Brave new world: Credit quality during COVID-19

How can your financial institution meet borrower needs while managing risk in your loan portfolio? That’s the burning question amid the COVID-19 pandemic and the massive response by policymakers.

The answer is via an “all-hands-on-deck” approach. Financial institutions will need to contact borrowers and work through each individual situation while diligently overseeing all outstanding loans and lines of credit.

The near-term focus should be on your current borrowers and then estimating what the demand-and-supply shock will ultimately hold for their respective businesses due to supply chain. An initial strategy should include a quick triage for the commercial portfolio and a review of the following key items:

Concentrations of impacted industries

Identify the current, biggest risk in the portfolio. The potential obvious sectors will relate to hospitality, including hotels and vacation resorts, certain commercial real estate, restaurants and food franchises, and retail small businesses. The FDIC released FIL-31-2020, which identifies situations whereby financial institutions should consider adjusting the calculations for credit concentrations.

Liquidity

Identify and confirm borrowers’/guarantors’ cash flow to access availability of liquidity on the largest borrowers within the portfolio.

Line of credit availability

Review the borrowers with revolving lines of credit to determine what usage will be required in the near term and long term and the potential that borrower usage may require additional liquidity at the financial institution.

Financial statements and tax return data

Due to the extension of the federal tax return deadline to July 15, current financial data may not be assessible until the third quarter of 2020. In addition, the information received with the 2019 tax return and financial statements won’t reflect the potential stress noted due to the large impact of the COVID-19 pandemic. Therefore, your financial institution should consider obtaining interim financial information to bridge the gap between the tax returns received and the current financial status of your borrowers.

We’ve compiled examples of basic information we recommend that financial institutions request for review based on impacted industry segments:

• Hotels/motels: current Smith Travel Accommodation Reports (STAR); current internal company-prepared financial statements; and occupancy and average daily rate (ADR) projections
• Residential income R/E: current rent rolls; current operating statements; status of property taxes; and deferred maintenance
• Commercial R/E: current rent rolls; current operating statements; lease status; tenant industry risk; property taxes; and deferred maintenance
  • Commercial R/E (owner-occupied):  company-prepared financial statements of the tenant; industry risk of the tenant; property taxes; and deferred maintenance
• Restaurants: company-prepared financial statements and projections; determining how successful current “takeout-only” operations are relative to covering fixed costs; and ascertain the going concern of operations in the future
• Construction lending: project status (in balance, sales, etc.) and absorption projections
• Assisted living facilities: company-prepared financial statements; state/federal inspection status; and occupancy projections
• C&I lending: company-prepared financial statements; industry risk; borrowing base compliance (asset-based lending); current availability for nonborrowing base governed revolving lines of credit; and current projections
• Personal borrowers/guarantors: liquidity verification; complete debt schedule; current credit report; income verification or W-2’s if necessary; and financial statement review for owner businesses generating distribution/dividend cash flow

Collateral

Determine how recent appraisals/evaluations are for those credits that are part of portfolio concentrations in hospitality, commercial real estate, and service-related industries.

• Commercial R/E: age of appraisal/internal evaluation; current net operating income versus appraisal net operating income; lease terms; accuracy and relevance of the discount rate utilized
• Accounts receivable: concentrations; related industry of customers; analyze A/R turnover changes; and field audit results
• Inventory: analyze inventory turnover calculations; and field audit results
• Marketable securities: current market value

Stress testing

Your financial institution should have a plan in place that provides for stress testing the various segments of the commercial portfolio and begins to anticipate the risk-rate changes that will be required for certain borrowers in troubled industries.

Revised Interagency Statement on Loan Modifications by Financial Institutions Working with Customers Affected by the Coronavirus

A recent Financial Institution Letter provided guidance to encourage financial institutions to work constructively with borrowers impacted by COVID-19. The agencies view loan modification programs as positive actions that can mitigate adverse effects on borrowers due to the impact of the COVID-19 pandemic.

The documents referenced above provide additional detail into topics including:

• Borrowers considered current (defined as less than 30 days) at the time “a modification program is implemented” wouldn’t be considered in financial difficulty.
• Short-term modifications made on a good-faith basis that were current prior to any relief aren’t troubled debt restructurings (TDRs). This includes short-term (e.g. six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are deemed insignificant.
• Guidance for past due reporting.
• Guidance for nonaccrual status and chargeoffs.

New SBA programs

Financial institutions are encouraged to consider relief available to small businesses through the SBA Economic Injury Disaster Loan program and the SBA Paycheck Protection Program. As such, financial institutions should consider segregating these loans from the commercial portfolio to appropriately monitor performance. The FDIC released FIL-33-2020 indicating that the FDIC won’t criticize financial institutions’ good-faith efforts to prudently use the SBA and Treasury programs to work with small business borrowers affected by the impact of COVID-19.

Scoping for external loan review

With the impact of COVID-19 on loan portfolios largely unknown, it may be an opportunity for your financial institution to reassess the scope and focus of your external loan review efforts. You should consider if the current scope of your planned loan reviews is appropriate to address the concerns regarding the overall impact on their loan portfolios.

• Is the current penetration target percentage sufficient to assess the overall quality contained within the loan portfolio?
• Is the penetration of the higher risk market segments mentioned above deep enough to ascertain the current risks noted?
• Should existing TDRs and current COVID-19-related modifications be a larger part of the current year loan review?
• Should external resources be utilized to assist internal loan review departments in the short term to verify the risk ratings derived by the financial institution?

In today’s challenging environment, there will be an increased reliance on loan reviews to identify and evaluate at-risk segments of your institution’s loan portfolio. Please feel free to reach out to the Plante Moran loan review team for assistance in addressing any loan review questions you may have.