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It’s ALLL About Perspective

By: Jamey King

Community banks are struggling to achieve capital adequacy and sustainable earnings, both of which are threatening their relevancy in the marketplace. Narrowing interest rate margins and new regulations restricting fee revenues, coupled with potential additional costs associated with tougher consumer protection standards, are putting increased pressure on the bottom line.

As if that were not enough, for banks with capital positions bolstered by TARP, the dividend resets in 2013 with many believing repayment will come from these same weakened earnings streams.

To compound the issues, community banks, by nature of their small sizes, need relatively small capital infusions, operate in proportionately small marketplaces, and their ability to grow organically is fairly weak — all of which creates questions about continued or new investment by traditional capital market players.

Finally, even if community banks survive, what will be left for the shareholders and how will a return on or return of this investment be provided? Recapitalization or mergers are the two likely answers to this question.

When discussing bank investment or acquisition, the major question for a potential investor or merger candidate is likely to center on the loan portfolio. Therefore, regardless of the robust allowance for loan and lease losses methodology or intricate risk-rating system, the loan portfolio will undergo scrutiny.

Understanding the Investor’s Loan Review Process

Investors see regulatory exams, audits and even risk-rating validation functions as only the beginning of a thorough portfolio evaluation. Questions will arise such as: How does the bank measure impairment? What is the likelihood a pass-rated loan will become impaired? What characteristics does the bank’s credit department believe to be predictive of future instances of non-performance? How is the opening balance sheet created based on the information presented by the bank?

Therefore, it is equally important for a community bank to critically assess not only the non-performers for severity of loss, but also the performing loan book with an investor’s eye, which is not likely in lockstep with the ALLL methodology or assumptions. Community banks must be able to properly document confirmatory due diligence to provide the foundation for their conclusions. A greater understanding of the loan portfolio reduces the cost of uncertainty frequently modeled by investors.

Spokane, Wash.-based AmericanWest Bank’s approach to evaluating target banks involves augmenting its own due diligence with a third-party assessment of the loan portfolios. AmericanWest is a $2.3 billion bank with more than 70 branches across Washington, Idaho, Utah and California and has announced or completed four mergers from January 2011 through March 31. Each announced merger involved an independent third-party evaluation of the loan portfolios.

“The proper review of these bank loan portfolios was required to assess the risk and estimated losses associated with each and ultimately gave us the insight we needed to move forward with the mergers,” said AmericanWest CEO Scott Kisting.
Different Results

The primary differences result from different methodologies and assumptions used to test the loan portfolio. The ALLL is required to be sufficient to absorb the expected losses in the credit portfolio. Management requires ALLL to include an evaluation of historical losses within similar asset types and environmental adjustments. The ALLL is largely based on historical performance augmented by qualitative adjustments. The measurement factors are, therefore, largely based on losses that have already occurred.

The ALLL is management’s representation of risk measurement and coverage of the portfolio and not the bank auditor’s representation. This function is typically a credit function not directly under the duties and responsibilities of the chief financial officer. This distinction is important as it denotes ownership by a credit professional of the largest question mark associated with an investment or acquisition.

An investor views a robust ALLL methodology primarily as a reflection on management’s abilities and understanding of its portfolio, and will likely incorporate the bank’s methods and conclusions into a range of potential outcomes. To become more comfortable with management reports, investors deploying a third-party review will require comments based on the bank’s methodology to include the risk-rating system, impairment measurement techniques driving historical losses, management’s threshold for determination of “impairment,” and adjustments based on other qualitative factors. What follows is a loan-level confirmatory review of a significant sample of loans minimally segmented by loan type and risk rating.

The loan level analysis typically involves a re-underwriting of most credits or relationships and the collateral properties or business assets, if any, securing the loans. An instance where the collateral coverage is estimated to be insufficient to cover the indebtedness does not mean that a loss is going to occur in a like amount, but instead forms the basis for an estimate of loss should the loan default. Differences between the bank’s internal evaluation and an objective third-party reviewer’s evaluation can be expected and are primarily based on forward-looking assumptions.

For example, a commercial real estate loan secured by a property with a major tenant with a lease expiring between six and 18 months from the most recent bank risk-rating date may be identified by the bank as a pass-rated asset, creating a low probability of default. However, a third-party assessment conducted by credit advisers with banking and real estate expertise may view this as an asset with a more elevated probability of default.

Additionally, the objective assessment of the asset would take into consideration the likelihood that market lease rates may have changed (declined, for this example) since the current tenant’s agreement, which when adjusted, may result in significant deterioration of value and drive higher estimated probability of default and loss given default.

An additional example involves the evaluation of owner-occupied commercial real estate where the cash flows from the owner’s business forms the basis for carrying the real estate at lease rates, which may have been fit to original loan terms and may not reflect market value. On a default caused by the business’ failure, an investor may assume the lease rates would revert to market rates, which may be different at the time of default as compared to lease rates used at origination. Again, a forward-looking assumption, which would be tempered by an estimated probability that default may occur.

Also, different portfolio management assumptions used by various investors can have a significant impact on loan portfolio evaluations. As a result, the bank should evaluate the loan portfolio to include a range of outcomes reflective of these differing assumptions. For example, an investor or acquirer may require a liquidation analysis of the loan portfolio. Such assumptions drive steeper discounting and higher losses necessary to dispose of the loans over a shortened marketing period.

On the contrary, if an investor or acquirer is looking to hold and manage the loan portfolio using various usual and customary asset management tools, such as A/B notes, loan modifications and extensions, foreclosures and adequate exposure to marketplace for retail liquidation of collateral properties, all in the normal course of business, losses may be minimized resulting in higher values for the loan portfolio. This type of investor is usually well-capitalized, which allows him to manage through periods of risk-rating downgrades associated with routine credit decisions, troubled debt restructuring modifications and OREO management.

According to Kisting, the third-party assessments conducted in preparation of AmericanWest’s mergers and acquisitions were performed by a team that included both practical bank credit experience and reviewers with skill sets necessary to understand the nuances among the credit types in the target bank’s loan portfolio.

“Including a realistic, methodical portfolio management viewpoint rather than one based on liquidation provides a realistic estimated expected loss preserving value for the shareholders,” said Kisting.

Banks with a handle on their loan portfolios and appropriate ALLL should be commended and not be discouraged by various estimates of loss within the same portfolio produced by different investor methodologies. At the same time, banks should know drivers of the differences and should be prepared for discussions and negotiations, which will make a difference for the bank and its shareholders.

Jamey King is director of bank credit advisory services for Sabal Financial Group, which provides advice to investors, investment bankers and financial institutions based on credit-related due diligence services that range from policies and procedures review to ALLL analysis. Contact him at jamey.king(at)

Copyright (c) July 2012 by BankNews Media