The write-downs are coming. Start preparing now.
By Eugene Ludwig, Wayne Rushton, Tom Freeman and Jeff Glibert
The crisis being triggered by the coronavirus pandemic is accelerating the financial industry toward an era of dramatically increased debt workouts and defaults. While the Paycheck Protection Program loans should end up on the government’s books, most loan write-offs and write-downs will be the burden of banks and other lenders.
This whirlwind needs to be carefully managed by banks. However, it also presents an opportunity to finally propel a much-needed policy modification in excessively narrow, often misleading marking methodologies that adversely affect regulation, banks, customers and the economy.
Periods of significant loan defaults are tough on banks and force unpleasant choices. To ensure the best loan modification, workout and collection results — and regulatory reaction — there are practical steps bankers can take.
First, bankers should inventory lending divisions to ensure policies, practices and procedures are up to date. Much has changed in accounting, compliance and valuation requirements since the Great Recession. It’s important to ensure infrastructure has kept pace, and responsibilities are clear across all lines of defenses.
Second, bankers will undoubtedly have to work out many loans to accommodate good clients. Yet because of the recent benign climate, many workout teams have gone on to other things.
This function needs to be brought back to par. There will be tension between those who hold the traditional “your first loss is your best loss” view, and others who want to keep good clients from failing. This team’s skill and circumspection is critical. For community banks, it typically includes the chief executive officer.
Third, credit talent needs to be reviewed on an individual and aggregated basis, focusing on experience and capabilities to defend portfolios and processes. This review — and plans to shore up gaps — should be approved by the board, and presented to internal and external auditors, accountants and examiners to ensure consistency with expectations.
The quality of bank processes and methodologies, and officer skills in defending the book can mitigate against the severity of directed write-downs or regulatory criticism (and even enforcement action). It would also be wise to train and coach less-experienced personnel in effectively presenting this material.
Negotiations with other lenders (particularly nonbanks) will require deftness, as different lenders may have varying short- and longer-term client objectives. Experienced negotiators in each relevant business line will be of great value.
Fourth, portfolios should be reviewed with an eye toward conservative but realistic valuations. Cash flows and debt-service capabilities and collateral valuations should be clear and well documented, and assets properly categorized as to performing or nonperforming status.
Be equally realistic in loan classification. Highly leveraged transactions, commercial real estate, mortgage, oil and gas and small-business portfolios are especially vulnerable to classification challenges.
Further, internal stress testing of portfolios including investments should be conservative. Be realistic in forecasting economic conditions, including a potential virus second phase mandating additional government intervention. Current credit portfolio performance may fall outside the pre-COVID credit-risk appetite. Exceptions should be reported to the board to ensure proper governance over aggregate levels and large individual cases.
Lastly, for a number of banks a new management information system will likely be required to track client requests for amendments, waivers and forbearance. Troubled borrowers can be expected to ask for new money. Each must be considered in the context of available collateral, going concern, client relationships and structure (i.e., debtor-in-possession loans). Internal consistency of approach in rating changes and client requests across regions, branches and, where appropriate, businesses is critical.
The financial regulators are not overreacting to the current credit crisis, but they will grade loans as they see them. And they may be more conservative than a banker in their shoes.
With the Financial Accounting Standards Board intrusion into the valuation process, grading loans has become even more challenging.
A good subject-matter expert should be prepared to review each troubled loan with examiners and accountants. They should also have the ability to quickly collate salient facts about individual and groups of loans and their collateral.
It also requires understanding the classifications standard examiners and accountants apply, including how those standards map to the bank’s own internal ratings.
Consider whether the overall objective would be better achieved by outright selling certain loans. If the immediate mark-at-sale is acceptable, this can help avoid valuation haggling and provides a measure of liquidity.
Beyond this, a fundamental challenge is how to achieve realism in valuations. Particularly in crises like this that are driven by temporary, nonfinancial influences, some accountants and some regulators can fail to acknowledge probable recovery values embedded in many assets.
The result is a misleading picture detrimental to the regulatory process, banks, customers and the economy. Whether ingrained in the allowance for loan and lease losses (ALLL), or the new current expected credit losses (CECL), such rules hinder regulators and bankers trying to use sound judgment.
The industry and government should try harder to avoid supervisory and resolution practices that rely too heavily on fire-sale liquidation values, to the detriment of the bank and borrower. In many cases, the borrower and/or its collateral have gone on to recover value, usually benefiting only unregulated players buying collateral at bargain-basement prices.
Today, regulators can temporarily assign “doubtful” rather than “loss” classifications to loans whose collection in-full is unlikely pending resolution of certain unsettled factors. However, they don’t have the ability to suspend charge-offs where longer recovery periods are involved, and current accounting standards for loan losses probably wouldn’t support it.
This is an important area ripe for a close policy look, sooner rather than later. During this crisis, there could be a “cooling off” period while this area is studied, and new rules are prescribed.
This is not to suggest wholesale, mindless forbearance. Rather, regulators, bankers and policymakers should apply sound judgment and methodologies rather than a narrow, point-in-time approach or formulaic pseudoscience that doesn’t take into account experience, judgment and historical valuation realities.
It’s time for bankers, trade associations, Congress and regulators to collaborate on sensible policy change on valuations. There would be considerable positive payoff for the economy, businesses and workers at a time when America desperately needs it.
Gene Ludwig is founder and CEO of Promontory Financial Group. He is also a former comptroller of the currency and a former vice chairman and senior control officer at Bankers Trust New York Corp.
Tom Freeman is a former chief risk officer at SunTrust and former head of credit analytics and reporting at Fleet Financial. He is also a former board member of the Risk Management Association (RMA).
Wayne Rushton is a senior adviser at Promontory Financial Group. He is a former senior deputy comptroller and chief national bank examiner at the Office of the Comptroller of the Currency.
Jeff Glibert is a board member at Deutsche Bank USA. He is a former managing director at Promontory Financial Group and held senior risk management positions at Lehman Brothers, Bank of America and Bankers Trust New York Corp.