Credit Risk Memos (CRM's)
For Small Business Debt and Repayment
Credit Awareness Tools & Insights
Management / Creditor
CRM #3 – Annual Term Loan Reviews
Long-term loans will be subjected to the annual term loan review function; these loans are generally secured by real estate, but may also include annually renewed lines of credit. Reporting covenants are generally prescribed in Loan Agreements and will require certain financial information corresponding to the type of loan and collateral. The loan covenants will be closely monitored to ensure the debtor remains in compliance at all times. Creditors may have certain size thresholds under which such reviews will be conducted, like $500,000 plus, or smaller loans with higher loan-to-value ratios.
For example, if a loan is secured by investor-owned or non-owner-occupied commercial real estate (NOO-CRE), the creditor is going to want to see a current rent roll showing all the current tenants and rental terms and conditions. The most recent year-end operating statement will be reviewed in order to determine the net operating income to service the debt repayments. If multiple NOO-CRE is owned, a Schedule of Real Estate Owned would be requested. The most recent year-end business and guarantor tax returns and financial statements will also be required to help verify the accuracy of the assets and the financial performance of the operating statements. Material assets will also likely be verified, especially the liquidity position. The annual review will likely include a sensitivity analysis for NOO-CRE properties, where the analyst will stress certain factors to reflect how much debt service capacity there might be under various stressors starting with full occupancy upon stabilization, current occupancy, and breakeven. A worthy stress test will ‘break’ the breakeven to show how far cash flow will fall in order to become insufficient, and stress the variables under a severe economic downturn.
Larger loans will likely require a lending officer to perform a site visit to inspect the collateral property. He will also be ascertaining whether the property has any adverse environmental conditions, and if it is being used in conformity with the Deed of Trust or Mortgage (or other Loan Agreement documentation), and not being used contrary to those terms (i.e., a marijuana related business, or MRB). Similarly, an owner-occupied CRE property will also require regular financial reporting on an annual basis, if not more frequent, when there has been financial deterioration. The same holds true for other term loans secured by equipment. For loans secured by current assets, like accounts receivable and inventory, similar inspections and field audits will be made, together with all the other reporting.
As part of prudent credit risk management practices, creditors strive to be informed about the asset quality of their loan portfolios at all times. Annual reviews are for ordinary times. Therefore, you can expect there to be, at a minimum, formal annual reviews conducted on your term debt. If you’re experiencing financial difficulties, the level of review will become more frequent. It is likely that you will have triggered a technical default on loan covenants that will allow the creditor to require more formal financial reporting, and problem loan administration measures will ensue. If there are multiple NOO-CRE properties in your portfolio, be sure to give a detailed real estate schedule that includes: entity name that owns the property, address, property type, percentage ownership, acquisition date, cost or basis, outstanding loan balance, creditor name, annual rent and income, operating expenses, net operating income, interest expense, principal paid, capital expenditures, net cash flow, depreciation and amortization expense, and the current estimated market value. The creditor will be able to quickly assess the financial condition of the NOO-CRE, in the eyes of the debtor, anyway.
In short, when a review of your credit file is underway, take this as an opportunity to be transparent and to work with the creditor. As a small business owner, you have an ownership responsibility to not only prepare your financial disclosure documents, but to prepare them in detail and accurately. This is all part of building a relationship of trust, as you may, if necessary, need to present financial information that will require a work-out or loan modification at some point.
CRM #15 – Documentation
Loan policies will define the necessary documentation and information (i.e., type and frequency) that will be required at loan origination and throughout the life of the credit. Appropriate and accurate loan documentation will help ensure the creditor is lending in a safe and sound manner. The creditor will have the original loan documents, their exhibits, and required signatures. The information is used by the lending officer, loan committee, as well as auditors and other external parties (i.e., regulators). Information is used to verify the identity of the borrower and signers, their historical and current financial condition, the purpose of the loan(s), primary and secondary sources of repayment, and the collateral used to secure the loan. This includes financial statements, credit reports, appraisals, etc. Files will also include the on-going receipt of financial statement reporting, creditor analysis, collateral inspections and field visits, and loan covenant monitoring. These data will serve as a basis for establishing the borrower’s credit worthiness and serve as a paper trail for external auditors and regulatory examiners to review.
The credit file will also include documentation for collateral lien perfection and collateral monitoring. If there are third-party contractual agreements with contractors or franchisors, the creditor will have taken as assignment of those contracts in the event the debtor defaults on the loan. With proper documentation and internal controls, the creditor will be able to ensure that any collateral is released back to the borrower at the appropriate time. Negotiable collateral, like a Certificate of Deposit, will be maintained under dual control by individuals that are independent of the loan function.
A well-managed credit risk management function will also enable the creditor to adequately service the debtor at all times, even when the debtor’s loan officer is no longer at the financial institution. Besides the Promissory Note, a risk-based Loan Agreement is used to control the borrower’s financial performance, often including performance-based covenants, reporting, affirmative measures and negative restrictions. Performance covenants should be adequately structured (hopefully) to give the debtor sufficient ‘room’ to operate his business before a violation is triggered as economic conditions deteriorate. The close monitoring puts the creditor in a position to accelerate or demand full loan repayment, if necessary.
Creditors need appropriate file documentation not only at origination, but throughout the lending relationship. They are required to operate in a safe and sound manner, and understanding your financial condition while the loan remains unpaid is critical. Your loan documentation will likely require you to provide more ongoing reporting than you may think is reasonable or necessary – especially if you’re experiencing financial difficulties. After all, the money has been advanced, “so why doesn’t the creditor just leave me alone”? “My (single-family) mortgage loan was disbursed seven years ago, and I don’t provide them with any more financial information, and all this is nonsense”, right?
Of course, consumer loans have their own underwriting requirements, but a business loan has a higher risk profile and the documentation is going to be appropriate for the underlying risk. If you don’t appreciate it, or like it, then, well, you don’t have to borrower the money, right? Financial institutions are required to lend money in a safe and sound manner, and most institutions have similar lending and underwriting requirements; you may just need to get a handle on what those documents really mean. Non-financial institutions or those not regulated like most institutions may have different standards, but their interest rates and fees may be much higher because of the increased credit risk.
That said, when you sign any loan documents, give yourself sufficient time to read, discuss, and understand what it is that you’re signing. A serious small business owner will do this. Not so astute business owners will just ‘sign away’, and run the risk of mismanaging the business itself – which creates a headache for the creditor should there be a decline in the business financial ratios, especially unwarranted hits to the business. How sharp is your pencil? How serious are you as a business owner?
NCARA believes you get what you want and deserve, so be judicious and smart when it comes to actually comprehending what your loan documents say. There’s nothing that says a ‘loan closing’ needs to be rushed and done in 10 minutes. It’s your business, so take better care and ownership of it – whatever it takes. Take care of yourself too; ask whatever questions you think you should, regardless of how much time it takes. Make sure you literally know what the creditor’s expectations are, what the due dates are, what the covenants mean, and everything else. Chances are, you’ll be much more successful, because when difficult economic periods come, as they surely will, you will have established a relationship of trust, respect, and mutual confidence with the creditor. Bottom line, you’re going to need that relationship when your financial performance is less than both parties expect.
CRM #20 – Foreclosure
Foreclosure occurs when the underlying collateral is liquidated due to there being an event of default on a loan. The collateral serves as a secondary repayment source, and when there’s a default, there’s a legal foreclosure process under which a creditor can pursue to help satisfy a defaulted debt. With real estate collateral in a Deed of Trust state, there will be a recorded Mortgage or Deed of Trust, giving the Trustee thereunder the right to take title of the real property at a non-judicial foreclosure or Trustee’s sale. Other states may require a judicial action (i.e., court proceeding, expensive, time consuming) to recover the collateral. Foreclosure on a commercial real estate property or a single-family residence would indicate that there is no other option left to the creditor to satisfy debt repayment. Of course, prior to the Trustee’ sale, the debtor will be given a prescribed amount of time to redeem the real property (i.e., payment in full), like 90 days. Then, if not paid off, the property will be noticed up for sale, within 30 days.
It’s possible during this time that a bankruptcy petition could be filed to ‘stay’ the foreclosure process until the bankruptcy court authorizes the legal action at a future date. Once the bankruptcy court has abandoned the real property, the creditor will pick up where he left off and proceed with the foreclose process.
Once the collateral property is actually noticed up for a Trustee’s sale on a specific date, the real property will be sold (i.e., public auction) to the highest bidder, possibly on the steps of the courthouse. The Trustee will actually read the Trustee’s Sale (i.e., foreclosure action) and then open up to the public a live bidding process to purchase the real property, sold as-is, to the highest bidder. The creditor will likely ‘credit bid’ an amount equal to the full outstanding balance owed on the loan, including all the unpaid interest, legal fees and costs. However, the credit bid amount will not likely exceed the current appraised fair market value of the collateral property recently obtained by the creditor. Obviously, before the creditor bids on the property, a determination will have been made as to any potential environmental risk associated with the property, as the creditor does not want to inherent any potential material environmental liability that it may not want to inherit.
Whomever the highest bidder is will immediately owe (i.e., same day) the Trustee the purchase price in certified funds. If someone bids higher than the creditor’s bid, the purchase funds, less costs and fees, will ultimately be forwarded to the creditor to help satisfy the underlying debt. If no one out bids the creditor’s bid, the creditor will own the real property for the amount he bid, and that amount will be credited against the outstanding balance. The real estate loan will no longer be a loan; it will have been paid, depending on the bid amount (capped at the current appraised fair market value), equal to the amount of the creditor’s bid and the remaining balance charged-off.
The creditor will now have another asset on its books besides a loan; it is called Other Real Estate Owned, or OREO. It will be valued at the appraised current market value of the real property. If there’s a deficiency balance after the amount bid at the Trustee’s sale, and depending on the State in which the property is located, the creditor may or may not be able to seek a deficiency judgment of any unpaid amount on the loan. The creditor will need to decide if it is even worth trying to collect on any deficiency or unpaid balance. Creditor’s usually don’t spend ‘good’ or new money after ‘bad’ money, or money it can’t collect.
Regarding personal property collateral, like equipment or inventory, once the creditor sues the debtor and possession is granted to the creditor, the creditor will arrange to have a Sherriff’s sale of the collateral. A Sherriff will arrive at an appointed hour and similarly conduct a public sale of the collateral. Usually the creditor will credit-bid its unpaid balance or current market value amount, take possession of the collateral, and proceed to arrange for it to be privately sold. One way a creditor can dispose of fixed assets, including inventory, is to arrange for competitors to come and place private bids to purchase the same, usually in bulk. The creditor may expect that the prospective buyers will bid amounts that are materially discounted; the buyers know the creditors must sell the personal property (the fixed assets are ‘not what the creditor does’).
So, the bids may make the creditors feel like they are being held hostage, but market bids are still market bids. It all goes to the highest bidder. Keep in mind, the standard is to have a commercially reasonable sale. If the right conditions are not present, the creditor can sale it another day. Also, depending on the volume of the personal property, a creditor may have to hire another firm or professional who specializes in selling such assets to at the highest price possible. On occasion, depending on the volume, creditors may want to place the inventory in the services of a professional auctioneer company who will arrange a public auction.
Liquidation of collateral is a fairly big deal. You, the debtor, may have sunk your life’s fortune into it, and will fight like mad to keep it. Debtors have been known to try too hard to hang on to it, even at the expense of their own spouses and families. NCARA believes there comes a time and place to ‘let it go’, and only you can make that decision. It’s just dirt, glass, rubber, metal, etc. What could be more important than one’s family, right? Anyway, there may very well come a time when real and personal property must be sold or liquidated to help satisfy repayment.
So, how will you handle it? Assuming the days of negotiating repayment are long gone, and you’re actually facing a collateral liquidation scenario – you have a choice to make. You can do it cooperatively, or not. Did you know that creditors may compensate, subject to negotiation, the debtor to cooperate in the liquidation process? Yes, pay you, the debtor to help liquidate the collateral. Who else knows the collateral as well as you, the debtor? It’s all part of negotiating the debt repayment of your loans.
Now, negotiate the secondary source, the collateral, especially if you have a creditor-debtor relationship built up on integrity, trust, and good will. Speaking of the collateral, can you, will you ‘stay with it’, safeguard it from theft or loss, even if you know the proceeds from its sale will be going not to you but to the creditor to satisfy your debt? Can you afford to help out? Have you built that out into your repayment strategy? Will you be instrumental in finding the right buyers who will pay the highest prices, and in the most reasonable amount of time? Think about it; who knows your accounts receivable and inventory better than you do?
Obviously, any chance of being involved in the collateral liquidation process will depend on you and the relationships you’ve created. If possible, why not you or one of your employees stay connected to the collateral liquidation process, be compensated, and dispose of it for the highest amount possible, under the creditor’s direction. You could at least offer to do so, right? That’s the take-away here.
As for not being cooperative, some debtors can be quite deceptive. But, that’s not you, okay? As the collection process heat up, especially when negotiations have failed, debtors can take the attitude that they will do everything they can to hurt the creditor’s prospects of being repaid. They may want to cause as much financial pain on the creditor as possible.
NCARA believes this should never happen or be the case, regardless of what may have transpired between the debtor and the creditor – never. Why? Because when the ‘dust settles’, and it surely will someday, you do not want to look back and see that you intentionally caused a creditor to whom you owed money, to incur more loss than was absolutely necessary.
You do not want to look back and recall where, the 48 hours before you expected the creditor would notice-up the accounts receivable debtors to have all payments go to the creditor, you contacted all of them and offered a 15% discount if they paid you now. Then, the next day, the creditor tries to collect the receivables and there are none – a clear and dishonest violation of the loan covenants you signed onto at loan origination. Or, the time where you went to the warehouse and cleared out the inventory to a hidden location before the creditor took possession, another clear violation of your loan covenants. And, the list goes on and on.
There is a better way to resolve any dispute. From the beginning, go all in with good-faith efforts. If you’ve screwed it up somewhere along the way, even now, and you have poor relations with the creditor, stop, and go back in and fix it. ‘Lay down some cards’, and seek a quick solution or remedy, and stop the fighting, if necessary. You do not want to ruin your personal and family life over material objects or dirt. You can always start up again, but don’t ruin your life over collateral, it is not worth it. It never will be either. Do what you can to assist the creditor to dispose of the collateral, and move on with your life. Do it in a way that you and the creditor could both go out and have dinner together after it was all over, even if that may not realistically happen.
CRM #23 – Inspections, Field Visits
Depending on the size of the credit relationship, creditors will conduct field visits and collateral inspections, say over $500,000. Creditors will go onsite at loan origination and on an annual basis. If the debtor is out of the creditor’s market area, a third-party creditor-approved inspector will be engaged to do the inspection. The physical inspection is part of an ongoing due diligence or credit risk management monitoring process. If an inspection reveals unwarranted risks (i.e., adverse environmental hazards, a marijuana-related business tenant, etc.) a new loan request may be terminated, or for an existing loan there may be an event of default.
The inspection may help determine if proposed collateral is acceptable or not. If the collateral is acceptable, ‘knowing’ the collateral, its use and condition, may help the creditor in understanding and obtaining a more appropriate and accurate valuation and loan structure. The creditor will be cautious to ensure the maturity or loan term will be much less than the remaining useful life of the collateral property. Real property may be impacted by having either functional or physical obsolescence, or both, or deferred maintenance.
An inspection helps the creditor to better understand the debtor’s operation and character. It will enable him to verify statements made by the debtor, and hopefully strengthen the lending relationship. Inspections are also the time when environmental questionnaires are given to the debtor for completion. Creditors will have formal inspection worksheets, be accompanied with interior and exterior photos, written narrative describing the condition of the assets, tenants occupying the building, deferred maintenance, noting any potential environmental or hazardous waste or other required remediation or monitoring, marijuana related businesses (MRBs), etc. The inspection will also enable the creditor to confirm whether or not any collateral issues may result in a condition of default, if such constituted an event of default.
Collateral is what it is. Creditors have ‘seen it all’, so don’t be too worried about trying to impress anyone. The most important part of any inspection or field visit is for you to build trust and mutual respect with the creditor. When the creditor or inspector shows up, block out enough time to complete the inspection. Ask upfront what the creditor’s objectives and procedures are so that you can make every effort to accommodate his request. Remember that premise or collateral inspections are generally buried into the Loan Agreement, and they can generally be performed at any time with reasonable notice to you.
The inspection, depending on the type, may consist of a collateral audit of the accounts receivable and inventory, or of the real property. The latter may take only 30 minutes or less. The audit may take part or most of the day. Regardless of the type, stay focused on the purpose of the visit and respect the agreed upon amount of time. Hopefully the creditor will be sensitive of your time. That said, having the creditor onsite may have additional advantages. It’s not often that the creditor will visit your business, especially a workout officer.
At the inspection stage, it is an opportunity to open the creditor’s understanding of your operation at a whole new level. If time permits, and it’s agreeable to both parties (you may as well ask for it), take the time to give the creditor a ‘walk-through’. Show the creditor how your business functions. If you’ve got something that you’re proud of, then shine a light on it. Build a basis to support your plan of repayment. There’s no time like the present. Leave on good terms; yes, make sure that happens.
CRM #27 – Loan-to-Value (LTV): Minimum, Maximum
Creditors have loan policies that reflect the level of credit risk established by the institution’s board of directors. These policies should address the maximum loan amount by property type, maximum loan maturities, amortization schedules, pricing for interest rates and fees, and well-established maximum LTV limits. Exceeding the maximum LTV limits would result in there being an ‘exception to policy’. Such exceptions could be approved subject to well-documented support and mitigating factors to offset the increased credit risk. As for the LTV ratio itself, it is relatively simple to calculate: outstanding loan balance (commitment amount)/current appraised value.
The LTV ratios of loans secured by real estate are closely monitored by the creditor, as this ratio represents the equity ‘cushion’ to protect the creditor should the primary source of repayment, cash flow, fail to materialize. Commercial real estate loans often have five, 10, 15, 20, 25, and 30-year maturities; that’s a long time, and anything can happen to a business’ cash flow and changing property values. As for loan structure, there can be a number of arrangements. For example, a loan with a five-year maturity date could have an amortization period of 25 years, as if the loan payments were to be based over 25-years and not five years, but with a balloon payment of the unpaid balance due in five years. The creditor may have the option to renew the loan for another five-year period, based on current underwriting at that time. Otherwise, the loan would need to be repaid; refinancing at a different institution may be the ultimate source of repayment for such a loan.
Obviously, the loan structure will have an effect on the LTV position of the loan, especially as real estate values increase and decrease. Collateral, a secondary source of repayment, is required to protect the creditor as ‘anything can happen’ by the time such loans mature. Creditors have maximum LTV requirements for real estate loan transactions at origination and at renewal or extension many years later. It’s possible the creditor will require the debtor to paydown a loan to the maximum LTV based on a current lower appraised value at time of renewal. Typical LTV requirements for various real estate collateral types, based upon the current fair market valuations, include:
50% to 65% – Raw Land; Commercial Investment: Agriculture land, commercial and residential land acquisition and development, non-owner occupied commercial and industrial, commercial speculative, hotel, mini-storage units, retirement/assisted living, faith-based, auto dealership, gas station (i.e., special use properties).
75% – Land Development: Single-family residential development (SFR), owner-occupied SFR, owner-occupied industrial (i.e., warehouse, manufacturing), owner-occupied office/medical/retail.
75-80% – Commercial: Multi-family, apartments, and other non-residential construction.
85% – Construction: 1-to-4 single family residence, improved property
Loans originated with collateral having high LTVs are often considered to be higher risk loans. It’s unlikely the creditor will finance a deal (i.e., loan amount) more than the internally set LTV limits similar to those noted. As market conditions change, as they regularly do, the LTV position could deteriorate (increase), or substantially improve (decrease). Generally, the higher the LTV, especially in an economic downturn, the greater chance of the loan going into default; the debtor has less interest or equity in the property.
Additionally, the less equity there is in a property as evidenced by a high LTV ratio, the more difficult it may be to sell – for the debtor, or the creditor. Further, the higher the risk, the higher the interest rate may be to compensate for the increased risk and the potential for loss. The lower the LTV, the more likely the debtor will step-up and protect his interest or equity in the property, and thus the interests of the creditor too.
In those instances where there might be a junior lien (i.e., 2nd mortgage or Deed of Trust recorded on the property), the creditor will measure the combined loans to the current market value and come up with a combined LTV, or CLTV, particularly if both loans are from the same creditor. The CLTV will still need to conform to internal loan policy limits. However, if the 2nd lien is from another lender it’s possible that it may work to the senior lien holder’s advantage. If the sale or liquidation of the collateral is appropriate, and if the current CLTV position is low enough, the junior lien holder may payoff, or ‘take out’ the senior lien holder to protect his interest. But, if market valuations are depressed, the interests of the junior lien holder will likely be ‘foreclosed’ or lost, when the senior lien holder takes back the property.
Think of the LTV as the risk the creditor has taken in the collateral you pledged. If there’s a 75% LTV, it means that the creditor has a 75% stake in the financing of the collateral, which leaves you, the debtor, financing the remaining 25% stake – even though you technically own 100% of the asset. Go up to 30,000’ and look at your balance sheet. True, you own 100% of the assets on the one side of the balance sheet, are 100% responsible to repay all the liabilities on the other side, and outright own the difference, the equity. The ratio of the liabilities you owe to the creditors compared to the owner’s equity shows how your assets are being financed. In the example used above, the creditors financed 75% of the assets and you financed 25% of the assets. This ‘leverage’ ratio would therefore be 3:1
Which one, the creditor or you, really has more at stake in the business from a capital perspective? It could be said that the creditors ‘own’ 75% of the business and you own 25%. Even if you technically own all of the assets, 75% of them are at risk and subject to the interests of the creditors. So, don’t get too comfortable, right? This should give you a better sense of why it is so important to deal with the creditor in good-faith. It matters not that the creditor may take in millions more than you and your business do. It’s about the fact that the creditor stepped up and financed your business’ assets three to one, in this example; those loans were given to you in good-faith, and you needed these creditors in order to have a shot at being successful.
‘Cash out re-financings’ are commonplace, especially during periods of economic expansion. A business’ cash flows are likely to become more seasoned over time, along with increasing property values, resulting in a decreasing LTV ratio. With a low LTV level, small business owners often will pull equity (or cash) out of their real estate collateral properties to use for a myriad of reasons or purposes. The creditor will want to advance ‘new money’ because there is abundant seasoned cash flow to support repayment, the loan is still well-collateralized with an acceptable LTV position, and everyone’s happy.
But what goes up, often comes down. And when real estate values decrease, especially after a cash-out refinance, it’s possible the maximum LTV position will be compromised. That in and of itself is not a reason for the creditor to be overly concerned, as long as the documented cash flows still support repayment. After all, the collateral is not the primary repayment source; it is only the secondary repayment source in case the primary source fails. When it does fail, then there’s a problem and reason to be concerned. Suddenly, loans may become impaired, subject to regulatory scrutiny, a potential shift in the interest accrual vs. nonaccrual status, a sale or liquidation of the collateral, etc. The debtor must understand the position and thinking of the creditor when it comes to the collateral, and maintain open lines of communication.
In an economic downturn, you also need to think more about the creditor’s position and give him due respect, maybe a lot more respect. Creditors simply want their money back. But between the time they loaned you the money and when they get repaid, you have to be very engaged and show actual ownership of your responsibility to repay. That said, you are to be empowered to have a significant voice in what happens, and how and when those debts are repaid. You too have much to lose, perhaps everything. That’s precisely why you, the debtor, must be empowered to repay your debts, as best you can. Understanding the current LTV position and any potential loss the creditor may face, will help in coming to a mutually acceptable repayment solution.
Still, however, there needs to be a paradigm shift to where you ‘step up’, in total good-faith, and lead the way to work out a solution to your debt repayment. Don’t forget that the creditor has put much more money, several times more, into your business than you have. Creditors also need to remember that you are a human being and not just a ‘number’ or a name on a report. The better-prepared you are, the better chance you will have to come up with a prudent repayment solution the creditor will agree to.
CRM #29 – Other Real Estate Owned (OREO)
Creditors often have some OREO on their books, real estate owned that is other than the real estate the creditor uses for its current premises for its own operations. Most often, OREO is acquired real estate through the collateral foreclosure process for secured loans. When the primary source of repayment (i.e., cash flow) is no longer there, the secondary source of repayment, the sale or liquidation of the real estate, may become the only remaining repayment source. Such a loan is called a ‘collateral-dependent’ loan, and the real estate is acquired by the creditor through the foreclosure process. Once a property is foreclosed by a senior lien holder, for example, the action will clear off any junior liens from the title to the property. The net proceeds from the (Trustee’s) sale will be applied to the outstanding loan balance. Instances do occur where it makes economic sense for the creditor to accept a ‘deed in lieu of foreclosure’ to help satisfy an outstanding loan balance. If a creditor takes possession of real estate collateral (but not title), this is called an ‘in-substance foreclosure’.
Financial institutions manage the OREO portfolio, which can increase substantially during an economic downturn, in three phases: acquisition, holding, and disposition of real estate. The acquisition phase is when the creditor obtains title to the real estate and it is transferred as an OREO asset at an amount that reflects the newly appraised value, less selling and disposition costs. At a foreclosure sale, the senior lien holder will usually ‘credit bid’ this amount, an amount that is known to represent the ‘fair value’, less the estimated cost to sell the real estate. Fair value is used for a sales price that a willing buyer and a willing seller would agree to; it isn’t a liquidation value.
The creditor will carry or hold the asset on its books at the fair value as periodically determined via the appraisal process, less estimated selling costs. If the creditor holds the assets for several years in a declining market, it’s possible new appraisal valuations will be needed and may result in the creditor having to ‘write down’ the balance to reflect the current market value. If the real estate market is increasing, the creditor may have a gain on sale to reflect the increase in value. Often, however, when disposing the asset in a flat or declining marketplace, creditors may have to take a discount in order to get the non-earning asset sold – especially if the OREO portfolio is large.
OREO is generally sold ‘as-is’ with no warranties whatsoever. The timing for selling OREO is to be within any State mandated holding periods, but is to be done in a prudent and reasonable manner. It is typical for a creditor to place the asset into the hands of a real estate agent to have it professionally sold in the market. The carrying value would have already accounted for disposition costs so the net proceeds would likely payoff the OREO balance on the books.
Obviously, if your defaulted loan made it all the way through the foreclosure process and into OREO, there’s no longer any interest in the collateral on your part. Creditors will dispose of their OREO assets at some point. Upon sale, the creditor will generally require payment from external sources and won’t finance the purchase itself. If the creditor does finance the sale of its OREO, it will conduct abundant due diligence and underwriting to show it was done in a commercially reasonable manner, and the buyer be fully qualified for the financing. The creditor would not likely be inclined to offer special concessions, terms, interest rate, and fees in disposing of an OREO property, less it be criticized by supervisory authorities.
NCARA believes the collateral liquidation process should be much rarer, and only necessary when all other alternatives have been explored and exhausted by the debtor and creditor. And that includes the filing of bankruptcy too. Keep in mind, if your business is a ‘zombie’ business limping along but essentially dead for all intents and purposes, is it fair to the stakeholders to continue the relationship? Do you have a forever ‘evergreen’ loan? Perhaps if a guarantor can become fatigued supporting a dead loan, so can a lender.
Where, when, or how do you become a zombie company? Perhaps a zombie business is one that cannot survive expect for some major outside support to keep the heart beating or the doors open, or one that can only pay interest payments forever, but will never be able to repay the actual outstanding loan balance. If that’s you, then rethink if you’re wasting everyone’s time and make a recommendation to look seriously at the real estate collateral as the only remaining repayment source. Maybe you should seek creditor concessions, or an “A” and “B” note restructuring? Maybe it’s time to be done with it, right? It’s a decision you will have to make, if the creditor hasn’t already made it for you.
CRM #31 – Problem Loan Administration
For any variety of reasons or circumstances, there will always be ‘problem or classified’ loans. The source may come from the debtor’s operations, market conditions, competition, or management’s decisions. Maybe the issues were exasperated by weak creditor credit risk management practices. Problem loans may be baked into the when the loans were first originated, such as: new start-up businesses, speculative ventures, insufficient collateral margin or lack of equity in the property, dealing with borrowers who lack character, poor underwriting on the level of debt service repayment ability, failure to obtain adequate financial statements, not understanding the loan purpose or borrowing cause, failure to recognize market demand (i.e., building lot concentration and lot absorption rates), or too much focus on income and fees. Problems happen, especially when there’s an economic downturn like the present.
Once in a while there is ‘self-dealing’ where unsound credit is given to insiders, or certain incompetence’s of lending personnel for specialty lending. The board and senior management may also fail to provide effective oversight, all the while there are changing economic conditions. Lenders often rely on oral or written information from debtors instead of verifiable financial information. Competition may also pay a role, as creditors will be tempted to compromise their credit standards and loosen loan covenants, etc. Institutions have been known to implement aggressive loan growth strategies for what ends up being short-term growth in earnings, but ends up with problem loans; such risks are unwarranted. Documentation errors have historically been the cause of material problem loans, but the quality of loan docs has improved greatly over the years.
Financial institutions have well-established credit and lending policies and procedures to identify early, and administer problem loans. If the creditor is paying close enough attention, it will be able to spot changes that need to be addressed. Management will have well-established policies to guide their expectations on how it intends to manage adversely risk rated or problem loans. Criticized loans are risk rated as Special Mention. Classified loans are risk rated Substandard, Doubtful, and Loss. Creditors generally know when financial performance is off, including collateral values and other metrics. Creditors focus heavily on managing problem loans in a timely basis, including individually documented problem loan ‘action plan’ reports (i.e., updated monthly or quarterly) that detail the overall steps to get your loan upgraded to an acceptable or Pass risk rating, or to a zero balance (i.e., possible liquidation of the credit).
Creditors will search to verify whether or not there are judgments against the company and its principles, including tax liens (especially Federal tax liens that may supersede the creditor’s interests, and secured (junior) liens by other creditors. Generally, and especially if the debtor is cooperative and is submitting the required financial statement information, a creditor will be able to gauge how solvent the company and its owners are, and how much longer they will be able to remain in business before having to file bankruptcy.
A Notice of Default, at some point in the problem loan process, may be recorded against the real estate collateral. The creditor will likely list all the conditions for which the default issues were based, and the debtor will be required to remediate each of the conditions before the default may be cured. For some conditions, the unpaid loan balance may even be accelerated, and a full payoff amount will be required, usually within 10 days, else the creditor may elect to pursue its legal remedies to collect the unpaid balance, including liquidation of the collateral. Prudent creditors are likely not going to ignore any conditions of default, because they realize that the sooner they address these problems the better chance they have in achieving their ‘least loss’, if any. The longer they ignore these conditions, the more likely they are to incur more losses as the ability to repay, and the condition of the collateral, usually deteriorates.
A creditor may enter into a workout agreement to repay the unpaid balance that summarizes certain negotiations, and will be binding on the creditor, debtor, and guarantor. The rights in the remaining loan documents will likely not be waived. A creditor may enter into a forbearance agreement where it will forbear taking further in exchange for the debtors to do certain things. A creditor may exercise his rights to ‘offset’ money the debtor has on deposit at that institution. In rare instances, a creditor may discount the Promissory Note and sell it in the marketplace, and thus be repaid usually at a hefty discounted rate. Of course, the creditor may have no choice but to turn to the collateral (i.e., foreclose on the real estate), or by taking back a Deed in Lieu of Foreclosure (for an agreed upon amount to satisfy the debt), pursue a regular non-judicial foreclosure in states that use Deeds of Trust, or a judicial foreclosure (court proceeding) against the property and the guarantors. If everything fails, a bankruptcy petition would likely ensue.
Examples of problem loan situations include delinquency, multiple renewals with unusual payments structure, evergreen loans (i.e., little principal reduction), declining credit metrics: working capital, lower trends in account receivable and inventory trends and aging, increase in accounts payable, declining revenues, increasing expenses, heavy debt/worth, poor cash flow. When problems are present, required financial reporting is often lagging; people hide.
So, if you experience diminished cash flow, collateral issues, or your financial performance is ‘off plan’, you can expect that the creditor will be formulating a plan of action to shore up the credit. It’s been this way for decades; the creditor is going to call the shots, including fixing any structural issues like enhanced financial performance covenants, more reporting and collateral, etc.
Of course, creditors will likely ‘work with the debtor’ for an orderly resolution, but this is where the paradigm shift must need take place. Small business needs to be the primary author of the so-called work-out plan with its own quantifiable measures and completion dates. Use your pro forma cash flow statement to show, even if it’s low, the available cash flow to keep you in business. Your efforts to find a solution with the creditor clearly demonstrates your willingness to remain committed to the financing (i.e., business, project). It will be apparent quite quickly that you are not committed to the loan if you avoid the creditor, or make threats to the creditor. Creditors can tell where you are, commitment-wise, so there’s no sense in trying to hide your real intentions. As you look for solutions, consider what changes may to consider in creating a workout plan, including modification and forbearance agreements: extended loan term or maturity date, lower interest rate, different payment date, lower payment amount, new guarantors, more collateral, or an “A” and “B” note split restructure.
NCARA believes you should make every effort to repay you loans in good faith. If in the end, it’s entirely impossible to do so, then so be it. It can be a cooperative liquidation in good faith too, in order to keep costs down. Creditors have even paid the debtor to help with the liquidation process to recover as much as possible for the creditor, the difference being less owed to the creditor too.
Don’t be surprised if, when you approach your creditor, there are new people assigned for the administration of your loan relationship. All products and services you have with the creditor will likely be under the approval of a ‘work out department’ or team, comprised of work out specialists as opposed to the usual relationship manager or loan officer on the loan production side. The latter may have a potential bias and be predisposed to taking or not taking certain actions that may be in his individual best interest as opposed to the creditor’s overall best interest. Having a problem or classified loan in an individual’s portfolio does not fit financially well with the individual loan officer. Transferring the credit, where it makes most sense, to another party will increase the chance of a more favorable outcome to the creditor – which may or may not be in your best interest. A new officer should be more objective and have more time for you, anyway. Hence, if you want a mutually acceptable outcome, you must be well-prepared to be the main source of authoring your work out plan. And it has to be done ‘early on’ in the process. Time is of the essence.
CRM #33 – Refinance Risk
Refinance risk is when a debtor is likely to default on his loan because he is unable to ‘refinance’ an outstanding balance when the loan comes due, or matures. Obviously, this means that his financial condition has deteriorated and other creditors may not be so willing to accept the increased credit risk through a refinancing. It can also mean that because of changes in interest rates (i.e. increases), and changes in underwriting criteria (i.e., more conservative), the borrower is unable to meet the new requirements; he can’t refinance.
Your current financial condition, market conditions, the potential timing on a refinance, and other factors may or may not be in your favor for a refinance. Don’t be surprised to find your loan risk grade downgraded to Special Mention (criticized rating) if your cash flow is just nominal or minimal, if refinancing is the only viable option for repayment. Where there’s no likelihood of reducing the principal balance, and you refinancing is or was your only option for repayment, your loan risk grade may be lowered to Substandard (classified rating). See CRM: Risk Ratings.
NCARA believes that debtors, the world-over, should pay very close attention to high debt levels and refinance risk. It almost sounds like a ‘warning’; actually, it is. If markets were to freeze up, if interest rates jumped excessively, or any number of things, you may not be able to refinance your unpaid loans at maturity. Frankly, the world has way too much debt, it’s not sustainable, and new record debt levels are here to stay as far as you can see. Not enough people are even willing to talk about this. For these and other reasons, you may find yourself trying to survive in seasons of default and restructuring everywhere, along with the multitudes of businesses that have high debt levels. Just saying.
CRM #34 – Renewals, Refinancing, Extensions, Modifications, Forbearance
When unpaid loans mature (i.e., balloon payment), the creditor may require a full payoff, renew, or extend the maturity date of the loan for another period of time. It’s likely the credit file will be refreshed with current financial reporting, somewhat similar to the original underwriting process. Existing loans may also be refinanced, with or without new money. The debtor may apply for a new loan to payoff an existing loan at another institution (refinance). Perhaps the terms and conditions will be more favorable due to competitive pressures. Or, when a loan matures, a debtor will be prepared to simply repay the loan.
On the other hand, in an economic downturn, a loan might be modified or restructured due to a debtor’s temporary adverse financial condition, or possible default. After all, it may be in both the creditor’s and debtor’s interest to come up with another repayment solution. Any such modification or forbearance agreement would still need to be prudent. Otherwise, the loan might be liquidated, with or without the cooperation of the debtor. Creditors will always be looking out to see any red-flags that shows the debtor may be experiencing trouble.
As repayment issues are identified, it’s possible for the creditor to enter into a Change in Terms agreement, or some other forbearance, modification, or workout agreement. These agreements basically provide temporary postponement of the creditor’s remedies to cure a condition of default. The agreements will outline certain conditions the debtor is expected to follow, and if not followed, the agreement automatically terminates. The wording in the agreements will cause the debtor to acknowledge that a default has occurred (and not waived), and may include language that releases the creditor of any potential lender liability.
During difficult times, in particular, debtors need special attention, but debtors also need to be empowered to come up with their own repayment solutions. Typical red flags facing stakeholders include the borrower and/or guarantor having insufficient (global) cash flow, delayed construction projects or those that are no longer viable, slow moving inventory and accounts receivable collections, lack of timely financial reporting, loan covenant violations, declining financial ratio trends, excessively high loan-to-value (LTV) ratios on collateral, more competitors, slowing sales and increased expenses, repayment that is dependent on the sale of the collateral, and other well-defined credit weaknesses, or worse.
In so some scenarios, and as a possible last resort, it may prudent to restructure the loan into two loans (i.e., ‘A’ and ‘B’ loans). The ‘A’ loan, legally enforceable, would be that portion of the current outstanding loan that is reasonably assured of acceptable repayment performance per the new terms thereunder. It would be structured such that it would be sufficiently supported by the then current available cash flow. Of course, the ‘B’ loan is the rest of the original loan not included in loan ‘A’, it would not be a bankable asset; it would need to be charged off the creditor’s books. Once the ‘A’ loan is repaid, however, the debtor can start repayment of the ‘B’ loan on reasonable terms.
In other situations, the portion of the loan that is insufficiently secured by the collateral and that cannot be supported by the available cash flow may ultimately be charged off. The interest accrual will be placed or remain on nonaccrual status while payments are collected and applied to the principal balance. The remaining portion of the loan balance still on the books will have to be well-supported by documented available cash flow, pro forma cash flow, and appropriate collateral coverage. There are a number of factors that must be in place before the loan can be returned to accrual status. After successive loan repayments have been demonstrated (i.e., six months), it is possible the remaining loan could be placed back on interest accrual.
Once the outstanding balance is repaid, payments will be applied as ‘recovery’ payments towards the unpaid balance of the charged off loan, and ultimately include unpaid interest. The creditor’s accounting for the loans, including any charged off portions, is solely an internal accounting matter. As for the debtor, he will continue to get monthly payment statements as if nothing had ever changed. It will appear the same even though there may have been charged off amounts, changes to the interest accrual status, etc. Just the creditor will be required to conduct certain accounting procedures for reporting problem loans on the books.
For consumers, red flags may mean a job loss, the loss of a family member, or a medical or health setback. The loan modifications or workout measures may be installed if the debtor maintains both an ability and willingness to make repayment. The creditor is supposed to be prudent such that these lending measures or decisions are considered to be safe and sound. Loans that are restructured can be have additional borrowers added or substituted, including additional collateral.
NCARA notes that timeliness is very important for entering into loan modification, forbearance, or workout arrangements. You know when your loan(s) mature, right? You also know how long it might take for you to prepare a workout plan to the creditor too. It means you having had sufficient time to prepare your financial statements, identify the root causes for the decline in financial performance, and more importantly, the preparation of your pro forma cash flow statement. The pro forma will have to be well-supported by assumptions, since this is future cash flow based on strategic decisions to remediate the weaknesses heretofore experienced.
These corrective measures may take at least 30 days in some cases. It may take longer if you have collateral issues, and the creditor has a list of items that he wants or needs too. So, if you have an upcoming maturity and you know you will be having to prepare and present a repayment solution, it could conceivably take up to 45 days or so to be ready. What about the time the creditor needs to do his underwriting, approval, and documentation work? There may also need to be a meeting or two, and that could also take a few days. Or more documentation. Realistically, you need 45-60 days, and the creditor needs 30 days. So, you’re looking anywhere from 10-12 weeks prior to the next maturity date. It’s time to get to work. Do. Not. Put. This. Off.
It is also important to put this ‘empowerment’ into some further context. Your creditor may be swamped with deals that are in need of urgent attention. Not to mention that unexpected events may come your way too. You know you’re not going to get the time and attention you deserve or want anyway, right? Can you imagine if you, a prepared small business owner, came in with a workout package that included the necessary items outlined in NCARA’s Credit Risk Memos? Do you want to shock your creditor? Okay, just come forward with the solution to your own repayment problems. You go in with well-supported key assumptions in your pro forma cash flow statement, and with identified root causes behind the deficiencies recently experienced. And so much more. And, you presented it all within 30 days of the maturity date. Talk about building credibility, trust, and transparency. How can you lose? You can’t.
CRM #36 – Restructured “A” and “B” Notes
Depending on the circumstances, a creditor may seek to remediate a nonperforming loan in default through a formal restructuring. The “A” and “B” note split option would be best utilized where there is a viable repayment source to repay some, but not all of the outstanding loan balance. The whole idea for such a restructuring is to recover as much of the outstanding loan balance as possible. This structure may imply that there were extenuating circumstances beyond the debtor’s control, or for some other reason, for the creditor to want to stay in the deal; it’s a prudent and reasonable approach to getting repaid as much as possible.
A nonperforming loan is formally restructured by taking the loan and dividing it into two separate notes, an “A” note, and a “B” note. The “A” note would equal that part of the original loan that the creditor (and debtor) believes will be fully repaid at the then current market interest rate over the remaining term. In other words, the historical and especially the pro forma cash flow statement will show what ability there is to service debt at the prevailing interest rate, obviously resulting in a new lower principal amount. The debt service coverage ratio should be, say at least 1.1:1.
The “B” note represents the remaining portion of the original loan not included in the “A” note, and that portion is uncollectible (regulatorily speaking) and must be charged off. The “B” note would have to receive material concessions such as to not infringe on the repayment ability for the “A” note. Maybe the “B” note terms will include a low interest rate, and a deferral of all principal and interest payments until the “A” note matures and is repaid in full.
The goal of the creditor will be to return the “A” note back to an acceptable risk rating, and to return the accrual status from nonaccrual back to accrual – just like a regular performing loan (and getting rid of the portion that cannot be repaid). That way, there is a restoration of as much of the original loan amount as possible without having to liquidate the entire loan.
Again, such a restructuring requires there to be an economically rationale, prudent, and documented basis for restructuring a loan into two separate loans. If structured correctly, over time, the creditor may be able to return the “A” note to accrual status as a normally performing ‘pass’ risk-rated loan, according to the demonstrated financial capacity of the debtor. To do so, the debtor would need to pay some six months of on-time monthly payments, or 12 months of quarterly payments). If the new structure includes too much principal in the “A” note, it’s possible the collectability may be questionable. The “B” note is charged off due to its being deemed uncollectible, but the terms of its repayment would be such that it would not interfere with the prospects of repayment for the “A” note.
Maybe debt is forgiven, or payments are deferred until maturity. The debtor is legally responsible for repayment of both notes notwithstanding the restructuring and charging off of the “B” note, including the non-accrued interest. Once the “A” note is repaid, payments due under the “B” note will commence (unless forgiven), and the creditor will apply the payments as ‘recovery’ income since it was previously charged off.
The restructuring effectively allows the debtor to pay as much of the original note as possible, recognizing that his financial condition resulted in him not being able to adequately repay the entire debt over a reasonable period of time, but possibly at a later time. Thus, the “A” and “B” note structure assisted the debtor by allowing him to remain in business and repay, hopefully, the full amount over an extended period of time. These actions are also in the best interests of the creditor.
NCARA firmly believes the global economy will experience seasons of default and restructuring over many years. Formal restructurings will be commonplace and “A” and “B” notes will be regularly used to meet the adjusted debt service capacities of small business. You should become acutely aware of how credit risk is managed by creditors so that you can create your own debt resolution proposals using these tools. You are certainly empowered to do so.
Placing special emphasis on your pro forma cash flow statement, you will be able to articulate the projected cash flows to support the highest possible levels of debt service. You must make certain the assumptions used in the pro forma are appropriate, well-founded and fully documented. Again, you are empowered, and you have to believe and understand why you’re empowered, to negotiate your own repayment solutions with confidence. The “A” and “B” note restructuring is an effective tool in taking a loan out of its non-performing status and returning an appropriate amount to a performing status.
CRM #37 – Risk Ratings, Loan Grades
Creditors apply risk ratings or loan grades to business loans as part of a credit risk management framework. The loans with acceptable risk of repayment are rated as Pass, and other ratings are made for loans that exhibit potential weaknesses, and those with well-defined weaknesses, or worse. Delinquency is one of the key credit risk metrics or indicators of a problem loan situation. The ratings framework enables management to assign an appropriate ‘reserve’ amount from earnings against potential losses for a given loan. It is imperative that the credit-grading system is effective in assigning risk grades accurately at all times and that any necessary changes in ratings are done on a timely basis. Pass ratings often range from, say, one to six, depending on the quality of the Pass rated credit; a loan secured by a Certificate of Deposit (i.e., cash secured) is perhaps the highest quality of a Pass rated credit (i.e., rated 1). Other Pass rated credits will have more credit risk, but are still acceptable (rated 2, 3, 4, 5). Creditors often include a ‘Watch’ risk rating too, which is still a Pass grade (rated 6), that receives additional attention from management.
Outside the Pass ratings (rated 1 through 6), is the ‘criticized’ rating called Special Mention, followed by the ‘classified’ ratings of Substandard, Doubtful, and Loss. Lending officers have the primary responsibility to identify emerging credit risks that might result in a downgrade from a Pass rating, with oversight support from management. Creditors often have an independent ‘loan review’ function, and outside consultants who will independently review loans and confirm the accuracy and timeliness of the risk ratings. Downgraded loans are regularly reported to senior management and the board of directors of a financial institution.
Creditors need to assess the debtor’s overall financial condition (i.e., credit quality) regularly. Key repayment sources include the debtor’s current and stabilized cash flow capacity, credit report performance, management’s character profile, the original loan purpose, current sources of repayment, collateral condition, guarantor support, and payment status. By the time credit weaknesses are identified, this usually results in a diminished ability to make the required payments and the loan become delinquent. Creditors use standardized risk ratings definitions as defined by regulatory agencies. (See: FDIC – Manual of Examination Policies)
Special Mention – “A Special Mention asset has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.”
Substandard – “Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.”
Doubtful – “Loans classified Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions, and values, highly questionable and improbable.”
Loss – “Loans classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future.”
Creditors are expected to operate with safe and sound practices, and asset quality (i.e., loans and investment securities) is paramount to their survival. Financial institutions are not supposed to have huge piles of classified underperforming, or worse – nonperforming – loans on their books. Creditors are expected to get those loans to performing status as they should, or get them to a zero balance as soon as is reasonably possible. Creditors can have only so many classified loans on the books before capital becomes an issue, together with regulatory repercussions. Management may also face the potential of missing out on bonuses because of numerous problem loans. Loans are traditionally risk rated a ‘Pass’ rating if they are loans with strong or acceptable repayment sources. As financial deterioration occurs, a Watch rating may be applied as an early signal to closely monitor the credit. Watch rated loans are still acceptable are considered as a Pass risk rated loan. Stakeholders sleep better at night when their loans are risk rated as Pass.
Management and lending personnel have been criticized by regulators for their failing to downgrade loans accurately or on a timely basis. Management may be ignorant or disregard warning signs and red flags about the debtor, and the economy or an industry. Management may even be neglectful and fail to closely monitor the situation, especially when the institution lacks the ability to shore up its capital base. Lending decisions may also be made in violation of safe and sound lending principles, involving over-lending, over-advanced, too speculative, dominating personalities and influential connections, friendships or conflicts of interest – all of which may lead to there being problem or classified loans.
Loans that are risk rated Special Mention (SM) are ‘criticized’, but not ‘classified’. You should expect more attention and monitoring efforts. The expectation is that the SM rated borrower will return to a Pass rating in the very near future (i.e., months), or it will deteriorate further and become a classified loan (i.e., Substandard, or worse). SM rated loans get management’s special attention, as uncorrected credit risk may result in deterioration of repayment prospects. So, creditors are going to be asking more questions and for more financial information. They will review and adjust inadequate loan documentation, review the condition and/or control over collateral, declining economic or market conditions, or declining trends on your balance sheet and income statement.
Loans that are risk rated Substandard (Sub) are ‘classified’ loans. This rating is another story altogether, and this is where it gets very serious. Insufficient cash flow is the standard reason for the Sub rating, and this underscores why you need to be armed with your pro forma cash flow statement, a month-by-month projection for 12 months showing what the available, though insufficient, cash flow will be for repayment purposes. The Promissory Note and Loan Agreement will likely need to be modified, or a Change in Terms Agreement negotiated and signed to reflect necessary adjusted terms. This may include a change in payment amount, the timing of payments, a reduced interest rate, payment deferral, or an extension of the maturity, etc. The negotiations may also include addressing violated loan covenants, taking additional collateral or any other type of agreement to shore up the creditor’s repayment sources. Ideally, you will want to negotiate your repayment well before it becomes a Sub classified credit. Depending on the severity of the repayment sources, the accrual status may remain on accrual, or be changed to nonaccrual.
Loans that are risk rated Doubtful indicate that the credit has deteriorated to the point there will be ‘loss’ in the repayment of the loan balance; the loan will be placed on nonaccrual and the creditor will no longer be taking interest income on the loan. This rating means that because of certain unknown factors that may strengthen the credit or work to its advantage, the amount of loss cannot readily be determined at that time. But, as soon as those factors are figured out (i.e., like a new appraisal, liquidation proceedings, capital injection, taking additional collateral, verification of environmental risk, or even a refinance at another institution), a loss amount can then be determined. Depending on the circumstances, it is possible a percentage of the loan can be risk rated Sub, another doubtful, and the rest rated loss.
Loans that are risk rated Loss are considered to be uncollectible, are no longer bankable assets. The loan balance must be written off in the period they’re deemed to be uncollectable. That doesn’t mean you no longer owe the money; it is to the contrary. Unless and until it is formally and legally discharged, or otherwise repaid, it is still owed, interest and all. Creditors will make every effort to collect as much of the loan as possible, even if it is internally charged-off as a loss on its books. Creditors collect ‘recoveries’, monies previously charged off, all the time.
Here’s the catch. You need to understand what these risk ratings mean. You can ask the creditor what your loan is risk rated, or its loan grade; it will change from time to time. But, understanding these ratings will help you understand what is happening with the creditor. And regardless of the risk rating, Pass through Loss, your Promissory Note and unconditional and unlimited individual guarantee, will require full repayment regardless of the internal risk rating and accounting. The creditor’s system will be able to produce a statement showing your loan payment status, including all interests, fees, and costs owed, anytime.
CRM #38 – Troubled Debt Restructured (TDR)
In a “troubled-debt restructuring,” a creditor grants the debtor a concession for economic or legal reasons related to a debtor’s ﬁnancial difﬁculties that it would not otherwise consider. In other words, the debtor needs to be experiencing financial difficulties, and, the creditor has extended a concession. The purpose of the TDR is to recover as much of the unpaid outstanding balance as possible. There are times when, in the best interests of the debtor and creditor, a loan will need to be renegotiated and classified by the creditor as a TRD.
Examples of a debtor experiencing financial difficulties may include: a default on a loan, uncertainty as to whether or not the business can continue to operate (i.e., bankrupt), and the inability to obtain replacement financing or service existing debt. The loan could be considered a TDR if these financial conditions are being experienced by the debtor, and, the creditor has given a concession that it otherwise would not normally grant, such as: an interest rate that is below the market rate of interest, forgiveness of principal or interest, and deferral or extension of payments. Renegotiated troubled debt may also include the transfer of real estate or accounts receivable from the debtor to the creditor. TDRs are considered to be impaired, and the accrual status is changed from accrual to nonaccrual.
In order for a loan to not be classified as a TDR, certain factors will need to apply. As for a reduction in the interest rate, if the debtor could get a lower interest rate from a different creditor, then that wouldn’t trigger a TDR status. Also, if the debtor’s financial condition improved such that he could qualify for a new loan at market interest rates and terms, it could be documented that it’s no longer a TDR after the year in which the restructuring took place, or if the loan is refinanced at market rates similar to non-troubled debtors. Also, in order for the nonaccrual status to be changed back to accrual status, there would need to be a history of sustained repayment performance (i.e., six months).
Due to the COVID-19 pandemic in 1Q2020, financial institutions are expected to work with debtors who are affected by the coronavirus pandemic. Debtors may not be able to meet their contractual obligations because of the effects of COVID-19, and loan modifications are viewed as positive actions than can help mitigate adverse consequences of the pandemic. Therefore, not all modifications are categorized as TDRs. Creditors are expected to take prudent actions that mitigate credit risk that are consistent with safe and sound practices. Therefore, short-term (i.e., six months) modifications made on a good-faith basis to debtors who were current on their debts prior to any COVID-19 relief, are not TDRs. Examples of short-term include payment deferrals, fee waivers, extensions of payment, or other insignificant enhancements. (See: Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus, dated March 22, 2020)
Maybe if your business loan needs mega assistance, a TDR is right for you. Financial institutions are required to account and report TDR classified credits. When you have financial difficulties, concessions can be made by creditors, and it may help keep your company in business. Concessions may be granted. If applicable to your situation, as you deal in good-faith, the creditor may see that your repayment proposals will result in it getting back as much of the principal balance as possible. See NCARA CRM: Restructuring, “A” and “B” Notes.