Something Smells in Here : Problem Loan Identification

Have you ever opened your refrigerator and were greeted with a smell that would knock out a horse?  A couple of years ago, we had something that had either died or was a growing scientific experiment in our fridge.  The smell was incredible.  Knowing that the only solution was to remove all items and totally clean the icebox, we put it off for a few days as we did not have time.  Soon, everything that was removed from the fridge had a stench and taste of the something between old sweat socks and dead raw maggot infested meat.  The only solution was a thorough cleaning complete with mask and gloves. 

Similarities may exist between the foul appliance and problem loans.  Everyone knows something smells rotten.  At first, no one wants to dig far enough to identify the problem.  Some shops are led by folks who want no bad news.  The messenger is shot, giving the message to avoid and push away anything credit that is beginning to be ripe.  Others refuse to spend time and money training their team members.  When problems occur, they can’t quickly identify them.  Still others continue to only harp on sales and production goals at the expense of credit quality. 

All these approaches gloss over the upcoming problems and are as effective in just adding a few boxes of Arm & Hammer as eliminating the rot.  Things may smell OK for a time, but eventually the dead body must be removed.

If you want to manage the smell, the first place to start is with the leadership.  An open, communicative culture must permeate throughout the organization.  This means that all news, no matter if it is good or bad, is welcome to be advanced.  In some institutions, weakening financial performance or negative headlines of a borrower is not welcomed.  Some shops have pushed production to the extreme that field lenders are either too busy to monitor their credits or they deny any issues as they push for the next closing. 

Credit leadership must also promote quality assets compared to just pushing more loans.  The leadership should also set up systems of internal and external loan review, periodic analysis on each credit, and establishment and maintenance of watch lists.  Watch lists should be expanded not only to cover substandard and worse credits, but also those which show weakness that may lead the borrower into a negative status.  Discussion of credits should involve the entire department to get input of everyone.  Different points of view are valuable in finding the best solution to manage the challenging credit.  Also, this discussion will provide good training to the less experienced credit team members. 

Solid portfolio management requires you to constantly survey the market area and look for possible pitfalls that can impact a large swath of borrowers.  Perhaps this is a dominance of a key industry or employer.  Many smaller institutions in a rural area may have an economy dominated by farming or ranching.  A severe downturn in prices or a widespread hail storm may impact many other businesses other than those directly involved in ag production. 

You should know any concentrations or granulations in your loan portfolio.  Granulation asks how diversified are your loans?  Concentrations of credit may be in an industry, borrower, company, region, or guarantor.  For many smaller lenders, it may be hard to have a well-diversified portfolio as this is not common in their market area.  Also, note that concentrations may mean that your shop has an expertise in managing and underwriting a particular type of credit.  I once ran across a bank that did a tremendous amount of loans in the trucking industry.  They had nearly 50% of their commercial loans to companies in those industries.  When I asked them about losses, the only significant loss they took was when they reached for diversity by lending on an office building.  They had decided to become more granular in an area they did not fully understand. 

A good example of a concentration risk that killed an institution would be the failure of LOMTO Federal Credit Union which lost $51.2MM on bad taxi cab medallion loans when it had only $185.5MM in assets.  The value of these assets plummeted after the popularity of Uber and Lyft.

Problem loan management starts with an assessment of your institution.  What resources do you have available?  Do you have staff with experience in working out problem loans?  What legal resources do you have at your disposal?  Do you have any third-party resources like Pactola to help?  Do you have the ability to have a dedicated department of talented people to handle workouts?  What time resources do you have available at your disposal?  Do you have any training that is available to develop your team members?

All these are items that leadership must be aware of in order to better identify and manage any foul- smelling credits instead of just pushing it to the back of the fridge.  In my next blog, we will look at direct warning signs that may train your bad credit blood hound nose to identify problems.