A fundamental principle of commercial lending is that commercial loans will be appropriately collateralized. Collateral is an essential component of a commercial loan transaction to protect the credit union from a loss in the event of a borrower default.
While collateral is a key consideration for a credit decision, a credit union should make credit decisions based on the adequacy and reliability of a borrower’s primary source of repayment—the net earnings stream generated from a borrower’s business operations. As such, collateral is not the primary source of repayment. A credit union should not use collateral as the sole basis for granting a loan.
A credit union that grants commercial loans must require sufficient collateral to protect against the associated risk inherent in its commercial lending transactions as well as to ensure it shares risk with borrowers as appropriate (see NCUA regulation § 723.5).
Most commercial loans provide funding to a borrower to purchase an asset or to provide working capital that funds a borrower’s inventory or accounts receivable during the business cycle. At a minimum, a credit union should require a borrower to pledge the assets being financed as collateral. Additional collateral may be warranted if a borrower’s assets are less marketable or if a loan transaction or relationship has a higher degree of risk. A credit union will determine the amount of collateral needed based on the creditworthiness of a borrower and the marketability of the collateral being pledged.
It is important that collateral be marketable and that it can easily be converted to cash. Marketability is influenced by the age and condition of the collateral, as well as the alternative uses for the collateral. For depreciating assets, such as equipment or vehicles, newer collateral in good condition would warrant a relatively higher LTV ratio. In contrast, collateral that has limited alternative uses, such as single-purpose real estate or assets with limited useful life such as used equipment or vehicles, warrants a lower LTV ratio.
With respect to any type of collateral, LTV ratio is the aggregate amount of all sums borrowed and secured by that collateral, including outstanding balances plus any unfunded commitment or line of credit from another lender that is senior to the federally insured credit union’s lien position, divided by the current collateral value. The current collateral value must be established by prudent and accepted commercial lending practices and comply with all regulatory requirements. For a construction and development loan, the collateral value is the lesser of cost to complete or prospective market value. See the construction and development loan section for details.
The amortization of a loan should reflect the anticipated useful life of the collateral, which is determined by the type and expected use of the collateral. A credit union should also consider the volatility of the collateral’s value and quantities. Current assets—especially accounts receivable and inventory—are dynamic, and have market values that change, as well as regular fluctuations in quantity-on-hand. When assets with such dynamic characteristics are provided as collateral, a credit union should consider a lower LTV ratio to offset the potential volatility of the assets. When establishing LTV limits, a credit union should use a reasonableness standard and align its policies with prudent commercial lending practices.
Accounts receivable is the money owed to a business for merchandise or services bought on an open account. Accounts receivable arise from the business practice of providing a customer merchandise or a service with the expectation of receiving payment per specified terms. These terms are generally included on the seller’s invoice to the buyer, with no written evidence of debt executed between seller and buyer.
Collateral that is less marketable, less stable, and less valuable should be monitored more closely than highly marketable, stable, and valuable collateral. A credit union should establish a policy for monitoring collateral, including systems and processes to respond to changes in asset values. For example, real estate in good condition and in demand may be inspected less frequently than assets more susceptible to frequent changes in value and which require regular reporting and monitoring to ensure continued compliance with collateral requirements (examples include inventory or accounts receivables).
To effectively confirm, value, manage, and control collateral, a credit union should have standards, procedures, processes, and policies in place:
The level of environmental due diligence required for each type of collateral
Collateral valuation method for each type of collateral, and
Acceptable LTV for each type of collateral
A credit union must establish underwriting standards (§ 723.4(f)) that include LTV ratio limits, as well as a methodology for valuing all types of collateral authorized in the commercial lending policy. LTV limits should be established based on a credit union’s internal risk analysis and industry standards.
The NCUA regulations generally require all federally related commercial real estate transactions that have a transaction value of $1 million and greater to be appraised by a state-certified appraiser. See the NCUA regulations part 722, Appraisals, for more information. For commercial real estate transactions that are below $1 million, written estimates of market value (also referred to as evaluations) are required unless specifically exempt. Commercial real estate is defined as a real estate-related transaction that is not secured by a single 1-4 single-family residence. This includes transactions secured by traditional commercial real estate such as apartment buildings, office buildings, retail shopping centers, but can also include transactions that are secured by more than one 1-4 single-family residences. Additional guidance concerning appraisal and evaluation policies, procedures, and processes is provided in NCUA Letter to Credit Unions 10-CU-23, Best Practices in Real Estate Appraisals, and the 2010 Interagency Appraisal and Evaluation Guidelines.
Except for the exemption for existing extensions of credit, which require evaluations, the appraisal regulation specifically exempts six categories of transactions from appraisal and evaluation requirements:
Unless specifically exempt, commercial real estate-related financial transactions $1 million and greater must have appraisals that comply with NCUA regulation § 722.4, Minimum appraisal standards, which requires that appraisals:
Unless specifically exempt, evaluations are required for commercial real estate-related financial transactions below $1 million. In accordance with NCUA Letter to Credit Unions 10-CU-23, Best Practices in Real Estate Appraisals, evaluations must be conducted consistent with safe and sound lending practices and must address the following criteria:
The individual performing the evaluation must meet the criteria under § 722.3(d)(2), Requirements, which are:
For further information on evaluations, including criteria for using AVMs, please refer to the 2010 Interagency Appraisal and Evaluation Guidelines.
NCUA regulation § 723.4(f)(5) requires credit unions to establish internal LTV ratio limits, which should be based on internal risk management analysis and accepted financial institution industry standards.
Accepted industry and bank regulatory standards for LTV guidelines for real estate include:
LTV Ratio Guideline
Land development or improved lots
Construction - Commercial, non-owner occupied multifamily, and other nonresidential
Improved property- commercial, non-owner occupied multifamily, and other nonresidential
See Appendix A to Subpart D of Part 34, Interagency Guidelines for Real Estate Lending.
While the NCUA does not require credit unions to meet these guidelines, the agency views them as reasonable benchmarks. They reflect common industry practice, and are appropriate for the risk associated with the types of collateral identified.
When calculating the LTV ratio for an acquisition transaction, it is sound practice for a credit union to establish the collateral value to be the lesser of:
This helps ensure a borrower’s capital is invested in the project or asset, which distributes risk between a credit union and a borrower.
A credit union that approves loans with exceptions to LTV policy limits must do so subject to prudent internal limits and track, and monitor these loans.
Seasonal and permanent working capital loans are generally granted to provide a borrower with liquidity to fund an increase in working assets (usually accounts receivables and inventory as they fluctuate through the business cycle). Because these loans are secured by assets that have volatile values and quantities, a credit union should closely monitor changes in the assets and ensure the loan balance does not exceed the value of the collateral or assets funded.
Lenders typically use an established formula to limit the loan balance to a percentage of the collateral value to ensure adequate protection. The eligible loan balance determined by the formula is referred to as a borrowing base. The advance rate is the percentage the credit union will lend against the value of eligible collateral.
A borrowing base is a collateral base that a borrower and lender agree to. It is used to limit the amount of funds a lender will advance a borrower. The borrowing base specifies the maximum amount that can be borrowed in terms of collateral type, eligibility, and advance rates.
A credit union’s credit agreement should require a borrower to periodically (typically, monthly) submit a borrowing base certificate to ensure a borrower’s loan balance is maintained in accordance with the established collateral margin. A credit union should regularly monitor and confirm compliance with the borrowing base requirement.
When valuing accounts receivable, a credit union should consider a borrower’s credit and collection practices. The valuation is generally done by requiring a detailed accounts receivable aging report that provides the customer name, amount owed, and payment status of each account. Using this information, a credit union should adjust its advance rate based on the quality of the accounts receivables.1The quality of the accounts receivable is determined by whether it is within the agreed upon payments terms. The formula allowance should be based on the payment status with older accounts receivable past the due date discounted accordingly.
For example, it may be prudent for a credit union to exclude all receivables owed from a customer when a customer has past due outstanding receivables. It is critical that a credit union regularly review a borrower’s credit practices. Advance rates for account receivables vary depending on the nature of the receivables. While lenders usually advance amounts equal to 70-80 percent of eligible receivables, a heightened level of risk may warrant lower advance rates.
The quality of a borrower’s recordkeeping can have an impact on the value of the borrower’s inventory. The general practice when valuing inventory is to fund the actual cost, and to exclude soft costs (such as overhead and freight) that do not add value to the inventory. Lenders should understand and be comfortable with the costing (accounting) methods a borrower uses to establish the lendable inventory value. The collateral value of inventory should be based on the lesser of cost or liquidation value.
In addition to accounting and recordkeeping accuracy, a credit union should also conduct onsite visits or field audits to verify the quality of a borrower’s inventory control systems, as well as the quantity, quality, physical condition, and location of all inventory.
Inventory advance rates generally range between 50 and 65 percent, depending on product type and state of inventory (raw materials, work-in-process, finished goods). Site visits and field audits may detect obsolete inventory which should be excluded from eligible collateral.
All of a borrower’s accounts receivable and inventory balances should be used as collateral to secure a loan, while only eligible accounts receivable and inventory should be used in calculating the borrowing base.
Seasonal working capital loans support a borrower’s liquidity needs resulting from a seasonal increase in working assets. Such an increase is due to increased activity during a borrower’s operating cycle (how long it takes a business to purchase goods or raw materials, convert those goods to inventory, sell the inventory, and collect the accounts receivable).
As seasonal demands subside, working assets convert to cash through the sale of the inventory and collection of the receivable. As working assets convert to cash, a borrower will repay the seasonal line of credit. A credit union may require a 30 to 60 day “clean-up” period following the seasonal activity, during which a borrower is required to maintain the loan balance at zero.
Although repayment is generated from the conversion of assets, a borrower must also be creditworthy and able to meet all financial obligations. A credit union should perform a complete financial analysis of all borrowers.
Permanent working capital is core working assets that are not influenced by seasonal influences on a borrower’s operation.
Some credit unions also offer permanent working capital loans. These loans are higher risk, as they provide longer-term financing that is collateralized by volatile working assets. A credit union that offers this type of loan should have policies and procedures in place that ensure the loan relationship is closely monitored and that changes in risk are detected early.
Because permanent working capital loans sometimes replace equity, a credit union should only offer such a loan to financially stable and strong borrowers. Like seasonal working capital loans, the loan amount for the permanent working capital loan is determined based on an advance rate against the core working assets, the repayment of the loan however, is generated from the borrower’s profitability over a number of operating cycles. Repayment is generally in monthly installments over a period of years. Due to the volatility of the security, a credit union often obtains additional (more stable) collateral.
The OCC Handbook, Accounts Receivable and Inventory Financing, has more information about working capital lines of credit.
A term loan should be secured by the asset(s) it finances. This type of loan is usually secured by a lien on land, buildings, and equipment purchased by a borrower. If necessary, additional collateral can secure a term loan when there are marketability concerns surrounding the purchased item being funded from the loan proceeds or there is additional risk associated with the loan relationship.
When establishing collateral protection (assets and LTV ratio), a credit union should consider the:
Impact of technology obsolescence on marketability of the collateral
Alternative use of collateral
Marketability of the collateral
When establishing LTV limits, a credit union should consider the value of collateral as protection against borrower default.
The most accurate means of determining value for collateral securing term loans is to obtain an appraisal performed by a qualified appraiser. Acceptable methods for determining valuations for non-real estate collateral include published value guides, public auction sales, and dealer invoices. When using such alternative methods, it is best practice to validate the value by a number of these sources. An appraisal may be necessary if there is a higher level of risk associated with the transaction or the collateral is of a specialized nature and the sources referenced above are not available.
When dealing with collateral that has limited alternative uses, credit unions should reflect the additional liquidity risk in the LTV ratio. Properties with limited usage may warrant lower LTV ratios. For example, a chicken broiler barn may have little residual value if a poultry farm loses a processing contract. Commodity prices and land values are also highly correlated, especially in agricultural regions where farmland has no other use. Other examples of limited purpose collateral include, but are not limited to, car washes, bowling allies, hospitals, churches, and self-storage facilities.
A credit union should verify it has legal and practical access to the collateral in the event of default. If the collateral is located on premises that a borrower does not own, a landlord’s waiver may be necessary to gain access to the premises and take possession of the collateral. Keep in mind, collateral may be located in several locations making it more challenging to access in the event of liquidation. For example, collateral may be located in different states and be subject to different legal jurisdictions. A credit union should adjust its LTV ratio limit accordingly.
A blanket lien or assignment is an agreement that gives a lender a security interest in all assets owned by a borrower. Some lenders use the term as a catch-all security interest covering every anticipated type of asset owned by a borrower. To perfect a lender’s security interest in a borrower’s personal property, a lender must file a financing statement describing the collateral in all its locations. To perfect the lender’s security interest in all real or titled property, a lender must specify the assets in the appropriate documents and must file the documents in the proper jurisdiction.
When a credit union requires a blanket lien, the valuation of collateral can be determined by appraisals or an appropriate discount to the book value of the assets. A credit union must fully understand the makeup of the assets and obtain a list of the assets that will secure a loan. While a borrower can prepare the list for fixed assets, the depreciation schedule is often sufficient.
For working assets, a credit union should analyze the accounts receivable aging reports and inventory lists. The credit union should also visit the site and visually confirm the condition of the assets. The book value should be adjusted based on the due diligence performed by the lender. The different asset classes that make up the balance sheet of the borrower may warrant different LTV ratio allowances.
An intangible asset is an asset that is not physical in nature. Such assets generally include:
Not all intangible assets are appropriate as collateral, including assets that do not have value independent of the owing entity (for example, goodwill). Licensed intellectual property may not be transferable. There could be restrictions on contract rights for both registered intellectual property and intangibles such as non-compete agreements, long-term supplier contracts and franchise agreements. A credit union should carefully determine whether there are any express restrictions on its ability to secure and perfect an interest in any intangible asset pledged as collateral.
Enterprise value is an economic measure that reflects a business’ market value. It is a sum of claims by all claimants, including creditors (secured and unsecured) and shareholders (preferred and common). Enterprise value is also referred to as total enterprise value, firm value, or going concern value. The going concern premise assumes a business will continue operating indefinitely.
Consideration of enterprise value may be appropriate in the credit underwriting process, but not as collateral for a loan. Enterprise value is not appropriate for use in real estate transactions and is not appropriate as a secondary source of repayment for most other types of lending transactions. When a lender forecloses on collateral, it usually means other sources of repayment have failed. In such circumstances, the business has most likely failed and is no longer a “going concern.” Furthermore, going concern value is not property in which a credit union can perfect a security interest. Therefore, an appraisal based on going concern value would be inconsistent with established industry guidance.
Unsecured commercial lending presents additional risk to a lender, and should only be granted on an exception basis and in limited quantities. A credit union must only offer such loans if the additional risk of not benefiting from a secondary source of repayment, is adequately offset by appropriate risk mitigants and documented in loan file (see § 723.5(a)).
Examples of appropriate risk mitigants include:
Unsecured loans should be tracked, and the board and senior management should receive periodic reports on the volume of unsecured member business loans. For more information, see NCUA regulation § 723.4, Commercial loan policy. A credit union must establish prudent portfolio limits for these types of loans, measured in terms of the credit union’s net worth.
Last updated February 5, 2020