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)

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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?