Whether or not Punxsutawney Phil or General Beauregard Lee predicts an extended Winter or an early Spring, we know the months ahead will have a lot of uncertainties and change. With the hopes of Spring and a fresh start to the new year, the constant reminders of a slowing economic cycle, mixed with varying opinions on inflation, is shaping up to be a restless year.
In the Fall of 2021, we reviewed a well-balanced and blended performing loan portfolio consisting of fixed-rate mortgages, commercial, and various types of consumer loans for a potential M&A transaction. The valuation model revealed roughly a 16.52% discount based on the “potential” of a rising rate environment. Consider that same portfolio and apply today’s rates; what would that discount look like now? What if that same portfolio was left unmonitored and were to experience a modest increase in past dues? Trying to identify the unknowns is the toughest part of any transaction. Whether you have an aggressive or passive management approach, this can severely impact the value of a loan portfolio.
Disruptions to the supply chains have negatively impacted small businesses and other economic sectors such as restaurants, retail, and the hospitality industries. These domino effects throughout those industries have caused delinquencies and criticized assets in SBA portfolios to start to tick up. With the rapid increase in the Fed Funds rates, many of the variable rate portfolios have seen a dramatic increase in their borrowing cost. Many of these payments have doubled from their original loan approvals and have created new cash flow strains for borrowers. With the lack of focus at the individual loan level, this could potentially cause the guarantee to be called into question. With the SBA shifting its focus from a rush to put cash into business owners through federal lending initiatives, they will now be focused on portfolio performance, management, and ongoing monitoring.
As we move into the next financial cycle, all industries will be faced with a myriad of challenges. In 2021 and 2022, farmers were faced with substantial increases related to fertilizer and fuel costs. As farmers sought and found new resources and reduced their reliance on imports from Russia, these costs are expected to continue to increase. As the cost of inputs for agriculture continues to hurt the American farmer, the overall cost of groceries, manufacturing, and distribution are not likely to show any immediate signs of easing either. Supply chain issues continue to hurt basic family staples such as eggs, grains, beef, and dairy, but new supply issues have arisen for materials used in packaging such as nitrogen, carbon dioxide, and aluminum.
Community bank and credit union lenders face increased risk in managing their loan portfolios from C&I, agricultural, and commercial due to the economic forces facing their clients. Relationship managers may have served themselves well by sticking with traditional financial reporting and underwriting guidelines. As a result, we have observed a decrease in policy exceptions that have helped mitigate additional risk for financial institutions. Business cash flows are starting to show some contraction and the need for solid annual reviews on large borrower relationships will be a large focus by regulators throughout 2023.
Such monitoring activities must include:
- Obtaining borrower and guarantor updated financial statements and tax returns
- Requesting interim financials on new business acquisitions and startup
- Increased reviews of borrowing base certificates
- Site inspections
- Collateral and documentation reviews
- Detailed borrower communication and interactions
Effective credit risk management should have a complete understanding of an institution’s overall credit risk by viewing risk at the borrower relationship level. While institutions strive for an integrated understanding of their risk profiles, much information is often scattered throughout the institution. Our most common exceptions identified in our reviews are often found sitting on the account manager’s computer desktop. Without a thorough exception tracking and risk assessment program in place, institutions that have weakened risk management practices could be targets for increased scrutiny by regulators and shareholders in upcoming exams.
The Fed has indicated that they will ease up on the drastic rate increases. However, they have left the door open to continue with moderate increases for the remainder of the year. With the end of governmental assistance, lenders will now need to be more diligent as they explore long-term solutions to address short and long-term cash flow needs to assist business owners through new business challenges and increased operational costs. During recent exams, regulators have returned to a more thorough review approach for commercial and SBA loan portfolios. Once encouraged to assist their borrowers to maintain operations by providing a multitude of solutions to meet their client’s needs, now regulators are focusing on portfolio servicing and monitoring to reveal new trends and signs that will help identify new stresses.
By necessity, many of the elements critical to a credit risk review have been lax for the past several years and regulators have not pushed the issue. Credit risk management for financial institutions now demands more urgent and rigorous attention as regulators return to more thorough examinations.
- Loan portfolios – Loan portfolios represent increasing yields however, they can pose significant new risk for many financial institutions. It is true that a large number of the recent loans are federally guaranteed SBA loans. Even so, between an automated review process, greatly expanded loan volume, and the ever-evolving regulations surrounding many of the loan programs, lenders face the possibility of far greater risk than leaders and governing boards may feel comfortable with – and for good reason.
- Unfunded loan commitments and lines of credit – From business owners to homeowners, few are immune to the financial ramifications of a year’s worth of rate increases. Advances on existing lines with increased demands could exceed predictions by a large margin. Is the institution prepared to meet these demands should they be realized? And, if so, at what cost to the overall asset management strategy?
- Investing strategy – The unpredictability of the economy has unsettled financial markets to no small degree. With unknown inflation and predictions of economic instability now being a reality, the fact remains that well-monitored loan portfolios will continue to be desired by investors. Responsible asset management requires a careful review of current investment strategy and adherence to board and regulator-approved policies.
We stated in March of 2022 that we expected to see an increase in loan downgrades over the next 12 to 18 months, and that time is now. As we return to core loan monitoring best practices by increasing interactions with borrowers to assess their long-term needs, now is the time for banks and credit unions to adopt a renewed focus on the basics of sound commercial loan and SBA portfolio risk management.
Should borrowers begin to request short-term extensions or modifications, be sure to take this time to document the file.
- Require interim financials to properly identify if the business has returned to normal operating levels
- Clearly state what the sources and uses of funds will be used for
- Require management to document how they plan to turn around the reduction of cash flow and liquidity and to return viable operations
- Review your collateral positions to ensure its condition and that liens are properly perfected
- Evaluate borrower and guarantor contingent liabilities
Self-identification of properly risk-rated loans and a proactive approach in identifying risk will be welcomed by regulators. With the extensions for business tax returns through 2021 and 2022, it is imperative to obtain current financials in a timely manner. Business startups and loans based on projections should have increased financial reviews, and since these businesses will not have the 2021 financials to reflect a historical or positive picture of the operations, annual and semi-annual reviews will need to note the changes in cash flows. Those that utilized original projections, or the previous business owner’s tax returns, will see the changes in liquidity since origination and will need to look at the borrower’s updated projected cash flows on an ongoing basis.
The risk environment has always been both complex and multi-faceted; independent support can assist in making sure that portfolio reviews are performed thoroughly and efficiently, as well as ensure management policies and procedures are being followed. Financial Institutions need to strategically focus on their portfolio needs and ensure all aspects of risk management are in line with established board-approved loan policies. If your financial institution is ready to identify the potential added risk generated by the events of the past year and prepare for the current one, reach out to the experienced advisors at Mauldin & Jenkins.