Commercial and Industrial Lending : Pitfalls and Risk Mitigants

1. Commercial and Industrial Lending:Pitfalls and Risk Mitigants Kevin Cragholm, Senior Analyst Dante Tosetti, Credit Risk Examination Specialist Randy Santos, Senior Analyst Adrienne Thompson, Examining Manager Tim Marder, Examining Manager (Facilitator) Call the Fed Webinar - September 13, 2012

2. Portfolio Shifts to C&I Loans “[T]o generate loan volume without increasing real estate lending, many banks are now targeting growth in commercial and industrial (C&I) loans, a type of lending with which they may have less expertise. In fact, banks have generally experienced higher loss rates on C&I loans than on commercial real estate secured loans (excluding construction loan losses), even through the crisis. So this portfolio shift has the potential to increase rather than decrease expected losses.” Elizabeth A. Duke, Federal Reserve Board Governor 2012 Bank Presidents Seminar, CBA

3. What are the critical factors a community bank’s senior management and board of directors should evaluate before expanding further into C&I lending?

4. Four Cornerstones OF C&I LENDING

5. MarketDYNAMICS

6. Personnel Considerations

7. Administration & Monitoring

8. Remediation Framework

9. Perspectives of C&I Underwriting

10. Perspectives of C&I Underwriting Financial Analysis Isn’t Enough to Bank on Financial Analysis: What is the number and is it good enough? Credit Analysis: Why is the number what it is? ABA Banking Journal July 27, 2012 By Jeff Judy www.JeffJudy.com Is it a duck or a rabbit?

11. Perspectives of C&I Underwriting Financial Analysis • Loan DSCR = 1.50x. And Credit Analysis • Does loan amortization match the purpose? • Is a rate shock needed? • Will future capex become an issue? • Is subordinated debt included? Young lady or old maid?

12. Perspectives of C&I Underwriting

13. Perspectives of C&I Underwriting QUESTIONS ABOUT EBITDA Earnings • Are earnings seasonal like 70% of all businesses? • What is other income and will it be recurring? • If expenses have declined (amounts or margins), why? Interest • Are historical interest expenses similar to the historical debt structure. If not, why not? Taxes • Don’t add-back taxes. Use EBIDA. Depreciation & Amortization • What are the economic lives of the assets? Question: Which line is the longest? Answer: They are all the same length.

14. Perspectives of C&I Underwriting There are sources of repayment within the balance sheet. UCA incorporates the balance sheet. Therefore… Use UCA

15. Watch the Add Backs

16. Perspectives of C&I Underwriting • Financial Analysis versus Credit Analysis. • Use UCA. • Watch the add-backs. Is it a vase or two faces?

17. Collateral Inspection Purpose The field audit should be approached with the idea of providing the lender with nonbiased, factual information about custody, type, quantity, and valuation of the collateral to make sound credit decisions.

18. Collateral Inspection Staging • New Relationship: • Qualifying prospective borrower • Existing Relationship: • Assessing ongoing performance • Exiting Relationship: • Determining work-out strategy

19. Asset Based Lending Candidates Categories • Profitable and Stable – Working Capital • Relationships with Cash Flow Problems

20. Asset Based Lending Candidates(Continued) Relationships with Cash Flow Problems • Uncertain or unpredictable cash flow • Inability to make agreed upon loan payments and past due trade creditor payments • Highly leveraged • Unsustainable growth • Diminishing sales without appropriate declines in costs • Limited secondary sources of repayment

21. Collateral Audit Scope • Background • Books & records • Key statistics • Turnover • Dilution • Past due • Concentrations • Borrowing base calculation • Inventory stages and locations • Shipping / performance test • AR activity review • Cash application test • Verifications • Accounts payable • Payroll taxes

22. What to Look for in an Outsourced Report • Differences between auditor’s calculated values and those on the borrowing base certificates submitted by the borrower. • The borrower should assist with the preparation of books and records. The auditor’s function is to verify, not create, the information. • The worst field audits generate more questions than answers. Major issues should always be brought to the attention of the borrower during the field examination. • If the major issue cannot be resolved on-site, it should be communicated to the lender. This gives the lender the ability to terminate the transaction and avoid embarrassment as well as incurring additional time and expense of a dead deal. • Completion time varies significantly based on the quality of the records, collateral, the number of locations and companies involved. Nevertheless, a long delay can be indicative of record keeping concerns with the borrower.

23. What to Look for in a Collateral Auditor • The firm’s field auditors should all have solid accounting and audit backgrounds, coupled with asset-based field exam experience in a multitude of industries. Resumes are a good source for this information. Firm should be able to cite the number of collateral audits they have performed by industry. • Due diligence field audits should be the firm’s prominent source of business, not a supplement to its core business or used as filler work. • The firm must have staff at all levels with the proper interpersonal skills needed to work effectively with the borrower. • The firm should be viewed as an extension of your own bank/department. • Solid references with sample audits and workpapers.

24. Collateral Auditor Search • Commercial Finance Association • The Secured Lender • The RMA Journal • CPA • Bankers • Appraisers

25. Credit Administration Highlights C&I loans often have unique characteristics which require specialized monitoring of financial performance, compliance with loan and financial covenants, and processes to address findings from collateral audits or inspections. Processing borrowing-base certificates and eligible collateral can be labor intensive, and may require specialized skills to ensure sound credit administration practices.

26. Ensure that all advance rates, sub-limits, financial covenants and financial statements are accurately captured for on-going monitoring. • Advance rates: • Triggers: assuming advance rates are industry and borrower appropriate at origination, under what circumstances could they be decreased or increased (change in dilution, for example) • Changes to advance rates: who is authorized to approve, who monitors changes, and is there reporting of changes. • Pitfalls: Loans or portfolios can take on additional risks and loans may become more difficult (or impossible) to exit; management may be unaware of increasing risk unless MIS is sufficient.

27. Sub-limits: • A/R and Inventory Structure: Ideally, A/R secures a larger portion of total availability and loan amount, both through advance rates and dollar sub-limits. (examples: advance rates of 80% for A/R, 40% of inventory; plus a hard dollar or percentage limit on the amount of eligible inventory) • Changes in sub-limits: Identifying who is authorized to make or approve changes, or temporary “over-advances”. • Systems capability: Systems may not be able to track sub-limits, and compliance can be tracked only through the borrowing base. Manual reporting or adjustments may be required. • Pitfalls: Inadvertent overreliance on aging or obsolete inventory.

28. Covenants(operating, financial or negative): • Tracking: In accordance with loan documents, and in conjunction with receipt of financial statements, may be tracked on a quarterly basis. • Need a defined process to ensure that all covenants are initially identified and tracked in a timely manner. • Ensure compliance with any unique definitions or formulas as defined. • May require a manual or custom form for tracking or documenting review. • Tracking process should include periodic certification from the borrower that they are in compliance with all covenants. • Monitoring: Who monitors and ensures that internal covenant analysis is current (tickler), that violations are cured within set time limits and non-compliance appropriately escalated. • Waiver of covenants: If not enforcing or waiving a covenant, ensure rights to enforce covenants are preserved (including written notification to borrower)

29. The borrowing base needs to accurately reflect the loan terms: • Accounts Receivable: • Eligibility: Reconciles sales, credit memos, and payments/receipts, and deducts ineligibles before applying advance rates. Common ineligibles: • Delinquencies, as defined in loan documentation • Contra-accounts/offsets • Foreign accounts/government receivables • Support: Define what you need to support each borrowing base; monthly receivables output can be time consuming to process. • Pitfalls: • Delinquencies: ensure that loan terms specify due date or invoice date eligibility, and that reporting from borrower matches • Borrower Account List: Needs to be kept current; critical in a default. • Reconciliation : Balance Sheet and Borrowing Base.

30. Inventory: • Sub-limits: common • Define: Raw material, work-in-process vs. finished goods • Ineligibles: • Work-in-process (WIP) • Raw material (or minimal advance rate) • Obsolescence (reserves) • Over-advances: • Who approves and how are they reported to senior management. • Policies and procedures need to define limits and approval authority.

31. Comments on administration of collateral audits, periodic valuations, access to legal counsel and fraud. • Administration of collateral audits: • Policy/procedures: Define process and time frame for review and corrective action by loan or relationship manager (how are the information and exceptions handled and by whom.) • Pitfalls: Failure to address identified deficiencies in a timely manner (expiration of key man insurance, failure to pay taxes, other insurance, additional debt, etc.) • Collateral valuations (Orderly liquidation vs. forced liquidation values): • Policy should define how often and under what circumstances • Appraiser with relevant industry experience

32. Legal counsel: • May require specialized legal counsel with expertise in UCC laws, providing guidance in securing assets and potentially work with lenders in Debtor-in-Possession financing. • My experience: need more readily available access to counsel for ABL issues than I did with CRE. Processes may not be as well defined as CRE foreclosures, for example. • Most community banks do not have in-house counsel, which may slow processes if problems arise.

33. Fraud – beginning of a relationship and as borrower deteriorates • Ensure financial statements and collateral are adequately validated at beginning of relationship. • Accounts Receivable: May quickly evaporate if borrower picks up checks directly from customers as lender tries to notify customers and collect receivables (diverting funds). • Reporting non-existent receivables by creating false invoices • Re-aging uncollected debts to increase eligibility • Inventory: Overvaluing or double counting stock (“Empty box “ experiences, equipment disappearing, risk from “routine” or predictable collateral inspections) • ln contrast, land doesn’t move.

34. Contact the Speakers • Kevin Cragholm, Senior Analyst kevin.cragholm@sf.frb.org • Dante Tosetti, Credit Risk Examination Specialist dante.tosetti@sf.frb.org • Randy Santos, Senior Analyst randy.santos@sf.frb.org • Adrienne Thompson, Examining Manager adrienne.thompson@sf.frb.org • Tim Marder, Examining Manager tim.marder@sf.frb.org