One bank I worked at had a division between management over sales and those over credit administration. The bank had a strong credit culture, so, usually the will of the credit administration folks would shape any sort of program that those whose bonuses were tied directly to the growth of the bank’s branches they ruled over.
But this was not always the case. One fine spring day, managers and lenders met with the senior vice presidents over the bank branches. It was a typical meeting held in the spring or early summer when the bank’s upper leaders announced our goals for the year. I always thought it kind of funny that in some cases half of the year had passed before you actually knew what the new “flavor of the year” was.
Something unique happened in this meeting. It became evident that the SVPs of sales and SVPs of credit administration were not in the same universe, even though they sat in the same room! Anyone who has been in lending long enough has experienced this. Probably one of the most famous examples is the mortgage crisis. I will digress a few minutes here to discuss that.
When I started doing residential mortgages in my career, everything was underwritten by hand, verified, and presented to a loan committee that met daily for a loan approval. This process was rather long (but not as long as some of the runaround a mortgage applicant gets today! Anyway, to remedy the problem, folks at Freddie Mac and Fannie Mae whose bonuses were tied up to the production of mortgages, derived a system where everything was underwritten by computer algorithms. The parameters of underwriting were stretched to a point where we began to see exotic products with no down payment, financing of closing costs, interest only, etc.
This created a huge demand for housing and we saw house prices triple in the 1990s at a time when real wages increased around 3% annually. Of course, the system crashed down and one of the biggest causes was the lax and insane underwriting standards. The movie The Big Short does a wonderful job explaining the mortgage mess.
Anyway, back to my bank story. A new product was announced for that year. It was called the “Business Streamline Line of Credit.” It was designed to be a small line of credit, usually no more than $50,000, that would be sold to business owners. The line had no maturity; it was based on a demand note. Payments were interest only, with no plan to amortize and retire the balance. The loan was also unsecured. The product would also be primarily administered by front line branch managers and consumer lenders, and not seasoned commercial lenders.
So after ten minutes into the presentation touting how great this product was, the time for questions from the audience began. One of the first ones was what about underwriting? All this was done on some business credit score system based entirely on a two-page application the borrower would fill out. We were told that because these loans were so small, that the money spent on full underwriting would make them unprofitable.
Next who was the target market? Anyone, as this product was designed to be a gateway product into new clients we had not worked with, not existing companies that we had a relationship with already and also understood.
Generous incentives were provided front line people who sold “Streamlines”. Goals were established for each market. For the next few months, anytime anyone opened a “Streamline” everyone received an email as to what a great job they had done. It was not long that we had amassed over $50MM of these loans on our balance sheet. What could possibly go wrong?
I have learned when that last question is asked, it usually is just before something bad hits. The program began to unravel. First, leaving this to people who had absolutely no business lending experience was a problem. We began to attract the unbankable customer others had turned down. And, we did it with an unsecured line of credit.
Next, since all standard underwriting went out the window, since it was “too expensive”, proper due diligence was also ignored as many of these lines were closed with companies that did not actively operate or with individuals who were not authorized to act on behalf of the company.
Most of these lines were maxed out quickly with no ability to repay the loan. When the crash hit, most lines in those situations were frozen and some sort of repayment plan had to be worked out. By the time I had left the bank. Nearly $10MM of the $50MM portfolio was charged off. Imagine what a 20% charge off rate with no collateral to recover would do to your balance sheet. Fortunately, they were large enough to weather it.
The geniuses who hatched the plan, left the bank for a new opportunity to screw up another financial institution, while credit administration stepped in to clean up the mess.
The lesson here is in commercial lending, niche products need to be analyzed and implemented carefully. If no one at all is doing this in your market area, you may become the lender of last resort, attracting relationships that will cost you a lot of money and staff time to manage.
Next, you cannot abandon sound underwriting principles. We come across that now with some CUs we work with who have such a product. They become obsessed with selling the loan without any strong consideration if the product makes credit sense. Less growth today with marginal clients will give you much more time with the good ones.
I want to end with a plug for our fall classes. Our annual Agricultural Education Forum in Miles City is on September 26 and 27th. At the time I write, we have 23 students signed up for that one. After going to the New Ideas Conference in Fargo, stay over later and attend our Small Business/Commercial & Industrial Lending all day October 5th and the morning of October 6th. Intermediate Agriculture Finance will be held the rest of October 6 and all of October 7th in Fargo. We have discounts for those who want to attend both of those classes. We end our fall classes with a session on Commercial Real Estate Lending at the Tin Lizzie Gaming Resort in Deadwood, South Dakota on October 17 and 18th. Come join us and you can participate in our first Blackjack Tournament.
Every year we are humbled and honored to be able to help our CU family grow in their knowledge and skills in the area we live in each day. We look forward to seeing people on your team this fall.