BankNotes ...

As the financial crisis deepened, regulatory requirements for financial institution's loan portfolios, both banks and credit unions, are much more stringent.  The thought is that institutions can no longer book loans and forget about them; they must go back regularly and revisit the value of the asset backing the loan and the credit worthiness of the borrower as well as other items that may change.  Considering the national financial crisis, many people have experienced changes in their personal and business finances.

As financial institutions prepare for or respond to an examination, questions around the loan portfolio are asked: what are the examiners asking for? How deep do they want the bankers to drill to find issues with the loan portfolio? What kind of data do they want from the institution? You may say, "but my institution is clean with very few problem loans, I won't need to do any of this research" - think again. They are also looking for loans that could go bad or the data to defend a clean portfolio.

Below are a few items taken from a regulatory agreement between a financial institution and their regulator, these are by no means comprehensive, nor are they the same for each regulatory agency, but each is similar in their requests:

"The Board shall develop, implement, and thereafter direct the Bank's management to ensure the Bank's adherence to systems which provide for effective monitoring of:  

(a) early problem loan identification to assure the timely identification and rating of loans and leases based on lending officer submissions;

(b) statistical records that will serve as a basis for identifying sources of problem loans and leases by industry, size, collateral, division, group, indirect dealer, and individual lending officer;

(c) adequacy of credit and collateral documentation"

The regulators are asking for probable loss modeling of the loan portfolio, which loans are likely to go bad based on objective statistical data. Along with stratification analysis based on loan officer, industry, size, collateral, division, group, indirect dealer; additionally the institution may need to show the stratification of loan grading, FICO scores, FICO migration, zip code, branch office, loan size, or any other important data point. The institution should know its loan migration, how many "A" grade loans in a portfolio have shifted over time to "B" or "C" or lower grade loans.

They also want the assets backing the loans reanalyzed to make sure there is still enough value behind the loan if a foreclosure or repossession is necessary. Real-time asset valuations combined with stress testing the portfolio will be the key; how does the financial institution get objective real-time values on the assets that back a diverse loan portfolio that includes consumer, residential and commercial real estate for thousands of loans? 

The Agreement goes on to state that the financial institution will...

"The Board shall within sixty (60) days employ or designate a sufficiently experienced and qualified person(s) or firm to ensure the timely and independent identification of problem loans and leases.

"The Board shall within sixty (60) days ensure that the Bank's management is accurately analyzing and categorizing the Bank's problem loans and leases.

"The Board shall establish an effective, independent and on-going loan review system to review, at least semi-annually, the Bank's loan and lease portfolios to assure the timely identification and categorization of problem credits. The system shall provide for a written report to be filed with the Board after each review and shall use a loan and lease grading system consistent with the guidelines set forth in "Rating Credit Risk" and "Allowance for Loan and Lease Losses" booklets of the Comptroller's Handbook. Such reports shall include, at a minimum, conclusions regarding:

(a) the overall quality of the loan and lease portfolios;

(b) the identification, type, rating, and amount of problem loans and leases;

(c) the identification and amount of delinquent loans and leases;

(d) credit and collateral documentation exceptions;

(e) the identification and status of credit related violations of law, rule or regulation;

(f) the identity of the loan officer who originated each loan;

(g) loans and leases to executive officers, directors, principal shareholders (and their related interests) of the Bank; and,

"The Board shall ensure that the Bank has processes, personnel, and control systems to ensure implementation of and adherence to the program developed pursuant to this Article.

In addition to the above requirements, this will require stress testing of the portfolio across several data points including, loan to value compression, FICO score movement, as well as interest rate adjustments. How will each type of loan portfolio respond to multiple, simultaneous stresses?

The board of directors has a lot of work to do in assisting the management team of the institution. The regulators are asking for more involvement with the institution and its problem loans requiring, objective defensible grading and stratification analysis, along with probable loss modeling, stress test simulations, and real-time asset valuation, of 100 percent of the portfolio. Moreover, if you think that your institution is completely clean - you are not on a problem list or don't have very many problem loans - well now you will have to prove it to the regulators.

Real, defensible, comprehensive portfolio analytics will be the solution - it will take a banker/CFO weeks or months to develop such a custom model for your institution in an excel spreadsheet. Or will it require anew strategy?

The Risk Management Association (RMA) just released 2009 Q4 figures showing that the downward slide of bank asset quality is beginning to level off.

The RMA is a nonprofit with 3,000 institutional members whose goal is to implement sound risk principles in the financial sector. Their Risk Analysis Service data report was released in conjunction with Automated Financial Systems, Inc., and is the self-professed only gauge of comprehensive credit risk. The data utilize figures from 17 top-tier banks.

Showing Signs of Recovery

From the press release: "The leveling off of the deterioration of commercial asset quality from the third to fourth quarter is a positive indicator that the economy is showing signs of recovery," said William F. Githens, RMA president and CEO. "However, the business banking sector continues to be a concern and is substantially underperforming the middle market and large corporate lines of business."

But while the rate of decline in asset value for big banks is only beginning to level off, specialty lenders are enjoying quicker successes. AmeriCredit, CapitalSource, Allied Capital Source, and CIT Group all posted 52-week high stock prices (TheStreet).

CIT GROUP

CIT Group, a commercial lender to small and medium-sized businesses, took its first bond to market on February 26 after emerging from a brief, month-long Chapter 11 reorganization in December. The bond, offered at $667.2M, represents a portfolio transition from commercial-paper-backed to equipment leases. Hopefully, this shift will lead the way to longer-term solutions to loan portfolio instability and vulnerability.

CIT's bond is issued through the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF), also known as "Bailout #2." CIT got in on the Facility just before its rapidly approaching final monthly application deadline of March 4.

It's a start, but CIT needs to secure other, low-cost funding that doesn't come from the government. Their bankruptcy had followed on the heels of nine consecutive losing quarters that totaled over $5B.

Whether CIT Group-and other lenders-will be able to remain solvent after TALF's discontinuation remains to be seen. What we know, though, is that small businesses are counting on the success of CIT and similar lenders.

Word on the Street

A recent CIT report-auspiciously titled "Lessons Learned-A Case for Greater Optimism" -surveyed owners and executives of 220 American small businesses (as defined by annual revenues from $1M to $15M) about the close of 2009 and their views of 2010.

Key findings:

• For 2009, 33% said their revenue "declined," and 26% said it "declined significantly"
• 64% said it was harder today to manage their company's cash flow than it was 12 months ago
• 90% agreed that current stimuli does not help them
• For 2010, a whopping 53% expected their revenues to "grow," and 8% expected their revenues to "grow significantly"
• 80% said they're now smarter about running their businesses
• 70% said the recession made them better leaders

Bankers should look at a systems to stress test their loan portfolios in an effort to better manage the risk. There are systems in the market place that will stratify/custom grade loan portfolios, stress test the portfolio along various key data points (not just interest rate stress), provide the probability of loss a portfolio will incur. These systems offer many other items of information that are essential to managing the loan portfolio and its risk, to both the bankers and the regulators.

After rumors and delays, the Fed has released the results of the stress tests that were imposed on the 19 TARP fund recipients. The tests, officially called the Supervisory Capital Assessment Program (SCAP), were intended to check the banks’ capital levels under extreme economic conditions.

The headline news from the Fed’s 38-page report is that 10 of those banks could face capital shortfalls if the assumed future conditions become a reality. Moreover, the cumulative capital shortfall among those 10 banks totaled $75 billion.  

A break from the traditional

The real story, though, is what’s behind that number. Most of the $75 billion shortfall is not attributable to Tier 1 capital deficiencies.

Tier 1 capital is a traditional measure regulators use to assess a financial institution’s health—but the SCAP tests dug deeper to analyze the composition of the banks’ Tier 1 capital. A specific area of focus for the Fed, and the source of the perceived shortfall, was Tier 1 common capital ratio. Although existing regulations don’t require it, the Fed now believes banks should maintain a large component of common equity within Tier 1 capital. As a result, the 10 banks will be asked to raise their common equity—even though their overall Tier 1 capital levels may be within the regulatory standard under the SCAP scenarios.

Regarding the Tier 1 common capital ratio requirement, American Bankers Association President and CEO Edward Yingling said in a press release, “The regulators are, in effect, changing the existing rules and requiring that a higher [common equity] percentage be held within the Tier 1.”

Officially, the common equity shortfall is being called the SCAP buffer, defined as Tier 1 common or contingent common equity.

Fund-raising

In most cases, banks will cover the SCAP buffers by selling common shares or converting existing preferred shares into common. Should those efforts fail, the government has said it will convert its preferred shares in the affected banks from TARP’s Capital Purchase Program to the new Capital Assistance Program (CAP). The CAP program securities are TCE, simply because they are convertible preferred shares.

Bank of America, which is deemed to need $33.9 billion in common equity, has already made its plans known: the bank will hoard earnings and sell assets and common shares to comply with the government’s request. In a CNBC interview, CEO Ken Lewis said, “Our game plan is designed to help get the government out of our bank as quickly as possible.”

Some banks better than others

The Fed report provides estimated losses and SCAP buffer shortfalls for each of the 19 banks. The banks that are projected to have the largest capital shortfalls include Bank of America at $33.9 billion, Wells Fargo & Company at $13.7 billion, GMAC, LLC at $11.5 billion, and Citigroup at $5.5 billion. These four and six more will have to present the Treasury with a capital plan specifying how they will raise the additional capital.

The nine banks that “passed” the stress tests are Goldman, JPMorgan, Bank of New York Mellon, MetLife Inc., American Express, State Street Corp., BB&T, U.S. Bancorp and Capital One Financial.

Click here (http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20090507a1.pdf) to access the complete SCAP report.

Late last week, executives from the 19 largest domestic banks were briefed on the results of TARP-related stress test, officially called the SCAP. The stress tests are intended to predict bank capital levels under deteriorating economic conditions in 2009 and 2010. Equivalent to a government-imposed pop quiz, the tests were incorporated into TARP after the Obama administration was handed the U.S. political reins in January.

The exact details of the test results are supposed to be kept under wraps until an official announcement can be made on May 4. Bloomberg has reported, however, that six banks failed the tests and will be asked by the Fed to raise additional capital. Analysts believe Bank of America, Citigroup and possibly Fifth Third Bancorp of Cincinnati are among the six.

Test assumptions

The stress tests used two scenarios to project the banks’ losses, revenues and reserve needs for 2009 and 2010. The more adverse set of assumptions included:

•    Negative 3.3 percent GDP growth in 2009 and 0.5 percent GDP growth in 2010
•    Unemployment of 8.9 percent this year, rising to 10.3 percent next year
•    Housing price declines of 22 percent this year and 7 percent next year

The value of testing the banks’ capital levels under these particular assumptions has drawn both criticism and praise—some say the assumptions aren’t extreme enough, while others argue that these scenarios will produce results that make banks look worse off than they really are.

Setting aside that argument, the Treasury intends to use the results to determine which institutions need to shore up their capital reserves—to ensure they remain well capitalized in a sharp economic downturn. The exercise is also intended to bolster the public’s confidence that the banking system has the capital to withstand further economic deterioration.   

The consequences of failure

Banks that fail the stress tests will be required by the Fed to raise more capital, preferably from private sources. It has also been suggested that a quick fix might be to convert the government’s preferred stock into common shares—but that scenario raises questions about how the government should appropriately manage its role as an investor.  

There has been no official word on the government’s intention to become a common shareholder in the banking system. Treasury Secretary Timothy Geithner has only said that the Treasury would be able to provide additional convertible preferred shares as “a backstop until private capital becomes available.”

Banks that end up needing additional taxpayer cash will undoubtedly be subject to greater government scrutiny and involvement. It’s a possibility that some industry executives and board members could even suffer the fate of GM Chief Rick Wagoner.