A bank’s highest pass risk rating (just before Special Mention) is often referred to in the industry as “Pass/Watch.” This is an extremely important risk rating and it’s crucial that the financial institution use it correctly.
At TGA, we are often asked which credits belong in this Pass/Watch risk rating. We have learned that the majority of the loans that are rated Pass/Watch fall into three main categories.
- Loans for which you do not have current financials and that are paying as agreed. Now, you don’t have to immediately move Pass credits to Pass/Watch once the extension periods for tax returns have passed. However, if the financials are two or more years old and the borrower is not responsive in providing them, then the loan should be moved to Pass/Watch. You simply do not know the current financial condition of the borrower to rate it otherwise. If you don’t have current financials and the loan is delinquent, you should risk rate it Special Mention or worse.
- Loans approved based on projections. These are typically startup companies and it is uncertain if they will be able to meet projections. In these cases, obtaining quarterly financial statements to ensure projections are being met is essential. Typically, a bank will not upgrade or downgrade these loans until a full fiscal year performance is available for review and the stabilization period has passed.
- Loans dependent upon the cash flow of the Guarantors. In these cases, the borrowing entity (or your collateral property if a loan is made to purchase an investment property) does not show sufficient cash flow to service the debt. However, the owner/guarantor has sufficient liquidity or excess income to support the loan. The loan is essentially dependent upon your secondary source of repayment. Our experience has been that these are the loans that owners/guarantors will divest of first during a rising rate environment or during an economic downturn.
Some banks place all new loans as Pass/Watch given their lack of performance. This is not a recommended practice as it can overstate the risk in your portfolio. The more dollars you have skewed towards the Pass/Watch risk rating, the riskier the portfolio. If you don’t accurately know the risk in the portfolio, then you can’t properly manage it or grow your portfolio in a safe and sound manner. We will address how to monitor this in future emails, or feel free to contact us to discuss.
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