The Six C's of Bad Credit

All experienced lenders have heard of the Five C's of Lending:  Character, Capacity, Conditions, Capital and Collateral.  Each of these is a factor, necessary factors in good loans and a lack of them can be a harbinger of problems to come.  But not as many people have heard of the Six C's of Bad Credit.  Avoiding these will help insure a higher probability of repayment.  In this post I will attempt to review these factors.

Complacency is the first factor.  It stems from the attitude, “I don’t need to watch this borrower; they have always paid on time.”  This blinds lenders from seeing the need to monitor the company which may end up with a nasty surprise when the default comes.  Complacency can come from an overreliance on past performance of the company, guarantors, or the economy.  Some may also look at the net worth of the sponsors of the credit and think there is no need to monitor the credit. 

Lenders tend to forget hard times of the past, in light of a good economy of the present.  Forgetting past losses and problems may cause the officer to be complacent in setting standards to properly monitor the credit.  A scarier factor is the lenders who have never seen hard economic times or had the privilege of working through a problem credit.  Without these experiences, the lender may not have a healthy degree of skepticism necessary to ask the tough questions to judge the merits and flaws of the credit request. 

Carelessness is the second factor.  One of the most popular forms of carelessness is sloppy, unorganized loan files with inadequate documentation.  In some cases, collateral is not properly perfected, resulting in the lender’s collateral position being compromised.  Sometimes, loan officers will fail to document conversations with borrowers and then are caught reconstructing the file at the last minute as the bank is taking the customer to court to recover the loan.  Or they may leave items out of loan documents that should have been in there to protect the lender.

Another popular form of carelessness is a failure to establish thoughtful, adequate covenants to monitor the company’s performance through the life of the loan.  Some lenders will treat a commercial loan just like a consumer loan, and that may be fine in the cases of smaller credits.  They may not worry about the file as long as payments are made.  Then when they finally get financials from the company, they are surprised the company has a debt coverage ratio below 1:1 and the company’s net worth has been drained from operational losses and owner withdrawals. Yet, with no covenants to enforce, the lender cannot take appropriate action to enforce the bank position. 

A Communication breakdown may be a simple problem, or it can bring down an entire institution.  The first breakdown may be between the officer and the borrower.  This can lead to a startled lender, when a seemingly good credit all of the sudden is incapable of making payments.  It is important to have good relationships with the borrower that fosters communication between your borrower and you as the officer.  Remember, you should have a commanding and current knowledge of your borrower.

But there can be a breakdown of communication within your credit union or bank as well.  There can be unclear credit quality objectives and desirable lines of business from the leadership to the front line lenders.  The organization may be plagued with an attitude by top management of “shoot the messenger” if any problems are reported from the field.  Thus issues may be covered up until the time to effectively deal with the problem is past and a real loss is staring the institution in the face.  All communication should be clear, concise, and yet comprehensive to include all pertinent information.

Contingencies are the next factor.  Lenders have one of the hardest jobs as they need to be correct 99.5% of the time.  Once your losses begin to creep up over that ½% level, it could begin to impair your capital.  Truly, commercial lending has one of the smallest margins of error of any profession.  Imagine what would happen in baseball if you had to get a hit that often to be successful! 

Lending is risk analysis.  We are to look at every bad thing that could occur and then decide on how likely any of those things can happen.  A lack of attention to a downside risk can hurt the ability of the loan to get repaid if the economy slows down, occupancy drops or company revenues fall.  This is why it is important to stress test the credit at underwriting in applying breakeven analysis, increase the loan interest rate, raise the cap rate, and also reduce company revenues to see how the credit will perform.

A focus on how to make the deal work is another way contingencies are avoided.  Instead of worrying about getting the principal paid back, bankers have worried about finding a way to get the money out the door.  Sales goals should never trump credit quality goals.  Also, the pricing for risk philosophy often times causes the lender to ignore if the risk is higher, so is the chance of default.

Competition causes lenders to do strange things.  Too often, credit decisions are based upon what the institution down the street is doing rather than concentrating on the merits and risks of the loan in front of them.  Unfortunately, this often leads to loosening credit standards down to the lowest common denominator.  When the losses begin to roll in, at least you will have company with other lenders who are in the same boat. 

Competition causes lenders to do strange things.  A competitive euphoria is a sickness that may cause the institution to lower the price or seek a reduced covenant or collateral position just to get the deal.  Oftentimes, the results of these closings are touted as the credit union having a stronger market share than its peers.  But higher market share with poor credits is not a way to build your shop.  The key here is the command, “Thou shalt not book loans just because the other CU does.”

Strong revenue growth objectives may cause the lender to be tempted to cut corners in order to get the deal on the books.  This is why attention also needs to be paid to the quality of the credit.  If you are operating on a 3% margin, just one $50,000 loss means another $1.67MM of good loans needs to be closed to make up for the loss. 

Cluelessness is the final factor.  What is most scary is when either a borrower or worse, the lender does not even know what they do not know.  This can come from inexperienced staff taking on lending functions in a vacuum, without additional outside support. 

If these six factors are minimized—Complacency, Carelessness, Communication, Contingencies, Competition, and Cluelessness—the lender can hope for above average results with managing their credits.--Phil Love