EXAM 4

Factoring

is purchasing accounts receivable from a business. May be on a full-recourse basis (the business promises to repurchase defaulted receivables), a non-recourse basis (the factor assumes the credit risk), or some other plan

Term loan

maturity in excess of one year.

Short-term loan

maturity of one year or less

Working capital cycles

vary by industry. Know the working capital cycles financed.

Closed-end loan

-A loan of a specific amount that is dispensed to the borrower in a lump sum or in draws (advances).

‟evergreen" loans

-Avoid that is repeatedly renewed with little or no principal reduction.

Global Cash flow

-Commonly used in lending to small business. Combines the business(es) cash flow with the personal cash flow of the owner(s)/guarantor(s).

Average collection period

-If the firm's turnover is slower than the industry, further investigation may be needed and the quality of receivables should be examined in greater detail. -A problem with the receivables turnover ratio: It compares receivables on the statement date with annual credit sales. The turnover ratio is distorted if the receivables don't reflect the "typical" amount of receivables on the books

Protection

-Legal capacity 2. Character 3. Financial capacity - focuses on income and cash flow statements, tax returns, debt coverage ratios

Lend Money Not lease it

-Lend money not lease it

Credit Risk Management

For most banks, the loan portfolio is the largest bank asset and the predominate source of revenue; it is also the largest risk asset. Loan portfolio management is the process by which the risks that are inherent in the credit process are managed and controlled. -Credit Risk Management covers many topics. Our focus will be on Loan Grading and the Allowance for Loan and Lease Losses (ALLL). First, though, review some terminology.

Substandard Loans

-Loans that are inadequately protected by the net worth or paying capacity of the borrower or the pledged collateral. The bank is likely to sustain some loss if he weakness(es) is not corrected but the amount of the loss can't be determined at this time.

Establishing A Written Loan Policy

-One of the most important ways a lending institution can make sure its loans meet regulatory standards and are profitable -should be modeled after the FDIC

. Business credit cards

In my opinion, this is a risky form of lending unless the credit card Is well collateralized, and most aren't. The borrower can run the credit card up to its limit and go into bankruptcy. You usually get nothing in bankruptcy because it is unsecured debt. If you wouldn't make an unsecured loan to a business, then why issue an unsecured credit card?

Frequency, Scope and Selection of Loans to Risk Rate

Internal Loan Review should be an on-going process. External Loan Review should be scheduled by specified management. The scope of the quarterly Internal Loan Review should include (there is overlap in this list): • Special Mention Loans over a specified dollar limit • All Substandard loans • All Doubtful loans • Impaired loans • Renegotiated or restructured loans • Non-current loans or non-performing loans (i.e., loans on which an interest or principal payment is past due 90 days or more • A sample of large loans not included above

Liquidity Ratios

Liquidity is a measure of the quality and adequacy of current assets to meet current obligations as they come due

Risk Rating 7 - Loss

Loans classified as Loss are considered uncollectable and of such little value that their continuance as a bankable asset is not warranted. This does not mean that the asset has absolutely no recovery or salvage value, but rather, it is not practical or desirable to defer writing off the asset, even though partial recovery may occur in the future. Assets classified Loss should charged-off in the period in which they become uncollectible.

Loss

Loans that are considered uncollectible and are of little or no value as a bank assets. (Charge-off 100% of such loans.)

Initial grade assessment

Loans that are individually graded should be assigned an appropriate credit grade at the time of origination. In some banks this is done by the originating loan officer, under the assumption that the servicing officer is the person who possesses the most knowledge about the borrower and the credit. This ignores potential conflicts of interest. The preferred practice is for the internal loan review function be performed by someone independent of the lending function.

Doubtful Loans

Loans that have all of the weaknesses of substandard loans but have deteriorated so much that they have a high probability of substantial loss. (Charge-off 50% of such loans.)

Risk rating 3 - Satisfactory

Loans to persons or entities of average financial condition, adequate collateral margins, adequate cash flow to service debt, and whose net worth consists largely of fixed assets. The entities may be minimally profitable now, with projections indicating continued profitability into the foreseeable future. Closely held corporations or businesses where a majority of the profits are withdrawn by the owners or are paid in dividends are included in this category. Overall, these loans are basically sound. (Most loans go into this category.)

Risk rating 1 - Excellent.

Loans to persons or entities of unquestionable financial strength, a highly liquid financial position, and with collateral that is liquid and well margined. Such borrowers have performed well on past obligations, and the bank expects their performance to continue. Internally generated cash flow covers current maturities of long-term debt by a substantial margin.

Risk rating 2 - Good

Loans to persons or entities with strong financial condition and above average liquidity that have previously satisfactorily handled their obligations with the bank. Collateral securing the debt is margined in accordance with bank policy guidelines. Internally generated cash flow covers current maturities of long-term debt more than adequately. Unsecured loans to individuals supported by strong financial statements and on which repayment history is satisfactory may be included in this classification.

Industry or peer analysis

Ratio analysis and comparable time periods; ratio comparisons among different industries.

Risk Rating Changes

Risk rating changes should be done internally by an entity that is independent of the lending function. Many community banks also retain an external consultant to perform an independent loan review and recommend risk rating changes

‟Permanent" current assets

are current assets held excluding seasonal assets. Such assets are replaced when they expire. -Purpose: Finance significant additions to inventory and accounts receivable. Primary source of repayment: Cash flow from operations. Remember, the assets financed must be replaced. Loan structure: Typically, a line of credit. May be revolving or non-revolving, depending upon the circumstances. If the loan is large relative to cash flow from operations, a term line of credit may be used. A "term" loan has a maturity greater than one year.

Floor Plan Loan

are loans to a dealer in durable goods to finance inventory; the inventory serves as collateral for the loan. Examples:floor plan loans to dealers in new and used automobiles, farm implements, manufactured housing, motorcycle, bass and ski boat dealers.

Seasonal current assets

are the additional current assets (inventory and accounts receivable) added to meet a seasonal increase in sales. They aren't replaced until the next seasonal period. -Purpose: To finance seasonal increase in inventory and receivables. - Primary source of repayment: Liquidation of the seasonal assets into cash. Note, the seasonal assets aren't replaced until the next seasonal period. This is an example of a "self-liquidating" loan, which is a loan made to finance the production of a good or service; the sale of the good or service generates the cash flow to repay the loan. Loan structure: Typically, a short-term closed-end line of credit. Usually, interest only until maturity. If a revolving line of credit is used, typically the borrower should reduce the credit to zero after the seasonal period.

Fixed assets

are those assets that are not expected to be converted to cash in one year, and include such items as land, buildings, trucks, equipment. -Purpose: Finance the acquisition of land, plant, equipment. - Primary source of repayment: Cash flow from operations. - Loan structure: Closed-end credit repayable in installments. Usually a term loan because the loan is large relative to cash flow from operations.

Loan Impairment

based on current information and events, it is probable that a financial institution will be unable collect all amounts due according to the contractual terms of the loan agreement. "All amounts due according to the contractual terms" means that both contractual interest and principal payments of a loan will be collected as scheduled in the loan agreement. However, an insignificant delay or insignificant shortfall in amount of payments on a loan does not mean that the loan is impaired.

Criticized Assets

-Other Assets Especially Mentioned (OAEM) - Loans that are currently paying but potentially weak - often because of documentation problems. -Sum of Special Mention Assets, Substandard Assets, Doubtful Assets, Loss Assets - Adversely Classified Assets

Three P's of credit

-Purpose -Payment -Protection

Payment

-Source(s) of repayment 1. Primary source(s) of repayment 2. Secondary source(s) of repayment 3. Loan structure or loan liquidation agreement

Gross profit margin

-The ratio shows the revenues remaining after the COGS to cover other expenses,Income taxes and, hopefully, profits.

Quick ratio

-This ratio indicates how much "quick" assets cover current liabilities. A ratio below 1.00 implies dependency on inventory or other assets to pay current liabilities

Accounts receivables turnover ratio

-This ratio indicates the number of times receivables turn over during the year. The higher the turnover, the shorter the time between sale and collection.

Purpose

-Use of loan proceeds Compliance with law and regulations 2. Compliance with loan policy - Exceptions 3. Source of repayment 4. Risk

Legal lending limits

-an unsecured loan to a single person cannot exceed 15% of a single national bank's unimpaired capital and surplus account

Composite and Component ratings

-based on a 1-5 numerical scale -1" indicates highest rating, strongest performance and risk management practices, and is the least degree of supervisory concern. -5" indicates the lowest rating, weakest performance, inadequate risk management practices, and the highest degree of supervisory concern -The (blank) rating usually bears a close relationship to the (blank) ratings assigned

Credit Concentrations

-consists of direct, indirect, or contingent obligations exceeding 25 percent of a bank's capital structure. In general concentrations may involve one borrower, an affiliated group of borrowers, or borrowers engaged in or dependent on one industry.

Regulation O

-governs any extension of credit by a member bank to an executive officer, director, or principal shareholder of that bank, of a bank holding company of which the member bank is a subsidiary, and of any other subsidiary of that bank holding company.

Loan review and grading

-helps management spot problem loans more quickly and acts as a continuing check on whether loan officials are adhering to their institutions loan policy

Equal Credit Opportunity Act of 1974 (Regulation B)

-inacted in 1974, that makes it unlawful for any creditor to discriminate against any applicant, with respect to any aspect of a credit transaction, on the basis of race, color, religion, national origin, sex, marital status, or age (provided the applicant has the capacity to contract)

Leverage ratio

-indicates the extent that creditors have financed the firm relative to the owners

Debt Service

-is usually defined as including: total expected interest expense + the principal portion of amortizing debt (including CPLTD- -Current Portion of Long-Term Debt, which is the same thing as CMTD--Current Maturity of Term Debt).

Types of loans made by banks

-real estate loans -financial institution loans -agricultural loan -commercial and industrial loans -loans to individuals -miscellaneous loans -lease financing recievables

Community Reinvestment Act of 1977

-requires certain lenders to make an affirmative effort to meet the credit needs of businesses and individuals in their trade territories so that no areas of the community are discriminated against in seeking access to credit

Term insurance

-s a type of life insurance policy that provides coverage for a certain period of time, or a specified "term" of years. If the insured dies during the time period specified in the policy and the policy is active - or in force - then a death benefit will be paid.

Factors determining the growth and mix of loans

-the profile of characteristics of the market area it serves -Lender size -experience, expertise, and management -expected yield

Loan review system

-• promptly identifying loans with potential weaknesses; • appropriately grade loans so that timely action can be taken and credit losses minimized; • identify adverse trends and isolate portfolio segments containing potential problems; • assess adequacy and adherence to loan policy and procedures, and monitor compliance with laws and regulations; • evaluate lending personnel, including compliance with loan policies; • provide senior management and directors with objective and timely assessment of overall portfolio quality; • provide management and the board of directors with accurate and timely credit quality information for reporting purposes, including determination of ALLL adequacy.

Collateral

. Availability of assets to serve as collateral b. Real property c. Personal property d. Some other considerations a. Ease of verification and control of collateral b. Stability of value of collateral c. Perishable? d. Foreclosure consideration

An appropriate ALLL covers estimated credit losses on:

. Loans that are individually evaluated and determined to be impaired under ASC 310-10-35* (formerly Statement of Financial Accounting Standards No. 114 or FAS 114, Accounting by Creditors for Impairment of a Loan. (Specific Allocation to the ALL) and 2. Pooled loans - groups of loans with similar risk characteristics that the bank evaluates collectively for impairment under ASC 450-20* (formerly Statement of Financial Accounting Standards No. 5 or FAS 5, Accounting for Contingencies . (General Allocation to the ALLL)

Common Size Income Statement

Each item in the income statement is expressed as a percentage of net sales. This helps the analyst trace changes in income statement structure in successive years, and to compare firms of different sizes

Loans to reduce some other liability or reduce equity

Examples: To reduce accounts payable and/or take discounts on purchases; to meet payroll; pay taxes, rent, insurance, utilities, etc.; repay debt; owner withdrawals/dividends.

Capital

focuses on the balance sheet

Substandard Assets:

is inadequately protected by the current sound worth and paying capacity of the borrower or the collateral pledged. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

Why did assets increase?

. Sales growth (either seasonal or long-term). This results in an increase in inventory and accounts receivable, and a corresponding need for financing (accounts payable, debt, equity, accrued liabilities). 2. Replacement/additions to fixed assets. 3. Slow-down in collection of accounts receivables, which is evidenced by a significant increase in receivables relative to sales (accounts receivable turnover or average collection period of receivables in days). A firm that sells on credit generates accounts receivable, which provides credit to the borrower. When it buys on credit (accounts payable) it is eceiving credit from the seller. Buying and selling terms (for example, 2/10/net 30) should be similar. Companies that pay their accounts payable before they collect their accounts receivable usually require more short-term bank debt. 4. Excessive investment in inventory or other assets, which is reflected by low turnover ratios. 5. Insufficient profitability as reflected in low margins, low ROA, and an inability to generate sufficient cash flow for internal financing.

Special Mention Assets

A Special Mention asset has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the assets or in the institution's credit position at some future date. Special Mention assets are not Adversely Classified and do not expose an institution to sufficient risk to warrant Adverse Classification.

Standby Letters of Credit (Off-Balance Sheet Activity)

A bank guarantees payment to a third party who is in a contractual relationship with the bank's customer. Funds are not advanced to the third party unless the customer defaults.

A loan to pay interest on a loan

A borrower can't or doesn't want to pay interest on a loan. The bank makes a new loan to the borrower to pay the interest. -It is too harsh to say that this should never be done. It is fair to say it should be infrequent and supportable, since both practices are signs that the borrower is not paying the credit as agreed

Capitalizing interest on a loan

A borrower can't or doesn't want to pay the interest on a loan. The bank rolls the principal and the interest due into a new loan.

Non-revolving Line of Credit (Closed-end Credit)

A commitment to lend a certain amount to the borrower, and the loan proceeds are advanced to the borrower in draws. Typical use: The bank does not want to advance the proceeds of the loan upfront, but only as needed by the borrower. The bank is following the loan proceeds into the item being financed. Examples: crop production loans, construction loans.

Revolving Line of Credit (Open-end Credit)

A commitment to lend a certain amount to the borrower; draws can be up to this amount and then repaid and re-borrowed. -The borrower has seasonal needs to finance working capital or to make periodic investments that will be sold to repay the loan. -If the business borrower is using the credit to finance seasonal increases in working capital, then after the season ends the seasonal assets decline and the borrower should be able pay off the line of credit (that is, the line of credit should have a ‟resting" period). Too often, this does not happen; this may be an indication that the borrower is undercapitalized (does not have enough of his own money in the business, which is often the case), or that the borrower has diverted some of the loan proceeds to an unintended purpose, or that working capital continues to grow after the season ends, or that the business is operating at a loss.

Guidance Line of Credit

A line of credit approved by the bank, but not disclosed to the borrower until some specific event, such as a request for funding from the borrower. (Also called an "unadvised line.") Or: A bank line granted to the customer that is used by the by the bank for internal management purposes and is not specifically communicated to the customer. Since the client pays no commitment fee, the guidance line can be canceled or withdrawn by the bank at any time. Provides credit for recurrent requests without referring each one to the credit committee.

Risk Rating 6 - Doubtful

A loan classified as Doubtful has all the weaknesses inherent in a loan classified Substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, values, highly questionable and improbable. These are poor quality loans in which neither the collateral, if any, nor the financial condition of the borrower presently ensure collectability in full in a reasonable period of time; in fact, there is permanent impairment in the collateral securing the loan.

Risk Rating 5 - Substandard

A loan classified as Substandard is inadequately protected by the current net worth and paying capacity of the borrower OR the pledged collateral, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Collateral Dependent Loan

A loan is considered "collateral dependent" when the repayment of the debt will be provided solely by the underlying collateral, and there are no other reliable sources of repayment.

Open-end loan

A loan of a specific amount that can be borrowed, repaid and re-borrowed.

Borrowing Causes

A. Increase Assets -Cash, accounts receivable, inventory, plant, equipment, land, etc. B. Decrease liabilities (excluding the loan) -Pay salaries and wages, accounts payable, interest, principal on debt, insurance, rent, taxes, etc. C. Decrease equity -Dividends/owner withdrawals, purchase treasury stock, etc.

Doubtful Assets:

An asset classified Doubtful has all of the weaknesses of one classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Common Size Balance Sheet

Each item in the balance sheet is expressed as a percentage of total assets. This helps the analyst compare changes in balance sheet structure in successive years, and to compare firms of different sizes.

Balloon" Note

An installment loan that does not fully amortize and has a principal balance at maturity. Example: A bank makes a loan to a company to purchase equipment. Monthly payments are based on 36-month amortization, but the loan matures in one year. The bank probably prefers to review the loan yearly rather than making a three-year loan

Loss Assets

Assets classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future.

The Allowance for Loan and Lease Losses (ALLL)

At the end of each calendar quarter, or more frequently if warranted, a bank must analyze the collectability of its loans and leases held for investment (excludes loan held for sale) and maintain an allowance for loan and lease losses (ALLL) that is appropriate and determined in accordance with GAAP (Generally Accepted Accounting Principles).

Composite 5

Banks in this group exhibit extremely unsafe and unsound practices or conditions; exhibit a critically deficient performance; often have inadequate risk management practices; and are of greatest supervisory concern. The amount and severity of the problems are beyond management's ability or willingness to control or correct. Immediate outside financial or other assistance is needed in order for the institution to be viable. Ongoing regulatory supervision is necessary. Banks in this group pose a significant risk to the deposit insurance fund and failure is highly probable

Risk rating 4 - Watch

Borrowers who have marginal cash flow, marginal profitability or have experienced an unprofitable year and whose financial condition is deteriorating. In the past the borrower has satisfactorily serviced bank debt but in recent months has either been late, delinquent in making payments, or made sporadic payments. While the bank continues to be adequately secured, profit margins have decreased or are decreasing, notwithstanding the borrower's satisfactory condition. Other characteristics of borrowers in this class may include inadequate credit information, deterioration of financial statements and repayment capacity, but with collateral that appears to limit exposure to loss. This rating includes loans to established borrowers who are reasonably margined by collateral but where potential improvement in financial capacity appears limited. Also included in this rating are loans to borrowers in industries that are experiencing elevated risk.

CAMELS

Capital Adequacy 2. Asset Quality 3. Management 4. Earnings 5. Liquidity 6. Sensitivity to Interest -is an internal rating system used by federal and state regulators for assessing the soundness of financial institutions on a uniform basis and for identifying those institutions requiring special supervisory attention.

Trend analysis

Comparing the same ratios of a company over time

Adversely Classified Assets or Classified Assets:

Sum of Substandard Assets, Doubtful Assets, Loss Assets

Composite 3

The bank exhibits some degree of supervisory concern in one or more of the component areas. The banks in this group exhibit a combination of weaknesses that may range from moderate to severe; however, the magnitude of the deficiencies generally will not cause a component to be rated more severely than a 4. Management may lack the willingness or ability to effectively correct weaknesses within appropriate time frames. Banks in this group are generally less capable of withstanding business fluctuations and are more vulnerable to outside influences than a composite 1 or 2 bank. The banks in this group may be in significant noncompliance with laws and regulations. Risk management practices may be less than satisfactory relative to the bank's size, complexity, and risk profile. The banks in this group require more than normal regulatory supervision, which may include formal or informal enforcement actions. Failure appears unlikely, given the overall strength and financial capacity of the banks in this group.

Composite 2

The bank is fundamentally sound. For a bank to receive this rating, generally no component rating should exceed a. Only moderate weaknesses are present and can be corrected by the board of directors and management. There are no material supervisory concerns and, as a result, the supervisory response is informal and limited.

Composite 1

The bank is sound in every respect, and generally has components rated 1 or 2. Any weaknesses are minor and can be handled in a routine manner by the board of directors and management. The bank exhibits the strongest performance and risk management practices relative to its size, complexity, and risk profile, and gives no cause for supervisory concern.

. Composite 4

The banks in this group generally exhibit unsafe and unsound practices or conditions. There are serious financial or managerial deficiencies that result in unsatisfactory performance. The problems range from severe to critically deficient. The weaknesses and problems are not being satisfactorily addressed or resolved by the board of directors and management. Banks in this group generally are not capable of withstanding business fluctuations. There may be significant noncompliance with laws and regulations. Risk management practices are generally unacceptable. Close supervisory attention is required, which means, in most cases, formal enforcement action is necessary to address the problem. Banks in this group pose a risk to the deposit insurance fund. Failure is a distinct possibility if the problems and weaknesses are not satisfactorily addressed and resolved.

Risk of "selling out of trust

The dealer sells some of the goods but doesn't reduce the loan.

Single Payment or ‟Bullet" Loan

The loan principal is due at maturity.

Installment Loan

Typically, the proceeds are advanced to the borrower upfront and the loan is repaid installments. (blank) may be monthly, quarterly, etc Typical use: The borrower needs the loan proceeds upfront and to repay in installments. Examples: automobile and home loans; acquisition of equipment and real estate.

Asset-Based Lending

Usually means a line of credit that is closely tied to the level of inventory and/or accounts receivable, which serve as collateral. The loan may increase as the size of these two assets increase. For example, a bank agrees to advance funds to a borrower equal to a certain percentage of inventory (say, 50% to 70%) and accounts receivable (say, 60% to 80% of accounts not past due more than 60 days). A Borrowing Base Certificate is should be used to submit valuations to the bank. - Loan risk increases when the bank does not verify inventory and receivables. Risk of fraud.