In our fall classes for Intermediate Agriculture Lending and Commercial Real Estate, we were fortunate to have a couple of examiners from the NCUA to take an hour and speak about their views on the state of business lending and what is upcoming for CUs in terms of business regulatory changes.
We all know that there will be a new business regulation soon. We do not know what will all be in that ruling, but we do realize that it will be less proscriptive and more principle based. Part of the delay is because the proposed changes generated more comment letters than any other regulation proposed by the NCUA. Whenever the regulation is complete, expect for more responsibility to be placed upon the shoulders of the individual CU.
There is a move to better quantify risk in an individual credit, industry, and the entire portfolio. The NCUA wants to see more objective measures of risk rating. Subjective adjustments should be tracked and then when the next review of the credit is completed, an analysis of the subjective adjustment on the credit should be viewed to see if making that adjustment was a correct assessment of the risk in the credit. As for the entire portfolio, the CU should be able to quickly identify where the risk issues are inside the portfolio. This could be from loans to a certain industry, geographic area, or borrowing group.
There will also be a new focus on loan covenants. Now we have seen many institutions who do not use covenants at all. At a minimum, on nearly all business credits, reporting covenants should be stated. These tell what ongoing information is required from the borrower or guarantors and when it is required. Fresh information is required in order to monitor the financial health of the borrower.
Performance covenants are woefully missing from many loans that we see. Now, I can see where this is not necessary for a small loan or a loan with an overly strong borrower, but would contend that every loan that is over $250,000, and many below that level, should have some form of performance covenant(s) tied to the loan. Covenants should be meaningful to the specific credit, tied to a certain measurement, and also managed well on an ongoing basis.
We have found some institutions that avoid covenants because they are unsure of what to do when the covenant is broken. A covenant violation does give you the option to call the loan, waive the covenant completely, or forebear the covenant to the next period. In all cases, a covenant violation is a great opportunity to visit with the borrower to understand what exactly is occurring with the company. The CU should also produce a covenant violation letter when a covenant is broken to outline where the failure is and what actions the CU is going to take. Also, if a covenant violation is waived, language should be in the letter to reserve the rights of the CU for all actions that are available in the loan documents for future violations if they occur.
Covenant violations should be tracked for the entire portfolio. Examples are what percentage of your portfolio has its DSCR below policy, LTV below policy, policy exceptions, or debt/asset ratio in violation? Further tracking should be made to all loans where the DSCR is below 1 on the portfolio compared to the percentage of the total commitments.
Global cash flow analysis is important to review. A big question is how re-occurring are the cash flows from the borrower and guarantor group? Now on a seasoned business that cash flows extremely well, global cash flow analysis is still good to look at, but will not be as important as a business with a weak or unproven track record.
These are just some of the items that will be required when the new regulation goes into effect. If you need assistance on a credit or your portfolio, contact us. This review and analysis is what we end up doing each and every day in our group. We would be glad to provide tools that will help increase your underwriting and credit management skills to not only please the examiners, but to also create a better performing portfolio.