A Training Session by National Community Capital Association 1 Risk Management for Loan Programs RESNA Alternative Financing and Telework Loan Programs Annual Meeting December 14, 2004

A Training Session by National Community Capital Association 2 Risk Definition - probability of loss or injury Through loan underwriting, lenders Remove risk (by structuring), or Accept risk (by understanding it) Expressions of risk are Probabilities – uncertain Obtained through subjective evaluation Often based on historical performance

A Training Session by National Community Capital Association 3 Loan Loss Risk Loan Loss Risk - the probability that a loan will not be repaid. Sources of Loan Loss Risk - Risk Profile of Loan Product Line (mission and market) - Loan Policies - Staff, Board - Environment (economic, political, geographic) Risk of Loan Loss is unique for each Lender

A Training Session by National Community Capital Association 4 How Do Lenders Manage Risk? Each Loan –Strong underwriting that identifies and mitigates risk –Technical Assistance –Firm approach to collections Whole Portfolio –Loan Policies –Loan Monitoring –Portfolio Management –Loan Rating Systems –Loan Loss Reserve

A Training Session by National Community Capital Association 5 Monitoring Prevent late payment problems! – Collect information and know what’s happening with borrowers – What are the red flags? – When should you make a site visit? – Contact borrowers as soon as problem is identified (don’t wait for delinquent payments)

A Training Session by National Community Capital Association 6 Monitoring Information Financial Statements / Tax Returns Insurance Updates Social Benefit Reports Collect and review info regularly

A Training Session by National Community Capital Association 7 Problem Loans When do loans go “sideways?” –First payment disasters –About 2 ½ years in Communication, Communication, Communication! Restructuring

A Training Session by National Community Capital Association 8 Collections The “won’t pay” vs. the “can’t pay” Have a definite schedule for dealing with late payments! How to make collections a priority Effective collections can prevent foreclosure

A Training Session by National Community Capital Association 9 Foreclosure When to foreclose Evaluating collateral value The legal process

A Training Session by National Community Capital Association 10 Problem Loans, Conclusions What were the risks that led to the problems? Had you identified them in your underwriting? Were there additional steps you could have taken to mitigate the identified risks? What (if any) lessons does this teach you for future lending?

A Training Session by National Community Capital Association 11 Portfolio Management Portfolio Diversification Risk Rating Systems Loan Loss Reserves

A Training Session by National Community Capital Association 12 Portfolio Diversification Why is a diverse portfolio important? What factors affect borrowers in general? –Economic, geographic, political, etc. What factors are important to your borrowers? Are some groups of borrowers more susceptible than others to certain events?

A Training Session by National Community Capital Association 13 Portfolio Diversification Limit portfolio concentrations: Single Borrower Limit Borrower type (individuals, businesses) Collateral type Loan structure Borrower location Industry Stage of development Risk Rating

A Training Session by National Community Capital Association 14 Questions? Comments?

A Training Session by National Community Capital Association 15 5 Minute Break

A Training Session by National Community Capital Association 16 Loan Rating System - Definition -A systematic methodology to estimate loan loss risk for each loan in a portfolio -Attempts to impose objectivity to a subjective judgment process True Risk of Loan Loss Rating Criteria …. Approximated by Credit Score Combine into Loan Loss Reserve Directly Related to

A Training Session by National Community Capital Association 17 Why Rate Loans? Management Perspective –To understand of the risks in your portfolio – and risk trends –To compare risk levels from loan to loan –To figure out who to monitor actively –Help staff and Board develop a common credit culture –Systematic way to calculate LLR Investor Perspective –Shows investors you are conscious about risk

A Training Session by National Community Capital Association 18 When to Rate Loans When you originate the loan Annual or semi-annual review of portfolio Significant change in loan performance or conditions

A Training Session by National Community Capital Association 19 Designing a Loan Rating System Step 1 Determine Rating Criteria – Unique set of risk factors Step 2 Determine Scoring Categories (A, B, C…) and relationship to LLR Step 3 Determine method for mapping Rating Criteria to Scoring Categories

A Training Session by National Community Capital Association 20 Designing a Loan Rating System (cont.) Step 4 Test and Tweak Step 5 Implement

A Training Session by National Community Capital Association 21 Step 1 - Determine Rating Criteria Common Risk Factors Factors Related to Borrower Factors that measure the 5Cs of Credit Factors Related to Loan Structure Amortization Schedule Collateral Factors Related to Environment Government Local Economy

A Training Session by National Community Capital Association 22 Design Issues Isolate factors that have accompanied delinquency, default or foreclosure Don’t choose multiple factors that address the same risk Too many factors will be a burden; too few will not result in a meaningful results Consider costs (time and money) of evaluating factors at underwriting and monitoring Step 1- Determine Rating Criteria

A Training Session by National Community Capital Association 23 Step 2 - Determine Scoring Structure Typical Scoring Structure Score Description Associated LLR 1 Strong certainty of repayment2% 2 Strong repayment expectation but a few issues could impair performance 4% 3 A number of issues could lead to nonpayment and default 7% 4 Repayment is uncertain25% 5 Repayment is very uncertain50% Note: Scoring Structure for your CDFI will vary!

A Training Session by National Community Capital Association 24 Step 3 - Map Loan Rating to Loan Score Two Common Methods Grouping Method (Examples 1 and 2) Mathematical Method (Example 3)

A Training Session by National Community Capital Association 25 Step 4 Test & Tweak Choose a representative sample (10 or more) of past loans Apply proposed Loan Rating System Revise (usually mapping methodology) Re-test

A Training Session by National Community Capital Association 26 Determine policy changes Obtain Loan Committee and Board approvals Implement process changes Step 5 Implementation

A Training Session by National Community Capital Association 27 Loan Loss Reserve (“LLR”) Contra-asset account Usually required by auditor Quarterly expense on Statement of Activities (P&L) Reduces value of Loans Receivable asset Smooths impact of losses – self-insurance Reflects risk of the portfolio – updated regularly

A Training Session by National Community Capital Association 28 LLR - Example Loans Receivable $ 1,000,000 Loan Loss Reserve (10%) (100,000) Net Loans Receivable 900,000 To set up or increase reserve: dr Loan Loss Expense $ 100,000 cr Loan Loss Reserve 100,000 To write-off a loan: dr Loan Loss Reserve $ 10,000 cr Loans Receivable 10,000

A Training Session by National Community Capital Association 29 Feedback Loops How does your organization learn about risk and become a better lender without becoming “too conservative?”

A Training Session by National Community Capital Association 30 Review Risk and Risk Management Monitoring, Collections, Problem Loans Restructuring & Foreclosure Portfolio Diversification Loan Rating System and Design Loan Loss Reserve

A Training Session by National Community Capital Association 31 Questions? Comments?