As a bank examiner in the 1960's, I came across some very interesting loans like the following one.
A $1 million loan, 150% secured by readily negotiable stocks. The borrower, a finance company, solicited depositors around the country for funds to make the loan, which were placed in CD's on which the bank paid the maximum legal rate. (Regulation Q was still in effect.) To further entice these depositors, the finance company agreed to pay them a premium out of its own pocket, over and above what the bank was paying on the CD's. And the borrower kept a compensating balance of 10% of the loan amount at the bank.
The loan's documentation was in order.
The finance company made interest-prepaid loans to individuals seeking tax shelters. These loans were secured by stocks, which the finance company then reassigned to the bank as collateral for its own loan.
It would appear that a bank could not negotiate a loan on more favorable terms.
Yet, something did not make sense.
The bank was located in Northern California, the borrower in Los Angeles, where certainly there were plenty of banks. That raised a red flag.
Did the good Los Angeles bankers know something that the northern banker did not know? Otherwise, it is reasonable to believe that one of them would have made the loan.
Almost at the bottom of the voluminous loan file there was a company brochure advertising the interest rate the company charged on the loans it made. It was a hair lower than the interest rate the company paid the bank on its own loan.
Ordinarily finance companies charged interest rates almost twice as high as the rate they paid the banks for their funds.
So, the question was not simply why the Southern California company borrowed funds from a Northern California bank, but rather how could the company make a profit paying more for the funds borrowed than it charged its own borrowers. And for this reason I, the bank's examiner, listed the loan for "attention."
A year later the loan defaulted and the bank took a loss. A recession caused the stock market to crash, and, apparently, the bank did not liquidate the collateral fast enough.
It is not known whether the bank made a margin call, but it is believed that the finance company might have made its money speculating in the stock market rather than from its lending activity. And, when the market crashed, the company went belly up.
Moreover, the company's customers, the same borrowers who had put up the stock to secure their own loans – the very stock that the company had reassigned to the bank – later sued the bank, claiming it had been negligent in not selling the stock fast enough to avoid a loss.
Even though this all took place half a century ago, there are at least three timeless lessons for bankers from this tale:
Ask tough questions. The bank should have seen the same red flag I did. It should have asked itself why a Los Angeles company would travel all the way to Northern California to get a loan.
Understand the source of repayment. The bank did not analyze the business of the borrower to learn about its operations when it was evident that its profits could not possibly come from a finance company's ordinary course of business. How did the borrower really make money?