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Preparing for the end game when underwriting new credits

1/10/22

By: Travis Knobbe

Most financial institutions we have represented over the years make a fine-line distinction between loan officers and asset recovery officers. In many instances, this distinction makes sense. If a loan officer considers too openly the risk for failure of a new loan, he or she may attract less new lending relationships and cut off the life-blood of that institution.  

That said, the problem with complete isolation of those two functions is this: if a loan officers fails to consider how the end game looks short of a full and timely pay-off, loan recovery efforts can easily (and often do) fall well short of the ideal recovery. Therefore, we offer some items for consideration at the earliest stage of lending. Here are some critical ways a loan officer might protect his institution if the borrower falls flat. These tips, we hope, help the loan officer, the underwriters, and the recovery officer alike. They definitely help our creditors’ rights team answer important the questions (that we outlined in part one of this series) early. 

The first thing a lender needs to do is to get a detailed financial statement from any obligors in the new credit relationship. Those obligors include all named borrowers and all parties asked to either pledge collateral or sign guaranty agreements. For any related parties not asked to sign guaranty agreements, the lender should understand why. If, for example, a small business borrower offers the guaranty of one member but specifically asks that another member not sign a guaranty, this should raise some flags. If the small business borrower has several affiliates that it does not offer as guarantors, the lender might review bank records to determine whether the affiliates receive transfers from the borrower on a regular basis. If so, making the affiliates guarantors could prevent recoverable assets from leaving the lender’s reach. 

In the collection endgame, one axiom remains sacrosanct. The more knowledge the institution possesses when it comes time to collect, the greater the institution’s advantage. If a borrower threatens bankruptcy, the recovery team can review the initial financial statement and determine what assets should be there. If the assets justified underwriting in the first instance, then, absent cataclysmic events in the interim (which we will discuss later in this series), the borrower should still have assets to recover in a threatened bankruptcy. If the borrower claims a completely different financial picture in the default and recovery phase than in the underwriting phase, this discrepancy can be used to the institution’s advantage in numerous ways. If the lender fails to get detailed financial statements during underwriting, however, the recovery team has no basis for comparison. 

Next, a lender needs to draw particular attention to financial covenants in the governing loan agreement. For example, most loan agreements require borrowers to provide detailed financial reporting on an interim basis throughout the life of the loan. If this is not part of your institution’s regular practice already, it should be. The lender needs to make a borrower aware that the lender expects that borrower to provide balance sheets, tax returns, and financial statements, at the bare minimum.  

During the collection endgame, the recovery team often suffers from a lack of meaningful data to review. Sometimes, the missing data can be as simple as being unable to answer the question: “how do I contact the borrower?” Did the borrower relocate during the life of the loan? Did the borrower disconnect its phone line? Being unable to track down the borrower to its current number, officer in charge, and address puts recovery behind the eight ball immediately.  

Beyond that, if a loan default occurs several years into its life cycle, then the financial statement obtained during underwriting would be stale. The picture of assets and debts carries less weight. Having more points of data against which to compare the financial picture at default affords the recovery team numerous advantages. Creating early expectations that the institution plans to collect financial data at regular intervals helps the entire team do its job effectively. 

Finally, a loan officer should work to understand as well as possible the nature of the underlying business if working with a corporate borrower. This holds especially true if the institution takes accounts receivable, inventory, or equipment as collateral. The loan officer should take detailed notes about everything he or she learns during the diligence process. For example, does the borrower collect the bulk of its receivables at time of delivery or at set times during the month? Does the borrower have peak seasons in its business cycle? Who are the borrower’s primary customers? The answers to each of the questions greatly help recovery understand its most viable paths to collection. If Atoms, Inc., represents the borrower’s largest customer, and Atoms, Inc., always pays between the first and fifth day of each month, then the informed recovery officer knows to send account demand letters to intercept those payments from Atoms, Inc., fourteen days before the payments would be made.  

While these two things seem simple enough, we have worked too many loan files missing this critical data. Recovery has never complained of having too much information, but recovery officers often lament just the opposite.  

For further information or inquiries please contact Travis Knobbe at [email protected]