Are You Prepared for the Next Generation of Problem Loans?? They May Already Reside on Your Balance Sheet!

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1 2017 Georgia Banking School Troubled Assets Course 218 May 11, 2017 Are You Prepared for the Next Generation of Problem Loans?? They May Already Reside on Your Balance Sheet! J. Michael Allen, Senior Credit Officer State Bank and Trust-Atlanta, GA ALL MATERIAL HEREIN IS WRITTEN BYTHE AUTHOR AND MAY NOT BE COPIED WITHOUT HIS OR HER WRITTEN PERMISSION. THE EXHIBITS SHOWN ARE PROPRIETARTY FORMS OF THE BANKS WHO GRACIOUSLY SUPPLIED THEM AND CANNOT BE COPIED OR USED WITHOUT THEIR EXPRESSED PERMISSION GBA AND THE AUTHOR MAKE NO REPRESENTATIONS OR WARRANTIES AS TO THE BINDING AND LEGAL EFFECT OF THE ENCLOSED EXAMPLES. PARTICIPANTS SHOULD CONSULT THEIR OWN LEGAL COUNCIL REGARDING ENFORCEMENT APPLICABILITY OF THESE DOCUMENTS.11111

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5 What Is Your Institution s Credit Culture? Is It: Relationship Driven Policy Governed Do You Know Your Customer Cash Flow Focused Pro-Active Ownership of Customers Healthy Skepticism Are Actions governed by Your Company s Values Balance of advocacy & objectivity Section 1 4

6 How Do You Lend Money How does your customer make money? Use of your proceeds? How will you get paid back? What are the risks to repayment? Have I mitigated the repayment risks? Section 1 5

7 Five Practical Workout Steps and Tips Find a default trigger Loan maturity Payment default Covenant violation Make a formal demand for payment ASAP Take steps to find and to garnishee assets and/or sue for judgment If you agree to waive default or re-set the loan: Use a forbearance agreement Include waiver of claims clause to hold harmless the bank Get additional collateral or guarantor support Don t cave in to a threat of bankruptcy Section 2 6

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9 What are the Troubled Signs to Look For? Remember The Debtor Knows More Than You! Request for restructure Collateral over advances Overdrafts Late Payments Tax problems - payroll taxes paid? Conversion of trade debt to notes payable Mismatched asset financing No strategic plan or direction High personnel turnover Frequent accountant changes Evasiveness of borrower Non-compliance of loan agreement terms Rapid growth in plant and equipment Section 2 8

10 Analyzing the Problem Loan: A Nine Step Process Documentation Review - What are you looking for? Do I tell all? New lien search and collateral valuation - true liquidated value Financial analysis Related family debt search - why is this important? Evaluate operational problems Evaluate financial problems Tools to Help You Analyze the Problem Site Visit Are there environmental concerns? Can this borrower survive? Decide what your plan is and execute Section 2 9

11 Your Weapons FOCUS: The goal? Return OF my investment and not ON my investment! Venue - your place or theirs? Pricing Amount Collateral Short term maturities Forbearance Agreements Acknowledgement of debt by debtor and guarantors Release of lender liability claims Payments on the note Payment of forbearance fee Pledge of additional collateral Board approval or no Section 3 10

12 Workout Negotiations Is a workout the better path or is it better to liquidate? Pre-work out letter No agreements until put in writing Go into negotiations with eyes open No guarantees of a happy ending Select the advisors of your choice Section 3 11

13 June 1, 2013 Ms. Ima Walker 1234 Missing Payments Road Walking, HM Re: Auto Loan Dear Ms. Walker, Pay by Friday or walk. Sincerely, Your Banker Bankersville, USA Section 3 12

14 Miscellaneous Considerations Documentation flaws - can I fix them and in time? Relationship history - course of dealing - How am I handling overdrafts? Lender Liability Risks Is there a basis for a claim? Promising future or additional financing Good faith and fair dealing - ethics Am I obligated to additional financing Control and interference Breach of Fiduciary Duty Fraud Exercise caution in documentation especially memos and s Is there anything that I should be afraid of (You do not know what you do not know!!!!)? Use the sixth C Common Sense Participation Risk(s) Collusion Risk Section 4 13

15 Guarantees Guarantor Defenses: Release of principal guarantor Release of co-guarantor Change in terms and proper disclosure Lender fails to follow loan agreement Lender fails to dispose of collateral in commercially reasonable manner Section 5 14

16 Construction Draw 15

17 Fund Control Challenge: Most Construction contract defaults are payment related! 16

18 Funds Control Continued Program should include: Review of monthly GC pay application request The collection of invoice support Audit of each line item of the draw request, matching the percentage completion to the appropriate invoice Rapid and accurate distribution of draw proceeds upon approval Change order tracking Lien waiver collection Maintenance of records Audit support 17

19 Don t let this.. 18

20 Reflecting on Recent Times Today SO.ARE THE BEST TIMES BEHIND US? WILL OUR PORTFOLIOS SEE MORE QUALITY EROSION? IF SO.HOW HIGH WILL THE NEGATIVE STATICS GO? IS IT POSSIBLE TO REPEAT THE PAST?????? Section 6 19

21 Reality Check Are We Repeating the Past Past Lessons Learned/Credit Management Due Diligence is key and must be commensurate with the credit size and risk. We must be independent and not rely on the deal sponsor or other parties to the transaction. Financial modeling is not due diligence Our Analysis and Focus must go beyond the Financial aspects and into Operating and Industry issues Historical performance is far more important in making an underwriting decision. Projections while appropriate, should not drive the credit decision, and can be misleading Yield cannot compensate or justify excessive Credit Risk Valuation/Values are not static and therefore our analysis should take into account all scenarios (good or bad). Since we rely on value for fallback, the valuation assumptions should be from a buyers point of view and presume and unplanned sale Analysis of Financial Risk and Debt Service capability must take into account the whole debt/capital structure not just our position in the credit Section 6 20

22 Reality Check Are We Repeating the Past Past Lessons Learned/Credit Management Continued While Lack of Syndication ability may mean that the credit risk is potentially unwarranted, Subscription demand does not always mean that the credit is a prudent one Micro management of credit and the loan Portfolios cannot save us from inordinate loan losses. Overall Portfolio Management including limits in size, diversification, concentration, exceptions, RR profile, etc. are necessary to long term success in credit Excellent Credit Administrative and Loan Review processes are limited in terms of risk of loss reduction where Fallback/Alternatives at the outset were weak In the long run, Excessively Large Credit Exposures cannot be justified, particularly in cases where Fallback, Asset Coverage and Cash Flow are variable and out control of risk is limited There is not substitute for Real Equity Understanding the total liability/creditor exposure is mandatory (off balance sheet debt) Getting Secured and acting early is key to loss avoidance, most likely when beliefs are positive Section 6 21

23 Reality Check Are We Repeating the Past Past Lessons Learned/Credit Management Continued Cash Flow is King Covenants and Structure don t repay the loan Over-reliance on Relationship can lead to imprudent credit risk, and loss of loan dollars and the relationship The 4C s of Management (capacity, character, competence, cooperativeness) are essential and as critical as the primary source of payment Section 6 22

24 Reality Check Are We Repeating the Past Past Lessons Learned/People Management Credit Risk Taking needs to be balanced and measured against our Lenders their skills, capabilities and limitations. Training and communication is essential Independent & Objective Credit thinking is unbeatable over time Incentives should not be based solely on loan production, but also include credit quality and risk management activities Portfolio Growth & Officer Growth must be in harmony Ignorance and Lack of Action are the biggest enemy in PLM Accountability for Pro-Active Risk Management needs to be at the individual and corporate level The repatriation of SAD/Credit Officers to Line and vice versa has great benefit over the long run A Strong Problem Loan Management Function Capability should not be viewed as optional or secondary Section 6 23

25 Reality Check Are We Repeating the Past Clearly, We Are Smarter & Better than Yesteryears BUT Looks Like We Have Made Some of the Same and Maybe Some New Mistakes WHY? Section 6 24

26 Outlook and Avoiding the Past The Winners are those that will: Being A Winning Lending Institution Have Culture and Discipline to Apply the Risk Management Tools & Lessons Learned, (particularly the Portfolio Management Level) Read the Warning Signs Early At the Individual and Portfolio Level Cull out the Winners from the Losers Early Migration Analysis Be Pro-Active in Managing High Risk Assets Sense of Urgency Think like Traders and not be afraid to Sell Risky or Known Problem Assets Be Brutally Honest and Thorough on the Origination and Review of Credit (DO NOT SELL CREDIT TO APPROVAL AUTHORITY) Stay within their Lending Capacity and Competencies Staff Properly and Arm their Officers with the Knowledge, Tools and Support Section 6 25

27 LET US REMEMBER Bad Loans Have We Really Learned From Our Past Mistakes? Those who Forget and Fail to Learn from the Past are Condemned to Repeat It and It s a Person s Ignorance that gets Them Into Trouble and Their Arrogance that Keeps Them There Section 6 26