Inside Banking Article
Credit Administration: Challenges and Opportunities
by Trudi Amundson
There can be a natural tension between bank lenders and Credit Administration. For a lender, their job, their compensation in fact, is based on their ability to put loans on the books. Each year they are given origination goals which may seem harder and harder to reach. Contrast that against Credit Administration who also wants to put loans on the books, but is willing to say no to a credit if it doesn’t meet certain guidelines. It can often make a lender feel that Credit Administration is standing in their way, making their job more difficult with some of their policies and procedures. I have spoken to more than one Relationship Manager who felt frustrated because they thought they had a good loan and for reasons they didn’t understand, Credit Administration would not approve it. And, sometimes a lender does have a good loan, but it is still turned down and reason is that Credit Administration is looking at the overall risk profile of the bank and may feel that there is a concentration in certain types of credits which makes the department unwilling to put any more of a certain type of credit on the books.
But, the relationship doesn’t have to be strained and a good lender will take the time to learn the importance of using Credit Administration as a resource rather than an impediment to their lending. Learning why Credit Administration has developed the policies and procedures for underwriting, and why certain rules exist will actually assist the lender in making high quality credits. Once upon a time, lenders were compensated simply for the amount of loans they put on the books, but most banks have learned that other factors need to go into how much a lender makes, such as the risk ratings of the credits in the loan officer’s portfolio, the overall performance of the portfolio and the amount of assets that need to be taken over by a bank’s work-out group. By working with Credit Administration, a lender can develop a portfolio that maximizes their income simply by complying with a few of the policies developed by the department.
The point of this article is to go over a few of the most common mistakes made by lenders by not following the policies and procedures established by Credit Administration. Many of them may seem obvious, but you’d be surprised by how many times I’ve seen loans go down the drain just because of a few mistakes or oversights by loan officers. Simple documentation mistakes or not following up on covenants can kill a loan. The following six points can make the difference between a good and bad loan and make the relationship between a lender and Credit Administration more tension free.
By now, it is obvious to most everyone that for a commercial loan or an on-going line of credit (excluding mortgages and HELOC’s) that it is prudent to ask for updated financial statements. Whether it is quarterly or annually, it is one of the most common covenants in any loan. But, unfortunately, many lenders fail to follow up on getting updated financial statements, or they get them and never give them a good review.
Although this happened many years ago (1991) it is still very relevant today, especially given the recent lo-doc, no doc housing loans coupled with the downturn in the housing market which caught many lenders by surprise. After a scathing report by its regulators, a thrift hired away two of the regulators to upgrade their Audit department and establish a credit review department. The then-President and CEO of the company decided to retire and a new President was brought on board.. The thrift specialized in multi-family lending and had a portfolio of approximately $1.7 billion in multi-family residential and commercial real estate.
As they ex-regulators started to review the loan files they noted that there were no recent financial statements in most of the files. Although the loan documentation requested updated financial statements, the thrift had never followed through. While some borrowers had supplied recent financials the loan officers had never reviewed them or compared the actual performance of the loans against the original underwriting. When the Chief Loan Officer was quizzed about the lack of financial statements, his attitude was the loans had been performing and there was no reason to follow-up on the loans. He also felt safe because in his mind real estate values in California never went down, only up. By 1992, real estate values in California were in decline and more than one lending institution was caught by surprise.
Requests for updated financial statements went out on the loan portfolio. Borrower response was mixed; some complied easily but most were angry that they were suddenly being asked to provide statements when it had never come up before. Overall compliance was approximately 40%, with the majority of borrowers ignoring both letter requests and telephone calls.
With the new financial information that did come in, the ex-regulators started reviewing the files. They found two consistent issues across the portfolio. One was that actual rents were generally lower than what had been used to approve the loans and secondly, the loans (which were adjustable rate credits) had been underwritten at the initial teaser rate and they were now fully indexed and debt coverage ratios were consistently under 1.00x. Some borrowers were paying $50,000 to $100,000 annually to make up the difference between the rents received on the properties and the required debt service.
The new President suspended all lending in the department, fired the Chief Lending Officer and all the other loan officers as well. New underwriting guidelines were developed; new loan officers and underwriters were hired and compensation for loan officers was changed to take the quality and performance of the loans into consideration. As the recession deepened and real estate values continued to decline, the loans began to default. A Special Assets department had to be established and they became a very busy group of people. Losses to the thrift were significant and it took a long time to improve the quality of the loan portfolio.
This example may seem extreme, but it underscores the need for updated financial data and the importance of actually reviewing the information that is delivered.
A few well-designed loan covenants can make all the difference in the quality of a credit. They are critical early warning systems that can warn the loan officer of potential trouble in a credit and give the loan officer time to resolve issues before the loan goes into default.
One needs to be thoughtful when designing loan covenants. I’ve seen loans which contain so many covenants that it becomes almost useless and monitoring compliance was too cumbersome. Then again, I’ve seen loans with almost no covenants, giving the loan officer no insight into the on-going performance of the credit. The only warning comes when the borrower stops paying, and by then there is nothing to be done except to write off the balance of the loan.
But is isn’t enough to put good loan covenants into the credit, they need to be reviewed and the loan officer needs to ensure that the loan is in compliance with the covenants as structured.
There was a line of credit that had been issued to a CPA firm. The company was a small regional firm that had a very good reputation in the city in which it operated. Because it is typical for most service firms such as law firms or CPA firms to pay out all revenue to its partners at the end of the year, the loan officer had established a capital requirement that was approximately the size of the credit. He had also put in a restriction on pay-outs to partners in the case of capital inadequacy. These two covenants ensured that if the line had to be paid back, the company would have the money in reserves to cover the credit.
The covenant called for capital information semi-annually. At the first covenant call the company supplied the information. The loan officer didn’t ignore the covenant, but discovered that capital had declined dramatically. When questioned, the firm explained that a key employee had left the company and they had to pay out his capital investment and revenue had dropped as his clients had started to follow him to his new firm. They also explained that they had to make pay-outs to two retired partners (a requirement that had been missed during the initial due diligence on the loan) and pay-outs to partners had to be made. They had used the line of credit to make the pay-outs to the partners so the line was fully extended.
The loan officer decided to waive the covenant requirements for the period in question. He wanted to make sure that he stayed in good relations with the firm. The CPA firm was optimistic that it could replace the revenue loss from the departure of the key employee and that they would be in compliance by the next period.
The next reporting period came along, and revenue had actually declined further as more clients from the key employee who had left the firm moved their business over to his new office. Capital was even lower, but again, the CPA firm presented a business plan that showed compliance by the next period. Again, the loan officer waived the capital and partner pay-out covenants. The next reporting period came along, and capital had fallen even further, the revenue growth had not come as expected and further pay-outs had been made to the partners. Again, the loan officer waived the covenants.
By the next period, the capital was nearly gone; revenue had picked up a little but not enough to meet capital requirements. Credit Administration stepped in, downgraded the credit and sent it to its Special Assets group. The loan officer was reprimanded for continual waiving of key covenants and his bonus for the year was adversely affected.
The loan officer had put in the right covenants to cover the risks of the credit, but by constantly waiving the defaults he allowed the loan to reach a precarious position. The obvious conclusion from this loan is that even if you put in the best loan covenants, not following up to ensure compliance or being too willing to waive non-compliance eliminates any positive effects of the covenants.
For many types of loans, accounts receivable lending, as one example, it is key to secure the loan with collateral. UCC filings and security agreements are two ways to secure a credit. The loan officer needs to make sure that the collateral is in place and adequately secured.
There was a working capital loan made to a manufacturer of new windows. The company was extremely sensitive to the new housing market. If construction slowed, the company’s revenue would be instantly impacted. This particular manufacturer operated in the Central Valley of California. When the sub-prime market crisis hit, this region of California was severely impacted, housing values were plummeting and borrowings on new construction vanishing. Contracting firms went out of business as new housing construction halted; the manufacturer of new windows was revenue plummeted. They laid-off employees, cut back on expenses, but it wasn’t enough. They began to be unable to make its debt payments.
The lender had established UCC filings for all of the company’s equipment and inventory, but when the bank went to foreclose on the assets, it was discovered that there were nicely filled out UCC filings in the file, but they had never been actually filed with the state leaving the bank completely unsecured. The loan officer had neglected to follow-up with loan servicing to ensure that the collateral had been adequately secured. The end result was an inability to get at any of the inventories or equipment of the company, the sale of which could have muted the loss on the loan. Instead, the bank had to take a total loss on the credit. While, the loan officer might have felt that it was loan administration’s fault that the UCC filings had not been filed with the state, remember the ultimate responsibility for any loan in a lender’s portfolio lies with the lender.
As a part of securing collateral on a loan, a prudent banker will make sure that the collateral is adequately secured through insurance. There are several types of insurance the lender can get, but the only one with real teeth is a “lender loss payable endorsement.” Under this form of insurance a separate contract is developed between the lender and the insurance company and it cannot be nullified by action by the borrower. It gives the lender the right to receive insurance proceeds in the event of a loss on the collateral, most often property, such as a commercial real estate building. However, it is just as important to get it on a home mortgage or anything where the bank is taking title to collateral.
However, the documentation states that if the insured does not pay for its insurance, the lender is required to pay the premium. To add protection to the loan, documentation between the borrower and lender should clearly state that the lender will make insurance payments in the case of a borrower’s failure to pay, and that payment will become part of the loan, or can be a trigger for default.
However, despite policies and procedures from Credit Administration requiring the lender to get this insurance, it is often over-looked. In the case of an extreme loss, such as a fire that destroys the commercial property in question, without this insurance, the loan balance is up in smoke.
Compliance and Documenting the File
One area that is consistently overlooked by lenders is denied loans and adequate documentation of the file. Both can get a lender into trouble with internal audit and credit review as well as with the regulators.
There are definitive rules as to handle a declined loan. A lender (excluding traditional mortgage loans which have their own specific rules) is supposed to send out a denial letter to the borrower explaining why the credit has been denied within a certain number of days from receiving complete application. One sticking point is what constitutes a complete application? In general, an application is considered complete if the lender has enough information to make a credit decision. There may be additional information that would be needed to finalize the loan, but if you have enough information to make a credit decision, then the application is considered complete. Lenders consistently forget to document their denied loans. They forget to send the lender a letter; they neglect to enter the information in the loan denial log. They may have communicated with the borrower by phone explaining why the loan has been denied, but that is not enough, it must be documented with a formal letter to the borrower.
Regulators always ask to look at the denial log and will review a few of the denied files. If they don’t see the documentation, you can be assured you will receive a negative comment by the regulators and there is nothing that executive management and Credit Administration dislikes more than a negative comment by a regulator. Make sure that you follow up with denied loans and take the time to make sure you are in compliance with the rules for denied credits.
Documenting the file with updated correspondence between the lender and the borrower is critical. Too many times, I’ve opened up a loan file and found no information other than the original credit memorandum and the original communication. To a regulator or credit review it appears as though the lender hasn’t had any follow-up with the borrower since the loan’s origination.
In most of the cases, there has been communication, but it is sitting in a file in the lender’s office, or filed away in their email accounts. Make sure that any recent discussions or communication is put into the loan file. But, be conscious of what you are writing. In one example, a lender sent an email to a borrower discussing a baseball game he had gone to with the borrower and the borrower’s mother. He made a suggestive somewhat sexual comment regarding the borrower’s mother. To him, it was a shared joke. The borrower was in his 60’s and his mother was in her 80’s. Between the lender and the borrower it was a joke that was not offensive to the borrower in anyway. However, during an internal compliance review, the auditor reviewing the file was very disturbed by the comment as she lacked the history of the relationship between the borrower and the lender. So, document your correspondence, but be careful what you say. There will be a third party reviewing your file and will be looking for any comments they find inappropriate.
Credit Administration does not need to be a lender’s adversary. They can be there to help a lender get a loan through the door. I recommend early communication with Credit Administration if your loan is not simply a cookie cutter credit. One Relationship Manager I worked with would engage Credit Administration from the beginning of the origination process. He would explain the loan, with any warts or deviations, at the beginning. Credit Administration was only too happy to work with the lender.
If the loan had no chance of approval, the Relationship Manager would know this before getting very involved with the borrower and ended up saving time chasing loans that were not going to be approved no matter what he did. Conversely, Credit Administration often made suggestions to the Relationship Manager on how to improve the credit, recommending certain covenants, discussing guarantees and other steps to mitigate the risk on the loan. The end result was that when the Relationship Manager was ready to present a Credit Memorandum on the loan, approval was instant and he was able to book credits that Credit Administration supported.
I hope that lenders view the stories contained in this article as enlightening and helpful to the lending process. It carries examples of where loan officers and Credit Administration clashed and how it could have been avoided. Just by following a few simple guidelines a lender can improve their relationship with Credit Administration and actually learn to use the department as a support to making high quality credits. Understanding that Credit Administration exists to ensure that the bank’s loan portfolio stays healthy should help lender’s understand why they set the policies that they do. Learning to follow those policies and communicating with Credit Administration will result in a high quality asset portfolio which maximizes the lender’s income and allows everyone to meet their goals and responsibilities.
Trudi Amundson began her career as a regulator and has spent 20 years in the financial services industry. She has worked both in Credit Administration and as a line officer originating and underwriting primarily commercial credits.