Effective with mortgage loan applications received on or after April 1, 2011, loan originators and mortgage brokers can no longer receive compensation incentives based on the pricing of the loan (e.g., the APR or loan origination charges). Instead, compensation must be based either on a fixed percentage of the loan amount or a flat dollar amount per loan.

In its analysis of the mortgage crisis, the federal government determined that the old compensation method — in which loan originators and brokers were compensated based on the profitability of a transaction — was one of the causes. For example, if loan originators and brokers could get customers to pay a higher than market rate or higher closing costs on a mortgage, they could receive additional compensation based on this higher amount. Such compensation models are now illegal.

A new anti-steering provision is also now in effect. This provision prohibits loan originators and mortgage brokers from steering customers toward a loan with less favorable terms in order to increase their compensation. Customers must be offered a mortgage with the lowest interest rate for which they qualify, the lowest points and origination fees, or the lowest rate for a loan without risky features like pre-payment penalties and negative amortization.

The Secure and Fair Enforcement for Mortgage Licensing (or SAFE) Act is another effort to enhance consumer protections and reduce mortgage fraud. It is creating a nationwide mortgage licensing system and registry for the residential mortgage industry by setting a minimum standard for licensing and registering of residential mortgage loan originators.

The initial period for federal registration will run from January 31, 2011 through July 29, 2011. All mortgage loan originators must register with the Nationwide Mortgage Licensing System and Registry database during this time period.

For more details or to access the registry, visit http://mortgage.nationwidelicensingsystem.org/fedreg/Pages/default.aspx.

Loan modification, however, may result in the creation of what’s known as a troubled debt restructure, or TDR. This distinction is important, because TDRs are subject to additional regulatory reporting, tracking and accounting requirements by the financial institution.

Concessions Are Key
Determining whether a loan modification constitutes a TDR is a two-step process: First, determine if the borrower is actually troubled. And second, determine if the modified terms you’re offering are more attractive than standard market terms.

Under GAAP, the modification of a loan’s terms constitutes a TDR if the lender grants any concession(s) to the borrower that it would not consider if it were not for the borrower’s current financial difficulties. These concessions may include things like lowering the interest rate, forgiving principal or previously accrued interest, allowing interest-only payments, and extending the loan’s maturity or amortization schedule.

Loan concessions may stem from an agreement between the bank and the borrower, or they could be imposed by a court. See the sidebar at left for specific TDR guidance.

It’s important to note that not all loan term modifications automatically constitute a TDR designation. For example, if the modified terms are consistent with market conditions and representative of terms the borrower could obtain in the open market, the restructured loan would not be categorized as a TDR.

Given the intricacies involved in TDR designations and the enhanced scrutiny regulators are placing on them, banks should establish policies and procedures to evaluate all loan modifications and concessions to determine whether they are TDRs or not. If a loan modification does meet the definition of a TDR, the bank must follow the accounting procedures set forth in ASC 310-40 (formerly FAS 114), including testing the loan for impairment.

Testing for Impairment
Banks must classify TDRs as “substandard” and, thus, test them for impairment. If found to be impaired, they must be written down to their current market value with the appropriate allowance for loan and lease losses (ALLL) adjustments under ASC 310-40, and the appropriate reserve provision must be made.

TDRs also must be segregated on financial statements and appear on the bank’s call report (not by name, but in the aggregate) through December 31 of the year that they are identified.

A loan is considered to be impaired when, based on current information and events, it is probable that an institution will not be able to collect all amounts due according to the original contractual terms of the loan agreement. Usually, a TDR that had been individually evaluated under ASC 310-40 would already have been identified as impaired because the borrower’s financial difficulties existed before the formal restructuring.

Banks should account for the modification of terms for a TDR in accordance with ASC 310-40. These require that impairment be measured based on the present value of the expected future cash flows, discounted at the effective interest rate of the original loan agreement. If the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recognized through a valuation allowance.

Beyond Masking
Loan restructures and concessions can be an easy way to mask some problems, but regulators today are digging deeper in order to get a true picture of what’s going on in banks’ portfolios. They want to see TDRs for what they really are — not just glossed-over problem loans.

Therefore, it’s important that your bank have systems and processes in place to accurately assign problem loans as TDRs when they should be designated as such.

What Constitutes a TDR?
ASC 310-40 provides the following examples of loan modifications that may lead to a troubled debt restructure (TDR) designation:

• Absolute or contingent reduction of the stated interest rate for the remaining original term of the debt.

• Absolute or contingent reduction of the face amount or maturity amount of the debt as stated in the instrument or other agreement.

• Absolute or contingent reduction of accrued interest.

• Extension of the maturity date (or dates) at a stated interest rate that’s lower than the current market rate for new debt with similar risk.

• Conversion of a loan from one that amortizes principal and interest payments to an interest-only loan, even at a market rate.

In short: A loan modification is a TDR if the borrower could not qualify for a loan with similar modified terms from another lender.

Our firm can work with you to create internal systems that can help you with TDR designations. Please call us today to learn more.

1. Paper equity and borrowed liquidity have a bad habit of disappearing when you need them most.

2. Contingent liabilities tend to become real liabilities at the worst possible time.

In today’s continued uncertain credit environment, the fragility of equity and potential exposure to loss posed by contingent liabilities are two areas community banks should pay especially close attention to.

Fragility of Equity

From the commercial lender’s perspective, there is a very real purpose to equity: It helps protect against loss in the event that collateral declines in value. Unfortunately, while the value of liabilities rarely shrinks, the current recession has made it crystal clear that the value of assets – real estate, in particular – can evaporate quickly, virtually wiping out equity almost overnight.

Of course, real estate has proven to be a sound investment over the long haul, which is why banks have historically been willing to lend against it. (Hence, the traditional lender’s mantra that “If you take dirt, you won’t get hurt.”) Despite recent declines, there’s no question that real estate will rebound when investors return to the market in search of bargains.

But how do we define “the long haul”? When does it begin and end? And how much capital will it take to ride out the current downturn, the length and severity of which no one knows?

During more normal times, equity requirements of 15 to 30 percent were usually adequate protection for lenders. But today, a 30 percent drop in the value of commercial property held as collateral is not at all uncommon. For example, if a borrower had $1.5 million in equity in a piece of property that appraised for $5 million 18 months ago, but the property is now worth only $3.5 million, the equity has essentially vanished.

This makes it imperative that banks have policies and procedures in place that will facilitate ongoing monitoring of borrowers’ financial information, and quickly and thoroughly review and act upon the information once it’s received. If any blips or concerns are spotted, these should be reviewed with borrowers immediately. If you don’t have confidence in their ability to devise and implement a plan for dealing with problems quickly, it may be time for them to find another bank.

Contingent Liabilities

There has also never been a more important time than now to be concerned with borrowers’ and guarantors’ contingent liabilities. The domino effect of business failures has turned liabilities that were contingent or indirect – like guaranteed loans, leases and lines of credit – into direct liabilities.

For example, consider a builder/developer who personally guaranteed the debt of his company. Everything was fine as long as he was selling houses, but once sales slowed down, liquidity dried up and his creditors started demanding to be paid, his problems mushroomed as contingent liabilities suddenly became very real.

The takeaway for lenders now is to view contingent liabilities as more than just an insignificant footnote on the balance sheet, if they’re even disclosed at all. To be safe, assume that they are real liabilities and plug them into your financial and cash flow analyses. Is cash flow still adequate to service both your loan and all or some portion of the guaranteed debt?

Unfortunately, reality can rear its ugly head when we least expect it. Lenders should not fall into the trap many borrowers do in thinking that their business ventures will always be self-sustaining. Dig deep into the numbers to determine whether borrowers have realistically planned for the possibility that they may, indeed, have to cover the debts and liabilities they’ve pledged to cover.

To do so, let’s first acknowledge the need for community banks to return to the most fundamental of banking models: gathering deposits from within local communities and leveraging them to make loans within those communities.

It’s clear now that many of the more non-traditional lending practices that had become commonplace – from subprime and Alt A loans to more relaxed lending standards – were direct contributors to the financial crisis and credit crunch that have dealt such a crippling blow to the economy, as was the heavy reliance of some banks on non-core funding.

Consider these 10 commercial lending fundamentals underscored by the financial crisis:

1. Return to the 5 Cs of credit. There’s no better place to start a discussion of back to basics than by returning to what have traditionally been considered the bedrocks of lending: an emphasis on borrowers’ character, capacity, collateral, capital, and current market conditions. A close look at the troubled loans in any bank’s portfolio will likely reveal exceptions made to underwriting guidelines that started with the lender ignoring one or more of the 5 Cs of credit.

2. Remember the importance of risk-based capital. In March, the federal government undertook an extensive examination of 19 of the country’s biggest banks, conducting stress tests to determine the adequacy of their capital levels. This unprecedented measure underscores one of the many lessons that can be learned from the financial crisis: Capital matters.

As a result of the stress tests, the fed instructed a number of the big banks to bolster their capital levels. Given this, regulators may also require community banks to maintain higher capital levels. This will restrict banks’ ability to lend and may crimp returns in the short term, but should ultimately lead to wider margins.

3. Don’t downplay the role of confidence and liquidity. At the root of all the problems that have emerged in the credit markets is a lack of liquidity. The liquidity crisis is a direct outgrowth of counterparties no longer trusting each other – and when confidence and liquidity dried up, the market collapsed.

4. Don’t ignore risk. Risk can be disguised, but it never disappears. Financial engineers convinced many that risk could be quantified, but we forgot that the financial models assumed there would always be a market that would substantiate the value of assets. When markets disappeared, asset values crumbled. The lesson: You can slice, dice and sell risk, but that doesn’t make it go away.

5. Beware of covariance. Many community banks that weren’t directly involved in sub-prime and Alt A lending learned the hard way that they weren’t necessarily shielded from the risks these types of loans posed.

For example, some banks active in acquisition and development (A&D) and construction lending lost sight of the fact that their takeout was a subprime, Alt A or jumbo loan. The collapse of the residential real estate market had a direct and adverse impact on their builder and developer portfolios.

6. Identify your total risk exposure with each borrower. A borrower’s exposure to risk may go beyond his or her loans with your bank, especially builders and developers. Therefore, you should be sensitive not only to the risk posed by loans in your own portfolio, but also to borrowers’ other projects – or in other words, to your total risk exposure. While your loans may be performing, a borrower’s projects and loans with other banks may be faltering, which could eventually impact you.

7. Determine your appetite for risk. The key to doing this is building a model portfolio that defines your risk tolerance. What percentage of the bank’s capital should be exposed to what types of loans (as defined by line of business, geographic area, industry, type of property, etc.)?

Making exceptions to policy – for example, with respect to debt-to-income, loan-to-value (LTV) and the borrower’s credit/FICO scores – is, in effect, the acceptance of higher risk loans. This underscores the importance of carefully measuring risk on an ongoing basis, closely monitoring loans that increase your risk, and regularly reporting your findings to the bank’s board of directors.

8. Employ risk-based pricing. The problem wasn’t simply that banks took on excessive risk. Rather, it was that that they didn’t adequately price for it. This encouraged many lenders to take risks they might not ordinarily have considered.

For the first time in many years, community banks have pricing power, since most of the non-banks and alternative sources of credit that usurped that power in recent years have disappeared. The keys to pricing adequately for risk are: 1) devising a pricing model that defines exactly what each loan must earn in order to cover costs (including the cost of risk) and meet profit expectations, and 2) creating pricing agreements that communicate these expectations to borrowers.

9. Remember that cash is king. It’s an old cliché, but it’s true today more than ever: There is no substitute for cash flow. Using current financial information, lenders should look at both the qualitative and quantitative elements of borrowers’ cash flow. What is truly driving cash flow? How stable and dependable is it? What effect will competition have on it? What are the cash flow trends, and how likely is it that they will continue? Not knowing the answers to these questions may set us up to return to an accumulation of excessive risk.

10. Establish expectations with borrowers. Clearly communicate to borrowers your expectations regarding their financial performance, the information that will be required to facilitate monitoring, and penalties that will be assessed for non-performance. Establish benchmarks that give you the ability to adjust pricing or call loans for non-performance, and don’t allow borrowers to repay interest with more debt or to increase their lending facilities arbitrarily.

Please contact our office to discuss these and other strategies in more detail.

Revisions to how companies account for off-balance-sheet items and loan-loss provisions will knock fair-value accounting off the front page with respect to financial reporting, according to James Kroeker, acting chief accountant at Securities and Exchange Commission. Read more…

He made these remarks during the annual meeting of the Institute of International Bankers in Washington.  The Journal of Accountancy published an article on the speech on March 5, 2009.

If I could dig up a speech given by the head of the Office of Thrift Supervision from the mid-80′s it would sound a lot like this speech given last week.  Back in the 80′s accountants had to deal with Regulatory Accounting Principles (RAP) as well as Generally Accepted Accounting Principles (GAAP).  RAP would allow savings and loans to defer losses on their books creating fake capital where GAAP would require them to write them off.  We called this RAAP/GAAP differences.

We all know how the S & L story ended and we shouldn’t repeat those mistakes.  I think it is important to stop discussing how the accounting rules should be changed and focus instead on nursing the banking industry back to health.  Just changing the accounting rules doesn’t change the underlying health of a company.  The issue regarding the proper amount that banks should have reserved today has more to do with appraisal issues surrounding the underlying collateral than accounting rules.  A lot of the collateral is not being traded anymore and in the case of land and development loans, residential lots are not moving as fast as the original appraisals assumed.

It appears the regulators are still confused about the fact that the allowance for loan losses is intended to recognize losses in the loan portfolio today.  Future losses should be accounted for by increasing capital.  To recognize future losses in the allowance for loan loss account because the underlying collateral is hard to value would be taking a step backwards towards eliminating the RAP/GAAP difference in the allowance for loan losses.

Buyers of distressed debt strive to purchase nonperforming loans at a discount and then use their experience in working out problem loans to collect them and turn a profit. They are set up with the infrastructure, expertise and personnel (e.g., attorneys, professional liquidators) to do this more cost-effectively than most banks can.

For community banks holding nonperforming commercial loans primarily secured by real estate or equipment, this may be a viable Option worth considering. However, you must take emotion out of the equation and reduce it to a simple business decision. Consider what will result in the most money to your bank, present-value, for the least time, cost and risk — selling the debt in the commercial marketplace, continuing to work with the borrower toward a resolution or liquidating it.

As the number of firms buying distressed debt grows, so do the options for sellers, who may have more bidders to choose from. Buyers need to build volume, so increased competition may drive the price for nonperforming loans higher.

Several different clearinghouses have also emerged to connect sellers of distressed debt with potential buyers. The most popular is www.DcblX.com, which operates the world’s largest online marketplace of buyers and sellers of commercial debt.Think of it as an eBay for debt: You simply input broad data on loans you want to sell into the website, and buyers come back to you with bids, with DcbtX taking a fee for successful matches.

Financial Lending Notes 2008:

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting tax or other professional advice or opinions on specific facts or matters and , accordingly, assume no liability whatsoever in connection with its use. The information in this publication is not intended or written to be used, and cannot be used, by taxpayer for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this publication.

HUNTERS AND SKINNERS

These challenges have led some community banks to separate the sales side of lending from the credit analysis and documentation side. Centralizing the credit function by allowing a credit analyst to do the ”heavy lifting” is one way to accomplish this, Thus freeing up commercial lenders to concentrate on business development. However, there are risks in this ”hunter and skinner” model – namely, that lenders with inadequate knowledge of credit analysis will bring in loans that are fraught with problems.

Many bankers are familiar with “two year wonders” – lenders who quickly grow large portfolios and then leave the bank about the time all the problems with the loans start to arise. That’s why lenders should receive at least a minimal level of credit training, even if they will be concentrating primarily on sales.

So the first step in hiring and retaining qualified lenders is to define your model: Is it a traditional community bank model in which lenders do it all, or a centralized credit function that separates sales and credit analysis? If you choose a traditional lender “do it all” model, your primary challenge will be either finding lenders who have the training to pull this off, or training them yourself.

LEVEL THE PLAYING FIELD

As noted earlier, finding welltrained lenders who can do it all is getting more difficult, and recruiting them may be even harder still. Few community banks can match the compensation potential offered by most large banks, so you must compete on a different playing field.

For example, stress the lifestyle advantages you may be able to offer lenders. High income potential is usually accompanied by high stress and long hours. Does your position offer fewer hours, a shorter commute, more flexibility – in short, a better quality of life? Another strategy is to hire relatively young and inexperienced lenders and teach them fundamental lending skills yourself- cash flow, loan structure, financial and tax return analysis and problem loan identification. This can be accomplished through a combination of online training programs (like those offeredby state banking associations and also found at http://rmahq.org and http://aba.com), conferences and workshops (like those offered by the ABA and BAI), lending schools and community colleges, and mentoring by more experienced lenders.

If you plan to train lenders yourself, realize that it will require a heavy investment of time and energy by your bank. A chief credit officer or senior lender with credit training experience should be in charge of the effort. Take advantage of as many opportunities as you can to participate in industry association events (e.g., conferences, seminars, trade shows) that will help your new lenders get up lo speed as quickly as possible.

Also allow them to attend loan committee meetings so they can see firsthand how loan requests are structured and presented. By letting them underwrite smaller accounts and work on loan spreads early on, you’ll help them gain confidence. You can increase their responsibility gradually as they demonstrate increased ability.

MORE TIPS

Here are a few more pointers for hiring and retaining lenders in today’s environment: Turn to your network. This is the first step in filling any key position, as the professional networks you and other managers have built over the years are usually your best source for qualified lenders.

Look closely at troubled banks. Lenders at banks undergoing turmoil as a result of the credit crisis may be more inclined now than they were a year ago to consider making a move. This includes lenders at some troubled large banks, who might not have been willing to consider moving to a community bank before.

Hire lenders who can bring customers with them. The mindset of the best lenders is that “borrowers do business with bankers, not banks.” Ideally, lenders you hire should be able to bring some customers with them. It’s hard to carry a new lender for a year or longer waiting for him or her to build a portfolio from scratch.

Structure compensation to incent retention. Compensation plans that feature “golden handcuffs” like deferred compensation will give lenders strong incentive to stay with you for the long haul, rather than jump to the next attractive offer that comes along. Similarly, consider having new lenders sign an employment contract to help protect your investment in their training. Acclimate new lenders to your bank. Once they are hired, there should be some kind of structured program lo help orient lenders. This includes educating them on your culture, credit philosophy, approval process, risk tolerance, etc. Don’t let them “learn” by getting beat up in loan committee during their first year.

Offer a clear career path. This is one of the most important keys to employee retention. For commercial lenders, this path should require a commitment to continuing education - Such as membership and activity in industry organizations like the ABA and RMA – in order to keep their skills sharp.

For help in your new lender recruiting, training and development efforts, please give us a call.

STRUCTURING: Lender Pay

The ideal lender compensation structure includes a balance of incentives so that a portion of remuneration is based on personal performance. It should consist of seven components:

• Business development
• Relationship management
• Bank profitability
• Portfolio profitability
• Asset quality
• Timely and accurate assignment of Asset Quality Ratings (AQRs)
• The number of unapproved or uncleared exceptions or variances from procedures

Financial Lending Notes 2008:

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting tax or other professional advice or opinions on specific facts or matters and , accordingly, assume no liability whatsoever in connection with its use. The information in this publication is not intended or written to be used, and cannot be used, by taxpayer for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this publication.