Executive Summary: Not all bad loans are created equal. While some loans illustrate fundamentally flawed approaches to lending, others demonstrate a bank’s commitment to its community and empathy for borrowers trying to “do the right thing.” In some cases, mistakes may have been made, but they were made for the right reasons.

 

 

In recent months, FIC has been largely focusing on issues related to managing FDIC Shared-Loss Agreements. In part, this has involved assisting banks in readying commercial loans within their acquired portfolios for possible submission to the FDIC for payment under the “guarantee” that the FDIC offers banks. We have reviewed thousands of loans, including commercial real estate (CRE), construction and development (C&D), and commercial and industrial (C&I).

 

Our work requires evaluating each loan carefully to determine whether it is appropriate for submission to the FDIC for payment and to assess the steps (for example, new appraisals, background memos, etc.) that need to be completed before doing so. Our assessment process has given us the opportunity to evaluate the loan’s purpose as well as the rationale followed by the bank in approving the loan.

 

Commercial loan errors are many
Oftentimes, we are stunned by what we find in the loan files of failed banks. Until the downturn, many banks seem to have been under the spell of pixie dust that distorted their judgment, causing them to forget basic economics such as the relationship between supply and demand as well as the need for a loan to have multiple repayment sources as a precondition of granting credit.

 

On the CRE side, these loans served as steroids allowing banks to grow at unprecedented rates; unfortunately, as with people who no longer take steroids, quick deflating can occur. Some of the problems with these loans include:

 

• Purpose. There is nothing wrong with companies refinancing to lower rates. What is wrong is when the bank lends against a temporarily high appraisal value and then compounds that mistake by allowing the owner/borrower to put a substantial amount of the loan proceeds into his/her own pocket rather than reinvesting funds into the company.

 

• Appraisal values. As noted above, in part due to competitive pressures and a too-rosy view of the real estate market, banks either increased the percentage they lent against an appraisal or put too much faith in an appraisal conducted during an economic bubble.

 

• Repayment methods. My training as a banker many years ago emphasized the need for three methods of repayment, not two, and certainly not one. As on the residential side, many lenders seem to have relied on a future refinancing as a major way out; they also relied on company-prepared projections to justify their loans.

 

• “Friends of” loans. Every bank we have reviewed has a number of loans made based upon the personal relationship of the borrower and a very senior person at the bank. Not surprising, those loans may not have received the same depth of analysis as some others.

 

C&D lending activities may be even more egregious than CRE. I have learned long ago that the institutional memories of banks are short. Internal staff moves, reorganizations and acquisitions, and changes in strategy all result in many banks failing to maintain certain core principles. Here is one that banks need to tattoo on their corporate chests: “When considering a land loan, think again.”

 

In one case we reviewed, a lender made a land loan to a developer even though he had not received the necessary permits required to build; those permits are still outstanding. In addition, the loan allowed the developer to take more money out of the deal than he had put in. No permits to build, but the owner in effect receives a gift of equity from the bank. Land loans can make sense, but they should always feature structures that are extremely buttoned down and bullet proof.

 

Bad bank basics
Failed bank portfolios share certain common features. First, exceptions to rather than standard credit practices are the norm. Rather than following a rigorous checklist related to credit decisioning and documentation, decentralized actions played a significant role in the bank’s demise. Further, lending was king at these banks rather than a focus on relationship management or providing client solutions. Many of these banks also suffered from low levels of client deposit capture, in part because bankers never asked for the commercial deposits.

 

Further, just as lending was king, so too were the lenders. Yet again, the critical role that credit and risk management need to play was undermined by senior management’s focus on loan growth. I have written before of a bank visit I made during a previous crisis. Touring that bank on our first day of work, I asked to meet the head of credit and to visit his area. Entering the windowless basement, I quickly realized that the physical space was a metaphor for how the credit function was viewed at that bank: pushed off to the side, kept out of the loop, etc. During our most recent crisis, the credit function was subservient to the lenders who, after all were growing income for the bank…at least for awhile.

 

A good bad loan
Much of the lending abuse seems to have occurred in the CRE and C&D areas. In general, C&I lending more frequently followed the standard “rules” governing this type of loan. We recently reviewed a loan that, while in trouble, was made for the right reasons and seems to typify the type of lending that regulators and the public expect banks to perform.

 

The borrower operates a small (less than $1 million in revenue) specialty machine shop in the midwest. He lives modestly with his wife and ten (not a typo) children in a house that no longer has any equity value. He had been an employee of the company prior to purchasing it. As part of taking over the company, he paid off some IRS liens from the previous owner. He had several years of good results and borrowed to expand, just like we are supposed to do in America. Of course, that was when the economy turned down and his (and the bank’s) fortunes went bad. Now, over his head in debt, he still hopes to restructure the loan and pay back at least a sizable portion of it.

 

After reviewing so many files that tell tales of thoughtlessness, laziness, and wishful thinking, this loan stood out as one that was made with a good purpose, had a reasonable chance of repayment, and yet simply did not work out for the borrower or the bank.

 

Concluding thought
There is a reason that loans are called “risk assets.” Many of the loans made in recent years added the word “high” to that phrase without adding appropriate structure or rate. Banks need to get back to the type of lending in which they are supporting people making things and for which their analysis is reasonable rather than driven by short-term economic swings.