Bank of America is a huge and therefore convenient target for journalists to bash. Recently the Los Angeles Times assailed B of A for cutting "some" small business credit lines. (Maybe they cut "some" but increased more of them!)
The news story, though a masterpiece of illogic, illustrates how unsound lending and loan administration naturally culminate in destructive servicing decisions. Not just for mortgages.
The focal point is the photo: a distinguished-looking, gray-haired gent in a handsome business suit and tie, who stares pensively and identifies himself as a B of A small business client. His customers call him Bobby.
Bobby explained to B of A that he's "a guy who's barely surviving." His business has shed 60% of its 200 employees. But it owes the bank $96,000. Bobby gives us no reason to anticipate improvement. Hmm.
Not a big problem for B of A. Still, how many of its 3.5 million (non mortgage) small business loans have such problems? If 10% go bad for $96,000 each, that would be a loss of $35 billion.
How did B of A dig or at least stumble into Bobby’s hole?
We can only go by what Bobby says — as interpreted by a reporter possibly biased against the bank, who at any rate betrays no comprehension of banking. But start there:
Up to now, Bobby has been paying interest only, at a rate of around 6%.
B of A's reported handling of the loan up to this point is absurd. A non-amortizing loan is like permanent capital — made available at a cost of 6%, much cheaper than B of A's own capital.
If the risk didn't increase there would never be a reason to call it, though the rate might be adjusted or renegotiated. But, when business performance and outlook deteriorated, the bank's best course of action was to accelerate payments or demand full balance — while Bobby still had enough cash to pay it off. This might or might not have been feasible in Bobby's case.
But even if the loan were called too late to achieve full repayment, the sooner it was called the better for the bank. In the absence of amortization, getting a few more payments while the business fails won't help.
Compare this with residential mortgages and with credit cards. For both, payments generally are required by law and regulation to be set at a level that assures significant amortization. On a typical credit card, the minimum payment is at least 2/3 higher than an interest-only payment would be. If the customer can't or won't make amortizing payments soon, then it's irrational to count on his doing so years later.
In Bobby's case, the bank set a payment level too low to amortize the loan at all. Then, as the business cratered (probably from 2008 all the way through 2011), it seemingly took no action. Finally, the bank called the loan — not because of Bobby's long-deteriorating situation, but because of a "change in policy." If the policy hadn't changed, would the bank have waited until the business got down to 10 or 0 employees, or was bankrupt?
Bobby is still paying 80 employees, but he says he can't afford to pay the bank even $1,000 more per month, claiming he's being pushed into bankruptcy. Sounds like repaying the bank hasn't been Bobby's priority — and he doesn't even recognize it as an obligation.
At the end of the day, Bobby's is one of two out of 3.5 million small business loans that the newspaper found to make their case that B of A is now tightening credit. What on Earth are these supposed to prove? And in this particular case, they should have done it much sooner!
If Bobby's loan had a profitable outlook, lots of banks would compete to take it away from B of A. You find out for sure by calling the loan. Doing so would justify no complaint at all against B of A. Assuming B of A needs to throttle its lending, others surely want to increase theirs.
But Bobby's loan is by now a terrible loan. If nature takes its course, B of A will take a loss. The loss will result from a loan that, if the L.A. newspaper tells this story correctly, was wrongly structured and then administered with persistent negligence.
The loss won't come because the original decision, "Let's make a loan to Bobby," was necessarily wrong — but because the terms and the subsequent line management were wrong.
Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian. He can be reached at email@example.com.