Happy new year! I am very pleased to welcome 20 new financial institutions to the Suntell family in 2014. We finished the year with a robust 20%+ increase in revenues with record earnings and strong liquidity. We are entering our 19th year of business and every year I would like to personally thank each and every customer that was able to see our original vision for credit underwriting combined with document management and workflow. We continue to invest our resources into our software product in order to continually deliver more of the functionality and flexibility you demand in an integrated system. Yesterday, I filled my tank up with gas at $1.93 a gallon. Who was able to forecast that a year ago? Six months ago? The stock market reached record highs several times in 2014. Unemployment is under 6% nationally and borrowing costs for home and car loans remain at record lows. It’s a great time to be a consumer if you have a job. In a consumer driven economy such as what we have in the U.S., I believe this bodes well for economic growth in 2015. The average consumer supposedly will save between $1,000 and $1,500 on fuel in 2015 if gas prices remain at current levels. That is a nice pay raise that nobody expected!
If you all read my quarterly columns, you know that I am always wary and full of caution, particularly when times are good. Everything is cyclical. What goes up must come down, and what comes down, must go up. What we don’t know is the timing of the cycles. As bankers, we are being trained to conduct stress tests to ensure that our loans can be repaid, regardless of what happens in any given cycle to changes in interest rates or the price of products and services provided by the borrower. But stress tests are not perfect if you do not test for the seeming outrageous or outlier conditions. For instance, you just loaned a borrower money in early 2014 to purchase oil production when it was around $120 a barrel. Your stressed test showed that it could still be repaid in 3 years if oil prices dropped 30% to $84 a barrel. All is good and you make the loan. Now that oil is somewhere around $60 a barrel, the stress test of 30% is fairly meaningless in your original forecast and underwriting. You likely have credit exposure or a classified asset on your books with credit exposure unless you had secured strong secondary or tertiary sources of repayment. In the example, it would have taken a 50% stress test to determine impact on debt service and collateral coverage. However, stress testing for a 50% decrease in oil prices might have raised an eyebrow or two by the loan committee as being unrealistic or overly cautious.
The moral to the story is to not fault the stress test forecast as part of your underwriting, but to not be afraid to stress test for the outliers of a cycle. It doesn’t mean those conditions will occur, but it does help you protect your institution in the event such an extreme change occurs. The stress test results could help you negotiate for more collateral, loan covenants or stronger guarantees at inception to protect against these outlier conditions. For those of you financing agricultural or farm real estate, I recommend similar stress tests. At today’s astronomical prices, your stress tests need to be forecasting the condition of each farm real estate loan as though farm real estate or commodity prices fell as rapidly or at levels similar to what just occurred with oil.
As times improve and economic activity is healthy, invariably I witness credit policies and requirements being relaxed as though bad times will never return. Documentation management and controls start to get sloppy. Potential concentrations in sectors begin to form. Every couple of years, I like to encourage our customers to re-assess your institutions loan policies, practices and procedures against those regulatory fundamentals published but sometimes forgotten when times are rocking and rolling such as they are now. The start of a new year is a great time to do a quick recheck of the basic building blocks of commercial loan portfolio management. I have shared this list in the past and would like to share again as a quick guide to conduct your annual commercial lending portfolio management health check. Have a great and prosperous new year!
The five basic building blocks of commercial loan portfolio management:
- Risk identification. Accurately determining credit risk of the borrower using a comprehensive approach that is reviewed on a regular basis is essential.
- Documentation and policy exception management. Don’t allow gaps in loan documentation to jeopardize enforcing the terms of a loan. Put policies and controls in place to rapidly address missing paperwork and minimize exceptions to the rules.
- Concentration of risk. Install procedures to identify loan concentrations with one borrower or group of borrowers, industry concentrations and concentrations by loan types such as commercial and industry, real estate, and consumer loans. If loan policy specifies or allows such concentrations, put additional procedures into place to identify and mitigate the risk.
- Collections and work-outs. Identify problems loans early on and work out solutions with the borrower early in order to save the loan. A foreclosure benefits neither party.
- Credit management systems. A comprehensive credit management system should be able to analyze and underwrite, risk rate, handle loan approval communication, track document and policy exceptions and manage collections. In addition, a well-designed system will provide the necessary reporting to provide management and the board the information required to understand credit and loan portfolio risk and trends.