The Sometimes Forgotten C - Capacity
By: Ed Spielbusch, Regional Manager - Southeast Region
In today's lending environment of elevated asset valuations it becomes exceedingly easy to do quick collateral evaluations, verify the traditional 20 percent margin, and renew for the next go-around feeling quite secure. Wait, haven't we traveled this road before? Does anyone out there remember the agriculture industry in the seventies and the resulting crisis? With the exception of what has been broadly publicized in the residential real estate market, asset valuations are at historical highs. I have always maintained that this is the most difficult and perilous lending environment that a bank can face. Lending policy margin requirements are applied to these valuations and we still arrive at net positions far in excess of what I can recall those assets selling for a decade or two earlier. Or, more dangerous yet, loans are booked at the cost of the asset relying on the appraisal to create the required margin. In these cases, the borrower is not a party to the risk. Am I taking on "Chicken Little" tendencies and predicting the sky is falling? No, I'm not that smart and didn't pay that close of attention in Economics class. However, margins can sometimes dissipate rapidly from those elevated levels leaving loans under secured, creating loss exposure. Prime examples currently exist in the residential real estate market where foreclosures have escalated, inventories of homes have swelled, and values are coming down. The root of this problem in many cases stems from overextended borrowers drawn in by teaser rates with no attention given to their ongoing repayment capacity. Adjustable rates are driving payments up beyond repayment ability, delinquencies are escalating, and foreclosures are increasing. So when do collateral and collateral values not come into play? The answer is when borrower repayment capacity supports the loans, payments are made, debt is reduced, and loan customers gain equity and financial strength by appropriately handling their obligations. In the numerous examinations that I have participated in over the past several years one recurring theme and recommendation continues to reveal itself in almost every case, and finds itself in those Reports of Examination. That theme is the need for repayment analysis and the documentation of such before the lending decision is made. Assessing a borrower's repayment capacity, and I mean their overall repayment capacity, is one of the basic premises of successful lending. More often than not, in reviewing credit files, evidence of cash flow crunching and debt service capacity is lacking. Many times, there is insufficient information within those files to make a reasonable analysis. Additionally, on occasion, when you find cash flow analysis some institutions forget to capture all of a customer's obligations to assess overall repayment ability. We often refer to this as a "global" cash flow. Just as collateral is one of the "Cs" of credit, so too is capacity or repayment ability. I am not implying that bankers don't intuitively give consideration to the ability to repay given their experience and knowledge. I would suggest, however, that improvements can be made in global cash flow analysis and its documentation in assessing the prospective success in a borrower's ability to meet their obligations.
