Credit Tips for Tough Times

We are now reaping the fruit of over-concentrations, increasing average loan sizes and mass-compromises on covenants and guarantees. As we work out of our problems, is the horse literally out of the barn and nothing else can be done? Below are some thoughts for the future.

• Identify leading indicators for credit problems. Credit ratings, whether your scale is 9 or 26, are a good first step but an insufficient tool to effectively predict loan deterioration. A critical element in controlling loan losses is early detection of problem loans, well before the credit is emptied out of all assets and possible recoveries. Focusing specifically on leading indicators will help you and your team spot problem credits and start working them out before they become "dead men walking". Examples of such indicators include:

• Policy exceptions. There is a direct correlation between policy exceptions and problem loans. Therefore, an increasing number of exceptions means that, eventually, this new vintage of loans will suffer more losses. Originating well is the first step to loss avoidance.

  Since not all exceptions were created equal, knowing which exceptions will more likely lead to losses is most helpful in clamping down on the right types of exceptions. Study your portfolio and identify the top 10-15 exceptions that are present in most of your loan losses, and ensure that, going forward, such exceptions are properly mitigated, altogether avoided or resolved within a predetermined timeframe.

• Staff turnover. I learn a lot from Bill Perotti, Frost Bank's CCO, and this is one of his early indicators. We typically focus on credit-related indicators to predict losses, but unusual RM turnover is an excellent predictor of future problems, and it well outside of loan package territory. It is often a sign of trouble among the lenders. Identifying other "unrelated" early indicators is an important task that CCOs should undertake as we move through this credit cycle.

• Robust loan agreement monitoring. Monitoring covenants, financial statements and other loan agreement components is no fun, but it sure is a great way to detect problem credits. Your borrower tells you the accountant is on vacation and the statements are late? The dog ate the receipts? Red flags should be rising all over this borrower; trouble is brewing.

  Aggressive monitoring also implies careful trend analysis. Subtle changes in the borrower's condition are a tell-tale sign of future storms. Slowly declining current ratios, cash flows etc. imply the need for early intervention.

• Site visits. Numbers don't always tell the whole story. Looking borrowers in the eye, assessing their mood, walking through plants and warehouses, can all tell you things the statements and financial analysis can't. Make the time to visit at least annually, and more often with key borrowers, to gather personal impressions of their business and its overall health. I know you'll tell me RMs are too busy to do so, but considering what's at stake, coupled with the fact that about 70% of new commercial business comes from current customers, makes this time well spent.

• Include workouts in credit training. Many SuperCommunity Banks have reinstituted the old credit training programs, now that the mega banks have all but abandoned them. These typically include spending time in the credit department, apprenticing with experienced RMs, etc. However, most new RMs, and even many of those with 15 years experience, have not encountered a downturn, let alone a meltdown like the one we're experiencing these days. They never had to actually work out a credit. Including this element in their training is a lesson for which there is no substitute.

• Post mortem in the loan morgue. Loan losses are an expensive tuition; we might as well learn from them to avoid future mistakes. Analyzing each loss to understand the root causes, timing of credit souring and other key findings is time well spent. Even if you will find that nothing needs changing, the process is worth going through.

• Don't compromise on loan review. Loan review is an important function. Vigorous loan review, both in terms of coverage and depth, is a major contributor to early detection. Further, ensuring that the function is conducted truly independently from the line is essential, whether you use internal or oursourced resources.

• Follow up on loan review findings. Too often we identify problems or issues that need resolution, yet our follow up process isn't crisp enough, nor does it have teeth or consequences. Addressing both is another way to enhance the quality of your loan portfolio.

• Go through every single name on your watch list. Reviewing the watch list with each responsible RM will decrease the likelihood that a borrower will crater on you suddenly. Make the time to do that, and to query the RMs about the borrower's suppliers and sub-contractors as well; they'll be the first to know if there are further issues with this credit.

• Remembering the basics. It probably doesn't need to be said, but lending practices during 2002-2006 indicate that repetition might be appropriate:

• Risk diversification across borrowers, industries and loan sizes cannot be abandoned.

• Collateral is no substitute for solid cash flow.

• Transaction lending is more risky than relationship orientation. Today we don't need this reminder, but when the cycle turns again, we will!