Improving Credit Quality

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Improving Credit Quality Reducing Loan Losses

• Presented by
• John Bourquard, Principal
• Doug Wagler, Managing Consultant
• BKD, LLP
• December 7, 2006

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BKDs Presenters
John Bourquard
Doug Wagler
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Topics Well Cover

• General Trends
• Industry Specific Trends
• Your Banks Current Level of Risk
• Credit Administration
• Early Warning Signs of Credit Problems
• Assessing Credit Culture
• Summary of Our Top Recommendations to Help You
  Succeed

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General Trends Interest Rates

• Approximate Weighted Average Prime Rate
• 2004 4.3
• 2005 6.2
• 2006 8.0

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General Trends Interest Rates

• For borrowers with floating rates, interest
  expense will be 29 higher in 2006 than in 2005
  83 higher than in 2004, all else being equal
• For highly leveraged borrowers with thin profit
  margins, the result could be losses

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General Trends Interest Rates

• If cash flow becomes inadequate, determine how
  the debt service is being paid
• Too often, it is being funded by the bank

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General Trends Housing Market

• In general, this has slowed
• While it may not cause a recession, it will
  certainly cause pain in certain markets for
  borrowers some banks

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General Trends Cap Rates

• What is a cap (capitalization) rate?
• It is the rate of return a potential buyer would
  demand as a return on an investment in real
  estate
• Cap rates drive the value

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General Trends Cap Rates

• Example of the use of a cap rate
• Projected cash flow of property 250M
• (net operating income)
• Divided by the cap rate 7
• Equals the value 3,571M

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General Trends Cap Rates

• For larger markets, cap rate compression (not
  increasing cash flow) has increased value in many
  cases
• This has been caused by declining interest rates
  increased availability of capital to be
  invested in these markets

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General Trends Cap Rates

• For smaller markets, the results have been
  varied, but in general cap rates have fallen
  have not risen as interest rates have risen
• The result

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General Trends Cap Rates

• Old Cap New Cap
• Rate Rate
• Net Operating Income 250M 250M
• Cap Rate 9 7
• Indicated Value 2,778M 3,571M
• Potential Loan Request _at_ 80 2,222M 2,857M

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General Trends Cap Rates

• 2,222M 2,857M
• Loan Loan
• Net Operating Income 250M 250M
• Loan Payments, 7, 20 years 206M 264M
• Excess/Shortfall 44M ( 14M)
• Debt Coverage Ratio 1.21 0.95
• Loan/Value Ratio 80 80

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General Trends Cap Rates

• 2,857M 2,857M
• Loan Loan
• Net Operating Income 250M 250M
• Payments extend to 25 years 264M 241M
• Excess/Shortfall ( 14M) 9M
• Debt Coverage Ratio 0.95 1.04
• Loan/Value Ratio 80 80

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Cap Rates Conclusion

• Be aware of the cap rates used to drive your
  appraised value
• Do not become too reliant on low loan/value
  ratios make sure the current numbers still
  support the value
• If low cap rates support a high value but not a
  high loan amount, reduce your loan amounts dont
  stretch for the deal

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General Trends Bank Performance

• Most banks have fared well in the past few years
• Per FDIC data, following 12 bank failures in
  2002, there were 3 in 2003, 4 in 2004, none in
  2005 2006
• The overall environment has been good, but there
  are several factors that could impact your
  portfolio use caution

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Specific Industry Trends

• Automotive Related
• Auto Dealers
• Contrast banks the manufacturers
• Are your controls sound?
• How do you manage the DDA?
• Become an expert

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Specific Industry Trends

• Builders Developers
• Inventory turnover has slowed
• Interest expense is up
• How is interest being funded?
• How good are your controls?
• Pay attention to financial condition not just
  loan/value ratios.

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Specific Industry Trends

• Lower-priced rental homes
• Flipping
• Fraud
• Banks advancing based on appraised value not
  cost

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Specific Industry Trends

• Contractors
• Always a concern
• Do not rely on receivables for collateral
• If you must lend to them, educate yourself on the
  particular risks of this industry consider
  outside collateral.

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Your Banks Current Level of Risk

• Delinquent Nonperforming Loans
• Lagging indicator of quality typically a good
  indicator of what you did several years ago

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Your Banks Current Level of Risk
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Your Banks Current Level of Risk

• While an improvement, even the classified numbers
  are a lagging indicator of quality

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How Good is Credit Administration?

• This is the real driver of your current level of
  risk
• Underwriting
• Complete data
• Thorough versus superficial analyses
• Assumptions
• Conclusions based on facts
• Documentation
• Appropriate documents
• Tracking of documents

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How Good is Credit Administration?

• The real driver of your current level of risk
• Monitoring
• Collecting analyzing financial statements
• Obtaining analyzing borrowing bases
• Addressing red flags
• Modifying terms as appropriate
• Controlling advances on construction loans

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How Good is Credit Administration?

• The real driver of your current level of risk
• Collecting
• Promptly requesting delinquent payments
• Nominal number of payment extensions
• Accountability of results

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How Good is Credit Administration?

• How do you assess credit administration?
• If you assess based on the end results, it may be
  too late
• Examiners
• Loan review
• Any third party

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How Good is Credit Administration?

• From our experience, the root cause of most major
  lending issues at banks has to do with credit
  administration
• Continually reassess your strengths weaknesses
  in this area

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Recognize Early Warning Signs of Credit Problems

• A few early warning signs
• Slowing accounts receivable or accounts payable
  turns
• Abnormally high usage of the line
• Increase in other investments on the balance
  sheet
• Large increase in personal credit card debt
• Negative trends in the statement of cash flow
  (UCA cash flow on many commercial spreads)

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Recognize Early Warning Signs of Credit Problems

• What prevents us from seeing problems clearly?
• Profits
• Paid as agreed
• Banked with us for a long time
• Good deposits
• Highly regarded in the community

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Recognize Early Warning Signs of Credit Problems

• What prevents us from seeing problems clearly?
• We think the issue is due to timing
• While I do not have interim financial
  statements, I believe they are on track for a
  good year
• Our feelings rationalization of problems get in
  the way
• Thoroughly objectively analyze critical issues
  in order to recognize problems early

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Recognize Early Warning Signs of Credit Problems

• Getting beyond Paid as Agreed How did they
  pay? A sample discussion
• Credit Staff ABC Company had a debt coverage
  ratio of 0.80 last year leverage is high. I
  think this is a loan we should pass on.
• Loan officer ABC has banked here for years
  has always paid as agreed. The numbers dont
  look great, but I have a lot of confidence in
  management. They have a good backlog, I do not
  have any concerns with the loan.
• Result Two frustrated parties.

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Recognize Early Warning Signs of Credit Problems

• Alternative discussion
• Credit Staff It looks like ABC Company has been
  a great customer of yours for many years has
  always paid as agreed. Projections for next year
  look good. We have some concerns about the 0.80
  debt coverage ratio last year, however. It looks
  like payments were funded by stretching payables
  from 45 days to 63 days by increasing the
  banks line. Have you discussed this with the
  borrower? Do you know the trades reaction? Do
  you know if this was a proactive payment strategy
  or if they were reacting to a need for cash?

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Recognize Early Warning Signs of Credit Problems

• Result There are real issues on the table now,
  which the loan officers often have not thought
  about everyone really needs to understand.
  Once these are addressed, the discussion of the
  credit will improve.

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Annual Assessment of Your Credit Culture

• Examiners
• Loan review internal or external
• External internal audit
• Management/self assessment
• Credit risk assessment as outlined in the
  Comptrollers Handbookexample follows

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Annual Assessment of Your Credit Culture
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Annual Assessment of Your Credit Culture

• The last chart is a sample of that found in the
  Comptrollers Handbook
• For more information, see
• http//www.ffiec.gov/ffiecinfobase/resources/aud
  it/occ-comptr_handbook_comm_bank_superv_a.pdf

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Our top recommendations to help you succeed

• Thoroughly understand the risk of the loans in
  your portfolio how your portfolio compares to
  other institutions be objective
• Look at individual credit issues objectively
  address them with facts not with your
  perceptions or beliefs

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Our top recommendations to help you succeed

• Stress test interest rates cap rates (if low)
• Compare current cash flow on a project to that
  projected in the appraisal
• If your borrowers cash flow is inadequate,
  determine how the payments were made

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Our top recommendations to help you succeed

• Continuously assess your credit administration
  credit culture how can it be improved?
• Trust your policy guidelines dont stretch to
  make a deal work

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QUESTIONS

• Please contact us with any questions
• John Bourquard Doug Wagler
• BKD, LLP BKD, LLP
• 201 N. Illinois Street 1360 Post Oak Blvd
• Indianapolis, IN 46244 Houston, TX 77056
• 317 383-3783 317 383-4287
• jbourquard_at_bkd.com 713 499-4600 (effective
  4/1/07)
• dwagler_at_bkd.com