal risk; profitability, liquidity and capitalization are better than industry norms 40

41. Pass ratingsAt least three categoriesAcceptable or Standard Primary source of loan repayment is satisfactory, with secondary sources very likely to be realized if necessary; loan within normal credit standards; requires average amount of Loan Officer attention; company is of average size within its industry and may have difficulty accessing or does not have access to public markets for short term or capital needs 41

42. Marginal RatingRisk rating systems should have a transitory or marginal risk rating classificationA credit union should have at least one of the following categories:Watch List Loans having potential weaknesses that deserve management’s attention; these loans don’t go on the special mention list. Not adversely classified and don’t expose an institution to significant risk. 42

43. Marginal RatingA credit union should have at least one of the following categories:Special MentionSpecial mention loans are commercial loans needing close operating attention or action to mitigate possible weakness. These commercial loans have emerging identifiable problems. 43

44. Adversely Classified Risk RatingsLoans with some impairmentFall into three categoriesSubstandard (least severe)Defined weaknesses or negative trends meriting close monitoring DoubtfulVital weaknesses exist where collection of principal is highly questionable Loss (most severe)Uncollectible and of such little value the continuance as an asset is not warranted 44

45. Substandard DefinitionAsset inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Assets so classified must have well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Categorized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Non-Interest accrual status has been attained 45

46. Doubtful DefinitionAn asset having all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions, and values, highly questionable and improbable. 46

47. Loss DefinitionAsset is considered uncollectible and of such little value that its continuance on the books is not warranted. This classification does not mean the asset has absolutely no recovery or salvage value; rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future. 47

48. Resource MBL Risk Rating Example DocumentRisk Rating Example

49. Key PointsWhen are ratings assigned?How often are ratings reviewed?SegregationExaminers 49

50. See Handout MaterialsMBL Audit Programs & Scope Considerations for Internal Audit

51. MBL Audit Workpapers

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54. Trace loan amount, date, payment, interest rate, and type from loan subsidiary system to loan note.Examine current credit report. If lender uses risk-based underwriting and/or pricing system, vouch credit score/grade to credit report.Examine documented approval within loan policy limits.Existence Assertion Testing

55. Trace loan amount, date payment, interest rate and type from loan subsidiary system to executed collateral documentsTrace loan covenant and financial statement requirements to executed business loan agreementTrace guaranty amounts and type of guarantees from loan approval document to executed guaranty documentsReview evidence of lien placement, such as UCC filing statements, a recorded mortgage, or final title policyReview final title policy; verify (1st Mtg.) or title search verify (2nd Mtg.)Review evidence that taxes are monitored and paid currentPolicy, Risk & Procedures Testing

56. Review evidence of hazard insurance naming lender as beneficiary for proper amount.Examine approval/credit file to verify borrower's cash flow position is reviewed and analyzed from the most recent F/S.Examine approval/credit file to verify borrower's leverage position is reviewed and analyzed from most recent F/SExamined approval/credit file to verify guarantor’s recent F/S are reviewed and analyzedVerify DSC ratio was accurately calculated and within lender's policy guidelineVerify LTV ratio is within lender's policy and supported by acceptable invoice, sales receipt, or appraisalPolicy, Risk & Procedures Testing

57. Examine credit file for f/s monitoringExamine credit file for covenant monitoringExamine approval for underwriter's recommendationExamine approval for deal's strengths and weaknessesExamine approval for deal's policy exceptionsExamine appraisal; trace amount and valuation date to requirement in the approval, such as if a new appraisal ordered prior to fundingExamine environmental due diligenceVerify loan is properly risk rated in accordance to institution’s risk rating policyAssess loan loss reserve for loan if there is a specific reservePolicy, Risk & Procedures Testing

58. Commercial Loan Workout Arrangements 58

59. Elements for Loan WorkoutsManage workout activityDocument financial conditionIdentify and track performance and riskRegulatory reportingLoan collection proceduresAdherence to lending limits 59

60. Loan Workout ArrangementsWorkouts can take many formsShould improve lender’s prospects for repaymentNeed to analyze repayment capacity and collateralMaximize recoveryCredit unions should not be criticizedConcessions require ALLL recognition 60

61. Analyzing Repayment CapacityPrimary focus of examiner’sBorrower characterNature and degree of protectionMarket conditions that influence repaymentProspects for guarantor support 61

62. Evaluating GuaranteesGuarantees may improve the prospects for repaymentFinancially responsible guarantorFinancial capacityAdequate support for repaymentLegally enforceable Guarantor’s global financial conditionWillingness to fulfill all current and previous obligations 62

63. Assessing CollateralOngoing procedure for monitoring valueA new or updated appraisal or evaluationMarket Value vs. Fair ValueCurrent “as is” conditionUse the market value conclusionWhat examiners will look at 63

64. See Handout MaterialsForeclosed and OREO MBL Assets

65. Cash Flow Analysis

66. Cash Flow Analysis

67. Cash Flow Analysis

68. Cash Flow Analysis

69. Cash Flow Analysis

70. 755 West Big Beaver Road Suite 2300Troy, Michigan 48084Thank You!2603 Augusta DriveSuite 1100Houston, Texas 77057www.doeren.comRobert Parks, CPADirector, Financial Institutions GroupOffice: (248) 244-3049Cell : (248) 709-1046Email : parks@doeren.comRobin D. Hoag, CPA, CMCDirector, Financial Institutions GroupPhone: (248) 709-1270Email : hoag@doeren.com

71. Services 71Financial Institutions GroupAuditMergers & consolidationsIT assuranceControls reviewsVulnerability assessmentsPenetration testingCommercial loan reviewLoan loss & delinquency controlRegulatory compliance services

72. The Risk Management Association: Annual Statement Studies – Financial Ratio Bookmarks 2010/2011 (www.rmahq.org)Also: See reference materials at the back of the NCUA Letter to Credit UnionsResources