We review hundreds of credit memorandums every month from a wide variety of community banks across the country. Generally, the credit memos are carefully considered, well planned and appropriately formatted. We read memos from banks ranging in asset size from $100mm to over $10B and loans ranging from $250k up to just over $50mm. We look at memos for annual reviews and submission for new CRE and C&I loans. While most bankers are skilled and proficient at formatting and arranging the layout of the credit memo, we would like to share our top recommendations for bankers for drafting better credit memos. These recommendations are not related to underwriting or credit analysis, but rather on the general content, style, and layout of the effective credit memo.
Ten Tips to Better Credit Memos
Risks Upfront: The overarching objective of the credit memo is to outline the pertinent risks of the loan and identify the mitigating factors to those risks. Every loan has some risks, and some loans have more risks than others. However, credit adjudicators (executive management, loan committees and board of directors) do not want to see ten main risks. The drafter’s job is to identify 3 to 5 main risks and then identify and explain fully those risks and the mitigation to those risks. We sometimes see memos with a laundry list of risks, but a drafter’s job is to identify the pertinent risks for that credit. Further, risks that affect all credits need not be mentioned. A recession will impact every borrower’s ability to repay the loan. Therefore, it is not a pertinent risk of a specific loan. Good credit memos will identify the top three to five risks and then show how each risk is protected or mitigated in the structure, pricing, cash flow, collateral or other support.
Persuasive: The main theme in a credit memo should be objective persuasion. The writer of the credit memo should be persuading the reader to approve the credit; however, the credit memo must lay out the pros and cons of the loan fitting the bank’s credit framework. In other words, a credit memo is an opportunity for a lender to be an advocate for the borrower using objective analysis and logical reasoning. Advocacy loses its persuasion if the analysis is based on feelings, is biased, or is simplistic. The credit memo should serve to persuade while acknowledging that every loan has risks. In a similar vein, we have run sentiment analysis on a variety of credit memos and have presented our analysis HERE. It turns out that the average bank uses about 5% more positive words than negative which is probably right about where you want to be.
Be Consistent: There are many good credit memo layouts (there are also some poor layouts). Once a bank adopts its internal format, resist the urge to change the format unless necessary. We see different formats and outlines from the same bank (drafted by different bankers at that bank). Changing formats confuses readers, who can no longer rely on context to find certain information within the credit memo. Board members and bank executives have little time to review the credit memo, maintaining a uniform format makes it easy to find information quickly. How much easier does it make it to have a consistent format? Our internal analysis shows that altering format takes an additional 20 minutes of review time per loan and presumably decreases analytical accuracy. That may not sound like much, but this additional time can add up over the course of a year.
Reduce the Narrative: Speaking of time, remember that the reader of the credit memo is strapped for time. The writing should address the readers’ objective of finding information easily and clearly. Using bullet points, boxes, subject headings and underscoring the important elements should be the drafter’s objective. Use more verbs and avoid passive language. If the loan is to be presented orally, recognize that most loan committees spend on average of three to ten minutes discussing a loan. Make it easy for each loan committee member to find the right information to help support the case for the loan during that oral discussion.
Centralize Underwriting: We see some credit memos prepared by lenders and some prepared by credit staff (credit analysts or portfolio managers). We see the pros and cons for each group preparing the credit memo. The biggest advantage of lenders preparing the memo is that the lender typically knows the borrower and the deal better than anyone else at the bank, and by preparing the credit memo the lender is honing a valuable credit skill. However, we are proponents of credit staff preparing the memo for a few reasons. First, on average we see credit staff with better analytical and drafting skills. Second, credit staff tends to draft more uniform analysis, and that helps loan committee make better choices in allocating the bank’s capital to the best loans. Third, credit staff is typically more objective in their analysis. Fourth, credit staff gains valuable experience in dealing more closely with lenders and interacting with borrowers in the preparation of the credit. Finally, freeing the loan officer from underwriting duties gets them more time in front of customers and potential customers which are presumably their highest and best use.
Cash Flow Analysis: For investor real estate properties, the credit memo should show the cash flow analysis, both historical and projected with downside scenario (both NOI and interest rate stress test). Equally important is the presentation of lease schedule summary. We find it odd that many credit memos leave this out. Lease structure and credit is central to determining cash flow stability. Every write up needs to explain the terms, price, renewal options, credit strength of the leases and material covenants such as co-tenancy clauses.
A Simple Format: While there are many formats that work for credit memos, the basic one that we like that follows the summary is as follows:
- Section 1 – Contact and relationship information
- Section 2 – Loan request (terms, conditions, pricing, ROE calculation)
- Section 3 – Credit Analysis – this includes cash flow, collateral, recourse strength, key ratios, trend analysis, and, most importantly, management analysis. Most banks spend more time on management analysis, and most loan committees value management analysis over financial analysis. Especially for smaller deals, and for those loans secured by real estate collateral and amortizing structures, management analysis is a very important part of the credit memo. The drafter should explain why the management of the borrower is key in risk mitigation.
- Section 4 – Risk assessment and mitigation of risk
- Section 5 – Appendix and supporting materials to include credit stress runs, cash flow modeling, current news and third-party reports (Paynet, credit rating reports, etc.)
Granular Credit Grades: One of our biggest concerns with community bank underwriting (and we have written about it extensively, most recently HERE) is the lack of granularity on credit grades. Most banks use eight to ten loan grades; only four to six are pass grades, and the vast majority of the approved loans fall into just two credit grades. It is difficult to make prudent pricing decisions if management cannot ordinal rank loans across a wider spectrum. One way to help alleviate this problem is to add “+” and “-“ to each loan grade thereby tripling the number of grades. This method does not need to be implemented across all functions within the bank, but simply using a + or – next to the grade in the credit memo can better help differentiate loans and make better pricing decisions. The credit memo is a perfect place for bankers to start increasing the stratification of loan quality.
Length: The length of the presentations that we see ranges from just a few pages (the shortest full credit memo that we have seen is just two pages) to over 30 pages. We are fans of shorter presentations and believe that the average community bank credit can be presented fully and completely in five to ten standard pages (appendices and schedules not included). We do not believe that the vast majority of community bank loans require more than ten pages to explain the credit and analyze the risk.
Use an Appendix for Support: If you need to include financial data for cash flow, collateral coverage or stress testing, add that to the appendix and clearly label it. By adding financial spreads and modeling to the appendix, you give the first level reviewer full access to information, but spare your board members from having to review the minutia. Few board members will review the appendix, but the five to ten pages of the memo is all they need to make an informed decision.
While there isn’t just one good format or style for a credit memo, we do see ample ways for bankers to enhance their drafting of the credit memo. Better style, format and planning can help bankers hone their skills and draft a more compelling and effective credit memo. If done correctly the result is faster production, quicker review times and more accurate analysis – a worthy goal if there ever was one.
Submitted by Chris Nichols on June 06, 2017