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Risk Management for Loan Programs

Risk Management for Loan Programs. RESNA Alternative Financing and Telework Loan Programs Annual Meeting December 14, 2004. Risk . Definition - probability of loss or injury Through loan underwriting , lenders Remove risk (by structuring), or Accept risk (by understanding it)

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Risk Management for Loan Programs

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  1. Risk Management for Loan Programs RESNA Alternative Financing and Telework Loan Programs Annual Meeting December 14, 2004

  2. Risk • Definition - probability of loss or injury • Through loan underwriting, lenders • Remove risk (by structuring), or • Accept risk (by understanding it) • Expressions of risk are • Probabilities – uncertain • Obtained through subjective evaluation • Often based on historical performance

  3. Loan Loss Risk • Loan Loss Risk - the probability that a loan • will not be repaid. • Sources of Loan Loss Risk • Risk Profile of Loan Product Line (mission and market) • Loan Policies • Staff, Board • Environment (economic, political, geographic) • Risk of Loan Loss is unique for each Lender

  4. How Do Lenders Manage Risk? • Each Loan • Strong underwriting that identifies and mitigates risk • Technical Assistance • Firm approach to collections • Whole Portfolio • Loan Policies • Loan Monitoring • Portfolio Management • Loan Rating Systems • Loan Loss Reserve

  5. Monitoring • Prevent late payment problems! • Collect information and know what’s happening with borrowers • What are the red flags? • When should you make a site visit? • Contact borrowers as soon as problem is identified (don’t wait for delinquent payments)

  6. Monitoring Information • Financial Statements / Tax Returns • Insurance Updates • Social Benefit Reports • Collect and review info regularly

  7. Problem Loans • When do loans go “sideways?” • First payment disasters • About 2 ½ years in • Communication, Communication, Communication! • Restructuring

  8. Collections • The “won’t pay” vs. the “can’t pay” • Have a definite schedule for dealing with late payments! • How to make collections a priority • Effective collections can prevent foreclosure

  9. Foreclosure • When to foreclose • Evaluating collateral value • The legal process

  10. Problem Loans, Conclusions • What were the risks that led to the problems? Had you identified them in your underwriting? • Were there additional steps you could have taken to mitigate the identified risks? • What (if any) lessons does this teach you for future lending?

  11. Portfolio Management • Portfolio Diversification • Risk Rating Systems • Loan Loss Reserves

  12. Portfolio Diversification • Why is a diverse portfolio important? • What factors affect borrowers in general? • Economic, geographic, political, etc. • What factors are important to your borrowers? • Are some groups of borrowers more susceptible than others to certain events?

  13. Portfolio Diversification • Limit portfolio concentrations: • Single Borrower Limit • Borrower type (individuals, businesses) • Collateral type • Loan structure • Borrower location • Industry • Stage of development • Risk Rating

  14. Questions? Comments?

  15. 5 Minute Break

  16. Loan Rating System - Definition • A systematic methodology to estimate loan loss risk for each loan in a portfolio • Attempts to impose objectivity to a subjective judgment process Rating Criteria 1. 2. 3. 4. 5. …. Directly Related to Combine into Approximated by TrueRisk of Loan Loss Loan Loss Reserve Credit Score

  17. Why Rate Loans? • Management Perspective • To understand of the risks in your portfolio – and risk trends • To compare risk levels from loan to loan • To figure out who to monitor actively • Help staff and Board develop a common credit culture • Systematic way to calculate LLR • Investor Perspective • Shows investors you are conscious about risk

  18. When you originate the loan Annual or semi-annual review of portfolio Significant change in loan performance or conditions When to Rate Loans

  19. Designing a Loan Rating System Step 1 Determine Rating Criteria – Unique set of risk factors Step 2 Determine Scoring Categories (A, B, C…) and relationship to LLR Step 3 Determine method for mapping Rating Criteria to Scoring Categories

  20. Designing a Loan Rating System (cont.) • Step 4 Test and Tweak • Step 5 Implement

  21. Step 1 - Determine Rating Criteria • Common Risk Factors • Factors Related to Borrower • Factors that measure the 5Cs of Credit • Factors Related to Loan Structure • Amortization Schedule • Collateral • Factors Related to Environment • Government • Local Economy

  22. Step 1- Determine Rating Criteria • Design Issues • Isolate factors that have accompanied delinquency, default or foreclosure • Don’t choose multiple factors that address the same risk • Too many factors will be a burden; too few will not result in a meaningful results • Consider costs (time and money) of evaluating factors at underwriting and monitoring

  23. Step 2 - Determine Scoring Structure • Typical Scoring Structure • ScoreDescriptionAssociated LLR • 1 Strong certainty of repayment 2% • 2 Strong repayment expectation but a few issues could impair performance 4% • 3 A number of issues could lead to nonpayment and default 7% • 4 Repayment is uncertain 25% • 5 Repayment is very uncertain 50% • Note: Scoring Structure for your CDFI will vary!

  24. Step 3 - Map Loan Rating to Loan Score • Two Common Methods • Grouping Method (Examples 1 and 2) • Mathematical Method (Example 3)

  25. Step 4 Test & Tweak • Choose a representative sample (10 or more) of past loans • Apply proposed Loan Rating System • Revise (usually mapping methodology) • Re-test

  26. Step 5 Implementation • Determine policy changes • Obtain Loan Committee and Board approvals • Implement process changes

  27. Loan Loss Reserve (“LLR”) • Contra-asset account • Usually required by auditor • Quarterly expense on Statement of Activities (P&L) • Reduces value of Loans Receivable asset • Smooths impact of losses – self-insurance • Reflects risk of the portfolio – updated regularly

  28. LLR - Example Loans Receivable $ 1,000,000 Loan Loss Reserve (10%) (100,000) Net Loans Receivable 900,000 To set up or increase reserve: dr Loan Loss Expense $ 100,000 cr Loan Loss Reserve 100,000 To write-off a loan: dr Loan Loss Reserve $ 10,000 cr Loans Receivable 10,000

  29. Feedback Loops How does your organization learn about risk and become a better lender without becoming “too conservative?”

  30. Review • Risk and Risk Management • Monitoring, Collections, Problem Loans • Restructuring & Foreclosure • Portfolio Diversification • Loan Rating System and Design • Loan Loss Reserve

  31. Questions? Comments?

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