Must Knows - 3.1, 3.2

Question 1

The two primary factors affecting overall asset quality

Answer 1

o quality of the loan portfolio

o the credit administration program

Question 2

The 17 items that must be addressed in a Loan Policy

Answer 2

o General fields of lending and the types of loans within each general field
o Lending authority of each loan officer
o Lending authority of a loan or executive committee, if any
o Responsibility of the Board in reviewing, ratifying, or approving loans
o Guidelines under which unsecured loans will be granted
o Guidelines for interest rates and terms of repayment for secured and unsecured loans
o Limitations on the amount advanced in relation to the value of the collateral and the documentation required by the bank for each type of secured loan
o Guidelines for obtaining and reviewing real estate appraisals as well as for ordering reappraisals, when needed
o Maintenance and review of complete and current credit files on each borrower
o Appropriate and adequate collection procedures including, but not limited to, actions to be taken against borrowers who fail to make timely payments
o Limitations on the maximum volume of loans in relation to total assets
o Limitations on the extension of credit through overdrafts
o Description of the bank’s normal trade area and circumstances under which the bank may extend credit outside of such area
o Guidelines, which at a minimum, address the goals for portfolio mix and risk diversification and cover the bank’s plans for monitoring and taking appropriate corrective action, if deemed necessary, on any concentration that may exist
o Guidelines addressing the bank’s loan review and grading system (“Watch list”)
o Guidelines addressing the bank’s review of the ALLL
o Guidelines for adequate safeguards to minimize potential environmental liability

Question 3

The 7 areas that should be addressed by an effective loan review system

Answer 3

• To promptly identify loans with well-defined credit weaknesses so that timely action can be taken to minimize credit loss;
• To provide essential information for determining the adequacy of the ALLL;
• To identify relevant trends affecting the collectibility of the loan portfolio and isolate potential problem areas;
• To evaluate the activities of lending personnel;
• To assess the adequacy of, and adherence to, loan policies and procedures, and to monitor compliance with relevant laws and regulations;
• To provide the board of directors and senior management with an objective assessment of the overall portfolio quality; and
• To provide management with information related to credit quality that can be used for financial and regulatory reporting purposes.

Question 4

The 4 minimum requirements of a loan review system

Answer 4

• A formal credit grading system that can be reconciled with the framework used by Federal regulatory agencies;
• An identification of loans or loan pools that warrant special attention;
• A mechanism for reporting identified loans, and any corrective action taken, to senior management and the board of directors; and
• Documentation of an institution’s credit loss experience for various components of the loan and lease portfolio.

Question 5

The 7 areas that should be addressed in a loan review policy

Answer 5

• Qualifications of loan review personnel;
• Independence of loan review personnel;
• Frequency of reviews;
• Scope of reviews;
• Depth of reviews;
• Review of findings and follow-up; and
• Workpaper and report distribution.

Question 6

Which type of losses are reserved for through the ALLL

Answer 6

loans and leases that the bank has the intent and ability to hold for the foreseeable future or until maturity or payoff. (NOT off-balance sheet items)

Question 7

Which type of losses are NOT reserved for through the ALLL

Answer 7

o Off-balance sheet, have a separate allowance

o Held for sale – on books at market value

Question 8

The three (or four) components of the ALLL – Historical Loss (FAS 5), Qualitative Factors (FAS 5), Impairment (FAS 114), Margin for Imprecision

Answer 8

• For loans and leases classified Substandard or Doubtful, whether analyzed and provided for individually or as part of pools, all estimated credit losses over the remaining effective lives of these loans.
• For loans and leases that are not classified, all estimated credit losses over the upcoming 12 months.
• Amounts for estimated losses from transfer risk on international loans.

Question 9

How to calculate the FAS 5 portion of the ALLL

Answer 9

o Accounting for contingencies – recognition of loss contingency
o Segregate non-impaired loans into groups with similar risk characteristics and estimate losses

Question 10

The 9 minimum Qualitative factors that must be considered as part of the FAS 5 analysis

Answer 10

• Changes in lending policies and procedures, including underwriting, collection, charge-off and recovery practices;
• Changes in local and national economic and business conditions;
• Changes in the volume or type of credit extended;
• Changes in the experience, ability, and depth of lending management;
• Changes in the volume and severity of past due, nonaccrual, restructured, or classified loans;
• Changes in the quality of an institution’s loan review system or the degree of oversight by the board of directors; and,
• The existence of, or changes in the level of, any concentrations of credit.

Question 11

The definition of impairment

Answer 11

Based on current information or events, it is probable that the creditor will be unable to collect all interest and principle payment die according to the contractual terms of the loan agreement.

Question 12

The difference between a loan that is not impaired and a loan that has an impairment amount of $0, and how the two are treated for reserve purposes

Answer 12

• A loan determined not to be impaired is placed into a pool under FAS 5
• An impaired loan with $0 impairment has no reserve and is not placed into a pool under FAS 5.

Question 13

The three methods of calculating impairment

Answer 13

1. Present value of expected future cash flows.
2. Fair Value of the collateral minus cost to sell if collateral dependent.
3. Under FAS 5, loans are collectively evaluated for impairment.

Question 14

When the fair value of collateral method of calculating impairment must be used

Answer 14

When the loan is collateral dependent.

Question 15

The definition of layering?

Answer 15

The inappropriate practice of recording in the ALLL more than one amount for the same probable loan loss.

Question 16

When an examiner should require the bank to make additional provisions to the ALLL

Answer 16

When the ALLL is underfunded.

Question 17

Characteristics of A/R financing

Answer 17

Short-term working capital and seasonal loans provide temporary capital in excess of normal needs.

Question 18

Advantages of A/R financing for both the bank and borrower

Answer 18

Several advantages of accounts receivable financing from the borrower’s viewpoint are: it is an efficient way to finance an expanding operation because borrowing capacity expands as sales increase; it permits the borrower to take advantage of purchase discounts because the company receives immediate cash on its sales and is able to pay trade creditors on a satisfactory basis; it insures a revolving, expanding line of credit; and actual interest paid may be no more than that for a fixed amount unsecured loan.

Advantages from the bank’s viewpoint are: it generates a relatively high yield loan, new business, and a depository relationship; permits continuing banking relationships with long-standing customers whose financial conditions no longer warrant unsecured credit; and minimizes potential loss when the loan is geared to a percentage of the accounts receivable collateral. Although accounts receivable loans are collateralized, it is important to analyze the borrower’s financial statements. Even if the collateral is of good quality and in excess of the loan, the borrower must demonstrate financial progress. Full repayment through collateral liquidation is normally a solution of last resort.

Question 19

The two methods used to make A/R advances and their characteristics

Answer 19

First, blanket assignment, wherein the borrower periodically informs the bank of the amount of receivables outstanding on its books. Based on this information, the bank advances the agreed percentage of the outstanding receivables.

Second, ledgering the accounts, wherein the lender receives duplicate copies of the invoices together with the shipping documents and/or delivery receipts.

Question 20

The uses of leveraged financing

Answer 20

Leveraged financing is an important financing vehicle for mergers and acquisitions, business re-capitalizations and refinancings, equity buyouts, and business or product line build-outs and expansions. It is also used to increase shareholder returns and to monetize perceived “enterprise value” or other intangibles.

Question 21

What is a leveraged financing transaction?

Answer 21

A transaction is considered leveraged when the obligor’s post-financing leverage as measured by debt-to-assets, debt-to-equity, cash flow-to-total debt, or other such standards unique to particular industries significantly exceeds industry norms for leverage.

Question 22

The initial step to assessing the credit worthiness of oil/gas reserve based loans

Answer 22

The initial step to assessing the credit worthiness of reserve-based loans is an analysis of the engineering function.

Question 23

The three critical concerns that must be addressed by an engineering report

Answer 23

The report must address three critical concerns: pricing; discount factors; and timing.

Question 24

Classification standards for Oil/Gas Reserve loans that are collateral dependent

Answer 24

First, 65 percent of discounted PWFNI should be classified Substandard. A lesser percentage or less severe criticism may be appropriate in cases where a reliable alternate means of repayment exists for a portion of the debt. The 65 percent percentage should be used when the discounted PWFNI is determined using historical production data. When less than 75 percent of the reserve estimate is determined using historical production data, or the discounted PWFNI is predicated on engineering estimates of the volume of oil/gas flow (volumetric and/or analogy-based engineering data), the collateral value assigned to Substandard should be reduced accordingly. The balance, but not more than 100 percent of discounted PWFNI of PDP reserves, should be classified Doubtful. Any remaining deficiency balance should be classified Loss.

Question 25

The 4 principal errors made when granting RE loans

Answer 25

the principal errors made in granting real estate loans include:

1. inadequate regard to normal or even depressed realty values during periods when it is in great demand thus inflating the price structure,
2. mortgage loan amortization,
3. the maximum debt load and repayment capacity of the borrower, and
4. failure to reasonably restrict mortgage loans on properties for which there is limited demand.

Question 26

The requirements of Part 365, outlined in 365.2

Answer 26

the fact that it requires each bank to adopt and maintain written policies for RE loans

Question 27

The supervisory LTV limits for the six different RE loan categories

Answer 27

• 65 percent for raw land;
• 75 percent for land development;
• 80 percent for commercial, multi-family, and other non-residential construction;
• 85 percent for construction of a 1-to-4 family residence;
• 85 percent for improved property; and
• Owner-occupied 1-to-4 family home loans have no suggested supervisory LTV limits. However, for any such loan with an LTV ratio that equals or exceeds 90 percent at origination, an institution should require appropriate credit enhancement in the form of either mortgage insurance or readily marketable collateral.

Question 28

The reporting requirements and risk limits related to loans in excess of supervisory LTV limits

Answer 28

loans that exceed the supervisory LTV limit should be identified in the institution’s records and the aggregate amount of these loans reported to the institution’s board of directors at least quarterly.
The guidelines further State that the aggregate amount of loans in excess of the supervisory LTV limits should not exceed the institution’s total capital.
Moreover, within that aggregate limit, the total loans for all commercial, agricultural and multi-family residential properties (excluding 1-to-4 family home loans) should not exceed 30 percent of total capital.

Question 29

What types of loans are exempt from supervisory LTV requirements

Answer 29

Loans guaranteed or insured by Fed, State, or local gov, and loans to be sold promptly on the secondary market with no recourse

Question 30

When to cite an apparent violation of Part 365 versus when to cite an apparent contravention of the Appendix to Part 365

Answer 30

It is important to distinguish between the regulation and the interagency guidelines. While the guidelines are included as an appendix to the regulation, they are not part of the regulation. Therefore, when an apparent violation of Part 365 is identified, it should be listed in the Report of Examination in the same manner as other apparent violations. Conversely, when an examiner determines that an institution is not in conformance with the guidelines and the deficiency is a safety and soundness concern, an appropriate comment should be included in the examination report; however, the deficiency would not be a violation of the regulation.

Question 31

The warning signs of a troubled RE market or project

Answer 31

• Rent concessions or sales discounts resulting in cash flow below the level projected in the original appraisal.
• Changes in concept or plan: for example, a condominium project converting to an apartment project.
• Construction delays resulting in cost overruns which may require renegotiation of loan terms.
• Slow leasing or lack of sustained sales activity and/or increasing cancellations which may result in protracted repayment or default.
• Lack of any sound feasibility study or analysis.
• Periodic construction draws which exceed the amount needed to cover construction costs and related overhead expenses.
• Identified problem credits, past due and non-accrual loans.

Question 32

The major risk of a construction loan

Answer 32

The major risk arises from the necessity to complete projects within specified cost and time limits.

Question 33

The two disbursement plans for construction lending

Answer 33

Loan funds are generally disbursed based upon either a standard payment plan or a progress payment plan. The standard payment plan is normally used for residential and smaller commercial construction loans and utilizes a preestablished schedule for fixed payments at the end of each specified stage of construction. The progress payment plan is normally used for larger, more complex, building projects. The plan is generally based upon monthly disbursements totaling 90 percent of the value with 10 percent held back until the project is completed.

Question 34

When an apparent construction or CRE loan may actually be considered OREO

Answer 34

When it is OREO in economic substance

Question 35

The four basic types of construction lending and their characteristics

Answer 35

1. Unsecured Front Money - Unsecured front money loans are working capital advances to a borrower who may be engaged in a new and unproven venture.
2. Land Development - Land development loans are generally secured purchase or development loans or unsecured advances to investors and speculators. Secured purchase or development loans are usually a form of financing involving the purchase of land and lot development in anticipation of further construction or sale of the property.
3. Commercial Construction - Loans financing commercial construction projects are usually collateralized, and such collateral is generally identical to that for commercial real estate loans.
4. Residential Construction - Residential construction loans may be made on a speculative basis or as prearranged permanent financing.

Question 36

The two main risk factors for agricultural loans

Answer 36

commodity prices and weather conditions

Question 37

Feeder Livestock Loans

Answer 37

Short-term loans for the purchase of, or production expenses associated with, cattle, hogs, sheep, poultry or other livestock. When the animals attain market weight and are sold for slaughter, the proceeds are used to repay the debt.

Question 38

Breeder Stock Loans

Answer 38

Intermediate-term credits (generally three to five years) used to fund the acquisition of breeding stock such as beef cows, sows, sheep, dairy cows, and poultry. The primary repayment source is the proceeds from the sale of the offspring of these stock animals, or their milk or egg production.

Question 39

Machinery and Equipment Loans

Answer 39

Intermediate-term loans for the purchase of a wide array of equipment used in the production and handling of crops and livestock. Cash flow from farm earnings is the primary repayment source. Loans for grain handling and storage facilities are also sometimes included in this category, especially if the facilities are not permanently affixed to real estate.

Question 40

Farm Real Estate Acquisition Loans

Answer 40

Long-term credits for the purchase of farm real estate, with cash flow from earnings representing the primary repayment source. Significant, permanent improvements to the real estate, such as for livestock housing or grain storage, may also be included within this group.

Question 41

Ag Carryover Loans

Answer 41

1. This term is used to describe two types of agricultural credit. The first is production or feeder livestock loans that are unable to be paid at their initial, short-term maturity, and which are rescheduled into an intermediate or long-term amortization.
2. The second type of carryover loan refers to already-existing term debt whose repayment terms or maturities need to be rescheduled because of inadequate cash flow to meet existing repayment requirements.