Commercial Loan Auditing For Internal Auditors June 15, 2011 Presented by: Robin D. Hoag, CPA, CMC Robert M. Parks, CPA
Objectives & Overview • Solid Understanding of MBL’s • Trends in Commercial Lending - MBL’s • Regulatory Consideration • Risk Management Implications • Basic Underwriting Criteria • MBL Audit Programs
Objectives & Overview • Commercial loan workout arrangements • Risk rating commercial loans • Internal controls • Resources • Internal Audit Roles
Regulatory Considerations • Policy – Board Reviewed and Approved • Experience in commercial lending - MBL • Loan Limits • Capital Limitations • Concentration risk • Credit Risk • Insiders
Member Business Loans • Proceeds used for commercial, corporate, investment, agricultural purposes • Balances aggregated to member exceed $50,000 • Participation loans, or purchased loans with the same origin from another credit union
Regulatory Considerations • Prohibited transactions for MBL’s • CEO, COO, CFO, senior executives • Family members of the above • Loans in which the credit union will share profits of the sale • Loans to compensated directors
Regulatory Considerations • Construction and Development Loans for Commercial or Residential Property • Limitation of 15% of net worth • Single family residences by individual with 25% equity interest are allowed
Regulatory Considerations • Policies – Written to manage the risk and loan types granted, board approved and annually reviewed • NCUA Supervisory Letter: 2009 Current Risks in Business Lending and Sound Risk Management Practices – A Must Read • Underwriting and MBL experience required -Two (2) years experience by your commercial lender at a minimum in the type of loans being approved and underwritten
MBL Policy - Regulatory • Minimums Required • Trade areas, geography – knowledge of value • Types of business loans to be offered • Limitations in terms of MBL to assets and net worth; individual types and aggregate • Individual member limits or concentrations
Regulatory Considerations • Analyze and Document borrowers ability to repay the loan; Underwriting • Financial Statements, borrower history & credit • Cash flow, interest rates, maturity structure • Tax returns • Collateral valuation • Ownership • Loan monitoring and servicing
Collateral and Security - Reg • 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)
Maximum Loans – Reg. 723.7 • Net member business loan maximum • One member or group of associated members • Greater of these two values below • 15% of net worth or • $100,000 • Unsecured MBL limitations • Must be Well Capitalized • Lesser of $100,000 or 2.5% of net worth • Maximum of all unsecured borrowers 10% of net worth; non-natural person credit card members for routine purchasing????
MBL Maximum Exposure • Lesser of 1.75 times credit union net worth or • 12.25% of credit union total assets • Aggregate limitation will include nonmember loan participation balances outstanding
State MBL Regualtions • Ten states have approved MBL regulations.
Credit Worthiness • Credit worthiness for the business and sponsor/guarantors is heavily scrutinized • Loans get paid somehow • Start-up businesses • Risk, collateral, management • Owner-occupied property
Include Five Cs of Credit (P) • Character • Purpose • Capacity • Conditions • Capital • Collateral
Basics of Commercial Underwriting • Cash flow analysis • Loan to value (LTV) • Credit worthiness • Property / collateral analysis • Secondary guarantees • Loan structure and covenants
Capacity Section Overview • Perhaps the most important issue • Explain: • What is borrower’s capacity to bear burden of proposed debt while still making necessary investments to remain competitive and or viable?
Cash Flow Analysis • Most important component • Debt service coverage (DSC) ratio • Minimum requirements • Riskier loan types
Capacity Components • Revenue stability & growth • Margin protection – Gross Margin/Sales Less: COGS Cost of Goods Sold • Cash flow • Fixed charge coverage • What is the hurdle? • What is pro forma (forecast or projected)coverage? • How much cushion is implied • Perform a sensitivity analysis
Cash Flow/Fixed Charge Analysis • Fixed Charge Coverage Ratio (FCCR) EBITDA / P+I+T+C+D • Forward looking analysis • Can they repay the proposed debt? • NOT a historical review of the performance, cash flows or loan structure covenants
Conditions • General • Define the industry • Specific • Assess the industry • Market position • Client specific
General Industry Conditions • Define and industry – General • Cyclical or Seasonal • Where are they now? • Growth, mature, declining, consolidating • Competitive threats • Legislative or political threats
Specific Industry Conditions • Assess the industry – Specific • Barriers to entry • Competition • Customers • Suppliers • Substitutes
Market Position Conditions • Market Position – Client Specific • Market share • Leader / follower • RMA statistics (resource & reference in materials) • SWOT analysis • Strengths • Weaknesses • Opportunities • Threats
Capital • Owner’s investment in the business • Paid in capital/Other equity • Retained earnings • Cushion to withstand disruption Member’s “skin in the game”
Capital Measurements • Minimum net worth (tangible NW) • Dollar value • Capital to capitalization • Equity / (funded debt + equity) • Debt to capitalization • FD / (FD + equity) • Debt to equity • Debt to enterprise value • (FD / (FD + market value equity) • Debt to EBITDA
Collateral • Secondary source of repayment • Specify what secures the loan • Identify any competing claims • Summarize important aspects • What is the primary collateral? • Quality of collateral (specialized, sing purpose, or active market) • Coverage rate or air ball percentage • Recovery costs and expectations
Loan to Value (LTV) • LTV ratio Loan Amount / Appraised Value = LTV • Key risk factor • Valuation of property • Maximum LTV ratio • Property types influence LTV
Property / Collateral Analysis • Property or collateral analysis is the valuation of assets pledged against a loan • Fair market value • Investment property collateral • Non real estate collateral • Forced sale of collateral
Internal Controls • Separation of functions is critical • Credit and Underwriting • Approval Process • Sales and Relationship Management • Collections and Workout Actions
Loan Risk Rating System • Primary indicator of credit exposure • Used for a variety of purposes • Approval requirements • Portfolio management • Identifying problem loans • Loan pricing • Loan loss reserve calculations • An important element • No one correct rating system
Structure of Rating System • Four minimum categories • Pass • Substandard • Doubtful • Loss • Additional categories • Watch list • Special mention
Pass ratings • At least three categories • Exception 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
Pass ratings • At least three categories • Acceptable 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
Marginal Rating • Risk rating systems should have a transitory or marginal risk rating classification • A 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.
Marginal Rating • A credit union should have at least one of the following categories: • Special Mention • Special mention loans are commercial loans needing close operating attention or action to mitigate possible weakness. These commercial loans have emerging identifiable problems.
Adversely Classified Risk Ratings • Loans with some impairment • Fall into three categories • Substandard (least severe) • Defined weaknesses or negative trends meriting close monitoring • Doubtful • Vital 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
Substandard Definition • Asset 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
Doubtful Definition • An 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.
Loss Definition • Asset 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.
Risk Rating Example • Resource MBL Risk Rating Example Document
Key Points • When are ratings assigned? • How often are ratings reviewed? • Segregation • Examiners
MBL Audit Programs & Scope Considerations for Internal Audit See Handout Materials