Risk Management for Loan Programs

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Risk Management for Loan Programs
RESNA Alternative Financing and Telework Loan
Programs Annual Meeting December 14, 2004
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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

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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

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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

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Monitoring

• Prevent late payment problems!
• Collect information and know whats happening
  with borrowers
• What are the red flags?
• When should you make a site visit?
• Contact borrowers as soon as problem is
  identified (dont wait for delinquent payments)

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Monitoring Information

• Financial Statements / Tax Returns
• Insurance Updates
• Social Benefit Reports
• Collect and review info regularly

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Problem Loans

• When do loans go sideways?
• First payment disasters
• About 2 ½ years in
• Communication, Communication, Communication!
• Restructuring

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Collections

• The wont pay vs. the cant pay
• Have a definite schedule for dealing with late
  payments!
• How to make collections a priority
• Effective collections can prevent foreclosure

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Foreclosure

• When to foreclose
• Evaluating collateral value
• The legal process

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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?

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Portfolio Management

• Portfolio Diversification
• Risk Rating Systems
• Loan Loss Reserves

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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?

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Portfolio Diversification

• Limit portfolio concentrations
• Single Borrower Limit
• Borrower type (individuals, businesses)
• Collateral type
• Loan structure
• Borrower location
• Industry
• Stage of development
• Risk Rating

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Questions? Comments?
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5 Minute Break
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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

Rating Criteria 1. 2. 3. 4. 5. .
Directly Related to
Combine into
Approximated by
TrueRisk of Loan Loss
Loan Loss Reserve
Credit Score
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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

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When to Rate Loans

• When you originate the loan
• Annual or semi-annual review of portfolio
• Significant change in loan performance or
  conditions

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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
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Designing a Loan Rating System (cont.)

• Step 4 Test and Tweak
• Step 5 Implement

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Step 1 - Determine Rating Criteria

• Common Risk Factors
• Factors 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

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Step 1- Determine Rating Criteria

• Design Issues
• Isolate factors that have accompanied
  delinquency, default or foreclosure
• Dont 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

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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!

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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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Step 5 Implementation

• Determine policy changes
• Obtain Loan Committee and Board approvals
• Implement process changes

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Loan Loss Reserve (LLR)

• Contra-asset account
• Usually required by auditor
• Quarterly expense on Statement of Activities
  (PL)
• Reduces value of Loans Receivable asset
• Smooths impact of losses self-insurance
• Reflects risk of the portfolio updated
  regularly

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LLR - Example
Loans Receivable 1,000,000 Loan
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
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Feedback Loops
How does your organization learn about risk and
become a better lender without becoming too
conservative?
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Review

• Risk and Risk Management
• Monitoring, Collections, Problem Loans
• Restructuring Foreclosure
• Portfolio Diversification
• Loan Rating System and Design
• Loan Loss Reserve

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Questions? Comments?