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Due diligence are you asking the right questions?

Lenders must mind the factors that form their thinking

In this column recently I described the importance of due diligence in underwriting credit with an emphasis on ascertaining the borrower's capacity to execute and accomplish his repayment plan. In recent weeks we have watched the not-pretty spectacle of the House committee investigating the Internal Revenue Service's handling of applications of non-profit and related corporations on allegedly illegal and partisan political grounds. These allegations carry due diligence activities to a chilling level of governmental intrusion.

Perhaps some of you saw the recent article in the Los Angeles Times that catalogued some of the bizarre questions of bank underwriters in reviewing mortgage loan applications.

Hopefully these are not the typical or normal work product examples but it's not hard to appreciate the stresses and strains of the recent Great Recession when confronted with examples such as these.

Questions asked ... and answered

Here are some choice examples of the results of due diligence in the pursuit of credit excellence:

  • • A self-employed applicant showing an income of $10,000 was asked for verification of the source of a $6 deposit.
  • • An applicant who had deposited $235 into her checking account, and had identified the proceeds as from a garage sale, was asked for a newspaper ad proving that she did in fact conduct the sale.
  • • A woman, recently widowed, was asked for a copy of her late husband's death certificate to explain why her social security benefits had declined during the past year.
  • • An applicant was asked to prove that he no longer owned a residence he had sold a decade earlier.
  • • An applicant who worked for a Fortune 500 company was asked why his office address was in a different location than the headquarters address listed on his pay stub.
  • • A teacher at a local parochial school was asked for a letter testifying that the school was part of the diocesan Catholic school system.
  • • An underwriter asked an applicant who had written a $167 check to a local grocery store for verification that he did not have a loan with the grocer.
  • • An underwriter inquired why a child listed as a dependent on the applicant's tax return was not similarly listed the previous year. When told that the child had been born subsequent to the start of the following tax year, the underwriter requested a copy of the child's birth certificate.
  • • One applicant was asked for proof that he was no longer under house arrest.
  • • A female applicant was asked why she changed her name after she married.

An uncomfortable parallel?

The above examples of the IRS's political inappropriateness of a certain line of questioning and of truly stupid questions arising in the loan underwriting process are not unrelated.

They reflect to me significant lapses in judgment and common sense. Both are examples of workplace cultures gone awry. Maybe we don't see egregious examples of a culture "gone off the rails" very often but could something similar and potentially pernicious to our own workplaces be occurring at our banks today, to lesser but still detrimental effect?

Arguably, the last ten years for banks and bankers have been extraordinary. So the question of "What is normal?" acquires an urgency to understand, interpret, and evaluate the fundamental attitudes and outlooks of our lending staffs.

The follow-up question is: What impact might these be having on the credit underwriting process?

There are corrective mechanisms at work to keep the results of loan underwriting within reasonable bounds. If a bank is too strict in the application of credit, it loses business. If it's too liberal and accommodating, the examiners exert a correcting influence, hopefully before any real harm is done.

What troubles me is that it is increasingly difficult to know how many of our colleagues honestly evaluate what more experienced lenders consider as "normal" and "appropriate." 

Impact of experience on your thinking

If you started your lending career in 1983 you have loaned money through two national recessionary periods including recently when business and economic conditions were among the worst of the last 80 years.

And you've also seen several prosperous years where lending money was relatively easy and productive. You've been both up and down in terms of the business cycle and had to collect some loans that you came to realize you shouldn't have made.

If you began in 2003, then you've known about equal periods of frothy excess and abject gloom. And if so, what are the normative lessons?  What have you learned that you should unlearn?  Where is the appropriate balance in judgment?  What are the long-term lessons that will condition your reactions and reflexes for years to come?

The implications for credit cultures are important and not necessarily evident.

While many industry observers are warning of credit excesses being incorporated into loan portfolios today, it's just as possible that we have acquired experiences that will make it difficult to rebuild loan portfolios in ways that will serve our communities in productive, sustainable and lasting ways.

One area where we should carefully examine our attitudes is in our mission, vision, and values statements.

I'm sure the IRS has agency mission and vision statements that convey a very different impression than the one that's developed as a result of three days of televised congressional hearings.

Do our own banks' statements fill space on our web sites and mean little more than advertising slogans and promotional pieces?  Or are we taking stock of where and who we are and using these opportunities to build a durable foundation? 

Now is the time to get thinking right

The time to take constructive action is now--when we can make a difference in the outcome.

What are your due diligence processes telling you? 

Are you building both a bank and a loan portfolio that you and your community can rely upon? 

Are you articulating standards of personal and professional behavior that add value to the business? 

Are you following them? 

This may be a larger and more strategic question than the level of credit risk in the loan portfolio.

Ed O’Leary

ABA Banking Journal Contributing Editor Ed O'Leary, a veteran lender and workout expert, spent more than 40 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses and has been a frequent speaker in ABA's Bank Director Telephone Briefing series. You can e-mail him at etoleary@att.net. O'Leary's website can be found at www.etoleary.com.

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