1A Training Session byNational Community Capital Association
Risk Management for Loan Programs
RESNA Alternative Financing and Telework Loan Programs
Annual MeetingDecember 14, 2004
2A Training Session byNational Community Capital Association
Risk Definition - probability of loss or injury
Through loan underwriting, lenders Remove risk (by structuring), or Accept risk (by understanding it)
Expressions of risk are Probabilities – uncertain Obtained through subjective evaluation Often based on historical performance
3A Training Session byNational Community Capital Association
Loan Loss Risk
Loan Loss Risk - the probability that a loan will not be repaid.
Sources of Loan Loss Risk- Risk Profile of Loan Product Line (mission and market)- Loan Policies- Staff, Board- Environment (economic, political, geographic)
Risk of Loan Loss is unique for each Lender
4A Training Session byNational Community Capital Association
How Do Lenders Manage Risk?
• Each Loan– Strong underwriting
that identifies and mitigates risk
– Technical Assistance
– Firm approach to collections
• Whole Portfolio– Loan Policies– Loan Monitoring– Portfolio
Management– Loan Rating
Systems – Loan Loss
Reserve
5A Training Session byNational Community Capital Association
Monitoring Prevent late payment problems!
– Collect information and know what’s happening with borrowers
– What are the red flags?– When should you make a site visit?
– Contact borrowers as soon as problem is identified (don’t wait for delinquent payments)
6A Training Session byNational Community Capital Association
Monitoring Information
• Financial Statements / Tax Returns• Insurance Updates• Social Benefit Reports
Collect and review info regularly
7A Training Session byNational Community Capital Association
Problem Loans• When do loans go “sideways?”
– First payment disasters– About 2 ½ years in
• Communication, Communication, Communication!
• Restructuring
8A Training Session byNational Community Capital Association
Collections
• The “won’t pay” vs. the “can’t pay”• Have a definite schedule for dealing
with late payments!• How to make collections a priority• Effective collections can prevent
foreclosure
9A Training Session byNational Community Capital Association
Foreclosure
• When to foreclose• Evaluating collateral
value• The legal process
10A Training Session byNational Community Capital Association
Problem Loans, Conclusions
• What were the risks that led to the problems? Had you identified them in your underwriting?
• Were there additional steps you could have taken to mitigate the identified risks?
• What (if any) lessons does this teach you for future lending?
11A Training Session byNational Community Capital Association
Portfolio Management
• Portfolio Diversification
• Risk Rating Systems
• Loan Loss Reserves
12A Training Session byNational Community Capital Association
Portfolio Diversification
• Why is a diverse portfolio important?
• What factors affect borrowers in general?
– Economic, geographic, political, etc.
• What factors are important to your borrowers?
• Are some groups of borrowers more susceptible than others to certain events?
13A Training Session byNational Community Capital Association
Portfolio DiversificationLimit portfolio concentrations:
• Single Borrower Limit• Borrower type (individuals, businesses)• Collateral type• Loan structure• Borrower location• Industry• Stage of development• Risk Rating
14A Training Session byNational Community Capital Association
Questions? Comments?
15A Training Session byNational Community Capital Association
5 Minute Break
16A Training Session byNational Community Capital Association
Loan Rating System - Definition
- A systematic methodology to estimate loan loss risk for each loan in a portfolio
- Attempts to impose objectivity to a subjective judgment process
TrueRisk of Loan Loss
Rating Criteria
1.2.3.4.5. ….
Approximated by
Credit Score
Combine into Loan
Loss Reserv
e
Directly Related
to
17A Training Session byNational Community Capital Association
Why Rate Loans?
Management Perspective– To understand of the risks in your portfolio –
and risk trends– To compare risk levels from loan to loan– To figure out who to monitor actively– Help staff and Board develop a common
credit culture– Systematic way to calculate LLR
Investor Perspective– Shows investors you are conscious about
risk
18A Training Session byNational Community Capital Association
When to Rate Loans
• When you originate the loan
• Annual or semi-annual review of portfolio
• Significant change in loan performance or conditions
19A Training Session byNational Community Capital Association
Designing a Loan Rating System
Step 1 Determine Rating Criteria – Unique set of risk factors
Step 2 Determine Scoring Categories (A, B, C…)
and relationship to LLR
Step 3 Determine method for mapping Rating Criteria to Scoring Categories
20A Training Session byNational Community Capital Association
Designing a Loan Rating System (cont.)
• Step 4 Test and Tweak
• Step 5 Implement
21A Training Session byNational Community Capital Association
Step 1 - Determine Rating Criteria
Common Risk FactorsFactors Related to Borrower Factors that measure the 5Cs of Credit
Factors Related to Loan Structure Amortization Schedule Collateral
Factors Related to Environment Government Local Economy
22A Training Session byNational Community Capital Association
Design IssuesIsolate factors that have accompanied
delinquency, default or foreclosure
Don’t choose multiple factors that address the same risk
Too many factors will be a burden; too few will not result in a meaningful results
Consider costs (time and money) of evaluating factors at underwriting and monitoring
Step 1- Determine Rating Criteria
23A Training Session byNational Community Capital Association
Step 2 - Determine Scoring Structure
Typical Scoring Structure
Score Description Associated LLR 1 Strong certainty of repayment
2% 2 Strong repayment expectation but a few issues could impair performance 4% 3 A number of issues could lead to nonpayment and default 7% 4 Repayment is uncertain
25% 5 Repayment is very uncertain 50%
Note: Scoring Structure for your CDFI will vary!
24A Training Session byNational Community Capital Association
Step 3 - Map Loan Rating to Loan Score
Two Common Methods
Grouping Method (Examples 1 and 2) Mathematical Method (Example 3)
25A Training Session byNational Community Capital Association
Step 4 Test & Tweak
Choose a representative sample (10 or more) of past loans Apply proposed Loan Rating System Revise (usually mapping methodology) Re-test
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Determine policy changes Obtain Loan Committee and Board approvals Implement process changes
Step 5 Implementation
27A Training Session byNational Community Capital Association
Loan Loss Reserve (“LLR”)
• Contra-asset account
• Usually required by auditor
• Quarterly expense on Statement of Activities (P&L)
• Reduces value of Loans Receivable asset
• Smooths impact of losses – self-insurance
• Reflects risk of the portfolio – updated regularly
28A Training Session byNational Community Capital Association
LLR - ExampleLoans Receivable $ 1,000,000Loan Loss Reserve (10%) (100,000)Net Loans Receivable 900,000
To set up or increase reserve:dr Loan Loss Expense $ 100,000
cr Loan Loss Reserve 100,000
To write-off a loan:dr Loan Loss Reserve $ 10,000
cr Loans Receivable 10,000
29A Training Session byNational Community Capital Association
Feedback Loops
How does your organization learn about risk and become a better lender without becoming “too conservative?”
30A Training Session byNational Community Capital Association
Review
• Risk and Risk Management• Monitoring, Collections, Problem Loans• Restructuring & Foreclosure• Portfolio Diversification• Loan Rating System and Design• Loan Loss Reserve
31A Training Session byNational Community Capital Association
Questions? Comments?