SNC Review Results: Non-Pass Originations at De Minimis Levels, but Oil and Gas Loans and Incremental Facilities Raise Concerns With Regulators

On Aug. 2, 2017, the Board of Governors of the Federal Reserve System (the Federal Reserve), the Federal Deposit Insurance Corporation (the FDIC) and the Office of the Comptroller of the Currency (the OCC, and together with the Federal Reserve and the FDIC, the Regulators) released the results of the most recent Shared National Credit (SNC) Program Review, the process by which the Regulators assess credit risk and trends and risk management practices with respect to the largest and most complex credits (loans of at least $20 million) shared by multiple (at least three) US regulated banks.

SNC Program reviews are conducted on a semiannual basis during the first and third calendar quarters (with some banks receiving two examinations per year and others continuing to receive only a single examination). The review released on Aug. 2 relates to the reviews during the third quarter of 2016 and first quarter of 2017.

The highlights of the SNC Program Review include findings by the Regulators that:

• Non-pass originations have declined to de minimis levels.
• While adversely risk rated commitments have declined slightly, an increase in adversely rated oil and gas credits has offset the improvement.
• Weaknesses in underwriting persist, particularly incremental facilities that permit additional first lien debt that can be used for any purpose, including dividend payments.

The ratio of adversely risk rated commitments to total commitments has declined from 10.3% to 9.7% year-over-year. In addition, the ratio of adversely risk rated commitments to total commitments excluding oil and gas has declined significantly, from 11.1% in 2014 to 8.1% for the current review period. The Regulators attributed this decline to improvements in underwriting and risk management practices consistent with the 2013 interagency leveraged lending guidance. Leveraged loans comprised 64.9%, of all adversely risk rated commitments. As a result of underwriting improvements, non-pass loan originations remain at a de minimis level. By comparison, in 2014, the Regulators identified more than 90 non-pass originations. During the 2014 review, the Regulators found that 42% of newly originated leveraged loans had leverage levels of 6.0x or greater; in the current period, only 30% of newly originated leveraged loans were at this level.

Adversely risk rated oil and gas credits have increased year-over-year due to continued reduction in revenue and strained liquidity, exacerbated by exploration and production companies with high leverage, primarily a result of debt-funded acquisitions during previous drilling expansion. Those credits are predominantly held by regulated entities, as opposed to non-oil and gas adversely risk rated credits which are predominantly held by non-banks.

The Regulators also noted that since the issuance of the 2013 interagency leveraged lending guidance and the subsequent “Frequently Asked Questions (FAQ) for Implementing March 2013 Interagency Guidance on Leverage Lending,” agent banks have improved their underwriting and risk management processes to reduce and manage risk of leveraged lending exposure. In particular, most agent banks are now better equipped to project future cash flows to assess borrower repayment capacity and enterprise valuations, which better align with basic safety and soundness principles. However, the Regulators noted $317 billion of leveraged credit in the respective agent banks’ lowest pass rating category, raising additional supervisory concerns.

The Regulators continue to be concerned that any downturn in the economy would result in a significant increase in adversely risk rated leveraged lending exposure. The Regulators noted several common weaknesses in underwriting, including ineffective covenants, liberal repayment terms and incremental debt provisions that allow for increased debt, which may inhibit deleveraging capacity and dilute senior secured creditors. Additionally, usage of incremental debt facilities shortly after funding an initial debt package may result in risk rating downgrades and non-pass originations. Incremental facility provisions in loan agreements rarely limit use of proceeds and can result in increased credit risk when utilized for non-cash-generating purposes, such as dividends. The Regulators warned that banks should exercise caution during the underwriting process to prevent incremental provisions from resulting in non-pass originations. Furthermore, the Regulators noted that they continue to see cases of aggressive projections used to justify pass ratings on transactions that examiners consider non-pass, albeit at much lower levels than in prior periods.