A World of Infinite Risk

The goal of extending any credit is to get repaid timely, with an adequate amount of interest earned for the risk taken. The less risk you take, the less interest you will receive. To take no risk is to sit on top of a pile of cash and not lend it out. While that is the surest way to guarantee money won’t be lost, no income will be earned either, which will inevitably create problems in funding salaries and keeping the lights on.

 And yet, I hear people comment that they are passing up on loan opportunities because risk is present.  I understand that some loans can be too risky, but no loan will be risk-free. Lenders will never find risk-free loans, and loans with minimal risk will have terrible yield. I’m not advocating chasing yield and accepting a high level of risk; but rather, I believe a lender should focus on how to mitigate risk.

 Mitigating risk means minimizing the likelihood and adverse effects of that risk. For example, if a borrower opens a restaurant, the lender expects to be repaid from the profit of that restaurant. However, the restaurant may fail. How then will the lender be repaid? The lender mitigates this risk by taking the restaurant property as collateral, and hopes, in a worst case scenario, to sell the property and use the proceeds to retire the loan. Taking collateral is probably one of the most common ways lenders mitigate risk.

 Mitigating risk takes on all sorts of interesting practices. For example, the NCUA limits how many participations you may purchase from one lender to mitigate the risk of poor underwriting and servicing from an uncontrolled source. Making loans that amortize before the end of the useful life of an asset is also a common way to mitigate the risk of the collateral resale value. Lenders may try to limit how many loans they have made to a particular industry to mitigate the risk they are exposed to in the case of a slow-down in that area. Lenders are faced with a wide variety of risks, but instead of avoiding them, good lenders try to live with them by mitigating them.

 I recently heard a lender was disinterested in funding one of our loans, because they were concerned the economy in the subject community was driven too much by a single industry. The fact of the matter is, this is simply another request which needs to be mitigated. The very nature of communities is they tend to exist or are founded for an express purpose, and they tend to be heavily invested in a particular industry. In Rapid City, it tends to be tourism. In Pierre, SD it tends to be State government. In Washington DC, it tends to be national government. Omaha and Des Moines are heavily concentrated in the insurance industry.

 Yes, a slow-down or change in any of these industries would definitely impact the well-being of these communities. But, do these industry concentrations mean they are bad communities to lend in? Definitely not, if you are mitigating the industry risk. If you can test how well the loan repayment would hold up in those communities based on potential downturns, or if the loan is structured in a way that increases the likelihood of repayment regardless of downturns, then proper mitigation is being enacted.

 And ultimately, the best way to mitigate the risk in the circumstance above is to make sure you don’t invest too heavily in that specific community! Perhaps one or two large business loans makes sense, but if 3x your net worth is invested in that community, which is dependent on a single industry, it may be a wakeup call that diversification is needed.

The bottom line is, if lenders refuse to lend simply due to the presence of risk, then a lender will always find a reason not to fund a loan. A good lender assesses whether the risk can be mitigated, or whether the risk is acceptable to bear.