Nearly three years after the onset of a financial crisis that will be remembered as one of the worst in our nation’s history, many banks are still dealing with the ongoing fallout. They continue to face rising levels of delinquencies, substandard loans and problem credits in their commercial loan portfolios.
Before you can decide how to deal with them, however, you must first determine which loans in your portfolio are, or will soon become, problematic. The earlier you can identify problem (and potential problem) loans, the greater your chances of some kind of positive outcome and recovery.
Spotting Problems Early
Identifying problem loans early enough to do something about them requires that lenders and your bank’s credit administration function work together. Since they are on the front lines, lenders are usually in the best position to spot problems early, and should be given the primary responsibility (and accountability) for doing so.
Some banks, though, have created compensation structures that do the opposite, providing disincentives for lenders to flag problems. Instead, your compensation plan should be created in such a way that lenders are incented to identify and act on problem loans as quickly as possible — and penalized for failing to do so.
By staying in close contact with borrowers and receiving timely financial information on a consistent basis, lenders should be able to spot potential problems years before they manifest themselves in the form of delinquent loan payments. At this point, it’s usually too late to salvage anything from the credit. Early indicators may include:
- Declining sales and gross margins
- Rising operating costs
- Slowing receivables and inventory turns
- Stretched out payables
- Declining liquidity and increasing financial leverage
- Heavy reliance on short-term debt
Once problem loans are spotted, you must quickly decide what to do about them. The longer you wait, the less likely it is that there will still be a viable core business, cooperative borrower, adequate collateral position, or an opportunity to move the borrower out of the bank and still salvage the credit. There are three primary remediation options:
1) Rehabilitation or workout
2) Liquidation with the borrower’s cooperation
3) Liquidation without the borrower’s cooperation
While it’s easy to get emotional about delinquent loans and credits, it’s important to remember that the final decision about how to deal with them should be a business decision, not an emotional one. In other words, you must determine which option will result in the most money for the bank (present valued) and require the least time, least risk and lowest cost.
The best way to determine this is by performing what’s known as a decision-tree analysis. This analysis will provide a side-by-side comparison of the financial impact of each option to help you determine which is likely to recover the most money for the bank.
Note: If you choose to work with the borrower on rehabilitation or workout, be sure to assign the task to a workout specialist. Not only will this free up your relationship managers to concentrate on preserving existing relationships and new loan activity, but it will also ensure that a trained expert is in charge of this complex and specialized task.
In your decision-making process, you may determine that you are dealing with an honest borrower with a viable core business who is willing to make personal sacrifices, but who simply has too much debt. In this case, several other alternatives may also exist:
Discounting the debt.
You could offer a discount for cash payment and movement of the debt to another bank, or keep the debt on your books. However, note that there are tax consequences to compromise of debt outside of bankruptcy.
Partitioning the debt.
Some banks are offering A and B notes, with A notes being what the cash flow will support and B notes being charged off with recovery at some point in the future. You could decide to forgive a portion of the B note annually based on the borrower’s continuing cooperation.
Compromising the guarantee.
For example, for every dollar of debt the borrower reduces through rehabilitation or raises in liquidation, you could reduce the guarantee by $1.50. In reality, you’re unlikely to collect the guarantee anyway, so bargaining away some of it probably won’t cost anything.
Selling the debt in the secondary market.
A growing number of firms specialize in buying nonperforming loans from banks at a discount and collecting them at a profit. In addition, there are clearinghouses that connect buyers and sellers of distressed debt, such as http://DebtX.com. Simply enter loan data into the website and receive indications of interest from potential buyers. The clearinghouse may then work with you to create a package to put out for bid.
Our firm can provide assistance in identifying and remediating substandard loans and credits. Please call us if you have any questions.