A TAXING TIME IN LOAN MANAGEMENT

What a strange year for taxpayers. You may not have looked closely at the reason why because you had a few extra days, but today is the official last day you can file 2011 tax returns and settle with the IRS without an extension. No, it really wasn't yesterday, so if you hid under the bed to avoid the tax man, you still have time to come out and file. The strange thing about tax day timing stems from Emancipation Day, which is a holiday observed in DC. Since the 15th was a Sunday and the next business day was Emancipation Day, an official holiday in D.C. since 2005, everyone picks up and extra day to pay taxes (it will happen again in 2018). Speaking of taxing things, consider the banker managing a loan portfolio in the middle of the worst economic downturn and banking crisis since the Great Depression. Many out there don't understand the stresses felt by lending teams over the past few years, or see the levels of exhaustion. We aren't sure how things were back in the last great downturn, but these bankers have fought fires at every turn. Now, just when the fires seem to be getting down to something manageable, these same people are faced with a burned out husk of a portfolio that needs to be refilled. Beyond getting lots of sleep and some vacation time, there are a few key things bankers can do to help ensure bank fires remain containable in the future. No one wants to see another credit downturn, but focusing on a few important takeaways should help just in case. Because we know you are all tired, we are going to keep our suggestions simple. One area that can be modified to be more effective is loan grading. Here, most community banks use a one dimensional system based on 10 grades that range from "pass" to "loss." This approach is simple and it also helps that the system is based on a rating structure used by regulators themselves (of special mention, substandard, doubtful and loss to identify different degrees of credit weakness). Pass credits are simply loans that do not fall into these categories and they actually have no formal regulatory definition. Over the years, regulators encouraged bankers to expand the number of pass buckets to capture more nuance and the end result seems to have coalesced around 10 grading buckets. These include: 1=pass, very low risk such as cash secured; 2=pass, low risk; 3=pass, moderate risk; 4=pass, average risk; 5=pass, acceptable risk; 6=pass, borderline risk; 7=special mention; 8=substandard; 9=doubtful; and 10=loss. The problem with this approach is that it is just too blunt, as huge percentages of loans nearly always end up sitting in only 2 pass categories. That just doesn't help very much. To expand grading, we suggest you start small. After all, the current approach to grading is simple, so anything else seems complex at first blush. That should not deter you from trying, however. Realize that the current grading system has issues and that people tend to be inherently biased by our very nature, which adds to the difficulty. Next, understand it can be argued that using a single grade reflects a loan's default probability (grade 1 has a low default probability and grade 10 has a high probability). The key is to have objectivity in whatever scale you use, so to improve things, start with the top 20% of the portfolio. For each loan in this group, calculate in percentage terms what you would expect to collect if the loan defaulted. Forget the fact that it hasn't defaulted and instead, ask yourself what percentage of the loan you would get back if it did go into default. Once that is done, simply take a spreadsheet, drop in the loan amount, multiply that by the probability of default (using loan grade), multiply that by the percentage you expect to lose (loss given a default) and you end up with the potential loss in dollar terms for each loan. Then, simply sort based on potential loss and you have the beginning of a two dimensional portfolio management tool. Even if you do nothing else beyond this, you will end up with a better idea of which loans to monitor more closely. Even those who procrastinate are sure to see the value in starting an approach like this. Speaking of procrastination - note that when it comes to tax time, the extra two days around Apr 15th do not translate over to exemptions or extensions (the overseas exemption due date is still Jun. 15 and individual federal income tax returns on extension are due Oct. 15).