Abstract: One of the first things examiners and lenders learn is the Five Cs of Credit. They are the tried-and-true rules of good loan making, consisting of character, capacity, conditions, capital, and collateral. The Five Cs represent the “Thou shalt” commandments of lending, the core of sound commercial banking. Then there are the Five Cs of Bad Credit: complacency, carelessness, communication, contingencies, and competition. These are the “Thou shalt not” commandments. Only by following the Five Cs of Good Credit and the Five Cs of Bad Credit can bankers be sure of not falling into the same traps that have tripped them up for years.
Full Text: Headnote This article first appeared in the January 1993 issue of The Journal of Commercial Lending, forerunner of The RMA Journal. The authors, in their introduction, stated their eagerness for bankers “to learn from the problems of the past few years; for unless bankers learn from history, they will be doomed to repeat it. ” In the following article, they add their current views, noting that “the relevance and applicability of what we outlined in the 1993 article remain unchanged. ” One of the first things examiners and lenders learn is the Five Cs of Credit.
They are the tried-and-true rules of good loan making, consisting of character, capacity, conditions, capital, and collateral. The Five Cs represent the “Thou shalt” commandments of lending, the core of sound commercial banking. The Traditional Five Cs of Credit I Character Thou shalt make sure that the company or person you are lending to is of upstanding character. Bankers want to get some sense of how their borrowers will react once times get tough. They hope to never find out how the borrower will respond to a real emergency, but if they have favorably assessed the borrower’s character, at least they have some sense of assurance.
Character also includes such traits as honor and trustworthiness.
Capacity
Thou shalt be sure that the company you are lending to has the capacity to repay the loan. If a company is not making money or generating a positive cash flow, odds are there will not be enough money to pay offits debt. Remember, bankers are in the business of getting repaid for the loans they make. III Conditions Thou shalt underwrite all loans with the understanding that business and economic conditions can and will change.
Bankers cannot predict the future, but being alert will allow the bank to react to deteriorations in the market quickly, rather than reacting at the bottom of a downturn. IV Capital Thou shalt make sure that the company borrowing money is adequately capitalized. This provides a cushion for any losses that may occur and helps keep the bank from ending up in bankruptcy court, haggling over the remains of a dead company. V Collateral Thou shalt make sure that collateral does not drive lending decisions. Credit factors should always be the primary consideration.
Having a tangible (that is, “seizable”) asset backing up each deal (collateral) means that if something goes wrong, the bank is covered. But if asset values fall, as they have in real estate, it means that banks move into the real estate management business.
The Five Cs of Bad Credit
The Five Cs of Credit should be thought of as commandments: Do this, check these, look for that. Unfortunately, they have not been able to keep banks out of the commercial real estate lending mess, the loan problems arising from highly leveraged transactions, or any of the other lending fiascoes of the past 30 years.
In other words, the Five Cs of Credit have been compromised. If we are to avoid another breakdown in the commercial lending system, it is necessary to add the Five Cs of Bad Credit-the five things to guard against-to the lessons learned from the most recent lending mistakes. Consider these the “Thou Shalt Nots,” or the five additional commandments of lending. They refer to complacency, carelessness, communication, contingencies, and competition.
Complacency
One of the key lessons to be drawn from the past couple of years is the importance of guarding against complacency.
Many bankers have said, “I don’t need to worry about that borrower; he’s always paid us on time. ” But that is obviously a dangerous assumption to make. Overreliance on guarantors has been a problem. What about the bankers who said, “That loan can’t go bad. Mr. Rich and Famous is guaranteeing it? ” Bankers who accepted those “solid” personal guarantees are more wary today of such offers than before. Overemphasis on past performance is another concern. The old adage that past success does not guarantee future success is very true. But it was ignored. How many bankers said, “The last three loans were paid as agreed.
So why worry about this one? ” Overreliance on large net worth is yet another concern. This is simply “good old boy” lending: “I know him. I know his family. They have banked here for years. He wouldn’t default on me. ” The next thing the banker knows, he’s sitting in bankruptcy court, wondering what happened. Old officers forgot the bad times. They deluded themselves into thinking that they would not see another recession, that things would just keep booming. As unfortunate as it is, the business cycle of expansion and recession is not going to go away. And finally, what about new officers who have seen only the good times?
When bankers don’t know what the bad times look like, it’s hard to maintain that healthy level of skepticism that good lenders need. Experienced bankers should emphasize to new lenders the danger of the good times because bad times always follow. Bankers’ problems can, in large part, be traced to complacency; therefore, the First C of Bad Credit should be Thou shalt not be complacent.
Carelessness
The second rule of bad credit-or mistake to be learned from-is carelessness. It was easy to say, “Don’t worry about the loan covenants or documentation. I’ll get to it later. Well, later is here, and there are a lot of loans out there with improper documentation, incomplete financials, and inadequate loan covenants. And no one knows where to find the information because the officer responsible is no longer working for the bank. And it’s all because someone was careless. Inadequate loan documentation. A lien needs to be filed on some assets. “Don’t worry, I’ll file it next week,” the officer says. When next week comes, the officer finds out that another lien was filed between last week and today. Instead of being the first lien holder, the bank is now second.
Oops. Lack of current financial information. Statements are not updated and appraisals are not completed, and before the banker knows it, a strong real estate developer has negative net worth and his property, which is the collateral for his loan, has declined 50% in value. Many times bankers do not even know when this happens because they have not looked at the financials in more than a year. Lack of protective loan covenants. Careless bankers sometimes fail to put language into the loan agreement that requires a closely held borrower to keep a certain level of equity in the company.
When these bankers get updated financials, they find out that the company is technically insolvent because the owners kept a tidy bonus last year even though the company lost a mint. Oops. Information not kept in files. This is such an easy trap to fall into that everyone is guilty of it to some degree. Many bankers do not document calls or conversations, and the next thing they know they are trying to reconstruct conversations from two years ago because their bank is taking the customer to court to recover a loan. Or worse yet, they are being taken to court in a lender liability suit over something they supposedly promised to do.
It is easy to avoid these situations-just write the information down. The Second C of Bad Credit is simple enough: Thou shalt not be careless.
Communication
A communication breakdown is a simple problem, but it can easily destroy an entire bank. Officers will say, “We didn’t know that we shouldn’t have been making those types of loans; nobody told us. ” Managers will say, “We didn’t know there was a problem; the line never told us. ” The bank board will say, “We didn’t know we shouldn’t have done that; the regulators never told us. Poor communication, up and down the line, is deadly. Unclear credit-quality objectives. Management must be clear on credit-quality objectives. Loan policy is written to provide standards for acceptable and unacceptable loans, but problems arise when no one follows the policies. Loan policy may say that loan-to-value ratios can be only as high as 70%, but deals go through at 95% or 100%. If loan committees wink and nod at policy, the message becomes, “Anything is fair game. ” Upward communication. Let’s say the front line does not communicate upward.
If the banker is meeting with the customers, she probably knows that a problem exists in a certain industry well before anyone else. Many times, though, the banker will assume that if she knows about a problem, everyone knows about it. But that is not typically true. There must be upward communication. Unclear communication by regulators. In the past, regulators did not communicate concerns early enough or consistently enough. While the definitions and rules, such as those for classification of credits, in-substance foreclosures, and nonaccruals, were changed, the standards were not always applied uniformly and consistently by regulators.
The result, in many cases, was a rapid increase in the level of classified loans, nonperforming assets, in-substance foreclosures, and so forth. Bank regulators are now striving to do a much better job of communicating all pertinent bank supervision policies and rules on an ongoing basis. The Third C of Bad Credit reminds us to be clear, concise, and attentive to important information: Thou shalt not communicate poorly.
Contingencies
The only reason lenders get paid is for taking risks on customers and being right about them 99. 5 out of 100 times.
The job is to weigh the risks of a loan and the odds of being paid back-in other words, to look at the contingencies. Bankers are supposed to look at every bad thing that can happen and then decide how likely it is that any of those things will happen. In the past few years, while basking in the sunny glow of the booming 1980s, bankers failed to look at the contingencies, instead believing, “What can go wrong? ” Not surprisingly, the answer was, “A great deal. ” These bankers also failed to explore the second or third ways out of loan deals available to borrowers and lenders.
Insufficient attention to downside risk. Many bankers think they are the brightest financiers on the planet, but few looked at what would happen to their loans if the economy slowed down. No one thought to ask the obvious-such as, “Can this developer really build another downtown office building when there is already a 20% downtown vacancy rate? If the economy slows down and no more jobs are created, who’s going to fill up all these shiny new buildings that collateralize our loans? ” Make the deal work. “Making the deal work” became the guiding principle behind every loan.
Instead of worrying about getting paid back, bankers worried about finding a way to get money to the borrower. Many said, at one time or another, “Your financials don’t look very good, but don’t worry; we can find a way to make this work. ” Price for risk. This was the last-straw mistake that bankers made. Instead of attempting to control risk, banks adopted the policy of pricing higher to compensate for the extra risk. No one thought to look at the reverse of this and say, “If a loan is riskier, isn’t there a higher chance of default? ” The Fourth C of Bad Credit is thus Thou shalt not ignore the contingencies.
Competition
Competition is probably the most important of the Five Cs of Bad Credit. Bankers started making decisions because of what the bank down the street was doing, rather than concentrating on the merits of the loan in front of them. They decided to do whatever it took to win business. Unfortunately, that meant making their credit standards as loose as, or looser than, everyone else’s. Instead of any one bank winning, all the banks ended up losing. Competitive euphoria. Bankers decided they were not going to lose deals, no matter what.
If a borrower said she could get a loan at prime-plus-one at a bank down the street, the banker up the street would offer prime-plusone- half. It didn’t matter that the banker should not have touched the deal with a 10-foot pole. “I’m not going to lose this deal to anyone” was the preferred way to look at it. Maybe the banker wanted to fully collateralize the deal, but the borrower was also negotiating with someone else. So instead, the banker went for 50% collateralization to get the borrower’s business. The banker’s attention was not on loan characteristics; it was squarely on the competition.
Market share. A bank lived and died by whether it was ranked first or third or fifth in its market. Rather than making decisions on whether a deal was profitable and the company was strong, the bank looked at the effect each deal would have on its market position. Revenue growth objectives. The only way for a bank to reach its lofty growth goals was to increase assets-which meant to make more loans. A bank’s objectives were set without much attention paid to the market the bank served. That’s not to say that a bank shouldn’t have goals. Rather, it needs to set priorities for reaching its goals.
Will a bank proceed at any price, or will it proceed only if it can do so with high-quality loans? That’s an easy question to answer now. The Fifth (and final) C of Bad Credit is to beware of doing whatever it takes to win: Thou shalt not be swept away by competition. Conclusion Nothing in this article should come as much of a surprise. Commercial banking will always be around, and mistakes will always be made. That’s why there are loan loss reserves and capital. The key, of course, is to remember these painful lessons so that no one has to learn them the hard way again. No one likes managing a portfolio of nonperforming credits.
And no one has to if he or she remembers the commandments of lending. There are the traditional Five Cs of Credit-the five things a banker needs to check before extending credit: character, capacity, conditions, capital, and collateral. These are the “Thou shalt” commandments. Then there are the Five Cs of Bad Credit: complacency, carelessness, communication, contingencies, and competition. These are the “Thou shalt not” commandments. Only by following the Five Cs of Good Credit and the Five Cs of Bad Credit can bankers be sure of not falling into the same traps that have tripped them up for years.
So, lenders, heed the 10 commandments of commercial credit and avoid becoming the grizzled veteran with a lot of war stories to tell. Sidebar RMA University offers a series of courses on The Lending Decision Process. Go to www. rmahq. org. Experienced bankers should emphasize to new lenders the danger of the good times because bad times always follow. Bank regulators are now striving to do a much better job of communicating all pertinent bank supervision policies and rules on an ongoing basis. No one likes managing a portfolio of nonperforming credits.
And no one has to if he or she remembers the commandments of lending. AuthorAffiliation Sam Golden leads the banking practice for Alvarez & Marshal. He can be reached at sgolden@alvarezandmarsal. com. Harry M. Walker is president of the Central Mississippi Region, Trustmark National Bank, Jackson, Mississippi. He can be reached at hwalker@trustmark. com. Sam Golden leads the banking practice for Alvarez & Marshal. (His article can be found on page 42) Harry M. Walker is president of the Central Mississippi Region, Trustmark National Bank, Jackson, Mississippi. (His article can be found on page 42)
Subject: Bank loans; Commercial banks; Credit management Location: United States–US Classification: 9190: United States, 8110: Commercial banking services.
