Recently, we have worked with some loans that seem to make little sense economically or in the credit sense. In some cases, the collateral is weak, advance rates are too high, or there may even be no collateral to speak of. Collateral is what you are left with whenever the payments cannot be made anymore from the borrower or guarantor.
Some have no history of being able to support the debt but the projections look good. Well, I have never seen any projection that does not look attractive. If a projection is much different than the history, there needs to be a logical reason.
Some had a lack of personal reserves to fall back on, either in liquidity or in guarantor cash flow outside of the company. This, coupled with any weakness in the company, and lack of adequate collateral is a reciepe for a loss.
In many cases, the reason for considering the request is the character of the applicant. Maybe he is well known in the community. Perhaps she has been a member of the credit union for decades. The borrower may also have a long term roots across multi-generations in the community. Maybe she has never ever missed a payment in the past.
While character is important. You would not want to lend to someone who you think is not trustworthy and who has a history of following through on their promises. But an over-reliance upon character as the sole positive reason to do the loan is dangerous.
It is dangerous because the lender is making assumptions that the circumstances which the borrower has acted upon, showing honorable character, in the past, may not continue in the future. This overlooks the importance of external forces upon the actions of the borrower.
How do you know what level of pain the borrower will experience before they cease providing payment support for a business that is failing? At what time does hope for the better future become replaced with fear and the guarantor just gives up? When is the point when the sponsor can’t economically support the deal anymore?
How many years of crop failure or low prices can the farmer survive? How much negative cash flow can the manufacturer absorb until they are forced to shut down? How long can the apartment building stay empty before the lender has to take it back.
Oh, character is important, but there is a level of pain where the sponsor cannot economically support the project or there is a time when the willingness of the sponsor to provide financial support is overtaken by the fear and loss of hope for a better future. It is at that point that the lender will be forced to close the business down.
So when looking at a credit request if you find the only reason for you to grant the loan is because of character, consider what may happen if the pressure of the outside overcomes the good character inside the applicant.