Jeff Judy

Jeff's Thoughts - July 20 , 2011

Rethinking Sources of Repayment

Every commercial banker knows that to get a credit approved, you need to lock in a "secondary source of repayment." Generally that means finding all the collateral you can, perhaps wrapping up a guarantor or two, and away we go.

I believe that if that very common phrase, "secondary source of repayment," does not blind us to what is really going on, and what is needed, it at least dims our vision a bit. I guess the only parts of that phrase I have trouble with are "secondary" and "repayment"!

Since we do not generally talk about tertiary or quaternary sources of repayment, "secondary" is the end of the line. And indeed we only seize collateral and pursue the guarantees once we get to default.

But few borrowers drop from "repaying as expected" to "default" overnight. If repaying in an orderly fashion through strong cash flow is the "primary source," Point #1 on the scale, and liquidating collateral is the "secondary source", Point #2, I think we need to be proactive about managing repayment when the borrower is at Point #1.3, or Point #1.6.

The examiners know that there is a progression in the borrower's deterioration. They place individual credits along the path from "Pass" to "Loss" in stages like "Special Mention," "Substandard," and "Doubtful." All along that path, alternative sources of repayment are available, such as:

Refinancing: If your borrower is headed for trouble, it's a great opportunity to let another bank take on the problem! And the time to offload your less desirable credits is before their prospects for repayment start to look too dismal.
Asset-based lending: Pass it on to some specialists who can manage the risk better than you can.
Sale of non-critical assets: Has your borrower really looked at some of the hard decisions that might be necessary to keep problems from getting worse? Just make sure that any sale of assets does not diminish your collateral, or reduce the borrower's capability of improving their results.
Capital injection: perhaps an infusion of cash is possible. It may be better for both the bank and the borrower, for example, if the owners support the business while it still makes a difference, instead of paying for their shortfalls through their personal guarantees after things fall apart.
Restructuring the credit: your agreement was, hopefully, the best deal for both parties at the time it was signed. The best deal is different now that the borrower's hit a bumpy patch, and both sides of the transaction may benefit from renegotiating those terms.

Depending on the type of business your borrower is in, you may have even more ways to keep the repayments coming in, at least for a little bit longer.

Which brings me to the second problem, the connection between "collateral" and "repayment." When we call collateral "the secondary source of repayment,' we are lulled into thinking that if the borrower fails, we will still get repaid, we will be made whole by the collateral and guarantees. We may be less likely to manage the deteriorating credit early in the game, knowing we have this abundance of collateral to bail us out at the end.

I regard collateral less as a source of repayment and more as a loss mitigation tool. By the time you seize the collateral, you are already going to take a loss, and maybe a substantial one: more often than not, as your borrower's financial health weakens, the value of both the collateral and the guarantees will diminish as well.

By proactively employing some of the alternative sources of repayment listed above as soon as you detect potential problems, you may keep scheduled repayments going a little longer. Those repayments eat away at the outstanding amount, reducing the eventual loss you may have to address one day with the final loss mitigation tool, collateral liquidation.

There are more choices than "either we get repaid by the cash flow of a healthy borrower or by the liquidation of assets from a failed borrower." Seeing those options requires a different philosophy of repayment and loss mitigation, a philosophy I'll flesh out in more detail in the next Jeff's Thoughts.