LOAN PORTFOLIO MANAGEMENT - YEAR 2

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1 LOAN PORTFOLIO MANAGEMENT - YEAR 2 Loan Portfolio Management - Strategies & Tools Michael A. Wear Senior Credit Analyst First National Bank of Omaha Omaha, NE mikewear@hotmail.com July 30, 2018

2 LOAN PORTFOLIO MANAGEMENT: STRATEGIES & TOOLS MICHAEL WEAR SECTION LEADER: LOAN PORTFOLIO MANAGEMENT GRADUATE SCHOOL OF BANKING - WISCONSIN AUGUST,

3 CREDIT QUALITY FDIC: Quarterly Bank Profile 2Q2018 2

4 In calm water, every ship has a good captain. -Traditional Proverb 3

5 CREDIT QUALITY FDIC: Quarterly Bank Profile 2Q2018 4

6 CREDIT QUALITY FDIC: Quarterly Bank Profile 1Q2017 5

7 CREDIT QUALITY FDIC: Quarterly Bank Profile 2Q2018 6

8 ALLL PROVISIONS & CHARGE-OFFS FDIC: Quarterly Bank Profile 2Q2018 7

9 LOAN LOSS RESERVE FDIC: Quarterly Bank Profile 2Q2018 8

10 LOAN ACTIVITY FDIC: Quarterly Bank Profile 2Q2018 9

11 LOAN ACTIVITY FDIC: Quarterly Bank Profile 2Q

12 LOAN ACTIVITY Loan Volume continues to grow 9 th consecutive year of GDP growth Credit Line utilization continues slight decline 8 th consecutive quarter Recent record-low Past Due & Non-Accrual levels* *During the past 33 years, the banking industry has reported only 12 quarters with a lower PDNA ratio all of which were in the years leading up to the credit crisis in FDIC Supervisory Insights (Winter 2017) 11

13 BAD LOANS ARE MADE IN -Esther George (Nebraska Bankers Association Credit Conference, 2006) 12

14 FORWARD-LOOKING CREDIT METRICS Out-of-area lending (including whole loan purchases, loan participations, and shared national credits) Acquisition, Development & Construction (ADC) lending Commercial Real Estate (CRE) concentrations Loan growth exceeding 10% year-over-year CAMELS 1-2 Banks 2013 = 23% As of 9/2017 = 33% Of these banks, only 6% indicated standards are loosening -FDIC Supervisory Insights (Winter 2017) 13

15 CRE CONCENTRATIONS - AsktheFed (January, 2018) 14

16 TROUBLED INDUSTRIES Historical Volatility: Budget motels Trucking Logging Golf Courses Retail Contractors/Developers Restaurants Ever-present: Leveraged Lending Recent Volatility: Oil & Gas Ag (producers) Taxi Services Big Box Retail Indirect Auto Loans Leveraged Buyouts ESOP Loans Enterprise Value Check Out: CNBC s 50 Disrupter Companies List On your Student Website: IBISWorld s Industry Risk Scores 15

17 THE POTENTIAL IS THERE Capital Expenditure-dependent industries: Ag, Mining, Utilities, Transportation, etc. Grow rapidly during economic expansions Weaken quickly during recessions Fintech: Banks financing non-bank financers Leasing Companies, Used Car Dealers Increased financing of sub-prime borrowers Longer loan terms Consumer Discretionary Spending: Luxury vehicles, high-end restaurants, spas, upperupscale hospitality 16

18 ARE WE GETTING LOOSE (AGAIN)? Some of the loans we see banks making today are going to customers who almost certainly would not have qualified for the same loan 4 to 5 years ago. Thomas J. Curry Comptroller of the Currency RMA Risk Management Conference (11/2015) 17

19 ARE WE GETTING LOOSE (AGAIN)? We still see competition driving underwriting standards [downward]. We still see relaxed covenants. Darren Benhart Deputy Comptroller of the Currency RMA Risk Management Conference (11/2016) 18

20 MATTERS REQUIRING BOARD ATTENTION Number of MRA s concerning Commercial Credit Underwriting: Up 24% (1Q2017 1Q2018) Number of MRA s concerning Commercial Credit Policy Exceptions: Up 45% (1Q2017 1Q2018) Examples: diminished protective financial covenants, generous cash flow adjustments, limited or no guarantees, longer amortization periods, extended interest-only terms, and higher loan-to-value ratios or advance rates. OCC Semiannual Risk Perspective (Spring, 2018) 19

21 EXAMPLE: POLICY EXCEPTION QUESTIONS Ask yourself then others tough questions like: Are all approval conditions consistently met before closing the loan? How prompt are post-closing [pre-funding] requirements obtained? Are limited guaranties becoming more the norm? Are supporting reasons getting weaker? Are trade reference checks being made? Is guarantor liquidity being verified? Policy exception trends are difficult to spot unless monitoring is consistent. Will someone notice when does the exception become the norm? Failure to enforce your own documentary terms and conditions will severely weaken your case if you go to court. 20

22 TRUE LOAN PORTFOLIO RISK MANAGEMENT A profound shift... From Reactionary: Managing Credit Risk Upon Discovery To Proactive: Scenario Testing & Incorporate Capital Planning 21

23 FIRE! ANALOGY 1. Where is the risk of fire? Identify Early 2. What would a fire do to the bank? Expected Loss (EL) 3. How likely is a fire to happen? Probability of Default (PD) 4. Are we doing things to increase the risk of fire? Re-evaluate: CRM/ERM, Credit Policy (Exceptions), Loan Review 5. What needs to take place to help prevent a fire? Refine: Risk Culture, Policies/Procedures 6. What do we need to put the fire out? Capital Planning, Manage Underlying Causes 22

24 A DIFFERENT PERSPECTIVE Traditional Credit Risk Mgmt. Loan Portfolio Risk Mgmt. Scope Product Type One Portfolio Incentive Loan Volume Economic Profit Philosophy Originate & Hold Underwrite & Distribute Risk Evaluate Transaction, Customer Loan Segments, Co-variance of Risk Pricing By Product Type Risk-based 23

25 CO-VARIANCE EXAMPLE: SUPPLY CHAIN Housing Starts Home Builders Co-Variance Furniture Stores Builder s Suppliers & Lumberyards Cement Manufacturing Cabinet Manufacturing Home Appliance Manufacturing Furniture Wholesalers Lumber Wholesalers Lumber Wholesalers Lumber Wholesalers OCC Semiannual Risk Perspective (Spring, 2018) 24

LOSS EMERGENCE EXAMPLE: TIME LINE Forward- Looking

of Income Loss Event Loss of Major Customer Job

Statement Monitoring Covenant Violation Delinquency

26 LOSS EMERGENCE EXAMPLE: TIME LINE Forward- Looking Change in Demand Economic Cycles Decline in Sources of Income Loss Event Loss of Major Customer Job Losses Property Values Decline Discovery Financial Statement Monitoring Covenant Violation Delinquency Response & Outcome Risk Rating Criticism Work-out Charge-off 25

27 HOW TO STEP-UP YOUR BANK S LOAN PORTFOLIO MANAGEMENT 26

28 ROOT LPM IN YOUR BANK S CREDIT CULTURE Risk Culture (Appetite) Policy & Procedures Loan Portfolio Management 27

29 STRENGTHEN YOUR 3 LINES OF DEFENSE* 1. Business Unit Individual accountability and responsibility for actions and decisions? Consequences? Are bank objectives weighed more than individual or profit center goals? Do we truly take the time to instill our values? Conduct Risk - $321B in fines issued globally. -- Boston Consulting Group (March, 2017) 28

30 3 LINES OF DEFENSE 2. Management Board governance CCO should not be alone to enforce discipline A culture of Everyone is responsible for risk. Establishment of CRO or risk committees (board or management levels) 29

31 EXAMPLE: MORE GRANULAR RISK RATING MATRIX 30

32 3 LINES OF DEFENSE 3. Loan Review Models are no substitute for hands-on review Traditionally aligned with (external) audit Current trend to align with risk management Reviewer s skill sets and experience; outsource benefits More proactive with Business Unit: Economic & competitive industry drivers Loan underwriting (collateral monitoring & covenants) Pre-closing (documentation, approval terms) Post-closing Periodic (annual) reviews 31

33 EXAMPLE: FILE REVIEW VS. LOAN REVIEW File Review (technical) Compliance with approval terms & credit policy Financials, DSCR, LTV Loan Review (risk identification, more strategic) Cash Flow analysis Collateral valuation Loan structure & documentation Industry trends Identify training needs 32

34 LOAN REVIEW VALUE ADDS Behavior alignment with credit policy, stated risk appetite Approving authority structure Checks and balances, Incentive plan basis Individual lender tendencies Risk Rating accuracy & migration Policy & Underwriting Exception management Loan Monitoring - commensurate with risk trends Adequacy of ALLL 33

35 EXCEPTION TRACKING (4 KEY AREAS) Risk Ratings Policy Exceptions Technical Exceptions Underwriting Exceptions 34

36 EXCEPTION TRACKING Risk Ratings Individual loans (material borrower changes vs. bank errors) Double-dips Aggregate Risk Ratings By loan segment Direction, Migration Overall accuracy Technical Exceptions Financials not received per approval Documentation shortfalls (e.g. missing info, signatures) Covenant violation without acknowledgment/waiver 35

EXCEPTION TRACKING Policy Exceptions Compliance with policy & regulations Guaranty coverage Outside market territory Concentration limit exceeded Approval authority not obtained Underwriting

37 EXCEPTION TRACKING Policy Exceptions Compliance with policy & regulations Guaranty coverage Outside market territory Concentration limit exceeded Approval authority not obtained Underwriting Exceptions Debt Service Coverage guidelines exceeded Collateral documentation issues Inspections do not meet approval requirements Loan term exceeds guideline LTV exceeds guideline Weak quality or timing of financial information Unsecured lending guidelines not met 36

38 CONCENTRATIONS CAN KILL Correlated credit exposure Borrowers Industries (co-variance) Supply chain risk (interest rates: developers, homebuilders) Common factor risk (fuel cost: trucking, ag production) Product Type (first mortgages, HELOC s) Community (smaller) banks are inherently less diversified than large banks Regulatory Guidance: OCC Semi-annual Risk Perspectives 37

39 CONCENTRATION EXAMPLE: MULTIFAMILY 38

40 MANAGING CONCENTRATIONS Risk Appetite Statement or Policy Board-driven: top-down support Goal: To ensure aggregate risks do not exceed the bank s risk capacity [capital base] Separate Statement or made part of Credit Policy Need to define: Geography primary and secondary market territories Industry or sector [first 2 or 3 digits of NAICS codes] Roles & responsibilities of management, lenders, staff Report types & frequency 39

41 MANAGING CONCENTRATIONS Concentration Reporting Graphs/Output are NOT the sole focus of managing concentrations Longer-term trends Notable recent developments Peer comparisons, if available Macro-economic Correlation Chart loss history of industry/loan type with changes in GDP, local unemployment, housing starts, or business conditions surveys, such as: Creighton University s Economic Outlook (business.creighton.edu/economicoutlook/) Aruoba-Diebold-Scotti Business Conditions Index (philadelphiafed.org) 40

42 Source: Philadelphia Fed 41

43 MANAGING CONCENTRATIONS Set Concentration Limits Individual Borrower (including related entities) Loan Type Collateral Type (CRE property types) Geography Bank s house limit (< legal lending limit) Exceeding the 100% or 300% CRE thresholds triggers robust risk management & higher regulatory scrutiny Approvals required when exceeding Concentration Limits. 42

44 EXAMPLES: MANAGING LOAN GROWTH Concentration Management Strategies for: Organic Growth Address existing concentrations when prospecting Discourage additional lending in over-limit areas Communicate credit expectations Tighten credit quality standards Inherent risk in just increasing loan pricing Purchased Loan Participations Evaluate in-house expertise Lead bank s culture, covenants, and monitoring Background checks on borrowers/principals 43

45 STRESS TESTING Identify triggers or key variables for potential losses Develop Scenarios and Test impact on DSCR & LTV Combine data variables for scenarios some examples: C&I = DSCR and LTV CRE = Occupancy (Vacancy), NOI, Cap Rate and LTV Consumer = Credit Bureau Score and LTV Assess bank s vulnerability to downside scenarios, using: Market (Economic) Analysis Correspondent Bank Follow favorite Economists American Bankers Association External sources of information Local/state government, industry trade magazines Real estate transactions, taxable sales data Google News Specific Industry info Personalize Google News for your Bank s portfolio mix 44

46 EXAMPLES: STRESS TESTING Using Stress Testing to Test Capital Adequacy Vulnerability x Likelihood = potential Qualitative Factor in ALLL Historical relationship between changes in Non-accruals and Charge-offs (time lag) What happens to ability to make Provisions with step increases in Non-Accruals? Shift in underwriting strategy and expected effect on loan volume Effect of losing or failure of a major customer relationship(s) 45

47 MONITORING PORTFOLIO PERFORMANCE Typical LPM Key Metrics: Past Dues / Total Loans & Leases Non-Performing Loans** / Total Loans & Leases Non-Performing Loans / ALLL Non-Performing Loans / Capital & Reserves [Tier 1 + ALLL] Classified Loans / Total Loans & Leases (+ OREO) Classified Loans / Capital & Reserves Net Charge-offs / Total Loans & Leases ALLL Provisions / Net Charge-offs **Total loans and leases > 90-days past due + non-accrual loans and leases + other real estate owned [OREO] 46

48 EXAMPLE: MONITORING PORTFOLIO PERFORMANCE Sample Scorecard 2018 Goal Very Good Satisfactory Key Credit Risk Portfolio Metrics Actual Results Needs Improvement Unsatisfactory Trend Past Dues / Total Loans & Leases < 1.00% < 0.75% 1.50% 2.00% 3.00% 1.75% 1.32% 1.02% NPL / Total Loans & Leases < 1.00% < 0.25% 0.75% 1.50% 2.50% 1.30% 1.10% 0.88% NPL / ALLL < 20.00% 20.00% 40.00% 60.00% 80.00% 42.00% 31.00% 19.00% NPL / Capital & Reserves < 30.00% 25.00% 40.00% 50.00% 60.00% 29.00% 16.00% 9.00% 47

49 7 WAYS TO USE LEADING INDICATORS 1. Use Vintage in Reporting Example: Past Dues by Loan Type and Number of Months since Origination (not calendar year/quarter) Apply to upcoming marketing blitzes or loan specials Compare with changes made in underwriting (policy & procedures) 2. Line of Credit Utilization Individual Customer and/or Industry Concentration Compare with other Customers in same Industry Unsecured Loan utilization (percent of outstandings) 3. Upgrade (Downgrade) Migration look for common causes Risk Ratings Non-Accruals 48

50 7 WAYS TO USE LEADING INDICATORS 4. Review New Loan Applications Approval & Declination Volume & Trends Reasons for Turn-downs Average Credit Bureau (FICO) scores on approved and declined Trends in types of requests or inquiries 5. Review Sales Calls Credit-worthiness of Prospects Reasons for not obtaining their business Lenders gravitating to lower-hanging fruit when lagging in production 49

51 7 WAYS TO USE LEADING INDICATORS 6. Peer Group Comparisons Custom Peer Group (similar portfolio mix, demographics) Volume changes in Loan Types (Call Report segments) Charge-off history during good/bad economic times. 7. Learn from Others Spilled Milk articles FDIC: Material Loss Reviews Reasons for failed institutions OCC: Semi-annual Risk Perspectives Networking & Risk Management Conferences 50

52 HOW TO GET THE MOST OUT OF YOUR LPM* Minimum [Traditional] LPM Reports: Portfolio Composition Borrower (related) relationships Call Report categories; Industries; Geography; Loan types Portfolio Risk Risk Ratings Large Loans Policy Exceptions Portfolio Quality Delinquencies (new, migration), Non-performing Loans Debt Service Coverage (DSCR, DTI), Loan-to-Value (LTV), Monitoring defaults *Source: Barrickman, John and Stein, Gary, RMA Journal (July-August, 2005) 51

53 HOW TO GET THE MOST OUT OF YOUR LPM* Minimum Types of LPM Reports to include: Loan Officer Assessments Addresses portfolio management (e.g. past dues, monitoring exceptions, maturity extensions, etc.) Ideally additionally addresses key drivers for incentive plans (e.g. portfolio net profitability, loss rates, etc.) *Source: Barrickman, John and Stein, Gary, RMA Journal (July-August, 2005) 52

54 HOW TO GET THE MOST OUT OF YOUR LPM* Avoid These Pitfalls: Focusing on outcomes, not causes Portfolio quality ratios reflect results of past lending decisions (possibly 3-5 years ago). Mergers & acquisitions affect on portfolio mix and dynamics Failure to adapt Not growing the portfolio monitoring with the growth of the bank Specialized lending (e.g. residential construction, trucking, hotel/motel) require different key variables to track. *Source: Barrickman, John and Stein, Gary, RMA Journal (July-August, 2005) 53

55 HOW TO GET THE MOST OUT OF YOUR LPM* Avoid These Pitfalls (continued): Present Snapshot only Limited focus, lacking perspective (historical comparisons) Numbers without Analyzing Lots of graphs, tables and data but no: Interpretation of results Discussion of trends Recommendations *Source: Barrickman, John and Stein, Gary, RMA Journal (July-August, 2005) 54

56 LPM: A CONTINUAL PROCESS Credit Culture Manage Risk Policy & Procedures Report Exceptions Assess Risk 55

57 TRUE LOAN PORTFOLIO RISK MANAGEMENT A profound and difficult shift... From: Reactive - Managing Credit Risk Upon Discovery To: Proactive - Scenario Testing & Capital Planning It s not too late to start, but it s later than you think. -Mike Wear (an old Credit Guy) 56

58 THANK YOU ADDITIONAL MATERIAL PROVIDED SEE STUDENT WEBSITE 57

Survey of Credit Underwriting Practices Office of the Comptroller of the Currency National Credit Committee October 2004

Survey of Credit Underwriting Practices 2004 Office of the Comptroller of the Currency National Credit Committee October 2004 Table of Contents Introduction 3 Part I: Overall Results Primary Findings 4