Second in a series: 3 "Cs" that dovetail well with committees

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 Don't miss Part 1, "Do loan committees really work?"

There is no single right, wrong, or best way to teach and instill credit principles to the lending staff. Virtually any well-thought-out series of experiences can be adapted to the need. But for long-term success, we should emphasize techniques that maximize the learning and mastery of fundamentals, while documenting the things that we do and why we do them.

A convenient way to understand this is to think how a committee process illustrates and emphasizes the Five Cs of Credit.

Not each of the Cs--Character, Collateral, Capacity, Conditions or Collections--is necessarily always equally well served by the sorts of credit committee experiences that most of us are familiar with. I think, though, that Collateral, Capacity, and Conditions are uniquely suited to illustrate a healthy credit committee process.

Collateral and your committee

Experienced lenders know that there is collateral  ...  and then there is collateral.

First of all, we bankers don't own it, we rarely take possession of it, we too infrequently inspect it with a critical eye, and are not often in the position of having to liquidate it.

Yet when we are in that position, what we don't know becomes critically important and often determines whether collateral is really a "secondary source of repayment." 

I make this point to illustrate that the liquidation of collateral is rarely the primary source of repayment in any lending deal. We usually don't accept collateral with the expectation that we almost certainly will have to liquidate it to be repaid. Maybe that's why we invest too little of our time and attention in really understanding what we've got in support of a particular credit extension.

There are humorous stories--aphorisms perhaps--that caution lenders never to rely heavily (or at all) on any collateral that flies, floats, or eats. While these may bring an appreciative chuckle, there are usually very serious reasons for this caution based on unhappy or unsatisfactory experiences. This calls to mind the definition of experience that one of my old and experienced bosses used to use:

"Experience is what you get when you don't get what you want."

What we don't know (and might at some point wish that we did) about collateral can be properly illustrated in a committee discussion without embarrassment to the presenter of a credit. A simple question or series of questions by one of the committee's more experienced lenders can be an excellent tutorial on the fundamentals of collateral as a source of repayment.

Capacity and your committee

Capacity is the anticipated ability of the borrower to perform as agreed. It involves an analysis of cash flows, an understanding of the risks of the business plan, an assessment of the skill of the business owner to accomplish his strategy and the like. But in a long lending career, and particularly from the perspective of a workout officer, the key ingredient to understanding capacity is to understand how the deal is supposed to work.

Sound simple?  Often it is. But sometimes, it's not.

There's an old expression from the study of architecture: "Form follows function." 

This means basically that there are sound reasons why a barn looks like a barn. It's also applicable in lending money. Lenders try to structure the repayment of principal around the borrower's receipt of funds from the use of the asset they financed.

A printing press has a useful life of perhaps seven years, so we wouldn't finance it on a series of 90-day notes nor amortize principal over a period longer than its useful life. Note that when accelerated depreciation is permitted under the tax code, experience has taught lenders to accelerate the amortization of the note to better reflect the anticipated receipt of the net revenues to be generated.

You might say, "This is basic stuff and we all know that." 

Maybe, but I've worked out deals where the lender (and perhaps the committee) had never appeared to even consider it.

Where this principle is often hard to discern is the occasional-to-frequent "disconnect" between the purpose of the borrowing and how we structure the note for ALCO or credit administration reasons. We may have a credit that by purpose has a five-year amortization schedule but because we don't want any long-term interest rate mismatches,  we might structure it on a one-year note basis. We also have a tendency to structure the maturity of notes around our own internal periodic reviews of credit quite apart from the original sense of the deal. Everyone in this example is assumed to understand that the original note will pay down through five discrete time periods (original note plus four renewals of gradually reducing amounts).

Yet, I've seen situations where, well into the repayment time frame, the bank tried to force a structure on the borrower that was inconsistent with the original intent, not to mention the inherent capacity of the deal to work as originally conceived.

This point was driven home to me years ago in a large real estate development credit. The borrower's plan was to acquire raw land; develop the site for home building (infrastructure); construct buildable residential lots; and then build and sell finished homes for its own account or sell finished lots to other builders. It was assumed in the case of one large tract in Florida that this would be accomplished in approximately a four-to-five year time frame.

Guess what? 

The market slowed considerably and a five-year deal turned into an almost eight-year deal. At about year three, some of the participants expected to begin to see some paydown of their loan facilities. At that point, I remember a bankers' meeting where I witnessed an awful scene of angry lenders who just didn't understand how the deal was supposed to work. Many of the bankers assumed the deal had cratered, while the only thing that was amiss was the expectation of the original time table.

The time to set the understanding of how a deal is supposed to work and to get the structure right is when it's approved. Later than that can lead to heartburn. Think back over the last four years and the worst credits that you've dealt within your banks and see if you recognize any misunderstandings that could have properly been cleared up by a clearer understanding of the borrower's capacity at inception.

Then ask if you think the committee process was as thorough as it needed to be.

Conditions and your committee

Finally, there is hardly a better forum in any bank than the credit committee to discuss local and regional economic conditions.

Everyone can participate and virtually everyone has some anecdotal evidence relating to pockets of strength or weakness in particular business sectors of the community.

This is where we as lenders add value to each other's understanding and then can use this data bank of useful information to assist our customers better assess the risks in their own businesses.

In many banks, credit committees are routine and humdrum. But they shouldn't be.

In fact, these committees are one of the best and most consistent opportunities for the continuing education of both experienced and less-experienced lenders.

Take a more critical look at the process in your bank. Are you making the most of this opportunity that is part of the fabric of your day-to-day credit culture?  

About Ed O'Leary:

Veteran lender and workout expert O'Leary 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 hear free audio interviews with Ed about workouts here. You can e-mail him at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it . O'Leary's website can be found at www.etoleary.com.

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