Select a sample of loans to be reviewed. The sample should be adequate to assess compliance with policies, procedures, applicable bank and regulatory guidance documents, and regulations; verify the accuracy of internal risk ratings; and determine the quantity of credit risk. The sample should also be used to test changes in underwriting, including borrowing base changes, and loans with over-advances. Refer to the “Sampling Methodology” booklet of the Comptroller’s Handbook for guidance on sampling techniques.

Prepare line sheets for sampled credits. Line sheets should contain sufficient information to determine the credit rating and support any criticisms of underwriting, servicing, or credit administration practices.

Obtain credit files for all borrowers in the sample and document line sheets with sufficient information regarding quality, risk rating, or both. Assess how the credit risk posed by the financial condition of the borrower will affect individual loans and the portfolio. In your analysis

• Determine the disposition of loans classified or rated special mention during the previous examination.

• Complete a thorough financial analysis of the borrower. Keep in mind that the primary focus with leveraged lending borrowers should be on analyzing recurring capacity of cash flow to provide repayment capacity.

• Determine whether the borrower complies with the loan agreement, including financial covenants and borrowing base requirements.

• Evaluate the effect of external factors, such as economic conditions and the industry life cycle, upon the borrower’s ability to repay

• Determine, for any seasonal operating advances or lines of credit, whether the trade cycle supports clean-up (complete payout) of that portion of the debt structure by the end of the normal business cycle.

• Review any term loans and revolving lines of credit used to support permanent working capital to determine whether cash flow provides sufficient capacity for debt service. Consider

  • A realistic repayment program when contractual debt service is back loaded and not coincident with expected increases in cash flow or asset value

  • Working capital changes and needs.

  • Discretionary and nondiscretionary capital expenditures, product development expenses, and payments to shareholders.

  • The level of other fixed payments and maintenance expenses.

  • Reasonableness of operating projections based upon past performances and strategic initiatives of the borrower

• Assess the borrower’s access to capital markets or other sources of funds for potential support.

• Evaluate the loan agreement to determine

  • Whether the loan structure is consistent with the borrower’s needs.

  • What collateral secures the loans and the accuracy of collateral descriptions, documentation and lien positions.

  • Advance rates against collateral and LTV constraints.

  • Level and reasonableness of financial covenants and triggers.

• Determine compliance with the above requirements of the loan agreement. If the borrower is not in compliance, determine the root cause, and assess the impact on credit quality.

For the loans in the sample, assess the quality of the collateral support by

• Reviewing quality and quantity of tangible support provided.

• Reviewing independence and integrity of collateral valuation and methodology.

• Determining reliance on “enterprise value.”

Review the frequency, quality, and independence of the bank’s estimate of the company’s “enterprise valuation.” Consider

• Competency and independence of individuals performing evaluations.

• Methodologies utilized.

• Reasonableness of assumptions supporting projections.

• Transparency of supporting documentation.

Analyze any secondary support provided by guarantors, financial sponsors, and endorsers. If the underlying financial condition of the borrower warrants concern, determine the guarantor’s, sponsor’s, or endorser’s capacity and willingness to repay the credit.

Assess credit risk posed by the obligor’s management team (specifically, by weaknesses in the team’s quality, integrity, or ability to manage current operations and future growth) by determining whether

• The bank’s internal analysis adequately addresses the ongoing quality, integrity, and depth of the borrower’s management.

• The bank has mitigated some of this risk by requiring key executives of the borrower to obtain sufficient life insurance policies payable directly to the bank, has loan covenants in place allowing the bank to reassess the borrowing relationship in the event of the loss of a key executive, or both.

Identify, document, and compile any policy, underwriting, and pricing exceptions in the loans sampled. If exceptions are not being accurately identified and reported, determine the cause and discuss with management. If warranted, commentary or schedules can be included in the report of examination.

Using a list of nonaccruing loans, test loan accrual records to determine that interest income is not being recorded.

Assign risk ratings to sampled credits. See “Classification Guidelines of Troubled Leveraged Loans” in this booklet’s introduction for guidance.

Review any changes to the leveraged lending policy and syndication procedures. Determine the effect on the quantity of risk.

Review the current underwriting guidelines or practices, and results of policy exceptions data gathered in Objective 1, Question 8. Assess how changes since the previous examination may affect the quantity of risk. This should be done in conjunction with the sample of leveraged loans reviewed. Consider changes to

• Advance rates.

• Collateral eligibility.

• Level of enterprise value reliance.

• The number and types of covenants.

• Repayment terms and maturities.

• Financial reporting requirements.

Determine whether changes in processes have affected the level of risk in the portfolio. For example, if the frequency, independence, or methodology of performing enterprise valuations has been changed, determine how the change will affect credit risk.

Analyze the level, composition, and trend of leveraged underwriting exceptions. If this information is not available from the bank’s MIS, develop it using the sample of loans taken during the examination. Determine whether the underwriting exceptions are increasing the level of risk within the portfolio or whether the exceptions are being properly mitigated.

If quantitative factors, such as delinquency, nonaccrual, adversely rated, average or weighted average risk ratings have increased, try to determine any correlation with changes in underwriting policy or practice.

Evaluate how the leveraged lending strategic plan may affect credit risk, including the risk associated with rapid growth, geographic expansion, new or increased focus on borrowers in industries to which the unit had limited or no prior exposure, new financial sponsors, etc.

Review the business or strategic plan for leveraged lending. Evaluate how implementation of the plan will affect the quantity of credit risk. Consider

• Growth goals and potential sources of new loans.

• Growth outside the current market area.

• New financial sponsors and industries.

• Concentrations of credit.

• Management’s expertise, history, and experience with the plan’s products and target markets.

• Volume and nature of syndication.

Analyze the composition of, and changes to, the leveraged lending portfolio, including off-balance-sheet exposure, since the previous examination. Determine the implications for the quantity of risk of the following:

• Any significant growth.

• Material changes in the portfolio to include

  • Changes and trends in watch, problem, special mention, classified, past due, nonaccrual, and nonperforming assets; charge-off volumes; and risk rating distribution.

  • Loans with over-advances.

  • Any significant concentrations, including geographic, industry, and sponsor concentrations.

Review the portfolio to determine whether there has been any shift in the sponsor or customer base that could increase risk. Such shifts might be to sponsors or industries with which the bank has limited experience or that possess more volatile earnings streams.

Analyze portfolio risk assessments of leveraged lending that management prepared. Determine whether management’s risk assessments are supported by the examiners’ analysis of the loan sample.

Review the local, regional, and national economic trends, and assess their impact on leveraged lending portfolio risk levels. Consider whether management has reasonably factored this data into projections of loan growth and quality.

Compare leveraged lending portfolio performance with planned performance and ascertains the risk implications.

If the bank employs concentration management tools (e.g., portfolio limits, loan sales, derivatives) to control credit exposures, analyze the impact on the quantity of risk. Consider

• The objectives of these programs.

• Management’s experience and expertise with these tools.

Review recent loan reviews of leveraged lending and any related audit reports. If there are any adverse trends in quantitative measures of risk or control weaknesses reported, comment on whether and how much they may increase credit risk.

Analyze the level, composition, and trend of documentation exceptions and determine the potential risk implications.

Determine the extent of direct and indirect equity investments by bank affiliates; assess the nature and level of potential conflicts of interest.

Analyze the extent of syndication activities regarding leveraged loans underwritten by the bank. Assess the age, nature, and level of pipeline exposure.

From your portfolio and transactional reviews, discussions with bank management, policy statements or other sources, ascertain transactions that contain characteristics of complex structure finance transactions that require further review. Consider:

• Transactions with questionable economic substance or business purpose or designed primarily to exploit accounting, regulatory or tax guidelines, particularly when executed at year end or at the end of a reporting period.

• Transactions that require an equity capital commitment from the financial institution.

• Transactions with terms inconsistent with market norms (e.g., deep ”in the money” options, nonstandard settlement dates, non-standard forward-rate rolls).

• Transactions using non-standard legal agreements (e.g., customer insists on using its own documents that deviate from market norms).

• Transactions involving multiple obligors or otherwise lacking transparency (e.g., use of special purpose vehicles (SPVs) or limited partnerships).

• Transactions with unusual profits or losses or transactions that give rise to compensation that appear disproportionate to the services provided or to the risk assumed by the institution.

• Transactions that raise concerns about how the client will report or disclose the transaction (e.g., derivatives with a funding component, restructuring trades with mark to market losses).

• Transactions with unusually short time horizons or potentially circular transfers of risk (either between the financial institution and customer or between the customer and other related parties).

• Transactions with oral or undocumented agreements, which, if documented, could have material legal, reputation, financial accounting, financial disclosure, or tax implications.

• Transactions that cross multiple geographic or regulatory jurisdictions, making processing and oversight difficult.

• Transactions that cannot be processed via established operations systems.

• Transactions with significant leverage.

In conjunction with the review of the adequacy of bank’s allowance for loan and lease losses account, determine the appropriateness of methodology relative to the level of risk assessed for the leveraged lending portfolio. Provide synopsis of results to the examiner reviewing the bank’s ALLL.

Evaluate the level of compliance with the guidance listed on the “References” page of this booklet. Relate the level of compliance to the quantity of credit risk. Test for compliance as necessary.

If violations or instances of noncompliance are noted, determine whether management has taken adequate and timely corrective action.