Collateral Evaluation and Credit Risk Management

1. Collateral Evaluation and Credit Risk Management

2. Contents 1. Why is Collateral Evaluation Important? 2. Types of Collateral and Regulatory Pitfalls 3. Evaluation of Collateral (RealEstate) 4. Evaluation of Collateral (Other Assets) 5. Protection of Collateral Creation of Security Interest Perfection of Security Interest 6. Collateral Management Collateral Management for Credit Risk Management Safeguarding the Enforcement 7. Enforcement of Collateral 8. Extinguishing Security Interest in Collateral

3. 1. Why is Collateral Evaluation Important?

4. Why is Collateral Evaluation Important? • The more accurate the evaluation, the more enhanced credit risk management in place. • Large actual loan loss exceeding the estimated LGD could lead to a serious depletion of bank’s equity capital. Value Added By reducing loss given default, the bank can reduce the margin without reducing value added. Expected Loss (PD × LGD) MARGIN Unexpected Loss (Required Return × Allocated Economic Capital) PRICE Operating Cost EL: Expected Loss PD: Probability of Default LGD: Loss Given Default UL: Unexpected Loss Funding Cost

5. Why is Collateral Evaluation Important? • LGD is estimated from default-weighted average loss rate during a certain time period. • Loss rate is given by: • To reduce average loss rate, banks need to collect on the default exposure as much as and as fast as possible. • If a bank does not properly estimate collateral values, the collection upon default would become smaller and take a longer period of time, leading to a depletion of capital and lower profits. PV at the default date of recoveries + PV of costs associated with collecting 1 - EAD (Exposure at default) PV: Present value Wrong Collateral Evaluation Higher Wright-offs Capital Waste Higher LGD Estimation Higher Provision Lower Profits

6. Role of Collateral in Financial Intermediation I • Collateral stabilizes financial intermediation • Collateral better aligns interests of the lender and borrower because: • The lender can maximize the safety of repayment • The borrower will minimize the risk taking • Without collateral: • The lender will solely rely on borrower’s cash-flow generated by the project (business) for the repayment. • The borrower tends to take more risks in the project (business), which may cause instability in generating cash-flow. • There will be more vulnerable banks and more risky businesses in the economy, otherwise, resulting in shallow financial intermediation.

7. Role of Collateral in Financial Intermediation II • Lender (specifically) • Encourage willingness of payment to reduce PL. • Substitute the repayments to reduce LGD. • Protects against borrower’s over-borrowing. • Borrower (specifically) • Access to credit: let borrowers monetize their illiquid assets to raise funds • Cost of Credit: potentially reduce funding costs for the lower EL calculated by the lender • Overcoming asymmetric information problems: access to funds even in a financially difficult time, or even without audited financial reports EL: Expected Loss PD: Probability of Default LGD: Loss Given Default UL: Unexpected Loss

8. 2. Types of Collateral and Regulatory Pitfalls

9. What is Collateral? • Under modern collateral law systems, collateral can be any asset which produces future cash flow directly or indirectly, and can be created by any lender and borrower, in any present or future assets and in all transactions, to substitute payments for a part or the entire outstanding debt upon default. • Under unreformed collateral law systems, there would be various constraints on asset types eligible for collateral, on persons or legal persons qualified to collateral agreements, or on the enforceability of some collateral, due to the lack of efficacy and integrity of the system.

10. Collateral Law Independent and comprehensive “collateral law” is rare: generally collateral law is a system which is constituted by several relevant laws and regulations. Extent of collateral After-acquired property Proceeds Supporting obligation Unmovable Collateral Real Property: Land and Building Plant and Equipment Natural Reserves Timber to be cut Goods Consumer goods Farm products Inventory Equipment Fixtures Accessions Intangibles Negotiable instrument Document of title Investment property Account (book debt General Intangibles Other kinds of collateral Deposit accounts Life insurance policy/health-care insurance receivable Collateral Laws and Collateral Types Source: Collateral, Collateral Law and Collateral Substitutes, B. Balkenhol and H. Schutte, Social Finance Programme, Working Paper No. 26, p17

11. 3. Evaluation of Collateral(Real Estate)

12. Principles of Collateral Evaluation • Collateral evaluation is not to find an accurate, unique price, but to find a price and logic which are realistic, practical, and acceptable by ordinary market participants. • Evaluate collateral on the basis of the market value rather than book value. • Apply the most conservative evaluation method. • If possible, collateral property should be located within a distance bank officers can take frequent visits. • Watch the market price if it’s rising fast: a price bubble may be developing.

13. Basics of Land Collateral Evaluation • Step 1: Estimate a price par square meter/feet either by: (1)The sales comparison approach (2) The income capitalization approach (mainly for lease properties) (3) The cost approach (in case of houses and buildings) • Step 2: Adjust the price by factors unique to the real estate (1) Usage of the property (2) Trends of real estate price (3) Conditions of the property/nature of the surrounding area (4) Legal issues

14. Sales Comparison Approach • If recent transactions or sells prices for the similar real estate are available in the city, town or village, the sales comparison approach provides good estimates. Price B (2,450$/m²)  30m  Unadjusted estimated Price E ($/m²)? Weighted-average of A and B (Price D)  50m Price C (1,900$/m²) 150m  70m Note: Each price points should not be separated by a major street or river, which affect the price differences Price A (2,000$/m²) 

15. Sales Comparison Approach: Example • Evaluate the land price E. • Three recent real estate transactions around E. • A: $2,000, B: $2,450, and C: $1,900 • On the map, locate price D between A and B • Distances between these points are: • A-D: 70m, D-B: 30m, D-E: 50m, and C-E 150m. • Then dollar price par square meter of E will be: (Price A × 30) + (Price B × 70) Price D = = 2,315 ($/m²) 70 + 30 (Price D × 150) + (Price C × 50) Price E = = 2,211 ($/m²) 50 + 150

16. Income Capitalization I • Find a geographically weighted-average rent price per unit of land in the same way before. Rent price B (320$/month)  15m  Estimated rent price E($/month?) Weighted-average of A and B (price D)  10m Rent price C (360$/month)  40m 30m Note: Each price points should not be separated by a major street or river, which affect the price differences  Rent price A (350$/month)

17. Income Capitalization II • Calculate the present value of the rent income for the certain future period. • Income capitalization approach using rents may be used in a situation where a loan officer knows the property concerned has a certain value for the market, but there is no way to reasonably estimate and explain the value due to the lack of transaction. • The estimated value may be much lower than a potential market value (additional margin for valuation uncertainty). • It depends on bank’s loan policy, but time horizon should be limited to 10 to 12 years. Annual rent – (maintenance cost + property taxes) PV= Σ ( 1 + r ) n PV: Present value

18. Income Capitalization Approach: Example • Evaluate the land price E. • Monthly rents of the three leasing properties are: A: $350, B: $320, and C: $360 • Distances between these properties are: A-D: 30m, D-B: 15m, D-E: 10m, and C-E 40m. • Using the above information, estimated rent price E will be: • Assume the annual maintenance cost including property taxes is $300, interest rate is 8%, and you calculate up to 10 years, then estimated collateral value is: (Price A × 15) + (Price B × 30) Rent D = = 330 ($/month) 30 + 15 (Price D × 40) + (Price C × 10) Rent E = = 336 ($/month) 10 + 40 10 Annual rent (336×12)–(maintenance cost 300) PV = Σ ( 1+0.08 ) t t=1 = 25,042 ($) PV: Present value

19. Income Capitalization Approach III • Basic concept of the capitalization rate • “The capitalization rate itself is a function of the investor’s desired return and a combination of the costs of debt and equity employed in making the investment.” (Bower 2001) • Factors affecting investors’ desired return on real estates • Culture, economic trends, other investment property type, other investment opportunities, etc. • In practice • The most simplified way is to use available loan interest rates for such an investment as a capitalization rate. • When interest rates are used as a capitalization rate, loan officers must be aware that the interest rate does not include necessary returns for taking risks inherent to the investment, hence, the outcome overvalues the real estate. Source: Understanding real estate values in a rising market—Brief Article, Gerald A. Bower, 2001 http://findarticles.com/p/articles/mi_m3601/is_29_47/ai_71565185

20. Price Adjustment I • Usage of the property • Own-use residential property • Most useful • Own-use farm and forest land/factory and warehouse • The income capitalization approach • Residential/business property for lease • Income capitalization approach • Rent prices in the neighborhood • Future occupancy rate estimation • Residential leasing property and business leasing property • For sale • Speculative in nature

21. Price Adjustment II • Trends of real estate price • Sales and transaction prices • Information from neighbors • Information from experts, brokers, sales registries, and mortgage registries • Income level of the area • Demand and supply conditions of the market • Published land prices and tax rates • Regional development plan • Availability of mortgage loan/foreign land ownership

22. Price Adjustment III • Conditions of the property/nature of the surrounding area • Geographic conditions, such as, close to the coast, river, cliffs, or located on tilted land, in a dip, on the weak stratum • Size of the real estate • Shape of the real estate • Location of the real estate in the block • Accessibility to the public roads • Accessibility to public and commercial facilities • Existence of unfavorable facilities • Municipal services available

23. Price Adjustment IV • Legal issues • Easements: restrictions, encumbrances, leases, reservations, covenants, contracts, declarations, special assessments, ordinances, or other items of a similar nature. • “Eminent domain”: in common law countries, the government may have the rights to buy real property without the owner’s consent for the purposes of public usage, such as public utilities, highway, airport, and railroads. • Legitimacy of buildings (illegal construction/usage) • What are the most major methods to evaluate real estate collateral in your country? Note: When the above legal issues are involved, the price of the property could drop substantially.

24. 4. Evaluation of Collateral(Other Assets)

25. Collateral Evaluation I • Farm Product/Inventory • Market price basis • Interview with major buyers • Market liquidity • Market size • Market volatility • Perishable products • Dealer listings, market sales reports • Location of the storage

26. Collateral Evaluation II • Mobile Vehicle • Secondhand car market price basis • Interview with experts and dealers • Maker, type, popularity, market, in case of inventory • Age, depreciation schedule, unpaid taxes, prior lien, in case of equipment • Government’s import tax policy or other policies affecting market

27. Collateral Evaluation III • Intangibles • Negotiable instrument: validity of the instrument, obligor, credit rating, maturity, type of transaction: collateral/repurchase agreement/discount • Document of title: bill of lading: validity of the document, location of the property, quantity, species/variety, measure/weight, value per unit, quality, condition, schedule, as well as marketability and market price. • Investment Property: issuer, credit rating, market price, market volatility, (maturity), OTC/exchange • Account (book debt): obligors, the extent of diversification, the length of terms, aging schedule, the past default rate • General intangible: variability of the right (document), terms and conditions, restrictions contained in the document, marketability, etc.

28. 5. Protection of Collateral

29. Creation of Security Interest • Elements to create valid security interest: • The debtor has rights in the collateral* • A security agreement must be authenticated by the debtor • A security agreement must contain a description of the collateral • A security interest cannot attach unless “value” is given* • “A value” in security agreement • A value is set in accordance with an amount intended to cover existing or future credit outstanding in part or in total. • Other Issues • Inter-creditor agreement • Pari-passu charge • Creation of security interest alone cannot preserve creditor’s priority over lien creditors and other secured parties with an interest in the same collateral. *Based on: Law in a Nutshell: Secured transactions, Richard B. Hagedorn, Thomson West, 2007, p57, 92, 95

30. Perfection of Security Interest • After perfection the secured party is protected against other creditors and transferees of the debtor and in particular, against any representative of creditors in insolvency proceedings instituted by or against the debtor.* • Depending on the jurisdiction, different collateral may have different rules for perfection • Perfection upon attachment alone • Temporary perfection in certain collateral • Perfection by pledge or possessory security interest • Perfection by filing (registration) • Perfection where filing is required under a special law • Perfection by public notice (example: news paper advertisement) *Based on: Law in a Nutshell: Secured transactions, Richard B. Hagedorn, Thomson West, 2007, p123

31. 6. Collateral Management

32. Collateral Management • Collateral Management • Collateral management includes two risk management concepts: • (1) Collateral management for credit risk management • (2) Safeguarding the enforceability Collateral Management Collateral Management for CRM Credit File • Record Keeping • Revaluation/Reappraisal against credit exposure Safeguarding the Enforceability Safe Custody/ Collateral Book • Numbering/Tagging • Maturity Management • Renewal of security interest • Periodical check of inventory

33. Credit File I • Record Keeping • Appraiser’s name, the effective date of the evaluation, and signature and address (when the evaluation is outsourced) • Description of the collateral • Real estate: ownership, location, shape, condition, developments, pictures, maps, neighborhood, usage, a copy of construction approval, attached easement, etc. • Goods: location of the goods, quantity, species/variety, measure/weight, value per unit, quality, condition, schedule • Intangibles: pledgor, amount, quantity, third party obligor, attached security interest, etc. • Description of the evaluation method employed • Description of the source information used in the evaluation • An estimated value of the collateral and the opinion of the loan officer on the evaluation Source: Interagency Appraisal and Evaluation Guidelines, FDIC, 1994

34. Credit File II • Reappraisal • Collateral should be regularly revalued depending on the collateral type. • Collateral value should be constantly monitored against credit outstanding. • Frequency of reappraisal depends on the market condition • Real estate (revaluation): every 6 months or 12 months • Real estate (on-site survey): every month or 3 months • Farm product: every week or month depending on the market • Inventory: depending on the market • Mobile vehicle: every 3 month or 6 month • Intangibles: daily basis if mark-to-market is required (depending on the type of transaction)

35. Credit File: Example • After evaluation of land and building the following credit/collateral balance table is updated. How do you interpret the table and what should be done? Borrower: ABC Trading Co. Internal Credit Score: 4B External: n/a As of: Mar 08 Thousand $

36. Safe Custody/Collateral Book I • Safe Custody • In order to safeguard and protect the enforceability of security interest, (1) collateral agreement and (2) pledged goods and documents should be put in a safe custody. • Collateral agreement (together with other relevant legal documents, record of registry, fire insurance policy for collateralized buildings*, etc.) may be kept in order by borrower name • Pledged goods and documents may be kept by type • Collaterals for which limitation period or maturity date is critical should be kept in order by such date. • Limited access to the safe custody • Protection from natural disaster Note: Fire insurance policy for collateralized building may be kept separately in order by expiration date because of the importance of the expiration date management.

37. Safe Custody/Collateral Book II • Collateral Book • Role of collateral book includes (1) administrating the collateral inventory, and (2) managing the expiration of limitation period and the maturity date for certain types of collateral. • Collateral book should be created separately for each type of collateral. • Collateral book should assign a number for each pledged goods and documents for the administrating purpose. • Pledged goods should be sturdily tagged with a note indicating name of pledgor, borrower number, date, collateral number, etc. • Collateral book should be managed by senior manager. • Inventory of collateral should be checked against the collateral book periodically (once in a month) • Adding and removing of pledged goods from the custody should be registered in the appropriate collateral book*. Note: When accepting and returning collateral, receipt should be issued to and received from the borrower by the bank, which should indicate concerned goods and documents in detail: type, number/quantity, date, with signature.

38. Safe Custody/Collateral Book III • Maturity for certain types of collateral • Negotiable instruments such as draft, certificate of deposit, and promissory note have maturity date. • In accordance with the collateral agreement, such negotiable instruments need to be settled without delay. • Expiration for certain types of security interest • Depending on jurisdiction and on type of collateral, a perfection of security interest may expire after a certain period (limitation period effects). • Such limitation periods should be carefully managed in the collateral book. A continuation statement should be filed within a certain period before the expiration to renew the perfection of security interest. • How often do you reappraise real estate collateral?

39. 7. Enforcement of Collateral

40. Enforcement of Security Interest I • Event of default • A breach by debtor of any of the terms of the security agreement • A grace period • Rights of secured party • Money suit • Repossession • Self-help • A pre-repossession notice • Foreclosure • Strict foreclosure • Deed in lieu of foreclosure *Based on: Law in a Nutshell: Secured transactions, Richard B. Hagedorn, Thomson West, 2007, p320-323

41. Enforcement of Security Interest II • Public or private sale • If it is applicable, private sale will be encouraged where private sales through commercial channels will result in higher realization on collateral for the benefit of all parties.* • Application of Proceeds • The expenses of retaking and disposing of the collateral, and attorney’s fee and legal expenses (if a country’s law allows) • The debt owed the secured party, including principal, interest or finance charges, and other lawful unpaid charges provided for the security agreement • The debt owed by junior secured parties • Residual rights *Based on: Law in a Nutshell: Secured transactions, Richard B. Hagedorn, Thomson West, 2007, p346

42. 8. Extinguishing Security Interest in Collateral

43. Extinguishing Security Interest • When all debt is repaid security interest should be terminated: • by filing a termination statement • by returning pledged goods and documents* • by returning the original security agreement • Preserving security interest long after the full repayment may: • let the borrower consider the lender being ready to provide another loan. • let the security party face unexpected liability caused by any damage incurred to the borrower by not possessing the pledged goods or documents. Note: When returning pledged goods and documents, receipt with the borrowers signature should be provided.

44. Useful Documents • Land Daministration Guidelines, United Nations, 1996 • This document has a slightly different view point but very useful to understand the value of land in a society. The document lists conditions of a good land administration system in a country, which are: guarantee ownership and security of tenure, support land and property taxation, provide security for credit, develop and monitor land markets, protect State land, reduce land disputes, facilitate land reform, improve urban planning and infrastructure development, support environmental management, and produce statistical data (111 pages) • Available at: http://www.ica.coop/house/part-2-chapt4-ece-landadmin.pdf • Valuation Standards: Are we doing it right?, Chris Thorne, IVSC, 2007 • This document tries to explain a new valuation concept for the globalized era. There are four dimentions to valuation standards: conduct standards, process standards, definition standards, and technical standards. It is useful to see how a leading institution in valuation standards consider the challenge of valuation standardization. (11 pages) • Available at: http://www.ivsc.org/pubs/index.html • Real Estate Principles: A Value Approach, David C. Ling and Wayne Archer • A similar type of presentation file which tries to explain how to evaluate real estate. It is useful to take a look at other presentations on the similar topic. The authors published a book “Real Estate Principles.” (52 slides) • Available at: www.bsad.uvm.edu/files/kcchiang/BSAD%20295/REP%20chapter%208%20&%209%20Appraisal.ppt