To recap on the 5 Cs of Credit so far, we’ve mentioned Character matters, because your borrower can’t repay you from jail. We learned Capacity should be about selecting the right credit structure and then focusing on cash flow as a primary source of repayment. So if you have an honest customer with a good ongoing source of repayment, what is there to worry about? Realistically, there will be little reason to lose sleep. But we do live in a world of infinite risk, and there is always something unforeseen that can happen that neither you nor the borrower could have ever conceived. Unfortunately, even the best loans can go bad for reasons nobody could have envisioned.
Recently, the CEO of Goldman Sachs, Lloyd Blankfein, summed it up best during a seminar he participated in. He said, “Most risk management is really just advanced contingency planning and disciplining yourself to realize that, given enough time, very low probability events not only can happen, but they absolutely will happen.” This is why, even with the best loans with no repayment problems, there is still a need for a contingency plan in case they do go bad. The most common solution is taking collateral which could be sold as a secondary means of repayment. Collateral is really “Plan B” to your initial credit decision. All good credit decisions have at least one good backup plan if the first source of repayment disappears, and really good credit decisions will have more than one backup plan.
Because collateral may have to be used as a source of repayment one day, it will command a lot of attention and analysis just like cash flow. I can think of a handful of times where I had to spend more time analyzing the collateral than I did cash flow. By now, it should not come as any surprise that there is no one-size-fits-all analysis that assesses collateral, but rather, each underwriting project will be tailored to the lending type and credit facility of the specific loan.
For revolving lines of credit, the collateral tends to be the output from the resulting business operations. Take a widget for example. A finished widget could be used as collateral, but let me ask you, what is a widget worth? I’m really not sure, and that makes me a little nervous to take a widget as collateral. I suppose it really depends on how easily I could sell that widget, which is described as “marketability.” Good collateral is marketable. How can you be repaid from selling collateral, if you have collateral nobody wants to purchase?
A widget is effectively inventory. Inventory can be broken into three components: raw materials, work-in-progress, and finished goods. Some guidance suggests finished goods are most marketable, but logically, raw materials could also be just as good, if not a better source of collateral. If the demand for widgets disappears, there may still be demand for the materials that were used to produce a widget (say for example, if raw materials were metals and aggregates). I believe it is universally agreed upon that work-in-progress is a poor source of collateral. What is half a widget worth, and who would need one anyway?
Once those widgets are sold, the business is waiting to collect on an account receivable. Those receivables can also be used as collateral. There are people who will purchase accounts receivable, and they are called “factors.” An account receivable is really only as good as the business or person who has to pay it, and the lender may have no way to know a receivable’s wherewithal to pay. In an ideal situation, receivables will be from several individuals or businesses, so if one didn’t pay, it would only represent a small loss to the business collecting the receivable. Concentration of receivables is a big risk, because one large customer struggling to pay could lead to large losses if they prove uncollectable.
Turning to term debt, the marketability issue becomes a large concern when financing equipment and machinery. For example, say a lender finances a widget-stamping machine. Naturally, he or she will take the stamping machine as collateral. What if the lender had to foreclose and take the stamping machine? What is a widget-stamping machine worth, and what else could it be used for? Some equipment is highly specialized and could have even been designed especially for the defunct business in foreclosure. This could leave the lender with nobody to resell the machine to. Because of these issues, it is not uncommon that equipment and machinery will require large down payments, and that often, this debt may also be secured by additional collateral the business owns, like real estate.
Real estate is a relatively preferred source of collateral for most term-debt financing, whether or not the subject debt was used to acquire real estate. Why do lenders prefer real estate? First of all, it is easy to find. To collect on inventory, receivables, or even some equipment, it will be challenging to locate where the collateral actually is. But as for real estate, you always know exactly where it is. Also, real estate usually has a readily determinable value, because there are several investors that usually establish a market for it.
With all collateral, although it is easily observed in real estate, there is a conundrum that can result with the market value of your collateral and the borrower’s ability to repay. If your customer is struggling, it may be an indication that the market value of your collateral is also deteriorating.
For example, say debt for Widget Inc. is secured by industrial real estate valued at $1 million. Widget Inc. goes out of business, because it is a recession and nobody is buying widgets. The lender forecloses on the industrial real estate, but finds nobody wants to buy industrial real estate. Why? Because it’s a recession, and no industry is expanding! The real estate was worth $1 million when demand was nominal, but now demand has dropped and buyers in the market won’t pay more than $650,000. Hopefully, the lender didn’t extend more than $650,000 in credit, even when he or she thought the property was worth $1 million. Generally speaking, it is unwise to lend the full value of the collateral. Leaving a margin between the value of the debt and full value of the collateral allows for changes in the market value of the collateral and any costs to foreclose and sell that collateral.
The costs to foreclose and sell are not only monetary, but they eat up a lot of time for several people at the institution. Depository institutions are set up to lend money and collect money, and liquidating property takes away from peoples’ primary job function. Cash flow should always be the primary source of repayment, and collateral should realistically be your contingency plan. If the reason for lending is based primarily on the fact that the collateral would have substantial value if liquidated, the institution isn’t accounting for all costs of the transaction and potentially originating a problem asset. It may be true the institution will not lose the principal being lent, but the time and effort to recover the principal will be costly and have unquantifiable burdens.
Collateral is really code for “contingency plan.” If there is no contingency plan for when your original plan for repayment deteriorates, then the likelihood of credit loss increases substantially. By asking yourself what your collateral position is if the worst possible scenario occurs, you actually think through a contingency plan to get repaid. Some institutions are in the practice of identifying three sources of repayment for each credit decision. The first source is usually the cash flow generated from the operating business. The second and third sources are typically reliance on selling collateral and having a guarantor provide some means of repayment. Additional sources of repayment could even come from collecting on cash or collateral from another source outside the business and its immediate owners. The important concept to grasp is the more means there are of getting repaid, the more likely it is the loan will be repaid!--Trevor Plett