Credit Risk Review (a/k/a Loan Review): A Value or a Burden?

For over 30 years, the regulators have advocated, or required, an independent validation of credit risk.  There is a good business reason for this function if managed well.  Banks spend a lot of money on CRR and internal audit, and in today’s heavy cost, heavily regulated banking world, you need to get optimum value for every dollar spent.  But is the board getting what it needs from it to influence decision making on strategic direction, personnel management and other key lending components?

 *Are you getting a mixed message from your regulator on CRR?

*Do you view CRR as largely necessary to satisfy Regulators and External Auditors?

*What questions does your board or management team ask about the value added?

*And finally: Is it risk based?

 This article identifies common misconceptions and deficiencies in CRR functions that we’ve evaluated in our roles as former regulators, bankers, or as independent consultants.  These reflections hopefully will assist you to proactively manage your CRR function. We routinely (yes, routinely) see such weak performance of CRR that it provides no reliable validation of loan risk ratings, overall portfolio quality or credit administration.  Following are, by order of impact, major observations: 

 1.      Hiring a CRR vendor to perform the function and failing to adequately police its performance or manage the process.  This is far and away the cause of the biggest loss of value.  It is unwise to hand off planning and execution to a vendor and assume it’s handled well.  Deficiencies include:

o   poorly conceived scope coupled with weak or nonexistent risk-based focus.

o   excessive coverage.  Over time, a paradigm has evolved that more coverage is better, and is favored by the regulators.  This is false, and is causing a huge waste of money.  We now commonly see annual CRR file review coverage of 60-80% of outstandings/commitments.  Moreover, the same borrowers and categories are reviewed year after year. While it looks good to show the board, regulators and auditors, the benefit is illusory and here’s why:

§  We have found that such penetration imbues production pressure on the people performing the file work.  This leads to a rush through files and, sometimes, failure to even discuss the credits with loan officers to assure a sound evaluation of the borrower.  Our tests of this work find shallow analysis, unsupported risk ratings, factual errors in calculations leading to incorrect conclusions, missed documentation defects, poor appraisal reviews and weak collateral analyses; all adding up to unreliable systemic findings on your credit world. 

§  To put into perspective, coverage of 60-80% is typically required only when a bank teeters on failure, and the regulators require this level of penetration to verify the extent of loss exposure in the portfolio.  Conversely, a good risk based approach should not target a coverage ratio, but also should not need to exceed 20-40% per year.  This can vary by year depending on how solid your credit function is based on CRR results. 

o   Conclusion oriented observations get lost in the bulk of the thick binder that is delivered to the board by the vendor after each target.  Further, the vendor report is often full of loan portfolio statistics that simply restate what is already in the routine board reports. You are charged for information you already have.  A board member does not have time to sift through this in search of meaningful conclusions.     

o   Overall conclusions are generic statements that provide little insight on validating the bank’s credit risk management.  Worse, these often provide false comfort to the board.  The author of this article has evaluated CRR in dozens of banks over the past 30 years, often after having identified systemic credit quality, underwriting and administration deficiencies in the subject bank.  In no case did CRR ever identify the systemic problems prior to the regulator doing so.   

2.      Inattentive Board/Audit Committee toward managing the process.  While CRR and Internal Audit are designed to be independent validation tools, it is often clear via discussions with board and audit committee members that they are not focused on where the risk is when providing direction on coverage or reviewing results of work performed.  This is usually due to inadequate training of board or committee members on risk based approaches; leading to inordinate participation by lending executives in administering the process, thus diluting independence. 

3.      Using unqualified or unmotivated personnel to perform in house CRR.  This is usually present when the bank is merely showing the regulators and auditors that it has a CRR.  We sometimes find that they are ‘going through the motions’, and committing many of the shortcomings described above.  The tone from the top does not illuminate the importance of the function.  Without a solid commitment from the top and sound execution, value is tepid or absent.

 At Pactola, we would be happy to meet with you to discuss our observations on how to maximize the value of your CRR.  We also have similar observations on internal audit and are qualified to address that as well.  It is very possible that you could cut the costs of these functions while providing more concise, risk based feedback to the board that feeds into good decision making.

Gary Stoley brings over four decades of experience with commercial, agricultural, syndications, asset based lending, leveraged transactions and retail. He has spent over 33 years with the Office of Comptroller of the Currency and then an additional five as a contractor for that agency. More info can be found at: https://pactola.com/credit-risk-advisory-services

Pactola Launches New Services

Listen up!  Pactola announces new services to support your credit administration functions.  These are Credit Risk Advisory (a/k/a Loan Review) and Contracted Problem Loan Management.  Both of these divisions are staffed with a team of seasoned credit veterans with experience in areas of commercial, agricultural, indirect, home equity, and other types of lending.  We also offer various individual services offered on an ala carte basis. 

One big feature is much of this review work can be completed remotely via our secure portals to transport file information safely. Discussions with officers can be made over the phone or using video chat systems like Teams or Zoom.   In today’s world where we deal with remote work environments and limited visits from outsiders, this feature helps limit face-to-face contact. 

Our Credit Risk Advisory Services is designed to help you evaluate the efficacy of your credit risk management function to ensure that the credit risk review mission is clearly set forth and sets objectives as defined by the Board and management.  Credit risk review function is driven by a sound risk assessment tailored to your institution.  Credit risk is evaluated properly, as defined by policy and scope, while values is added via insight and observations of individual lending credit relationships, sectors, portfolios, collateral, purpose, and economic trends.  Reporting includes findings prioritized based upon risk, root causes of systemic deficiencies, practical solutions to address core problems, management corrective plans, and best practice considerations. 

Ultimately, if you are spending lots of money for a third-party loan review report that just checks the box of an examiner requirement, this process is falling quite short of what a good review process can accomplish.  Our approach is to provide you with a study that shows the strengths and weakness of your credit organization and provide you with a path to improve. 

Contracted Problem Loan Management can provide additional support to your credit team to help manage the upcoming problem loans that we will all see from the impact of the economic downturn and lockdown.  Many institutions do not have a seasoned special asset group internally they can send their problem credits to be managed.  This requires either hiring problem credit managers, which can be expensive.  Existing staff can also manage their problem credits.  The challenge here is so much time will be spent on problems that you will lose good credit opportunities that your competitors will be jumping on. 

Another option is to partner with seasoned credit folks to help manage some of your problem credit accounts.  We have a team of professionals who have experience with managing problem credits that can assist your team, thus saving you time to focus on your good clients while saving you labor cost of additional staff. 

Our Credit Risk Advisory Services are led by Gary Stoley.  Gary spent 33 years as a regulator with the OCC before retiring in 2010.  He has experience with all areas of credit from policy framework to collections.  His experience is in many sectors of lending:  small business, oil and gas, agriculture, C&I, asset based lending, secured financing, A/R lending, factoring, home mortgage, equity, indirect auto, and unsecured personal loans.  You can contact Gary at gary.stoley@pactola.com

Our Contracted Problem Loan Management  is led by Randall Pownell.  Randy has over four decades of experience with commercial and agricultural lending with extensive experience with collections and problem loan management with the Farm Credit Services.  You can contact Randy at randall.pownell@pactola.com

Bar Napkin Analysis for Member Business Loans

As a CUSO that helps smaller Credit Unions with the startup of their Member Business Lending departments, after drafting a loan policy, the next thing I hear is ‘What now?’ This is a loaded question, because every member and his or her request is going to be different, but there are some basic steps that you can follow to help you determine the credit worthiness of a member’s request before too much time is wasted.

Step 1: Don’t start out quoting rates!! Starting out quoting rates before you know the details of the loan request is setting yourself up for failure. First, a member that is shopping for the best rate isn’t likely to be with your Credit Union for the long haul. Smart business owners know that there is value to a good relationship with their lenders, and if that comes down to an extra .5% on a loan, they will be willing to pay it. If they walk, you will likely see them back in a year when they find out their bargain basement interest rate wasn’t all it cracked up to be. Second, interest rates should be reflective of the structure and general risk of the loan. Quoting the same interest rate for a 5-year single family residential rental loan as a 12-month term line of credit that is tied to a borrowing base makes no sense. The latter is going to require significantly more time to monitor and service, and inherently carries more risk.

Step 2: Have your member complete an application. Pactola’s website, www.pactola.com, has applications available to download for both commercial and agricultural loans, and each include a complete checklist of the items that your member will need to provide. These items will get you started on your bar napkin analysis of the credit request. If your credit union is a subscriber of Pactola, shoot us an email with your logo and we can get these applications customized for your Credit Union as well.

Step 3: Evaluate the collateral. Depending on your Credit Union’s loan policy, you will want to evaluate the collateral to make sure it is within your loan policy’s limits and is readily marketable. If it is equipment, do you need to discount the estimated value due to age or condition? You will then want to look at the maximum loan term, amortization, and LTV your policy will allow. Let your member know these terms so they know how much equity they will need to bring to the deal, and that those terms are how you will initially analyze the loan, but are not guaranteed. These terms are relatively fluid until closing.

Step 4: Time to analyze. Now that you have received the historical (or proforma, if a start-up) financials on the business, it’s time to analyze. Ideally, the primary source of cash flow is going to come from the gross revenues of the business. This can be rental income, sales of goods, cattle sales, etc., but this is how we want our debt to get repaid. Starting with the Net Income, add back any Depreciation expense, Interest expense, and Amortization expense. You have now calculated the business’s Net Operating Income (NOI), or EBIDA. This is the cash the business has to service its debt. Again, this is a bar napkin analysis just for you to see if there is merit to the request; these calculations can get much more complicated depending on the business. You will then calculate the estimated Debt Service Coverage Ratio, or DSCR, which is the NOI divided by the proposed debt service. Ideally, you want to see this above a 1.20x. If they are in that gray area of 1.10x and 1.20x, it may be worth looking at further; however, if it is below the 1.10x level the primary source of cash flow starts to be put into question.

Step 5: Look at the Guarantor’s resources. The secondary source of cash flow after the business revenue is likely going to be your guarantors’ cash flow and resources. Do they have a strong equity position or are they highly leveraged? Do they have liquidity to help supplement any cash flow shortages? What are their assets? Do they have diverse income sources, or are they solely reliant on the business for cash flow? Although a full personal tax return spread is not necessary at this stage of evaluation, you can usually get a good feel of the guarantor strength by answering these questions. Having a strong guarantor to backstop a loan is especially important when the cash flow from the business is weak or erratic.

Step 6: Underwriting. Once you have a signed term sheet and all of the necessary items from your borrower, it’s time to dive into underwriting. Business loans are evaluated based on the 5 C’s of Credit: Character, Capacity, Capital, Collateral, and Conditions. If you have a new business lending department or just don’t have enough staff resources to do underwriting in house, Pactola can act as your third-party underwriter.

Whether your Credit Union is just starting its member business lending department or you have found yourself struggling with initially evaluating a loan request, these steps can help get a good conversation going with your member and prevent wasted time on poor requests. Pactola is here to help in making your lending department great!

When EBIDTA is Leaky

In my days as a young pup commercial lender, I first learned of EBIDTA.  To those of you in rural Missouri (where I came from) this stands for Earnings Before Interest expense, Depreciation, Taxes, and Amortization.  It may also be known as Traditional Cash Flow (TCF).  Basically, the thought here is, how much money does the company generate after paying all its operating expenses?  That is the amount you have left over to satisfy debt payments, make capital improvements, and reward the owners. 

To the lender, understanding this concept is incredible.  Now you have a tangible method to see if a business generates sufficient funds historically, or in projections, to make the debt payments required on the loan you are underwriting.  When I first discovered this, I thought I found the golden key that would unlock the mysteries of commercial underwriting.

The problem is that it only unlocked some of those doors and often, as in credit analysis, the answer may not indicate something good or bad, but point to further digging that needs to be completed.  One of the first examples of how wrong relying on EBIDTA came with the WT Grant bankruptcy in 1974.  Grant was a large retail chain with a long history of impressive earnings growth.  They had a strong TCF or EBIDTA.  To creditors it looks like they could easily handle the debt payments that they were required to make.

The bankruptcy caught a lot of creditors by surprise and this generated a large leveraged buyout.  What happened?   Almost all the TCF was eaten by increases in accounts receivable.  This left a fraction of the cash that was needed for debt service, instead of a multiple thereof.  Unfortunately, A/R does not pay the loans; cash does.

In this case, EBIDTA measurement failed to identify the leaks that drained cash from a business that looks outwardly profitable.  This set off alarm bells in the banking community and identified the need for a deeper dive in the analysis of the company.  Accountants went to work and began to create what became the statement of cash flows to help capture what is happening with the company cash from both a direct and indirect method.  Bankers created the Uniform Credit Analysis (UCA) method to analyze sources and uses of cash.  This has become a standard of spreading software that is used every day by lenders. 

TCF works generally well when you have a loan on commercial real estate, where the amount left over after EBIDTA is usually free of leakage and can be used for payments, CAPEX, and owner distributions.  But absent of that type of credit, your solid boat of EBIDTA, may end up being as porous as your kitchen strainer.  Consider these leakages:

Accounts Receivable may increase to levels where they use up cash and leave none available for loan payments.  A/R is not cash, but the sales do go into the top line of gross income and, if sold with a positive margin, will increase the EBIDTA.

Inventory is another use of cash.  I once looked at a retail business that continued to borrow repeatedly as they poured all profits back to getting more stuff they could sell.  Their inventory levels were so high that at then current levels of sales, it would take 2 ½ years just to sell through the stuff.

Accounts payable that are paid quickly are a use of cash.  Many times, generous terms with suppliers may help the company avoid the need of an operating line.  Having A/P turns that are much shorter than others in the industry may keep you on great terms with the suppliers, but also increases the need for borrowing.  I once studied an ice cream shop that had no debt, real estate of over $3MM in value, and took care of all their financing with 45 day terms with all their suppliers.

Capital expenditures, or CAPEX, can be a huge drain on EBIDTA.  If you have a business that requires the purchases of new equipment or long-term capital improvements to real estate for the business to continue to generate positive cash flow.  An example here would be a manufacturer who must replace machinery that normally wears out with use.  Another example is a hotel that has to replace case goods and floor coverings in a room.  In either case, large sums of money need to be spent to continue generating the top line revenue.

Owner dividends or distributions are also another leak of TCF.  Now people go into a business or purchase a piece of real estate, to receive some personal reward after satisfying all debt and operational expenses.  A challenge here is if the business owner or farmer drains off excessive amount of profit in good years, they may not have resources in the poor years to take care of your debt. 

So, is the EBIDTA or TCF that you are looking at subject to leakages?  This is an important analysis as you consider your possibility for repayment of your loan.

Is EBIDTA the Holy Grail of Understanding a Company?

I remember the first time I was in a classroom at the bank I worked for in Jefferson City, Missouri.  I was a seasoned banker, but quite a young pup when it came to the commercial and agriculture side.  One of my banking mentors taught a short class on how to figure the Debt Service Coverage Ratio (DSCR).  This is figured by taking EBIDTA (Earnings Before Interest Depreciation Taxes and Amortization) divided by the annual debt service requirements for the firm. 

I was amazed.  I was looking for the holy grail, the excalibur that I could use to dissect the financials of a farmer or a business and gain clarity of whether the company could manage the proposed debt requirements for the loan request.  I thought I had just conquered commercial lending.

EBIDTA or another similar term, Net Operating Income, is not only used in calculating the DSCR but is also used in figuring value by using Cap Rates.  So now I was even more excited that I could not only see if the company could service its debt, but I could get a value of the company or the collateral as well.  Now the conquering of commercial lending turned into a mastery of the subject.   High fives all around.

My mom always warned me about getting "too big for my britches”.  That is good advice, as life is a constant learning experience, and just when you think you are really solid, get ready for a fall.  This was the case with my supposed mastery of the subject.  I quickly learned there is no holy grail, only road signs to help you determine the health of a firm.

It all came clear with a manufacturing company who wanted to acquire a new machine.  I did all the due diligence and determined that the customer could historically service his existing and proposed debt based upon my EBIDTA and DSCR calculations.   I completed my write-up and sent it to my boss.  The wise sage requested to see a detailed depreciation schedule.  I wondered why, since you could get the whole depreciation figure from the income statement without looking at the schedule. 

The sage called me in the next day and said, "Young grasshopper, the company has three pieces of machinery that will need to be replaced next year according to their history and depreciation schedule.  Where will the capital come from for the machinery?"  The manufacturer had equipment or parts that went on larger pieces of equipment which would wear out every two years and need to be replaced.  Since the replacement would be completed and benefit the company beyond this fiscal year, they capitalized and depreciated the asset instead of expensing it as a repair item. 

So, I had failed to account for that planned expense.  Calculating it in took my slam dunk deal into questionable territory or maybe a denial.  I trudged back to the company's CFO to get more answers. 

An important factor in analyzing a company is to look at required and necessary capital expenses that will be required to maintain the current level of production.  For my firm, the $150K for machinery press and drill parts was necessary for keeping three key machines running to continue production of granite countertops; otherwise, the company could not machine cut the countertops and would have to cut all by hand.  This would either require more staff or less production, either of which would drop the NOI substantially.  We had to uncover how those items would be paid for.  In this case, the company had set aside most of the money and was planning to pay for the last 1/4 with cash from several large sales they were to get in the next two months. 

This was a case in which only looking at the EBIDTA or NOI to figure the DSCR was not enough.  It required a further look into the planned capital expenses to determine the adequacy of cash in the company.

It is possible that the EBIDTA number can be understated.  I have banked with some hotel operators, who will expense any repair or improvement item for the hotel:  light bulbs, replacing broken furniture, new carpet, or repaving the parking lot.  All of these have different treatment accounting-wise.  The light bulb is a consumable item that should be run through the repair expense.  Replacing broken furniture can either have an expense for the broken piece depreciated out and the new one capitalized, or one could just expense the new one in the repair line.  The carpet should be depreciated over the expected life of the carpet.  In the case of this hotel, it was around 5 years.  The parking lot had an expected life of 15 years. 

If all of these items were in the repair expense, it would be counting repair items that would not necessarily be occurring every year.  Perhaps you may want to do that if you have a property that is requiring large amounts of ongoing capital investment year after year.  But in most cases, the one-time expenses should be pulled out, and a capital expense allowance can be used.  This is an estimate that on an average given year, some percent of gross income (usually 3-5%) will be spent on capital improvements for the property.  Using this method will help average out the EBIDTA in years when improvements are made and expensed, and in those years when no additions are done.

The Commandments of Borrowing

1.  Asking “How?” and “What are the proceeds used for?” is just as important as asking “How much?”  In the majority of borrowing situations, the business owner focuses only on how much money they need as their primary concern.  But understanding what the proceeds will be used for and how the loan will be repaid is equally important, because ignoring these issues could lead to borrowing wrong.

“Is borrowing wrong even possible?” you may ask.  It is not only possible, but it is probably likely, unless both the debtor and the lender approach each borrowing situation armed with a firm understanding of the basic financing patterns and the lending requirements for the correct structuring of liabilities.  Improper financing can be the death to a business. 

2.  Growing businesses and farms will often require an increased investment in both current and fixed assets.  It is incorrect to assume that growth in revenues will occur without any required growth in assets.  The only case where this is not true is if there is gap of unused capacity within the growing company and an increase in efficiency where the result is an increase in sales. But in most cases, if your borrower expects to double his sales, it will require an increase in resources to accomplish that.

3.  Fluctuating current assets should be financed by cash or short-term debt and paid off by cash flow.  Recently, I saw a financial statement from a company that had a large debt to a supplier that was over six years old!  This is a situation where the borrowing was improper.  If you borrow money from a lender or a vendor to get supplies that you need to manufacture your product, that debt should be paid off when you sell the product and are paid.  It should not be paid off from net profits after all other operating expenses are taken care of. 

Lenders can help manage this structure with using borrowing bases and other controls to force the business to pay back the operating lines in a timely manner.  This also requires understanding how and when cash flows through the business for proper structuring.  Lines should be reviewed at least annually and should be monitored at least monthly.

4.  Permanent current assets are financed by equity, permanent current liabilities or intermediate term debt and are paid off by net profits.  Any seasoned lender has been in a place where a line of credit becomes “evergreen,” in that it does not get paid off or reduced in outstanding balance.  This is a clue that the line is improperly structured.  These debts should be placed on an amortized payment and paid off by the net profits of the business over a reasonable period of time, perhaps up to 5-7 years.  The struggle here for the lender is how to properly collateralize this loan, since assets such as real estate, buildings and equipment may already be pledged.  Use of a government guarantee like the SBA may be a nice alternative to mitigate the risk. 

Permanent current assets are the base levels of cash, accounts receivable and inventory that these items never drop below.  If a company has an accounts receivable level of $50,000 and inventory of $50,000 with sales of $1MM, then it is expected that the company would need to have receivables of $100,000 and inventory of $100,000 to reach sales of $2MM.  This is assuming the accounts and inventory receivable turnover ratios remain constant. 

Of all the needs for lending, the most difficult may be the permanent current asset financing.  When a company has real growth, as opposed to a seasonal fluctuation, that represents a permanent increase in current assets, these will behave like a fixed asset.  This should be financed with equity, permanent current liabilities, expanded terms from suppliers, or intermediate term debt. 

5. Fixed assets are financed by equity and long-term debt and are paid by net profits of the business.  Most of these assets are capitalized and depreciated.  Fixed assets usually relate to fixed costs, those that do not change relative to sales over a reasonable range.  Increases in fixed assets should lead to greater capacity for the business to increase revenues. 

These are generally the easiest to finance.  The amortization term should not exceed the useful life of the asset.  Proper LTV, LTC, and terms are usually spelled out in your loan policy. 

6.  Ignoring these principles will lead to friction between the borrower and the lender.  It could lead to a business that fails and a lack of sleep as the loan officer worries about the customer.   Proper adherence to these ideas will give the business or farmer the best chances for success and also grant adequate cash flow to sustain the business.

MWBS Can Help Increase Your CUs Earnings with Farmer Mac

Midwest Business Solutions is excited to add another tool that can help make your credit union money—Farmer Mac loans.  MWBS is now a direct seller to Farmer Mac.  FM offers a variety of fixed and variable rate financing on farmland, ranch land and farm facilities.  Leased farm ground may also be eligible.  Variable rates can fluctuate monthly, or on a one, three, five, ten, 7/1, or 10/1 year basis.  Fixed rates can be locked up to 25 years.  Amortizations on these loans can run up to 30 years.  The property must be involved in production of an eligible commodity as those listed by the USDA and must have at least $5,000 of annual gross agricultural sales.

FM also offers an AgEquity Line of Credit that gives the farmer a 5 or 10 year draw period followed by a repayment period of up to another 25 years.  The payments during the revolving draw period are interest only and will fluctuate monthly. 

Mortgage amounts are typically up to $11 million, and the maximum loan request for any one borrower is up to $30 million.  Payments can be set up monthly, semi-annually or annually for your borrower’s convenience.  The interest rates will be directly competitive with those at FSA or with an insurance company who finances farm ground.

These loans also represent no risk to you, as they are all sold into the secondary market.  You can think of it as a FannieMae or FreddieMac loan for farmers.  Since this is the case, your institution does not need to have an experienced ag or business lender on staff.  Any institution could participate in this loan.  Those CUs who have ag loans on their books, may find this product valuable to manage your balance sheet exposure.  You can move the term debt on the land to a FM product while you keep the equipment and operating line debt.  This can also help manage duration risk of placing a large fixed interest rate loan on your books while giving your farmer a product he wants.

The best thing is that even though this product is sold into the secondary market, you still have an opportunity to make money.  You can make money at origination and also can make servicing income throughout the life of the loan, even though it is not on your books.  If you had a FM loan with an average balance of $1 million and were making 50 basis points on the servicing side, this would translate into another $5,000 of non-interest income for your credit union. 

You can find out more about our FM loans at www.mwb-s.com/farmer-mac.   Our site also has information on the different FM loan types, an underwriting grid for various FM loans and a series of questions to help you talk about this product to your customer. 

We will be sending out rate sheets on a weekly basis for the Farmer Mac products.  If you want to get on our rate sheet email list, email me at phil.love@mwb-s.com.

How MWBS Manages a Participation Loan

Do Participation Loans Scare You?

The proper answer here is:  “They should!”  Especially if you do not have a clear idea at any time how the file is being managed.  Concerns over what information is or is not present in a file and if the risk profile has changed from what you know will keep you awake at night.  Thinking about how an examiner will treat a participation that lacks proper loan documentation is downright a nightmare!

 Recently, we closed a major participation loan.  Even after the closing, there exists some confusion among the participants as to what role MBS plays in the transaction and what role the credit union plays.  In this blog, I thaought it valuable to provide an overview of what each stakeholder does in a MBS participation.

Pre-Underwriting to Term Sheet

The interaction between MWBS and the member is determined by the lead credit union.  In the most recent loan we closed, the lead was not familiar with lending in the borrower’s industry.  They provided us the contact information, and we met directly with the partnership group to discuss the project and gather all necessary documents to underwrite the loan.  We also met directly with the general contractor and the developer of the retail/office development.  After these meetings and our collection of information, we worked with the lead credit union as to acceptable terms for the loan.  These terms were documented to the client in a term sheet.

Each interaction with a commercial or agricultural member is different.  It is the responsibility of the lead credit union to determine when and to what extent to involve MWBS directly with the client.  I have spent over 20 years in the field.  I hated when my relationship with the client was usurped by a manager who had nothing better to do than to meddle.  Sometimes I had to apologize to the client after the meeting just to keep the relationship going.  At other times, directly bringing in an expert from the credit side of the shop helped strengthen the customer relationship and navigate the credit request into a closed loan. 

So it is my belief and also the position we take at MWBS, that the level of direct interaction between MWBS and your customer is determined by you as the lead.

Underwriting to Loan Sale

Once the borrower approved the terms, we then continued the underwriting process by analyzing all relevant information and preparing a comprehensive write-up.  The lead credit union reviewed both the write-up and all source documents, made suggestions for improvements on the credit analysis and then approved the deal.  In this case, the credit union did not want to own the entire credit, so a participation sale was needed.  MWBS revised the write-up for the sale and began to market the opportunity, first to MWBS members, then MWBS subscribers, and finally to any other interested funding source.  In each presentation, the interested loan buyer had access to both the credit presentation and all source documents to make their own judgment about the appropriateness of the credit for their portfolio.

At the same time, all other things necessary to complete the underwriting, such as the appraisal, environmental report and title work, were all ordered and reviewed by MWBS.  These documents, along with MBS reviews, were presented to the participants.  

Closing

Closing documents were prepared by MWBS.  We have a loan document system that allows us to prepare appropriate closing documents, applicable in any state.  In this case, we had participants in North and South Dakota, a borrower in North Dakota and a project in Minnesota.  The document set was sent to all participants and borrowers for review prior to closing. 

MWBS worked directly with the title company to arrange the closing and utilized the title company to close the transaction and handle the filing of all appropriate lien documents. 

Construction Management

MWBS will manage the construction process on this loan.  We have contracted with a title company to handle all disbursements and lien waiver collection.  We also have a third party architect that will provide percentage of completion inspections throughout the process.  This is in addition to the general contractor and architect of the borrower signing off on each draw request. 

Draw requests and inspections will be presented to the participants when funds are needed.  Each participant will be able to review the request and will then electronically transmit the funds to MWBS’ account.  MWBS will then directly pay the title company, who will pay the construction bills.

Loan Servicing

MWBS services its own participations.  All bills and statements are generated by MWBS and sent to the customer.  Any other customer communication, such as sending tax statements, comes from MWBS.  Payments are sent to MWBS and applied to the loan, utilizing the core processing system of MWBS.  Monies are distributed to each participant, along with a detailed breakdown of how they should be applied.  It is the job of the lead and its participants to apply their payment appropriately.

Loan File Management

It is my belief that if you are the participant on a loan file, you should have access to whatever is in the file.  We provide that through a secure electronic file that can be accessed on-line.  Each credit union participant has its own folder set up on our servers and its own unique password.  A credit union can log in and view its loan files in an indexed fashion whenever it wants. 

File management is ongoing, and MBS utilizes an electronic tickler system to track when information is required to be placed in the file according to the loan covenants.  Notifications can be sent directly to the borrower and communicated to the lead credit union, if assistance is needed to collect documents.  MWBS reviews these loans in light of the current financial information on an annual basis.  A term loan review is prepared, along with a new risk grade, reflecting the current condition of the credit.  All this information is placed in the electronic file.  Loan owners can access current information that has been processed by MBS inside the file.

The Role of the Credit Unions

The loan owners may find this structure is different than other participations they are involved in.  The lead credit union helps determine the direct level of involvement MWBS has with the client.  The lead may assist MWBS in obtaining all the necessary documents for underwriting, but the lead does not produce the loan documents, close the loan, accept payments from the customer and pay all participants directly.  All this is handled by MWBS. 

I would like to say the participants can just sit back and relax after the loan is closed, but I would be lying if I told you all you had to do was to clip payment coupons that we send you.  The loan participation is still an asset on your books, and as with any asset, you must watch and monitor it as if this were money from your own grandmother.  The MWBS structure gives you the proper tools to do that.

Selling from the Front Porch

I used to love going with my parents to my Aunt Betty and Uncle Andy’s house when I was young.  They lived on a farm in the country.  We would usually get there in the late afternoon and begin to spend some time fishing or picking fruit and vegetables from their large garden and orchard.  The work was followed by a hearty supper, which always included some form of meat.  Andy was a hunter, and you were never told what you were eating until after the meal. 

We typically would retire on the warm Missouri summer nights to the front porch, where we would work on processing the garden produce.  Oftentimes, we would have a glass of sweet tea or some homemade ice cream.  We would sit together, talk and share our lives with each other.  It was what happened after supper that taught me some of the best lessons on sales that I have ever learned in my life. 

Saying you were sold something is always a negative, saying you bought something is always a positive.  Jeffrey Gitomer says it like this, “People hate to be sold something but they love to buy.”  I first learned this one night when a neighbor of my uncle’s dropped by to complain about the “lemon of the truck he was sold.”  The salesman had “sold him a bill of goods” about the truck’s ability.  My uncle, who has always been a proud GM owner, began to rave about the Chevy truck he recently bought. 

If you listen to yourself and to other people, you will find this principal to be true.  Every time you have a bad experience with something you bought, you never want to take ownership that you actually made the decision to buy it, but that you were “tricked” into acquiring the item by a salesperson.  When you make a purchase you are proud of, you tend to puff out your chest and announce to the world how smart you are.

People don’t care how much you know until they know how much you care.  I saw this with a few salesmen who would wander up the driveway when we were snapping beans.  One guy, who was selling encyclopedias, was interested in only finishing his well-rehearsed sales speech and ignored some of the questions my aunt had.  He was only interested in getting to the close.  He ended without any sale, because he did not care about the customer. 

The knowledgeable salesman was in stark contrast to a fuel salesman. My uncle used a bit of fuel around the farm in his equipment.  One evening Joe, the fuel salesman, came by.  He did not have a well-rehearsed sales speech and was not in a hurry.  Instead, he sat down in a chair on the front porch and began to shell peas with the rest of us.  He was genuinely interested in my family as we shared life together.  He did not get the sale that evening.  It did take several more evenings of snapping beans and shucking corn on the porch, but eventually, he did get my uncle’s business, the business of the rest of his family and also the majority of the neighbors.

People find it easier to buy from people they know and like than from strangers.  Not only that, but if they know and like you, they will refer other people they know to you.  The adults in my family would frequently recommend mechanics, butchers, ag suppliers and anything else that they had a good relationship with and they trusted.  They were also not afraid to tell about those they wouldn’t touch with a ten-foot pole.

In order to sell, you must first come up to the porch.  No matter if you like it or not, we all must sell to survive.  Even though credit unions tend to be more relational than our banking brethren, we still must sell ourselves and our institution.  The most successful sales people are those who are wise enough to take the time to join your members and future members on the front porch or the back deck.

These are two places where life slows down.  Everyone on the porch is a real person who has hopes, dreams, history, fears, successes and things that keep them up at night.  You can be successful on the porch if you show interest and are genuinely curious about other people.  It is in the sharing of life that relationships are built.  As those relationships are built, your credit union will grow as more members come into your group.  They will not do so because you had the best rate or the best product.  They will do so, because they believe you are the best one to meet their financial needs.

Someone once asked me how I could so naturally visit with business owners and walk away with loans and deposit accounts.  I smiled and said if I ever lose my bearings, I just close my eyes briefly and step onto their porch.  If you want to be successful, sit down and pour a glass of tea.  You may find the pace a little slower than the telemarketer, but you will find some friendships that will last a lifetime.

Challenges with Available Collateral and SBA Loans

Small Business Administrative (SBA) loan requests are not to be declined solely on the basis of inadequate collateral.  Lenders can use the SBA program for borrowers that can show they have an adequate repayment ability and cash flow but have inadequate collateral to fully secure and repay the loan if it defaults. 

SBA will require that the loan must be “fully secured”.  This means that the loan must have a security interest in all available assets with a combined liquidation value up to the loan amount.  “Liquidation value” is the net amount expected to be received after the asset is sold.  This net amount considers all care and preservation expenses and existing liens have been taken care of. 

As a lender, the SBA requires you to identify all available collateral and determine the liquidation value of each one.  The liquidation value may be determined by the lender based upon their conventional or SBA lending policies. These must be consistently applied from loan to loan.  The SBA does not define exactly how a borrower’s personal residence should be valued.

In the SBA Standard Operating Procedure (SOP) 50 10 5(E), Chapter 4, the SBA does require that lenders secure each loan to the “maximum extent possible up to the loan amount”, utilizing the assets tied to the borrowing business as well as the personal assets of each principal.  It does not matter if those personal assets are owned individually or jointly.

If the loan is not fully secured, the lender should determine and certify that no additional collateral is available.  This should be documented in the file.  If there is a collateral shortfall, this should be mitigated by the other strengths in the file.  If other assets are available, they should be taken as collateral.

In the SBA 7(a) loan, it is a common practice to take the borrower’s primary residence as additional collateral for the loan to prevent a shortfall or impairment to an SBA Guaranty, in the event of liquidation or default at a later date.  There are two exceptions to this rule:

1.  A personal residence that has equity less than 25% of the property’s fair market value.

2.  When there is a legal impediment, such as an irrevocable trust or a prenuptial agreement, that prevents the borrower from using a spouse’s individually-owned property to secure a loan.

In the SBA 504 loan, it is extremely rare for a Borrower’s personal residence to be taken as additional collateral.  This may be more desirable to the member.

Proper handling and securing of collateral when using an SBA loan will provide protection for your Guarantee.  The SBA program should not be used to place a marginal loan on your books.  A problem loan that has an SBA guarantee will require a lot of your time and effort to manage the credit.  The SBA program should be viewed as a way to help mitigate the risks for a good credit that may have some weaknesses in the collateral coverage.  

Leverage Ratios

Leverage Ratios measure relative levels of financial risk taken on by creditors and shareholders of a business. This risk is based upon the fixed payment requirements of debt. They show how much protection the company’s assets provide for a creditor’s debt since all assets are funded by debt or equity. This is where the equation assets = liabilities + owner’s equity comes from.

The Debt-to-Worth Ratio shows the degree of protection that is provided by the company’s creditors. The higher the ratio, the more leverage there is in the company and the more of the company’s assets which are funded by debt. This measures the company’s ability to liquidate its assets in order to retire debt. It can also be used by the reader to measure how much a company can reduce the valuation of its assets before creditors may sustain a loss.

This ratio can vary greatly between industries and companies in an industry. It can also vary by how a company is set up. For instance, S-Corporations, partnerships and some LLCs are set up as a pass through entity where the tax liability is transferred from the corporate level to the personal partners or members. Often, distributions will be made to the owners to help them satisfy tax liability that was created by the company operation. This can reduce equity in the company.

The ratio is calculated as follows: Total Liabilities / Net Worth = Debt-to-Worth Ratio

If a company is in a negative equity situation or has assets with values that are lower than the total of the liabilities, that company is considered insolvent.

If we have a company with $2MM in liabilities and $1MM in equity then the Debt-to-Worth (D/W) is 2:1. So for every $1 the owners have at stake, the creditors have $2 at risk. These relative values could be much different if the market or liquidation values differ greatly from what is shown on the balance sheet.

The Debt-to-Tangible Worth Ratio is slightly more conservative than the D/W Ratio. This removes any intangible value from the equity side of the equation. If our company above had $500K of value in goodwill, a patent, trademark or other intangible asset, this would be removed from the equity side of the equation.

The calculation here is: Total Liabilities / (Net Worth – Intangible Assets) = Debt-to-Tangible Net Worth Ratio.

$2MM / ($1MM-500K) = 4:0 In this case you can see that removing the intangible assets makes the leverage increase.

The Long Term Debt to Net Fixed Assets Ratio measures the amount of debt that funds the fixed assets of the company. If you had a value of 0.54, then 54 cents of each dollar of assets is funded by debt; the other 46 cents is funded by equity.

The Debt-to-Capitalization Ratio is often used by bond rating agencies like Moody’s and S&P to measure the permanent capital of a company—its long term debt and net worth. This shows what percentage of the company’s permanent capital is financed with debt compared to equity. This ratio ignores any short term liabilities that may be tied to financing receivables or inventory and may be repaid by current asset turnover or seasonality changes. This also shows how the company is relying on long term debt which finances assets and the level of profitable operations to support the leverage. The calculation is as follows:  Long-Term Debt / (Long-Term Debt + Net Worth) = Debt-to-Capitalization Ratio

If our example above has $1.5MM in long term debt and $1MM in net worth, the calculations would be as follows:

1.5MM / (1.5MM + 1MM) = 0.60 The company’s long term creditors would supply 60 cents and the investors would supply the other 40 cents of each dollar of capital.

Customer Loyalty is Golden

My oldest son took a seasonal position at Best Buy this past Christmas.  He is very skilled and knowledgeable at all things electronic, gaming and computers.  One evening, after work, we sat at our kitchen table, and he shared stories about the silly things various customers did that day.  After a half of an hour, I asked him how he liked his job.

“It’s great.  But if I could not deal with customers, it would be awesome!” he replied. 

His answer reminded me of a Peanuts comic with Linus and Lucy.  Linus has decided he wants to be a great doctor making a great difference in humanity as we know it.  Lucy tells him he cannot do it, because he doesn’t love mankind.  In the final panel, Linus declares, “I love mankind.  It’s people l can’t stand!”

If we are honest, often in the day, we have the attitude toward our members like my son and Linus.  So one day, centuries ago, some business owner came up with the idea that his company needed to satisfy his clients.  Customer satisfaction became the byword that has been charted, measured, surveyed and analyzed since that time. 

Satisfying your members or your clients is worthless.  Think about it.  If I go to a store or a restaurant and leave only “satisfied”, will I go back again?  Perhaps.  That establishment has gone into the pool of possible places to shop the next time I need that item.  Will I go there again?  Maybe.  But they will compete in my mind with all the other places where I was only “satisfied”.  My final decision will be based upon the cheapest alternative among all the shops that only “satisfied” me. 

I worked in a savings and loan in my hometown in the early ‘90s.  We did a lot of residential mortgages, so my goal was to develop relationships with each Realtor in town to get them to send their clients to me.  My goal with each one was to exceed the expectations of the client and the Realtor.  One year, the largest real estate company in my town sent half of the closings his office did to me.  They also did not recommend any other mortgage place but mine.  This happened, not because of mere customer satisfaction, but because of the relationship I built with them.

The true gold in them thar customer hills is loyalty.  If I my members are loyal to me, they love me. They know every time they do business with me, not only are they satisfied, but they have received added value to make them even more successful.  Coming back to me is an automatic response for them and not a decision based upon price.  They also will tell everyone they know about me, and their testimonial is precious.  If you are one of the very few lucky ones, they will even bring potential clients to your desk. 

Think about it.  My wife and daughter love Starbucks.  The price of the coffee and tea there doesn’t faze them.  They like the quality, taste, atmosphere and friendliness of the staff at Starbucks.  In one community we lived in, the only store where there were friendly people was at Starbucks. 

Now they can probably get the same product at another store, perhaps one even less expensive.  But is that in their decision process for good iced tea?  No, because they are loyal to Starbucks.

Customer loyalty is your goal.  Every contact you have with a business client is an opportunity you have to continue writing the story between you and that client.  What kind of story are you writing?  The first step toward loyalty is to treat your members the way you would treat your favorite sports hero, celebrity, friend, grandmother or yourself. 

New Business Ideas: How to Determine the Contenders from the Pretenders

A client sits across your desk and pours out a business idea that he needs financing for.  At this point, you don’t know if his idea is destined for failure or will be the next success.  After all, most successful businesses once started with someone with an idea sitting across the desk of a loan originator requesting a loan to get started or to go to the next level. 

Commercial and ag lending is humbling.  You can review the facts and make the best judgment possible on the loan request, but you never know if it was a good decision until much later.  The only good loans are those that eventually pay off.  So, hindsight is always 20-20, but there are some signs you can look for to determine if the idea presented to you is worth an investment in the form of a loan from your institution or not. 

Experience and Education.  Does the customer have experience in the business field that he wants a loan?  Borrowers who have the training and work experience in the field they will be operating in have an advantage compared to those who do not.  You would not want to give a loan to someone to open a medical clinic that does not have the background to operate the business.  This principle will apply to whatever business you are looking at. 

Not only do you need to look at the background of the borrower in front of you, you need to look at the experience and training of his key personnel compared to the skills required to make the business work.  For example, if you had a few good cooks with only culinary skills who want to open a restaurant, there may be some challenges since they do not understand such things like managing staff, running the “front of the house,” and optimizing cash flow.

Equity.  Successful business owners have “skin in the game.”  This can come from cash, property, or equipment they are bringing into the business.  You should run from any loan request where the borrower is expecting you to provide all the proceeds for the project and there is no investment from the borrower.  If the borrower’s idea is good enough, the request is for a venture capitalist not a credit union.

Earnings.  Good loan requests on established businesses will have a history of earnings that can support the request.  The challenge is what do you do when you are dealing with a new business venture or a huge increase in the business where there is either no history or not substantial history to support the request? 

A good lender will look for mitigating factors to combat this risk.  How reasonable is it that the business will succeed?  Does the borrower have other source of income to sustain his life while the business is in its early stages?  Can you look at some option like a government guarantee to reduce your credit union’s exposure?

Ease.  I call this the “ease test.”  Pretend that the only source of loan money was from your dear, wonderful grandmother.  She has worked her entire life for her meager nest egg and now is relying on you for investment advice.  If you took her money and lent it to your borrower, how easy would it be to explain to her your lending decision?  Would she be proud of your action?  Or, would you have to spin a verbal tale to her to justify your actions?  If you want to be a little more scared, you should be prepared to explain your decision to your management or to your regulator. 

Remember lending is more of an art than a science.  I cannot tell you that every request you have that meets these tests will end up as a good loan.  I also cannot tell you that if a request was lacking in an area or two if it will turn out to a problem loan.  I can tell you that lending involves looking at the overall picture and applying a good dose of common sense.