Stress Testing the Loan Portfolio

Mike Lubansky, Director of Consulting Services

Sageworks
The Leader in the Financial Analysis of Privately Held Companies
O - (919) 851-7474 | F - (919) 851-6718
info@sageworks.com
www.sageworks.com
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About Sageworks & Our Speaker

 Financial information company that provides credit and risk management

solutions to financial institutions

 Data and applications used by thousands of financial institutions and

accounting firms across North America

 Mike Lubansky
 Mike is a director of consulting services at Sageworks, where he oversees
product development and implementation in the financial institutions market. He
serves as the in-house stress testing expert at Sageworks and has been a
featured speaker for audiences of both financial institutions and regulatory
agencies on matters pertaining to the banking industry. Most recently, he spoke
before federal examiners at the FFIEC, on the subject of stress testing
approaches and challenges.
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Agenda

1. About Sageworks and Our Speaker

2. Poll
3. Regulatory Requirements: Who, What and When
4. Stress Testing Objective
5. Why Stress Testing’s Important
6. Types of Community Bank Stress Testing
7. Biggest Challenge: Data
8. Scenario Selection
9. Maximizing Value of Reports
10. Sample Stress Tests
11. Common Mistakes
12. Q & A
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Quick Polls
1. Types of Stress Testing Performed
2. Obstacles to Stress Testing
Regulatory Update: Who, What and When

 2006 Interagency Guidance on CRE Concentrations

 Banks with 100% of total capital in construction, development and land-related
loans

 Banks with CRE representing 300% of risk-based capital.

 Primarily “bottom up” analysis

 2009 CCAR
 Requirements for 19 largest U.S. banks

 “Top down” annual analysis

 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act

 Banks >$10 billion in assets

 “Top down” annual analysis like under CCAR

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Regulatory Update: Who, What and When

 2011 OCC Comptroller’s Handbook “Concentrations of Credit”

 “Banks of all sizes will benefit by supplementing stress testing of significant
individual loans with portfolio and firm-wide stress testing”

 Prescribes “top down” and “bottom up” analyses

 2012 Interagency Expectations for Stress Testing by Community Banks

 Recommends some type of sensitivity analysis to assess potential impact of adverse
outcomes on the bank’s finances

 Prescribes “top down” and “bottom up” analyses

 2012 FDIC “Stress Testing Credit Risk at Community Banks”

 Defines stress testing for community banks and provides example methodology

 2012 OCC “Community Bank Stress Testing: Supervisory Guidance”

 Recommends at least top down stress testing for banks <$10 billion in assets

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Stress Testing Objective

 Thesis from Regulatory Bodies:

Every bank should stress test their loan portfolio.

 Objective?
 Assess risk by loan and concentration

 Evaluate impact of policy changes in the bank

 Assess needs for the allowance and capital adequacy

 How much?
 Determined by size, complexity of a bank’s loan portfolio and risk appetite

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Why Stress Testing’s Important

 Best practice for banks that

demonstrates proactive and progressive
improvement

 Identify pockets of portfolio that are

vulnerable to a variety of outside factors:
e.g. changes in short term interest rates
or deteriorating real estate market
conditions

 Recognize overexposures in
concentrations, geographies, industries
or types of real estate

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Why Stress Testing’s Important

 Increase banks’ ability to mitigate risk by targeting potentially problematic

loans for additional scrutiny, such as more frequent rent-roll reviews or
owner-income updates

 Provide bank management with clues on how to amend credit policies,

pricing or business strategy based on desired risk profile

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 Why Stress Testing’s Important

ALLL Provisions

Capital Adequacy

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Types of Community Bank Stress Testing

 Borrower/ Relationship Sensitivity Analysis

 Bottom Up Scenario Analysis

 Loan Migration Analysis

 Reverse Stress Testing

 Enterprise Level Stress Testing

 Stressed Loss Rates (Simple Capital Stress Test)

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Typical Bank: Disconnected Systems

Current Appraisal
Values
Rent Rolls

Core Processing
System

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Biggest Challenge: Data

 Accumulate and examine data for largest real estate exposures or the
segment with higher dollar/ higher risk—should be the first priority

 Develop a process for accumulating the necessary data on ongoing basis

and account for different data sources
 Help identify data weaknesses within the institution for that and other segments

 Expand stress testing coverage to include other portfolio segments over time

 Review processes over time to ensure the right data is included

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Sample Portfolio Analysis, Coverage

 334 Loans in sample as of 1/31/2012

 54% of Pass-rated CRE, Multifamily

& Construction

 C&I loans with real estate collateral

treated as CRE

 Includes loans reviewed between

12/2010 and 3/2012

 Coverage increases every quarter

 Income properties (263 loans, 84%

of exposure):
 174 Multifamily (53% of exposure)

 38 Retail (11%)

 17 Industrial (10%)

 34 Office & Other (9%)

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Bottom Up Stress Test: Identify concentrations

High risk
concentration

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Examples of Data Elements Needed

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Bottom Up Stress Test: Determine Scenarios

Determine Scenario

 Scenarios range from

moderate to severe
 Use current market data or
bank’s historical data to
validate scenario variables
 Combine scenarios to
evaluate total exposure in
some cases
 Larger institutions can use
loan migration analysis

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Bottom Up Stress Test: Results

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Estimate Rating Migration

 Loan-by-loan post-stress DSCR and LTV used to estimate potential

migration to criticized and classified ratings

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Rating Migration Change based on NOI Stress

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Interest Rate Sensitivity: Potential Grade Migration

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Selected Peer Comparisons

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Sample Top Down Approach

 “For most community banks, a simple stressed loss-rate analysis based on

call report categories may provide an acceptable foundation to determine if
additional analysis is necessary.”
 OCC Supervisory Guidance– Community Bank Stress Testing– 10/18/2012

 Segment the portfolio into pools with similar risk characteristics

 Develop “stressed” loss rates for each segment; consider:

 Bank’s historical loss rates over several stress periods

 Peer/ market loss rates over several stress periods

 Results of any “bottom up” stress testing

 Calculate Stress Period Loss amounts (2 year timeframe)

 Estimate Earnings impact, apply to Tier 1 Capital ratios

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 FDIC Supervisory Insights Example
1. Estimate Portfolio Losses Over the Stress-Test Horizon
Stress Period Loss Rates, Two Yrs Stress Period Losses, Two Yrs

Est. Portfolio Moderate Case Severe Case Moderate Case Severe Case
Balances, in $ Stress Stress Stress, in $ Stress, in $

Construction & Development 124 14.0% 25.0% 17 31

Commercial Real Estate 22 2.5% 5.0% 1 1
Residential Mortgage 372 2.9% 6.5% 11 24
Other Loans 125 5.0% 10.0% 6 13
Totals 643 35 69
2. Estimate Revenues and Impact of Stress on Earnings
Moderate Case Severe Case
Stress, in $ Stress, in $
Pre-provision net revenue (over two years) 31 25
Less Provisions 35 69
Less Tax Expense (Benefit) -1 -13
Net After-Tax Income -3 -31
3. Estimate Impact of Stress on Capital
Moderate Case Severe Case
Stress, in $ Stress, in $
Beginning Tier 1 Capital 88 88
Net Change in Tier 1 Capital -3 -31
Ending Tier 1 Capital 85 57
Estimated Average Assets 850 816
Estimated Tier 1 Leverage Ratio 10% 7%
One Bank’s Approach: Top Down Stress

 “Base Case” is calibrated to the latest default and loss data (December 2012)

 “Q1-2010: Severe Recession” is the stress scenario replicating Bank’s default and
loss experience from April 2009 to March 2010. This was the longest (18 months)
and deepest recession since the Great Depression. During the period:
 National Unemployment Rate peaked ~10%

 Home Prices decreased 30% peak to trough

 Bank had the highest level of nonaccrual/delinquent loans at March 2010

 Bank recorded $108 million in realized losses

CDR Severity
Mar-10 Dec-12 Mar-10 Dec-12
Commercial Loans 12.4% 9.5% 52% 37%
Commercial Real Estate 6.5% 1.8% 44% 26%
Community Association 1.3% 4.6% 47% 37%
Cooperative Real Estate 3.3% 0.8% 49% 40%
Share /Single Family
(Consumer) 4.8% 3.1% 51% 44%
5.7% 4.0% 48% 37%
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Portfolio Stress Losses: Results Overview

($000) Base Severe Recession

Cumulative Annual Cumulative Annual
UPB Loss Loss Loss Loss
Commercial 809,588 (76,911) (28,457) (100,389) (52,202)
CRE 641,869 (11,554) (3,004) (41,721) (18,357)
CMA 138,431 (6,368) (2,356) (1,800) (846)
Coop 780,096 (6,241) (2,496) (25,743) (12,614)
Consumer 1,195,513 (37,061) (16,307) (57,385) (29,266)
3,565,498 (138,134) (52,620) (227,038) (113,286)

Bank’s reality check of the above summary:

Approximates Bank’s Loan Loss Approximates the $108 million of

Allowance at Dec 2012 of $52.6 losses experienced during the
million. (Including FAS 114 and FAS 5 period April 2009 through March
Allowances). 2010. The “high-water” mark of
Bank’s losses during the Great
Recession.
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Sample Segment Top Down Stress Setup
Commercial Real Estate
I. Scenario Parameters
No Default Base Q1-2010
CDR 0.00% 1.20% 6.00%
Loss Severity 0% 25% 42%
Recovery Lag (Months) 24 24 24
Prepay Multiplier 100% 100% 100%
II. Fair Value & WAL
Fair Value 210,486,568 208,850,747 199,027,155
UPB 214,165,722 214,165,722 214,165,722
Price 98.3 97.5 92.9
WAL 2.5 2.4 2.1
III. Projected Losses
Cumulative ($) $ - (1,635,822) (11,459,413)
Cumulative (%) 0.00% -0.80% -5.40%
Annual Loss ($) $ - (678,439) (5,386,358)
Annual Loss (%) 0.00% -0.30% -2.50%
+ Qualitative Adj. 0.00% 0.00% 0.00%
Adj. Annual Loss (%) 0.00% -0.30% -2.50%
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Other Types of Stress Testing

 Loan Migration Analysis

 Looking at how loans migrate under stressed scenarios and how it would impact
asset quality and capital

 Reverse Stress Testing

 Running various stress tests to determine a “break point” that would cause the
bank’s capital levels to fall below satisfactory levels

 “Enterprise Level” Stress Testing

 Combining results from the various credit risk stresses with results from interest
rate risk and liquidity risk stress tests

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Is the Bank Getting the Most from the Process?

 Aside from organizing the different data sources, banks should identify the
best, most useful types of reports
 What loans/borrowers are struggling? What industries are struggling? Is the bank
stressing these industries to predict future issues?

 Frequency of running the reports and sharing results with board

 Can the bank demonstrate what kind of potential losses it might have if a
certain stress occurred? How would that stress affect earnings/ capital?

 Verify accuracy, timeliness of the data used for the stress testing

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Quick Polls
1. Stress testing solution from Sageworks
2. Stress testing resources from Sageworks
Questions?
Mike Lubansky
866.603.7029 ext. 651
Mike.Lubansky@sageworks.com

Additional whitepapers and archived webinars available at www.sageworksanalyst.com.

Featured whitepaper – Stress Testing: The Who, What, When and Why
Featured resource – Stress Testing Template by Sageworks
Selected References

 FDIC Supervisory Insights 2012

 OCC Community Bank Stress Testing, October 2012

 CEIS Review Methodology for Stress Testing; Peer Stress Results

 Sample bank’s Top Down Stress Test

 Sageworks Clarity Stress testing sample data and results

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