Partners (Winter 1996)

American Gothic Why Loans Go Bad
John Campbell
Conventional loans don't always perform as agreed. In this article, an examiner reviews some of the reasons loans go bad, and offers several suggestions to prevent problems before they arise.

Why do some loans, originated as apparently sound credits, deteriorate as they age? Over the years, I have heard literally hundreds of "why's". Often a loan officer who originates a loan that ends up on a bank's watch list, on a delinquency report, or in the workout department, points to external factors outside his or her control.

Problem credits are frequently attributed to a personal tragedy experienced by the borrower, an unpredictable reversal in a borrower's financial condition, fraud or misrepresentations by borrowers, borrowers that become uncooperative after the loan is made, a downturn in the local or national economy, natural disasters, and other events that some lenders feel were not foreseeable or controllable.

I think there is a more basic reason for loans going bad than the various "why's" discussed above. Although many unexpected events contribute to loans going bad, most loan problems that I have seen resulted primarily because lenders did not closely adhere to fundamental underwriting practices. Lenders need to anticipate a wide range of possibilities. Adhering to time honored lending practices will protect the organization when the unexpected occurs. Lenders who do not closely evaluate a customer's ability to repay in various scenarios -- including adverse circumstances -- and structure loans accordingly, often find the obligations they have booked end up in the charge-off records. Underwriting should include consideration of the "what if's" and provide for repayment if things don't go as anticipated.

A type of loan that I have routinely seen in South Florida, the undeveloped land loan, often provides an example of faulty underwriting. All too often a lender violates fundamental underwriting rules when he or she makes a vacant land loan. In most cases, the repayment of these loans is dependent on resale of the collateral property and typically there are no other reliable backup repayment sources. Generally borrowings made on the undeveloped land are to borrowers with limited cash flow to service the obligation. If the borrower does not or cannot sell the property in a relatively short period of time, the lender is often faced with deciding between either foreclosing on the property or deferring payments for extended periods.

Underwriting standards are sometimes sacrificed because of market competition. In rare cases, it is appropriate for a bank or other lending organization to approve loans that are exceptions to standard guidelines. However, the pressure to compete often drives an organization to approve too many loans that do not conform to the institution's or industry lending guidelines. The current banking and general business environments seem to be stimulating growth initiatives and strong competition in a saturated market. Those influences may negatively affect adherence to prudent lending standards.

One loan officer I recently spoke to alluded to pressure on lending standards. He referred to the "hope factor" as one significant deterrent to sound underwriting. A lender, he explained, often hopes a marginal loan presented for approval at an institution will improve based on some future event. Loan committees may also overlook shortcomings in a loan presentation and approve a loan because of promises a borrower has made, other unrealized expectations, and the competitive push to book loans.

A borrowing applicant, for example, may indicate that even though the historical cash flow from an income producing property being pledged as collateral does not provide adequate debt service coverage, a new lease being negotiated will provide the necessary coverage. Or a borrowing entity may provide very positive earnings projections despite losses in previous years. In order to make a deal work, the lender and committee may be tempted to stretch loan to value guidelines without thoroughly assessing anticipated cash flows or fail to closely evaluate projections.

Excerpts from the Robert Morris Associates annual fall conference held October 20-22, 1996, and comments of local lenders evidence a general industry concern that nationwide lending standards may be under stress. The principal concern expressed was that there is extremely heavy competition among lending institutions that is putting pressure on underwriting standards. In his keynote address at the RMA conference, David A. Daberko, Chairman and Chief Executive Officer, National City Corporation, Cleveland, Ohio, said "... the most compelling issue in corporate banking today can be put very simply: There are too many dollars chasing too few deals, creating an undesirable underwriting environment." He noted that "... the signs are there to be read by all of us: slowing asset growth, narrowing margins, more lenient terms."

The current strong business cycle has lasted longer than many have expected. The stock markets are at record highs, retail sales remain strong, and corporate profits are generally solid. Some economists feel that economic growth will continue unabated for several more years. However, some analysts feel that with increasing numbers of personal bankruptcies and increased levels of consumer debt delinquencies, an economic downturn may not be far off. Lenders who do not factor the possibility of a weakening general economy into loan decisions and who fail to maintain tight underwriting standards, may be booking loans today that will be tomorrow's problems.

Underwriting Standards

Sound loan underwriting standards should ensure that a thorough analysis of loan purpose, repayment source, and collateral are being performed. Analysis of financial information, projections, and cash flows are critical for maintaining credit quality. Loan structure, terms, and covenants must be consistent with the above analysis. The borrowing history and background of the borrower, and industry and economic outlooks, generally need to be reviewed in detail as well.

John Campbell
John Campbell is an examiner with the Miami Branch of the Federal Reserve Bank of Atlanta.
The size and complexity of debt dictates the extent of financial analysis. Questions to consider are:
  • Does the analysis contain appropriate financial ratios, trends, and cash flow history and projections to determine the financing needs and repayment capacity of the borrower?
  • Are important items like salaries, fees, dividends, notes receivable and payable to insiders evaluated?
  • Are significant balance sheet and income statement changes properly explained and are financial statement footnotes reviewed?
  • Does the lender properly identify and review contingent liabilities?
  • Is the quality of financial information submitted by the borrower commensurate with the size and complexity of the loan?
  • Is the funds flow statement (source and use of funds) evaluated?

The following controls should be in place to ensure that the lending organization initially and routinely thereafter verifies the existence of, inspects the condition of, determines the value of, and perfects its interest in the collateral:

  • The value of significant collateral should be assessed by independent parties and reviewed for reasonableness by in-house staff.
  • An environmental assessment also should be performed by independent parties for real estate collateral.
  • Lien and litigation searches need to be performed.
  • For receivable financing, current agings should be reviewed for trends, concentrations, ineligible accounts, and compliance with any borrowing base formula.
  • Inventory collateral schedules should be received and reviewed on a regular basis and adjustments made for obsolete or ineligible items.
  • Listings of equipment held as collateral should also be routinely evaluated considering "in place", "orderly liquidation" and "fire sale" values.
  • Routine visits to the borrower's place of business should be made to determine the condition of business operations, and the existence and condition of tangible collateral.
  • Frequent repricing of liquid and readily marketable collateral should be undertaken to ensure that proper margins are maintained.
  • Intangible assets should be evaluated using discounted current value of cash flows, multiples of net income, commissions or sales, recent market sales or franchise values.
  • On-going reviews of compliance with loan agreement covenants should be conducted and events of non-compliance tracked until cured or waived.
Underwriting should provide a clear understanding of the lender's and borrower's responsibilities under the borrowing arrangement. All pertinent details relating to the loan should be documented in writing, including secondary and tertiary repayment sources, requirements for borrower's submission of financial information, detailed collateral descriptions, and default provisions.

While all good lenders take risk, and sometimes the best laid plans go wrong, "an ounce of prevention," as the saying goes, "is worth a pound of cure."

Return to Index