The Future of Commercial Underwriting and Tracking
The Great Recession started about 10 years ago and with that, we saw 528 bank closures in the United States. Since 2016, there have only been 11 bank failures – a stark contrast to where we were a few years back – and the economy continues to grow. In April, our country reached a milestone as it reached the second longest US expansion on record. This is great news for the economy, but it should raise some concerns for community banks. Historically speaking, small business loans that go bad are often made during the last couple of years of a recovery, which may be where we are right now.
For a long time, regulators have expressed their concerns about this very issue. For example, in the Semiannual Risk Perspective, the Office of the Comptroller of the Currency (“OCC”) encouraged lenders to focus on maintaining “sound credit standards within risk tolerances” in light of the lengthy expansion. Regulators want banks to be thinking about credit risks should economic conditions worsen.
After the recession, banks naturally improved their underwriting standards to help mitigate any undue credit risk, and to ensure added protection for their shareholders. While underwriting standards have improved, competition for loan growth and narrowing margins amongst community and national banks have caused some to ease general loan underwriting practices to be less stringent and more accommodating to borrowers.
Some practices which have regulators concerned are:
- Inappropriate financing of working capital
- Longer term maturities on fixed rate loans
- Increased maturities and renewals of interest only loans
- Non-Recourse Lending
- Reduced monitoring of individual borrower concentrations
- Higher Loan to Value (“LTV”) ratios, with increased part 365 reporting
- Failure to monitor or to enforce covenants which were part of the loan approval
It’s important to keep in mind that many of these issues were problems long before we hit the Great Recession in 2008. Community banks are posed with the difficult challenge of increasing their loan production based on competition from other banks, while also maintaining their strong underwriting practices and compliance with Board approved loan policies.
Improving your Underwriting Practices
Below are a few things to consider when it comes to improving your underwriting practices.
Debt Yield: Interest-only loans or loans with longer amortizations may allow customers to have acceptable debt service coverage ratios with high levels of debt. Low cap rates can yield higher than normal appraised values for commercial real estate pledged as collateral. Debt Yield is the ratio defined as the Net Operating Income (“NOI”) divided by the Loan Amount. The biggest advantage of debt yield is that it provides a static measure of risk. It cannot be manipulated by longer amortizations, interest rates, or any other factors.
Debt Yield is essentially the rate of return on the property. It’s more of an apples to apples comparison of properties from a leverage standpoint. 7.8% is the traditional failure line for most commercial property types, although 7.2% is the failure line for multifamily loans. One drawback to debt yield is that it doesn’t factor in guarantor support from a global perspective.
See the examples below:
Leverage: There is a new formula underwriters can use that uses a leveraged EBITDA to measure cash flow. The formula is: Funded Debt (Senior Interest-bearing obligations) / EBITDA. This formula removes the impact of low interest rates, extended amortizations, and high LTV ratios from the equation. Regulators consider a leveraged EBITDA ratio of 6x or higher to be highly leveraged. Most banks should want to see leveraged EBITDA ratios no higher the 3x or 4x.
Standards: Don’t wait until problem loans start to rear their ugly head—by then, it might be too late to take action. Re-examining your loan underwriting standards in light of the regulators’ concerns could help avoid major problems down the road.
Are you tracking Exceptions and Variances?
Another issue for bankers is making exceptions to policies and variances to procedures to push a loan approval through. Problems can arise when banks don’t make a clear distinction between exceptions and variances and track them regularly. Loan policy helps guide the processes used by bankers to underwrite and approve loans. They include maximum loan amounts, annual financial statement reporting requirements, and the use of ratios like debt service coverage and loan-to-value when making lending decisions. Variances from procedures should require approval from the next highest levels of management for commercial lenders.
Policies are rules regarding what your Bank’s unique tolerances are for commercial lending. For example, your policy might state that you won’t make loans outside of your defined market area or to businesses in certain industries. Approval of exceptions and variances should be tracked regularly, at least quarterly, reviewed by credit administration and reported to the appropriate Directors Loan Committee. The report should always answer the following:
- How many exceptions and variances are occurring?
- Are they concentrated among certain loan products or certain markets?
- Are there certain lenders that are making most of the exceptions and variances?
Tracking exceptions and variances allows a management to identify trends that might provide early detection or indicate potential problems or inherent risk factors within the portfolio. Tracking and reporting will provide data needed to determine if the level of exceptions and variances are acceptable or if the bank should consider changing the guidelines or even updating loan policy.
Part of the Credit Reviews we perform at PKM is to determine the possible exceptions a bank has on its commercial customers. We recommend that banks have an exception rate less than 25% resulting from a targeted review. If you ever have any questions regarding regulatory concerns, exceptions or variances, please let us know – we’re here to help.