PROBLEM LOAN IDENTIFICATION AND RESOLUTION...Comerica Bank) Huntington National Bank (Still Exists)...

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PROBLEM LOAN IDENTIFICATION AND RESOLUTION

Michael D. Davis President/Owner

Heritage Management Services, Inc. Naples, FL

hike4mike.davis@gmail.com 614-325-4550

August 6 - 8, 2018

Problem Loan Identification and ResolutionAugust 6, 2018

Introduction & Overview

Instructor Background

U.S. Army – Infantry Captain University of South Florida – BA in Finance The Ohio State University - MBA Manufacturer’s National Bank (Merged with DB&T to form

Comerica Bank) Huntington National Bank (Still Exists) AmeriTrust Bank, N.A. (Acquired by Society Bank, N.A.) Society National Bank, N.A. (Merged with Key Bank, N.A.) Provident Bank, N.A. (Acquired by National City Bank,

N.A.) National City Bank, N.A. (Acquired by PNC Bank, N.A.) PNC Bank, N.A. (Still Exists)

Participant Introductions

Name/Title & Bank/Responsibilities

Experience with Problem Loans: 1 – 5 Scale, 1 being least experienced

Any course objectives? Or – A particular situation requiring identification of a problem loan that you would like to discuss?

Overview: Why is this class important to You?

• Banks are highly leveraged, low margined businesses in highly competitive markets, impacted by market risk, interest rate, and collateral risk

• Every loan is a good loan at the time it is structured. However, a recession exacerbates the underlying problems. During periods of growth the lending practices tend to be less stringent, which can become problematic when there is an economic downturn

• We may or may not be going back into recession (as of May 2016) but things certainly don’t look robust

• A bank should strive to long term good credit quality sustainability instead of a boom and bust approach to making loans

• When addressing the issues of problem loans, the bank faces other risks and costs

Overview: Costs of Problem Loans (in addition to principal loss)

• Legal Costs• Today the going legal fees for wortkout (bankruptcy) attorneys approach the high end

of the legal rate charts.• Personnel Costs• Loan Officers, workout officers, management, etc. can quickly become very expensive if

a large number of loans become a problem, as it did in 2009.• Interest Cost• When a loan is non-accrual, interest expense is not covered by interest income• Administrative Costs• Addressing problem loans is time consuming and increases overhead costs and reducing

opportunities for bank growth and expansion• Reputation Cost• The lenders to Enron were not happy to share this fact with the market, posting

business assets for foreclosure, does not make the bank popular in the community Regulatory Cost Says it all

A Math Problem Involving a Problem Loan

If you have a $1 million loss from a $5 million loan, how much (in $) of new loans must you make for an entire year to offset this loss?

For the purpose of this illustration, assume your new loans on average yield the same as your Bank’s ROA X 2.

Steps In Monitoring Credit Quality Review Financial Statements (How Often?)

Review Collateral Reports (What type of Reports?)

Perform Periodic Field Exams (What is a Field Exam?)

Make Timely Borrower Visits (What should you look for?)

Review Industry Trends (Why is that Important?)

Set Specific Expectations and Goals (Why is this the least used monitoring method?)

Primary Areas of Monitoring

Earnings

Liquidity

Management

Communications

Strategy and Tactics

Exercise I - Early Warning Signs

In your groups, Pick your “Top 3” in each category of Early Warning Signs

Be prepared to explain why they are your Top 3

What would you add to the list that is not there?

Keep the list and your notes handy, we will be referring back to these throughout the day

KEY ISSUE: Just because we are presenting these as warning signs, it does not mean the deal is a train wreck, it just means look out!

I. Earnings

Earnings or lack thereof, are often a precursor to a problem loan

If a company is having trouble making money, it will eventually have trouble making principal and interest payments on the loan

You want to focus your thoughts on the quality of the earnings by traveling back up through the income statement

II. Liquidity The balance sheet in general, and the working capital

accounts in particular, can telegraph a message that things may be getting dicey in the future

If it takes longer to sell my inventory, there’s a reason

If it takes longer to collect my receivables, there’s a reason

If I’m forced to pay my bills faster, there’s usually a reason

The reasons for this liquidity pattern are usually not very good, this is not always true, but it is incumbent upon you to find out why

III. Management This is probably the most important part of

understanding the genesis of a problem loan

Unfortunately it is also the most difficult to ascertain

You are judging people and their reaction to adverse situations, this is not easy to judge

An example:

A company in the chicken processing business, seasoned management (34 years + in business) faced rising costs and an inability to raise prices – What would you think of management?

IV. Borrower Communication

The flow of information is like Niagara Falls when times are good, it dries up like a Texas stream in the summer when the news is bad

Borrowers in general, and small business borrowers in particular, are often petrified about what the bank is going to do

Human nature prompts many borrowers to delay the bad news as long as possible in the hope that things will get better

V. Strategy and Tactics Almost every change in business strategy involves risk

(and reward)

Apple Computer was a sleepy niche PC company with a very good product and 5% market share that was going nowhere

Apple Inc (not Computer) is now a company that designs and markets consumer electronics, computer software, and personal computers

Risk? Sure. Reward? Absolutely!

How much risk should the bank shoulder vs. the risk the business owners should shoulder?

Early Warning Signs

(What to look for in Financial Statements)

Exercise II

Drypers Diapers

Sales Concentration – The Obvious one

What’s not so obvious:

2015 2016 2017

AR Days – Wal-Mart 31.8 44.07 43.03

AR Days – Other 12.4 12.5 12.7

Inventory Days 81.5 70.5 103.63

Chamberlain Furniture ?

Southwestern Products

Greiner Contracting ?

Lessons Learned – Top 5 + 1

Over-leverage caused by excessive optimism on the part of the bank and the borrower

Officer complacency due to length of existing relationship

Lack of evaluation of management’s strengths and weaknesses

Too much reliance on collateral and guarantors and not enough on cash flow

Officers not fully understanding the nature of the borrower’s business

Character flaws, borrower’s character was not fully evaluated or appreciated

Tomorrow’s Class Luck Dairies Case Study

• Read Case Lead-In

• Complete Assignment One

• Be Prepared to Discuss Assignment Two Tomorrow

QUESTIONS ?

Trivia Test

Needed Actions in a Deteriorating Loan Situation

Increase Frequency of Visits to Business

Expand Contact Base at Business

Review All Documentation

Update Collateral Valuation

Make Sure All Financial Information is Up-To-Date, Complete and Understood

(Cont.) Needed Actions in a Deteriorating Loan Situation

Understand Management Plan of Action

Request Updated Forecasts

Perform Special Investigations (Lien Search, Tax Payments, Collateral Inspection, Etc.)

Ask for Professional Help

Be Careful of Lender Liability Issues

Steps In Dealing With Deteriorating Loans

Factual Analysis

Legal Analysis

Pre-Workout Agreement

Workout Plan

Step 1: Factual Analysis

Review Loan Documents

Completeness

Terms and Conditions

Perfection of Collateral

UCC Search

Title Insurance / Lien Search

Review Financial Information

Step 2: Legal Analysis

Enforceability Proper Signatures Is There or Will There be a Default? Has the Borrower Been Given Proper

Notice of Default? Proper Notaries on Real Property Lender Liability Issues (we’ll discuss

later)

Step 3: Pre-Workout Agreement

Develop / Document The Understandings With Your Borrower

No Commitment From The Lender Until All Proper Documents Are Entered

Lender Does Not Waive Any Rights Or Remedies Of Existing Or Future Defaults

Reduce Everything to Writing

Step 4: Workout Plan

Question 1 - Is the Problem Solvable?

Question 2 - Under What Conditions is it Solvable?

Question 3 - Are the Resources Available to Accomplish a Workout?

Is the Problem Solvable?

Is the Management Capable and Trustworthy?

Is there a Viable Business Core?

Are the Owners and Outside Counsel Cooperative?

Can the Debt be Moved?

Under What Conditions is it Solvable?

Are The Negative Trends Reversible?

Will Pay Downs Continue During The Workout?

Will Cash Flow Remain Ample?

Are the Resources Available to Accomplish a Workout?

Can Assets or Parts of the Business be sold Quickly?

Do Owners / Guarantors have the Capacity to Put Money Into the Business?

Are Turnaround Specialists Needed?

3 Rock Solid Rules in a Workout

If You Cannot Improve Your Position, You Shouldn’t Try A Workout

Never Give Anything Away, Always Trade Up

Never Throw Good Money After Bad

Luck Dairies Case Study

What Early Warning Signs Did You Find?

Break Into Groups to Complete Assignment Two.

Please Be ready With a Spokesperson For Your Group.

Lender Liability

When the borrower perceives bankand business not on the same team.

4 IMPORTANT RULES TO REMEMBER.

Lender Liability Issues- Consider the Consequences

Act Promptly

Do Not Take Adverse Actions Without Giving Fair Notice

Always Make Sure the Borrower Understands What is Expected

Lender Liability Issues- Act Consistently and Honestly Avoid Empty Threats Do Not Create False Impressions Keep all Promises and Commitments Make Full Disclosure of Material Facts Do Not Change a Course of Dealing Without

Proper Notice Do Not Dictate Who to Hire or Fire Do Not Chose Which Creditors Will or Will Not

Be Paid

Lender Liability Issues- Do Not Exercise Excessive Control

Do Not Exercise Significant Influence in Major Decisions Affecting the Business

Do Not Act as an Officer of the Company Do Not be Arrogant, Express Personal

Animosity or Demonstrate Malice Do Not Permit a Personality Conflict or

Deteriorated Relationship Interfere With Your Treatment

Leave Your Personal Bias at the Door

Lender Liability Issues- Maintain Effective Document Trail

Reduce all Oral Understandings into Writing

Make all Documents (Internal and External) Objective, Unemotional, Businesslike and Accurate

Everything in Writing Must be Written as if You Want it Read in Court

Tomorrow's ClassChristy Candies Case

Read Case Study

Be Prepared to Provide Answers to the Questions

QUESTIONS ?

Even More Trivia

Types of Workout Actions

Reservation of Rights Letter

Actions to Create Cash and Loan Reduction

Actions to Enhance Credit

Encourage a Move to a New Lender

Forbearance / Modification of Defaults

Reservation Of Rights Letter

Spells out existing defaults by Borrower

Tells the Borrower the Bank has certain rights and remedies under the existing documents

Also tells the Borrower that just because the Bank isn’t taking immediate action does not preclude the Bank from future action at its discretion

May spell out expectations of Bank

Actions to Enhance Cash a/k/a Cash Is King What Can My Borrower

do to Enhance the Cash Flow of his Business?

• On a Short Term Basis?

• In a Worsening Situation?

• In a Crisis?

Cash Budgeting

What is This?

Why is it Needed?

How Far Ahead Should Be Projected?

How Often Should it Be Updated?

Credit Enhancement

Additional Collateral

Additional Guarantors

Subordination of Other Debt

New Sub Debt or Capital

Rates and Term

Alter Covenants

When Would you Use a Forbearance Agreement?

When Wouldn’t you Use a Forbearance Agreement?

Attempt to Eliminate Disputes

Dispose of Existing Claims

Explain the Nature of the Restructured Transaction

Provide an Understanding of Future Expectations

Forbearance / Modification of Defaults (Cont.)

What Can Be Modified?

What Is A Proper Time Frame?

Does The Guarantor Need To Be Party To The Agreement?

Team Discussion - Christy Candies

What are the potential warning signs within the Company itself?

What are the potential structural warning signs imbedded in the loan request?

Christy Candies

Christy Candies – Part Two

Read Part Two of The Case.

Discuss the Case Within Your Group.

Answer the Questions in the Case.

Be Prepared to Present Your Group Solution.

Christy Candies – What Happened?

Taking Judgment (“Calling The Loan”)

When should you take judgment against a borrower?

So You’re Granted a Judgment, What does That Mean?

Who Should Be On Your Team?

Alternatives To A Workout

Receiverships

Liquidation of Assets / Business

Bankruptcy

Receiverships

Manages and Preserves Assets

May Operate the Business

Provides Protection For All Creditors

When Does A Receiver Make Sense?

When Doesn’t A Receiver Make Sense?

Salient Receiver Powers

Bring and Defend Actions

Take and Keep Possession of Real and Personal Property

Collect Rents and Other Obligations

Enter Into Contracts

Open and Maintain Cash Accounts

Sell Property Free of Liens

Liquidation

Consensual

Article 9 Transfer

Other Creditors

Non-Consensual• Levying on Property

• Garnishment• Wages

• Monies

• Right of Offset

Article 9 (UCC) Transfer

Far less expensive than a Bankruptcy

Reasonable Notices required

Must be “Commercially Reasonable”

Price itself must be Reasonable

Conveyance includes all rights of the Debtor and discharge of the liens

Avoids negative publicity

Bankruptcy

Is This A Good Thing For The Lender?

Is It A Good Thing For The Borrower?

What Does It Do For The Guarantor?

Types Of Bankruptcy• Chapter 7 – Liquidation

• Chapter 11 - Reorganization

Advantages Of Bankruptcy From The Lender’s Point Of View May Offer Only Vehicle To “Control” And

“Limit” Risk Offers A Forum Of Jurisdiction Over The

Conduct Of A Business Full Examination Of What Payments Have

Been Made Creditors Are Categorized, With Secured

Creditor Entitled To Protection May Position The Business to Continue To

Operate

Luck Dairies / Review

Now Is The Time To Take

Good Notes

QUESTIONS ?

Thanks You For Your

Participation

The Workout GuysDuring the good times,

you feel like you’ve been banished to the basement

In bad times, if you do your job right, you’re the

superhero