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Stress Testing Participations

Stress Testing Participation Loans

Stress Testing ParticipationsOverview: Participation loans often have characteristics quite different from other loans in the portfolio, and therefor it is useful to be able to stress test those loans separately from others. A recent addition to the Madison Report library makes it easy to stress test participation loans separately from other loans in the portfolio.

There are many factors that make participation loans different from others in the portfolio. They are usually larger loans, participations purchased were originated by another lender and are typically serviced by that lender, and the underwriting standards applied to these loans may be more rigorous than others in the portfolio.

Consequently, when stress testing the portfolio it may be useful to exclude participation loans so that the other loans in the portfolio may be evaluated. Or it may be useful to exclude only participations purchased so that stress tests are applied only to loans that were originated by the client organization.

Finally, while participation loans may have been underwritten with more demanding criteria, they also tend to be larger loans, so that if a problem occurs, the consequences are more pronounced. That being the case, it is useful to be able to select only participation loans, or only participations purchased, or only participations sold and test those loans.

The ability to easily include or exclude participation loans from stress tests provides added value to stress test reporting.

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Portfolio Stress Testing

Portfolio Stress Testing

Portfolio Stress TestingOverview: Portfolio stress testing is important today because of the soft economy and because bank regulators are expecting lenders to be able to stress test their portfolios. We think that portfolio stress test should be able to assist in evaluating the impact that various changes will have on the quality of individual loans and the total portfolio.

Some of the parameters that should be stressed include:

  • Higher interest rates for floating rate loans and refinancing rates for fixed rate loans.
  • Cap rates for commercial real estate loans � changes in cap rates will affect valuations.
  • Collateral or business income
  • Collateral or business valuations

Users should also be able to specify the Default Conditions that give rise to losses and the cost to collect defaulted loans. Losses should reflect the value of all collateral for the loan.

Stress tests should apply conditions on a loan by loan basis, showing the results for each loan and for the total portfolio. Going from simple to complex, stress test results may include:

  • A simple ranking of loans by stressed Debt Service Coverage Ratios (DSCRs) and Loan to Value Ratios (LTVs)
  • Estimated changes to Loan Ratings
  • Estimated loan losses
  • Estimated changes in the Allowance for Losses on Loans and Leases (ALLL)

Stress tests conditions and parameters should be easy to apply to the portfolio and facilitate the ability to perform �what if� analysis, eventually ending up with parameter sets such as best case, expected case, and worst case.

Stress test can be applied to the portfolio as it stands right now, or by projecting scenarios into the future to see how conditions would change based on scenarios of future conditions. The time series analysis embodied in future projections can allow users to project forward recent trends to better understand their future consequences. But this analysis requires more data for the portfolio and more time developing and evaluating future scenarios.

Results also need to be in a format that supports presentations to senior management, directors and regulators. All assumptions should be noted on the document and other notes and analysis should be included as well.

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Keeping Regulators Happy

Keeping the Regulators Happy

Some may say that this is an impossibility, but we have some thoughts that will make it easier to comply with the Guidelines on Concentrations in Real Estate Lending (FIL-104-206) and other banking regulations. As qualifying commercial real estate loans exceed 300% of capital, or construction loans exceed 100% of capital, banks become subject to increased regulatory attention to their commercial real estate loan portfolios and are expected to implement heightened risk management practices.

Here are four items that we think will go a long way toward better risk management of the portfolio and may even make your regulators happy.

  1. STRESS TEST THE PORTFOLIO. Be able to quickly and efficiently stress test the entire portfolio to identify loans that may be weak under the stressed conditions. These loans can then receive closer scrutiny, and might be placed on the watch list if appropriate. Factors to stress would include collateral value, collateral income, loan rate, and cap rates.
  2. BOARD AND MANAGEMENT REPORTING.  The ability to easily provide Management and the Board with comprehensive reports on the current quality of the portfolio and current trends is key. The reports should focus on credit quality issues such as delinquency status, non-performing loans, adversely rated loans, reserve levels, the distribution of loans by loan rating, among other items.  Reports should include hard data and a graphic display as well. Management should be able to look at real time reports, and review sets of reports at periodic review meetings.
  3. SLICE AND DICE THE PORTFOLIO. While it is important to have a standard set of reports that can be produced quickly and efficiently, standard reports will never be able to reflect subtle changes in the portfolio or address all issues. So it is important to be able to easily and quickly create variations of reports that group data as needed with appropriate group totals and averages, sort data in a meaningful manner, and filter portfolio data so that reports focus on sub-sets of loans that are of special importance.
  4. MAINTAIN CURRENT DATA.  One of the more difficult issues is to maintain current information for borrower financial statements and tax returns, collateral valuations and operating statements,  UCCs, insurance policies, loan ratings, etc. Reports that display “old” or out dated information are important especially if it can identify situations where a lot of information for a single loan is out of date. An effective, flexible and easy to use Tickler System is also an important tool to ensure that data is kept up to date.

A good commercial loan system should be able to provide all of these features and much more. If you would like to see how the Madison System addresses these issues, give us a call to schedule an online demonstration.