Do nothing-that is, nothing until you've come up with a strategy based on the borrower's real future with your bank

Many a bank CEO quotes the axiom, ÏIf you havenÌt got any bad debt, itprobably means you arenÌt doing enough lending.Ó Problem is, thereÌsnever an axiom for the morning when an objectionable smell beginswafting out of a commercial loan folder.

Merrill Reynolds, Jr., used to work for a community bank CEOwho hated to watch any loan go bad. This CEO insisted that his lendersgo to the mat before letting one thin dime slide.

As a result, Reynolds says, that bank spent huge sums on legalfees. More than once, heÌs certain, the bank would have come out aheadif it had simply negotiated a settlement.

A veteran banker and former examiner, Reynolds is now president of atraining and loan review firm called The Bankers Edge, New Braunfels,Texas. He is a frequent lecturer at industry events, including the ABACommercial Lending School.

While Reynolds thinks his old boss was extreme, heacknowledges that the CEO at least had a consistent strategy when itcame to working out problem credits.

All too often, Reynolds continues, most lenders have no strategy at all. Indeed, most often, they procrastinate or deny.

ÏThe biggest misconception bankers have is that things willsomehow get better if they do nothing, that things will get better ifthey wait,Ó says Reynolds. Maybe cheese, wine, and bourbon improve withage, but bad loans donÌt.

On the other hand, says Reynolds, handling problem credits doesnÌt benefit from kneejerk reactions, either.

ÏSome bankers think that loan workouts are something they cando casually, that they can go in and shoot from the hip,Ó Reynoldsexplains. ÏBut you canÌt just go in and negotiate a deal.

First stage: Recognizing a problem
It may seem obvious to a third party, but all too often, saysReynolds, the greatest barrier to improving the eventual collectabilityof a loan is getting the lender to recognize that a credit is introuble. In spite of both common sense and regulatory reportingprocedures, itÌs not unusual for a lender to insist that a borrowerÌssituation isnÌt bad, or, at least, not as bad as it looks.

Taking a realistic look at the loan file, and at theÏoff-balance sheetÓ side of the loan and the borrower, is critical.ÏWhen my firm looks at a credit in the course of a loan reviewengagement, we look at financial symptoms as well as nonfinancialsymptoms,Ó says Reynolds.

Financial factors are obvious, of course, if the borrower hasstopped paying or is continually paying late. At the same time, thelender has to assess how much of the problem arises because of businessfactors, and how much came about because of personal troubles, such asa family medical crisis, divorce, or what Reynolds calls Ïthe threeBsÓÛÏbabes, booze, and bookies.Ó With many women now in business, thewording of the phrase is dated, but Reynolds has seen all of thesefactors cause problems.

Once the lender has recognized that there is a problem, asecond hurdle remains before constructive action can be taken:Convincing the borrower, as well, that there is a problem.

That said, itÌs critical that while the lender is takinginitiative, that the lender likewise avoids taking control. There is aline of court cases where lenders have been sued because they did so,or tried to.

The ground under your feet.

Before a bank can move to the next step, it has to get a firm idea ofwhere its side of the credit stands. A key issue, according toReynolds, is the nature, and validity, of the bankÌs security interest.

At one extreme, he says, would be a commercial real estateloan secured by the land itself. The land canÌt up and move, so thereis some time for being deliberative and definitive. At the otherextreme, however, is accounts-receivable and inventory financing.Collateral in such liquid, fungible form dictates fast action before itwalks away.

Almost as critical as the nature of the collateral, though, isjust how well the bank is really secured. Lost documentation, ordocumentation thatÌs been handled incorrectly or tardily, may mean thatthe bank has nothing but the borrowerÌs good name and credit between itand nonpayment.

Depending on relations between the bank and the borrower atthe point when things go bad, the bank may not even have that. Case inpoint, says Reynolds, is the borrower headed to bankruptcy court, whomay not be inclined to pay the bank much of anything if there isnÌt asolid collateral arrangement involved.

Going into a workout negotiation, Ïthe leverage you have as abanker depends on the level of security you have,Ó says Reynolds. Nosecurity, no leverage.

Another important factor for the lender to examine, prior tosettling on a collection strategy, is the broader relationship betweenthe bank and the borrower. What does the bank stand to lose, in the wayof deposit business, trust business, and so forth, from the borrower orthe borrowerÌs family, if the bank should decide to get tough?

Often, says Reynolds, short of a case of outright fraud, a community bank will find that it has to avoid hardball.

Choosing a strategy
At this point, the bank must determine whether it is dealing with a rehabilitation or an exit strategy.

ÏThese are the opposites of each other,Ó says Reynolds, and he explains the difference in this way.

In a rehabilitation, the bankÌs goal is twofold: to recover asmuch as possible of the loan amount while ensuring that the bank alsoretains as much as possible of the original, overall bankingrelationship with the borrower and related parties.

By contrast, an exit strategy is more straightforwardÛthe bank hasdetermined that it wants to get as much money back as possible, andthat it no longer wishes to do business with the borrower.

While much of the rest of the process looks similar inadministrative form, no matter which strategy is pursued, the tacticsused may differ markedly.

Document, document, document
Once a loan or borrower is identified as a problem, the bankÌsregulator will expect to see paperwork indicating how the bank is goingto handle the situation. Reynolds says this not only keeps theexaminers happy, but is important for internal, practical reasons, aswell.

Reynolds says the central document is an action plan, consisting of:

A statement of the bankÌs goals for the troubled loan. This would address, among other factors, the best possible case that can realistically be expected (versus 100% recovery); the worst such case; and the initial best estimate of the actual recovery.

A statement of the strategy the bank will pursue to maximize recovery, including a sense of the timing, interim targets, and so forth. In addition, this part of the plan should include mileposts where the bank will consider if its original strategy is working or if a gear shift is called for.

A estimate of what the bankÌs recovery will eventually look like, when all financial elements are factored in, and how large a loss the bank will end up sustaining.

1. Quarterly updates, with appropriate changes.

 

Who will carry out the strategy?
ÏA chairman of the board that I know likes to say, ÎYou make the loan,you collect itÌ,Ó says Reynolds, but the consultant thinks thatÌs a badidea. Partly thatÌs because the lender may feel his or her reputationinside the bank is on the line. But what concerns Reynolds just as muchis that banks that have devised incentive schemes and performanceevaluations for their business lenders typically donÌt build anyelement into their plans for success at collecting. As a result, hesays, when lenders want to look good, they concentrate on the factorsthat are measured. So, while the bank may want them to be working aproblem loan, they may instead be out making calls to meet quota.

Ideally, if a bank has sufficient problem loans to warrant it,it should have a dedicated workout officer. If volume isnÌtsufficiently high to warrant that, the bank may want to hire a workoutconsultant, or, alternatively, have lenders swap.

Reynolds suggests a team effort. Different viewpoints may generatefresh thinking, and, as Reynolds says: ÏFour ears are better than two. BJ

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