Lenders Need Training in the Basics
Our front-line lenders are probably younger and less seasoned than ever.
Many have never before underwritten or administered credits in a recessionary environment.
Because of this inexperience, other weaknesses in the banking industry, and the softness of the economy, it is time to emphasize the basics of lending.
In the early 1970s, construction loans were underwritten on the basis of a good market (vacancies were running around 3%), preleasing of 50% or more, 10% to 20% cash equity, and a firm takeout commitment from a financially responsible longterm lender.
By the mid-1980s, construction loans were being made without preleasing and without equity or takeout commitments - despite vacancy rates near 20%.
The Five P's of Credit
Lenders were straying from the basics of credit, the five P's: people, purpose, payment, protection, perspective.
People. Our primary emphasis should be on the competency and integrity of the people who manage the enterprises to which we lend.
One key is to insist that borrowers work in their particular areas of expertise. Time and again in the 1980s, financing was afforded to developers who strayed from their historical success areas. Home builders moved into the development of commercial office building; office warehouse developers worked on apartment buildings and condo developments.
Many of these product-line changes were not complemented by the hiring of competent people familiar with the new areas. As a result, cost overruns became commonplace.
Purpose. What is the purpose of the loan? Is it legal? Is it logical? Can it be productive?
The logic and potential of many real estate investments made during the past decade are questionable.
Overbuilt markets with low absorption rates rarely create opportunities for new projects to generate enough cash flow.
Such conditions are leading to the return of more stringent underwriting standards. Reflecting these are lower loan-to-value ratios, higher preleasing and equity requirements, and significantly higher debt service ratios - all backed by long-term paying leases from highly capable lessees.
Payment. This credit principle is directly linked to the purpose of the loan. The absence of such linkage was the No. 1 cause of credit losses in the 1980s.
The basic principle of payment is that the asset financed should pay for itself - that is, repayment should be scheduled to coincide with the cash conversion of the asset.
Too many of the projects financed in the 1980s were predicated on inflation escalating the rent rolls and thereby generating enough cash flow to properly service credit. These escalation assumptions were accepted despite a growing vacancy rate.
Protection. This is our alternative source of repayment. Protection represents the safety factor that examiners look at when reviewing our loan portfolios.
For riskier credits, protection is formalized. The considerable leverage of most developers is one indication of high risk. Another is extended repayment periods.
In real estate, the value of protection was injudiciously based on pro forma assumptions of future possibilities, as opposed to realities at the time of the loan origination. Reliance on stabilized future appraisal values lulled bankers into advancing 100% against the cost of projects with below-cost market values. The failure to adjust forecasts to reality led to aggressive underwriting.
Perspective. This means taking a step back to look at the entire lending relationship, to review the risk/reward trade-off.
Such review should include the cost of funds and of servicing, the time value of money, and a credit risk premium.
The desire to participate in the boom in real estate of the 1970s and 1980s led many lenders to significantly underestimate the credit risk and skimp on construction oversight servicing.
|Focusing on Fundamentals'
A focus on fundamentals must begin with training frontline lenders as well as all other members of the credit underwriting team.
Robert Morris Associates, the trade group for lending and credit professionals, has launched an industrywide campaign called "Focusing on Fundamentals." Our group is rededicating itself to helping members and others get their institutions back on track if they have strayed from prudent lending.