Problem Loans

I live at sea level but only two hours from Mt. Rainier. We had a very late summer this year, some would say we missed it altogether in the Northwest.

But Friday was a summer day. Warm but breezy. Lots of sun. And late August is a great time to visit Mt. Rainier as the wildflowers pop in profusion.

Right? Not quite.

A late summer at sea level, it turns out, means a late summer on the mountain. The wild flowers are not out yet. And on the Skyline Trail, you cannot even get past Myrtle Falls without traversing some snow.

Don't assume...

If you were to go to the Rainier National Park website to check on trail conditions before heading up to the mountain with athletic shoes instead of climbing boots, and without your climbing poles -- I can't imagine who would do that -- here is what you'd find:

August 17, 2011: Mt. Rainier received a heavy amount of spring snow this year creating hazardous conditions in the backcountry. Subsequently we expect a very late melt-out this summer. Issues to consider are route-finding, creek and river crossings and trail damage. Good navigation skills are needed in these conditions. It is easy to get disoriented and/or lost. There are also steep, icy slopes in numerous locations around the park. Always check with Park Rangers for trail conditions before heading out into the backcountry.

Rather than the anticipated 3 hour hike, with a 1,700 foot elevation gain, we headed up one way, turned back due to snow, tried another, turned back. It was still breathtaking but not what we expected.

And if we plan to see the wildflowers, we need to head back up in a few weeks. I'll check online to see if they have popped before I drive the two hours each way to see them!

Lenders: What assumptions are you making about your borrowers?

About how their business is doing because:

  • it is 'Back-to-School' season
  • the recession is over
  • your other borrower's business is improving

Directors: What assumptions are you making about your financial institution?

About how you are doing because:

  • management is upbeat
  • the recession is over
  • the other directors don't seem as concerned

Check your assumptions by checking in...

For lenders and business bankers, not only is it a great time to visit business borrowers to be sure you have a good sense of how business is going, but it is essential because other business bankers looking to increase market share or re-balance their loan portfolio might just get there first.

And if you are a director? Never stop asking those substantive questions to continue monitoring the health of your financial institution.

What is good enough?

One last thought. Just because conditions are less than what you expect doesn't mean they are not good enough. We had a fantastic day. Be open to what you'll find when you ask the questions you should ask. And then make a fresh assessment of the situation.

This article,The Allowance for Loan and Lease Loss Becomes a Heavier Burden for Credit Unions, includes my thoughts on one of the up-and-coming challenges for credit unions and banks in keeping up with the time necessary to review loans for impairment to calculate ALLL accurately at the same time that loan volume is (finally) ticking up.

Read the article...

The issues this article touch on are the very same for community banks.

BTW...I have a strategic partnership with the software company, Sageworks, mentioned in the article. They have a new software solution for ALLL and my clients, readers and subscribers get a significant discount. Let me know if you are interested in a demo and I'll get you the discount!
For some lenders, the delinquency/charge-off figures continue to rise as banks and credit unions work through their challenging loans. Here are two ideas for improving the charge-off ratio:

Loosen credit policies and guidelines

At the CUNA Lending Council Conference last week, CLOs and CEOs pondered this idea. Here is what they came up with.

Carefully review which segments of your loan portfolio are performing well. Consider whether you might be comfortable loosening the loan guidelines for those segments. If you can make more performing loans, that brings the ratio of delinquencies/charge-offs to performing loans back down.

Great idea!

Catch problem loans before they are delinquent

Why wait for them to miss payments. As an example, running credit checks on performing loans uncovers borrowers whose credit scores are slipping, even though they still are paying as agreed. Reaching out with alternatives to this group can result in a borrower continuing to pay as agreed or perhaps a loan modification before they go delinquent.

It is interesting that in some cases, the A and B borrowers are more likely to pay right up until the time that they hand you the keys because they have never been delinquent before. They may not realize there are alternatives.

What are you doing to manage the delinquency/charge-off ratio?

To prepare for a CNN interview on the 'freeing up' of small business lending, I had a very interesting discussion with:

•    Director of SBA Special Assets with a national $282 Billion Bank
•    CEO of a one branch local business bank in Washington
•    CLO of a $8.6 Billion State-wide CU in Washington State
•    Chief Risk Officer of a family-owned 17-branch bank in Oklahoma
•    30+ year business banker with a regional $ bank in Washington State

Federal Reserve Chairman Ben Bernanke had just come out with his speech (another one) about what it will take to improve availability of credit to small businesses in America.


Economy is better but is not good.

There is a lack of demand for good quality business loans.

Some loans they might have done themselves get done through SBA loans instead.

Underwriting standards may be a bit tighter, but in many cases the loan requests do not even meet the pre-recession standards. Many small and medium-size businesses have not recovered to the point that they are again credit-worthy...yet.

Examiners come into play in three ways:

1) What was well-capitalized may not be enough to satisfy examiners.
They want higher which may constrain a banks growth if they cannot raise capital. Also, banks even who are well-capitalized cannot take a chance of a bad mistake. Too costly. Thus more conservative.

2) Still want a shift to C&I from CRE. I heard from one bank CEO some regulators are also more concerned about owner-occupied CRE, not just non-owner occupied. Banks that are conservative have seen a difference...owner-occupied considered safer.

3) Emphasis, rightly so, on good credit analysis including tax returns and financial statements. If a lender is confident in a business loan but the recent numbers are not up to snuff, the lender may have less latitude in making that loan.

The impression as to whether Examiners are too restricting or not varied among the business lenders I spoke with.

The end result...the high-level regulators and the politicians say easing credit to small businesses is a key to our recovery. But the regulators visiting the banks are still very cautious and conservative.

Business bankers all said:

Credit analysis skills are more important than ever.

Understanding of business fundamentals, the ability to ask probing questions about recent and projected performance, and the ability to clearly articulate the results in a loan write-up, to loan committee and ultimately to regulators is key.

A banker from a family-owned bank said that the small banks in rural America may not make it. There will be consolidation.

The Credit Union Advantage? De Novo?

The Credit Unions may have an advantage in that many have few loans on the books to go bad but are able to capitalize on an existing relationship. Actually, the same can be said for De Novo banks.

Is it better than last December?

CNN's Colin Barr and I talked last December. Heasked about the general sense of things in comparison to our last conversation.

I said I get the impression that business lenders feel things are improving, but there is a long way to go. There is more interest and activity, but it has not turned into enough doable loans...yet. The bank CEO said it is like we had pneumonia...and now there is a bad, lingering cough. The cough is better than pneumonia but...

Colin asked if the sort of euphoria at the beginning of the year that we had turned the corner has had an impact on business lending. I told him...

There is a series of things that have to happen:

  • A small business owner has to have confidence that the euphoria or improved consumer/business confidence will turn into increased demand for their goods or services
  • The small business owner has to translate that into projections s/he is confident in
  • The small business owner then has to come up with a plan and consider whether they have sufficient liquidity, capital or access to funds to carry it out
  • The small business owner has to articulate that plan to a business lender with enough information that the lender has confidence in the outcome
  • If recent operational history has been challenged, the business owner has to overcome low DCR or loan-to-value assumptions with compelling mitigating factors
  • If convinced, the lender has to articulate all of those things through the written write-up and presentation to loan committee (if it is over his/her lending authority)
  • Ultimately, if the loan is made, the regulators will scrutinize the decision

It is getting better...but is still painful.

Business lenders in many cases have a long-standing relationship with their borrowers. They would make the loans if they could sufficiently mitigate the risk and pass scrutiny. Not only are they in 'business' to lend money, they also have a commitment to their customers and their community. Thousands and thousands of minds are working hard on this problem at every level.<

Do you agree?

Or do you have a different take on what it will take?
Toolbox for Finance offers this article by SAP: Managing Cash Flow in Times of Crisis.

It is a good article to read if you have business borrower's challenged by cash flow...and I am guessing that most of your business borrowers are. In tough times, improving the management of the company cash cycle is a priority.

When a business lender understands 'best practices' in managing company cash flow you can be a better resource for ideas and, through your conversation with the borrower, better assess if they are doing everything they can to protect their cash flow.

Here are a few of SAP's tips for improving the credit-to-cash cycle with my thoughts added:
  • Add an up-front credit evaluation.
    • Linda's thoughts: Pre-recession a company may have checked credit before they offered terms to a new customer. Now for major customers, checking credit before each major sale may be necessary.
  • Do not rely on a single before-sale evaluation.
    • Linda's thoughts: Besides an external credit check periodically, monitor all major accounts for signs of trouble. Put a 'Google alert' with the customer name to stay on top of major news. Keep in touch.
  • Monitor outstanding accounts receivable closely to drive timely collections and ensure low DSO (Days Sales Outstanding).
    • Linda's thoughts: Consider a phone call the day after the bill is due. Instead of asking for their payment, check in on the quality of your service or what else you might do for them. Then ask about the bill. Chances are they may bring it up before you do.
  • Conduct careful receivable aging analysis.
    • Linda's thoughts: This will help in two ways. It will provide the early warning sign that collections efforts may need to be improved. And it will alert management that alternate cash flow sources may need to be found before the problem gets worse.
  • Systematically pursue follow-up collections on overdue accounts.
    • Linda's thoughts: Especially for smaller businesses, this can be haphazard. As the lender, consider finding some good resources for information on this (the SBA for example) and offer it to all of your business customers.
I would add:
  • Depending on how severe the cashflow issue is, consider running a 13 week cashflow forecast and updating it weekly
  • Review the concentration risk of relying on one major customer. Take action to diversify the client base to reduce the chance that one bad debt could take the business down.

What are your suggestions for managing the cash flow the company already has coming to them?

What works on auditors may work on lenders

A 2009 study performed by researchers at the University of Massachusetts at Amhurst demonstrated that  auditors are less likely to find manipulated earnings when management directs their attention away from areas of financial statements that contain errors.

The auditors were split into four groups and here was their success at spotting a $450,000 error in an audit where $100,000 was the materiality threshold:

  • 7% of the group that was 'baited' into looking at a section of the financial statements that contained no errors found the big one.
  • 44% of the groups pointed in the direction of minor 'distracting' errors or diversions like a risk alert that an employee with little accounting experience had recently been put in charge of noncurrent assets found the big one.
  • The article in CFO magazine did not share the success rate of the group that was told nothing.

The take-away for lenders and underwriters?

You are more likely to look for bigger problems when you find smaller problems with the numbers, and I think that is a good thing.

And it is natural for a borrower to direct your focus to what is going well. That does not mean they are hiding something else.

But it doesn't mean they aren't! Be careful to do your due diligence on all material aspects of the business and don't fall victim to the fraudsters diversion tactics.
Here is an interesting post by Jane Harford, FHA DE Underwriter writing for the National Association of Mortgage Processors blog.

She does a great job of listing the red flags that pop for her and what she would do next as a loan processor. As usual, what makes a processor nervous perhaps should have made the loan officer or originator nervous.

Jane and I both like to highlight potential red flags and then remind you that these are not deal killers for the most part. They need to get your attention so you can follow up. One or two, much less of a problem than eight or nine!

The Dirty Dozen

Here is her list with her comments and mine:

  • Providing an incomplete or handwritten 1003.
    • Jane: If the entire file is not put together yet, the processor might not notice 'issues' with the file as items come in piecemeal.
    • Linda: As a RE investor, my 1003 was always handwritten. I think Jane has a great point, though. The ability to analyze a complete file instead of dragging info from the borrower every step of the way gives you a clearer picture.
  • Employer's address is listed only as a post office box.
    • Jane: The business may not exist.
    • Linda: My business address is a PO Box.
  • Borrower's education completed differs from his/her job category and level.
    • Jane: Just because they have a pay stub to support their wage does not mean they did not fabricate it. Pay attention if the level of salary or type of job does not make sense for the education.
    • Linda: Good call, Jane. I had not thought of that one. I would add to consider previous work experience as well. My husband, for example, earned a horticulture degree but ended up in construction.
  • Borrower's office phone number is the same as the home phone number.
    • Jane: This could mean the borrower is self-employed or not employed at all.
    • Linda: Even if self-employed, home-based 'serious' businesses have a separate phone number. If the business phone is answered by a kid who then yells 'Mom, it's for you!' that would concern me.
  • Assets don't seem to be consistent with the borrower's disclosed income.
    • Jane: If the assets are not consistent with the borrower's income or the recent balance in their bank accounts, recently opened, are significantly higher than their 'average' balance, Jane asks us what we think the red flags are.
    • Linda: I am not sure what she thinks they are. I would guess overstating assets. Or perhaps Mom and Dad 'lent' her money just before the mortgage application so it would look like she has the down payment. I would add that frugal people often have assets that seem high compare to their income so, as Jane suggests, notice and follow up if you have a concern.
  • The borrower's income is not consistent with his/her age and education status.
    • Jane: She did not add comments on this one.
    • Linda: I agree, and also think that it is getting more difficult to guess what income should be based on age and education. The impact of the recession on job disruption has to be factored in.
  • Borrower's home phone number has a different area code from the work phone number, even though they are in the same area.
    • Jane: She did not add comments on this one.
    • Linda: My kids are keeping their cell phones as their only personal line and often still have the number from when they lived elsewhere. Again, good to notice, and this may be the explanation.
  • Borrower is purchasing an investment property, but rents for primary residence.
    • Jane: She did not add comments on this one.
    • Linda: Good call, again one that would not have jumped to my mind. I can think of good reasons, but it would be less likely to buy investment property before primary residence.
  • Unrealistic drive time between home/work for an owner occupied purchase.
    • Jane: In her comments, she added unrealistic distance between primary residence and second home.
    • Linda: I continue to be amazed at how far people commute to work. That said, you would know what is realistic or customary in your geographic area.
  • REO schedule shows that borrower owns property, but no mortgages appear on the credit report.
    • Jane: Did not feel the need to expound on this one.
    • Linda: Neither do I. Cross-checking is one of the best ways to catch any kind of fraud. Check tax returns to financial statements. Check application to REO. Check REO to credit report. I own property free and clear. It is a reasonable question to follow up on.
  • Debts listed on 1003 show no mortgage debt, but a check of MERS shows that borrower is on an existing mortgage.
    • Jane: Check this out.
    • Linda: Ditto.
  • Borrower's answers to the declaration questions differ from the documents provided and the profile that the borrower fits into.
    • Jane: This needs to be clarified, explained, and satisfactory documentation provided.
    • Linda: If you are the person talking to the borrower (as opposed to looking at their file) add what they say verbally to this idea. Sometimes you catch fraud because the person cannot remember all the ways that they lied in the application and say something that is not consistent.

    What is on your fraud watch list?

Your business borrowers are making big decisions in very 'confused seas'. Is it time to:

  • Rehire workers?
  • Add to production?
  • Beef up inventory?
  • Market more aggressively?
  • Borrow money?
Last weekend I planned to take the kayak out for a trial run. I moved the seat forward and wanted to see if it improved my stroke.

Thumbnail image for Thumbnail image for BankerKayakWhiteBackgroundSmall.PNG
Tide was the highest early in the morning and in front of my house, putting in at high tide is easier. But, ah, this is the Pacific Northwest. The day would be at it's warmest around 2pm...maybe up to 55 degrees!

  • Was tide or temperature the most important factor?
  • Since I can know tide with certainty (I can look it up on charts or just look outside) but cannot know the weather with certainty, should that impact my decision?
  • How much more difficult would it be to put in around 2pm, the scheduled low tide? I'd have to carry that kayak across mud to do it. Isn't that why I bought a 34 lb boat?
  • What is the benefit of getting it out of the way (early morning) versus getting sidetracked (or comfy in front of the fire with a good book) later in the day?
  • Does the fact that I can do something about temperature (wear more clothing) and cannot do something about tide come into play?
  • Is it time to take low tide out of the equation by buying portable wheels?
Look at the steps your businesses and business borrowers are taking as we move into the recovery. Most decisions will have some certainty and some uncertainty. Sometimes quick action is the best move and other times holding off will be better. It is uncertain which is best in each situation.

As the business lender, you may be called upon to pass judgment on the results of this borrower's decision-making when you consider their next loan.

As the business owner, you may be reluctant to share all the false starts, missed opportunities or initiatives that just did not work.

But if a business is not willing to suffer a setback right now, it may not be taking any action at all. That is probably the wrong move, too.

  • Did I go out in my kayak?
  • If I did, when did I go?
  • Tides or temperature...what do you think?
  •  Email me and I'll tell you!

I predict the 2009 tax returns will be filed earlier rather than later. Why? The congress has liberalized the rules for carrying back Net Operating Losses. If the business paid taxes in any of the prior 5 years, they can carry back the loss to any of those years. Tax refunds anyone?

If that is the case for some of your business borrowers, you will soon be including 2008 and 2009 in your analysis, the worst years of the recession. So here are your questions:

  1. How do you (or will you) qualify a borrower for a business loan when the two or three most recent year's tax returns or financial statements do not support the loan request in terms of required debt coverage ratio and other financial requirements?
  2. How do you distinguish a business that has done poorly from a business whose owner chose to forgo profits to keep their business recovery-ready?
  3. If the business owner chose not to pay themselves during the downturn in order to keep their staff, continue to market in a downturn and otherwise keep the business as strong as possible, how will that impact your analysis of them as a guarantor? (They may not 'qualify' even if their business is now doing well and back to paying them.)
  4. What compensating factors are going to make up for a recent two or three year's financial performance that is not sufficient to qualify for the loan?
  5. Are loans to continuing businesses going to need to be assessed more like loans to start-ups?

What do you think?

Peanut butter is sticky. Jelly slides right off. If your business borrower is pursuing growth during the recession, use this analogy to evaluate their choice.

This thinking was inspired by today's post in  Steve McKee's blog: Find Your Nerve. Each business day in the fourth quarter an executive from a different company weighs in with a guest post.

In today's post, Opting Out of the Recession, Eric Bipus CEO of CNH says:

Before we go rushing head first to implement a recession-busting growth plan, the key strategic question to consider is whether or not our actions will lead our companies to a permanent shift in market position.

The Peanut Butter Strategy: Market Share that Sticks

PnutButter.jpg True, Mr. Bipus did not mention peanut butter in his article. But it is what came to my mind immediately. (I guess that is because I did not have my peanut butter on english muffin yet this morning.)

In balancing the two competing objectives of minimizing any hit to profits while attempting to capitalize on long-term growth opportunities, CNH found three opportunities that compelled them toward the growth strategy.

  1. Opportunity to create strong relationships with competitor's distributors
  2. Opportunity to take advantage of weaker competitors currently at risk
  3. Opportunity to capitalize on recent product innovations
And this reality...they would lose market share if they retrenched while their competitors invested in growth.  Read the post here.

CNH did not opt out of the recession.

Taking advantage of recession-induced opportunities is definitely participation.

  • What stories can you share of business borrower's successful efforts to solidify market position and/or grow their business during the recession? 

  • How are you as a business lender going to differentiate between
    • a business whose profits are down because they are challenged by the recession and
    • a business whose profits are down because they are strategically taking advantage of the recession to grow their business?