I have grown frustrated over the past couple weeks as I’ve heard loans related to the North Dakota oil boom are being viewed as substandard simply because they are in western North Dakota. Many are adversely classifying these loans despite no delinquencies or the strength of the guarantors. This begs the question, is it correct to adversely classify a loan because of fears induced by the media or because of personal prejudice towards certain industries?
I think it is important to examine loan classifications to understand whether loans are being classified appropriately. It should be pointed out that the NCUA does not require credit unions to adopt the uniform regulatory standard classifications of substandard, doubtful and loss. So what one credit union considers pass or watch-list, another credit union may consider substandard. Banks, on the other hand, have a more uniform standard of how these ratings are applied. This discussion will focus on the definitions as they apply to banks, since most sophisticated credit unions have an analogous system.
Loans that are classified substandard have a well-defined weakness that jeopardizes repayment. Symptoms of a substandard loan include delinquencies, collateral shortfalls, and diminishing prospects that outside sources of repayment exist. Therefore, if a loan does not have delinquencies, and there is little reason to believe a delinquency will result in the foreseeable future, it is challenging to understand why a loan would be adversely classified. Likewise, if the guarantor has ample resources despite a slowdown in the market, the argument that the market alone is a reason to adversely classify a loan seems like a hasty decision.
There is another regulatory peculiarity that may result when a classified loan is a participation. As a CUSO, we service loans that can hypothetically have inconsistent classifications depending on the institution. For credit unions outside of energy producing states, an energy exposed loan may swiftly be judged as substandard because of all the negative news about the energy sector. However, for those loan reviewers accustomed to seeing loans in the energy sector that are well acquainted with the facts, the same loan may be considered “pass” due to prevailing facts specific to that loan.
To prevent these inconsistencies, the NCUA and the institutions they regulate would be better served if the participation loan was only reviewed once at the level of the principle underwriter. The findings on that loan, as well as the classification, would be duly disseminated and uniformly applied in all institutions. The regulators would then only be concerned with whether a purchasing institution completed their due diligence when they run into that same loan again.
Returning to the point, it is important to know what a loan classification actually means, and institutions should be ready to justify their risk ratings based on those meanings. All business lending is an opinion that has different points that can be argued, and there is no black and white decision that a regulator or loan reviewer can outright impose without having to consider your argument or justification.
Ultimately, people who review loans are still people, and sometimes their personal biases can affect their decisions. It is tough to ignore the 24-hour news cycle that is constantly trumpeting anything of interest in economics and politics. But, we need to remember to evaluate loans based on their true definitions and based on the actual facts that pertain to each individual loan, and not based on ominous assumptions we render from the news.