In addition to those detailed in our article, Commercial Lending…After The Crisis: Back To Basics, here are two more hard lessons learned from the financial crisis:
1. Paper equity and borrowed liquidity have a bad habit of disappearing when you need them most.
2. Contingent liabilities tend to become real liabilities at the worst possible time.
In today’s continued uncertain credit environment, the fragility of equity and potential exposure to loss posed by contingent liabilities are two areas community banks should pay especially close attention to.
Fragility of Equity
From the commercial lender’s perspective, there is a very real purpose to equity: It helps protect against loss in the event that collateral declines in value. Unfortunately, while the value of liabilities rarely shrinks, the current recession has made it crystal clear that the value of assets – real estate, in particular – can evaporate quickly, virtually wiping out equity almost overnight.
Of course, real estate has proven to be a sound investment over the long haul, which is why banks have historically been willing to lend against it. (Hence, the traditional lender’s mantra that “If you take dirt, you won’t get hurt.”) Despite recent declines, there’s no question that real estate will rebound when investors return to the market in search of bargains.
But how do we define “the long haul”? When does it begin and end? And how much capital will it take to ride out the current downturn, the length and severity of which no one knows?
During more normal times, equity requirements of 15 to 30 percent were usually adequate protection for lenders. But today, a 30 percent drop in the value of commercial property held as collateral is not at all uncommon. For example, if a borrower had $1.5 million in equity in a piece of property that appraised for $5 million 18 months ago, but the property is now worth only $3.5 million, the equity has essentially vanished.
This makes it imperative that banks have policies and procedures in place that will facilitate ongoing monitoring of borrowers’ financial information, and quickly and thoroughly review and act upon the information once it’s received. If any blips or concerns are spotted, these should be reviewed with borrowers immediately. If you don’t have confidence in their ability to devise and implement a plan for dealing with problems quickly, it may be time for them to find another bank.
There has also never been a more important time than now to be concerned with borrowers’ and guarantors’ contingent liabilities. The domino effect of business failures has turned liabilities that were contingent or indirect – like guaranteed loans, leases and lines of credit – into direct liabilities.
For example, consider a builder/developer who personally guaranteed the debt of his company. Everything was fine as long as he was selling houses, but once sales slowed down, liquidity dried up and his creditors started demanding to be paid, his problems mushroomed as contingent liabilities suddenly became very real.
The takeaway for lenders now is to view contingent liabilities as more than just an insignificant footnote on the balance sheet, if they’re even disclosed at all. To be safe, assume that they are real liabilities and plug them into your financial and cash flow analyses. Is cash flow still adequate to service both your loan and all or some portion of the guaranteed debt?
Unfortunately, reality can rear its ugly head when we least expect it. Lenders should not fall into the trap many borrowers do in thinking that their business ventures will always be self-sustaining. Dig deep into the numbers to determine whether borrowers have realistically planned for the possibility that they may, indeed, have to cover the debts and liabilities they’ve pledged to cover.