A couple of new items that many of you, in credit union commercial lending departments, will hear from the examiners this year is Risk Rating Migration and Loan to Value Migration. These things sound like the annual trek of birds or animals to warmer or more inviting lands as winter begins to break onto the horizon. But it has nothing to do with that.
The migration is simply keeping a historical record of any changes in the risk rating or the LTV over the life of the loan. This could simply be done on an excel sheet or if you are utilizing a file management program (we use Suntell in our shop) you can track those changes inside the program. The purpose of this is to show that you are managing the credit file properly.
The best time to record any change in the risk rating is at the annual risk review time. But, this should not be the only time, if new major information comes to your attention that can dramatically change the risk rate either up or down, the loan needs to be re-risk rated. The goal of a risk rate is to accurately show the risk of a commercial or agricultural credit on a pre-determined scale. If you need help on creating a scale, call us.
It would be a best practice to find several different financial performance indicators that can be used to accurately gauge the risk in a credit. Now these factors will not be the same for all credits. A rented office building has different applicable risk indicators than an operating line on cattle. So, different risk models would be most applicable for different types of credit. As a general rule, one could use three model groups: Commercial Real Estate, Commercial and Industrial, and Agriculture.
It is also important once the indicators are checked, that they are reviewed and the ranges of the indicators are reviewed to make sure they are accurately displaying the risk. Also, do not be afraid to override the risk model if outside information comes to light that could harm the company. An example here may be a company that is performing well but has litigation that will have a major negative impact on the financials.
So back to the risk rating migration. The practice here is to keep a historical log of the risk rating. The log should be backed up with your annual risk review and the log should also indicate when the risk rating was last reviewed and by whom. It should include thoughtful analysis on the true risk, instead of being like a bank I once worked for. Everything was rated at the average pass grade despite any other performance measures that may indicate another grade is applicable.
The LTV migration is a bit trickier. The first fear is that you have to order an appraisal or get some form of evaluation from a third party on the property each year to determine value. Requiring new appraisals each year would put the credit union in an enormous competitive disadvantage with other lending sources.
One method is to figure a new value for the real estate using the cap rate that was provided by the appraiser. A cap rate is calculated by dividing the net operating income of the property by the property value. So if you know the current NOI and also the cap rate, you can calculate the value by dividing the NOI by the cap rate. My suggestion would be to run this calculation when you do your annual risk review. This makes the assumption that the cap rate will be constant from the original appraisal. If you have knowledge of market cap rates changing on the type of property that you have lent on (as they will do), then you can change the rate. Just provide some narrative as to how and why you calculated the new LTV in your risk review.
The overall lesson here is the officer needs to stay on top of the credits in his portfolio. Tracking changes in risk rating and also tracking potential LTV changes are just two tools that are used in managing the credit risk.