Years ago, at one of the banks I worked at, we had financed a business which suffered a severe downturn in its performance. The company no longer generated enough revenue after operating expenses to satisfy all its debt obligations. Consequently, we downgraded the credit appropriately and began closer monitoring of the situation.
We followed the correct procedure with obtaining all updated financials and liquidity verification with all the guarantors for the credit. We were provided a new business plan and budget for the business. At first, there was little worry among our lending team as the pockets of the guarantors were deep and it initially looked like they could weather many years of losses at the level the company was experiencing. The guarantors also appeared willing to support their obligation.
At first, all seemed to go well. Payments were kept current even though the company continued to struggle. About six months into the plan, things began to go sideways. Business continued to be poor and the sponsors behind the credit now were having problems with making the payments. But how could that be? The guarantors had shown they had multiple accounts that could support the deficiency in the credit for what seemed years.
We asked the guarantors for updated financial statements and discovered a large portion of the cash they held did not show up in what they now provided us. So, what had happened? Where had the money evaporated to?
The answer came from the performance of the other business ventures they were involved in. Most were marginally profitable. Several, including an investment in a closely held airline required capital injections of tens of thousands of dollars monthly. The answer to the missing cash was in their contingent liabilities.
Contingent liabilities are loans with other entities as the borrower, but your sponsor on the credit may have signed a personal guarantee on it. In some cases, this may be something minor, like signing a guarantee to make payments on a car loan if you son fails to.
At times, these guarantees can be quite major and potentially require large outlays of resources to support the credit. Since we failed to ask this information, we were caught blindsided when our strong guarantors now were too weak to continue supporting the debt. Ignoring your borrower’s or guarantor’s other contingent liabilities, is to ignore what may be the major source of personal financial success or failure. This can have a huge impact on your sponsor.
So what things are needed to look at any contingent liability exposure? A good start is to obtain financials and tax returns on any entity that your borrower has signed for. This will give the analyst some historic basis for the performance of the companies your borrower/guarantor may have obligated himself/herself for.
More information is helpful. Understanding the relationship that your sponsor must the entity they have signed for is necessary. The analyst will also need to know the outstanding balance or commitment, the type of credit, and the amount or percentage of the loan guaranteed. Is the credit open-ended or closed? Is the borrower that your sponsor has a contingent liability for, in compliance of all covenants or are they in default? What are the penalties for default? What is the annual cash flow from the company? How does that compare to the annual debt service requirements for the company?
All these questions are valid when understanding the potential exposure your borrower/guarantor may have with obligations they are not directly responsible for. In each case, these items may make a huge impact on their ability to successful support your credit.
If you have questions, let us know. We also have a good contingent liability sheet that is in the loan application package that is on our website at www.pactola.com/forms