PROBLEM LOAN IDENTIFICATION AND RESOLUTION
Michael D. Davis President/Owner
Heritage Management Services, Inc. Naples, FL
[email protected] 614-325-4550
August 6 - 8, 2018
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Problem Loan Identification and ResolutionAugust 6, 2018
Introduction & Overview
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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?
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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
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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?)
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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!
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I. Earnings
Earnings or lack thereof, are often a precursor to a problem loan
Why?
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
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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
Why?
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
Why?
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
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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
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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 ?
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Southwestern Products
?
Greiner Contracting ?
.
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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
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QUESTIONS ?
Problem Loan Identification and ResolutionAugust 7, 2018
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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
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(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
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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)
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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?
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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?
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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
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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.
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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
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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
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Tomorrow's ClassChristy Candies Case
Read Case Study
Be Prepared to Provide Answers to the Questions
QUESTIONS ?
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Problem Loan Identification and ResolutionAugust 8, 2018
Even More Trivia
–
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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
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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?
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Credit Enhancement
Additional Collateral
Additional Guarantors
Subordination of Other Debt
New Sub Debt or Capital
Rates and Term
Alter Covenants
Forbearance / Modification of Defaults
When Would you Use a Forbearance Agreement?
When Wouldn’t you Use a Forbearance Agreement?
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Forbearance / Modification of Defaults
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?
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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
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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?
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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
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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
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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
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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
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Luck Dairies / Review
Now Is The Time To Take
Good Notes
QUESTIONS ?
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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