April 1, 2020
The late Yogi Berra was once quoted as saying, “It’s déjà vu all over again.” While the baseball Hall-of-Famer probably wasn’t addressing bank credit portfolios, he certainly could have been. Amid uncertain times to include low oil prices and a concurrent economic slowdown, the question becomes, “Where’s the risk?”
As we know, past performance is not necessarily indicative of future results. However, for loan growth nationally and in several regions, the correlation between patterns that existed from 2000 to 2008 and from 2010 to 2018 is high. Put another way, the rate of loan growth is similar in both periods.
Statistics may paint a fuzzy picture of what’s really happening. While there have been some noted differences, such as construction lending growth rates slower than the early 2000s, and a shift in the mix of loans towards commercial real estate, the overall trends suggest it’s time to ask, “What happens now?”
Banks should be looking closely at the factors that caused past losses and examine them considering today’s underwriting standards. Did changes in your underwriting criteria from the last recession matter? Can you quantify what your bank is doing differently and how it’s making a difference?
Or, while every intention has been to be more conservative in your underwriting, is your bank’s competitive position requiring it to “except” enough policy initiatives to have rendered moot what you’ve done since the last recession?
As you work forward, the issues your organization should be focused on include:
Watch debt service ratios carefully
Many banks are “collateral” lenders and make exceptions for Debt Service Ratio (DSR) requirements if the loan-to-value is strong. But look closely at the reasons for any low DSRs. Some low DSRs are inevitably due to rehabilitation or speculative commercial property. In either case, evaluate how a borrower will reach the DSR requirement, and how fast it will happen, giving stress to cash flow should rates rise.
These are critical as we move to the end of the economic cycle. It’s also important to consider how underlying economics have affected securing collateral. Get, for example, rent rolls, rate and occupancy data and other financial indicators that can allow you to make effective measures on net operating income, or EBITDA.
Double check your appraisals
If significant differences exist between the income and market approaches to value, take a hard look at the variance and how it was reconciled. Test the cap rate. Also, seemingly advantageous loan-to-value ratios and marginal DSRs could be a sign that an appraisal needs a closer review due to a changing market environment. Look closely at the comparable properties and be sure they truly are comparable, especially on specialty or unusual assets. Are there more recent changes in market values that are not reflected in the most current appraisal?
What does CECL tell you?
If your bank still treats Current Expedited Credit Losses (CECL) as an unwanted houseguest, you are missing out. Take a hard look at the results from your CECL model, even on a preliminary basis, and look closely at where the risk in your portfolio resides. Does the model give you guidance on how you should manage new originations, loan sales, and administrative time?
Look at portfolio exposure limits
As market indicators change, take a close look at what your loan policy’s exposure limits should be. Most banks used qualitative assessments to determine limitations on classes and types of loans. CECL’s output gives a second, more quantitative assessment to consider.
What do you want from your loan review
Loan review expectations range from “ticking and tying” credit calculations to review of grading and credit administration. We believe the focus should be on portfolio risk and identifying leading-edge indicators of potential loss. While documenting compliance and “getting the numbers right” is important, these actions are everyday occurrences and should be checked on routinely with credit updates and new loan originations.
Ultimately, the process of loan review and credit management is finding the problems and anticipating trends before the problems find your bank. The process has changed considerably with new and more sophisticated tools and the challenge for financial and credit administrators is to build out and operate a system that mitigates the problems of 2008 to 2012.
How We Can Help
Ankura is a global consulting firm best known for how we assist clients. Our financial services experts work closely with our clients on risk assessment, valuation, and advisory assignments. Our loan review processes assist clients in finding and quantifying risk, valuing transactions, improving profitability, and advising on optimal portfolio strategies.
Our approach to credit risk is multidimensional. We bring together financial and valuation experts, modeling and risk experts, and real estate appraisal experts to assure a comprehensive look at your loan portfolio. Our proprietary real estate databases are able to pinpoint problems in credit portfolios, both on a credit selection and risk identification basis.
Our professionals have hands-on experience in banking, modeling, enterprise risk management, capital planning, consulting, regulatory compliance, governance, and data analysis. Our team has the essential subject matter expertise to advise and execute on the most difficult risk and regulatory matters.