Structural Weaknesses of Loan Underwriting

4/29/2010

By Daniel R. McDonald

When underwriting a loan, one is bound to run into weaknesses. There are many types of weaknesses out there, but this article focuses on structural weakness associated with underwriting credits. A small degree of structural weakness may be found in virtually all credits. The presence of multiple structural weaknesses may bring increased scrutiny to a credit by your regulator. Lenders should analyze the overall state of a borrower’s industry, financial condition and banking relationship to determine structural weaknesses.

Examiners look at, but do not limit their search to, the following structural weaknesses:

• Indefinite Purposes: When underwriting a loan the purpose should explicitly state for how the proceeds will be used. Loans with ambiguous purposes will garner extra regulatory scrutiny.
• Liberal Repayment Terms: A loan without a clear and reasonable repayment program presents extra risk. Maturities should relate to a repayment horizon, stale lines of credit should be amortized and loans should never be rewritten to postpone maturity. Additionally, loans should not be advanced to fund interest and maturities should match useful asset lives.
• Weak Covenants: Loan covenants are an important aspect of providing proactive relationship management. Covenants should not be waived or rewritten due to a borrower’s inability to maintain the original standards of the loan.
• Poor Financial Performance and Analysis: Financial performance and analysis is paramount in underwriting credits. Companies need sufficient cash flow with an acceptable cushion. Tangible net worth should be present to provide for a cushion for unforeseen circumstances. Ratio analysis is also another valuable tool in understanding the financial position of a credit.
• Insufficient Collateral Analysis: Collateral documentation is very important. Loan officers need to make sure liens are attached and perfected, collateral margins are sufficient to provide a cushion in the case of collection, and advance rates should reflect the useful life of the collateral pledged.
• Inadequate Guarantor Support: Loan officers should analyze guarantor support in the context of actual expectations of the guarantor. One should ask if the guarantor can and will be able to support the debt in the event that the borrowing entity cannot repay.

Actively searching for structural weaknesses in underwriting only helps to maintain the financial health of your bank and is a prudent lending practice. For more information please see the Office of the Comptroller of the Currency Comptroller’s Handbook.