Jeff Judy
Jeff's Thoughts - August 3 , 2011
My Collateral Philosophy
In the previous issue of Jeff's Thoughts, "Rethinking Sources of Repayment," I wrote about viewing collateral less as a "source of repayment" and more as a loss mitigation tool. I also suggested that there are many alternative sources of repayment that can be applied to mitigate the eventual loss along the way, as the borrower deteriorates, rather than waiting to make up the entire gap with collateral once the borrower is in serious trouble.
I suspect that collateral has become such a routine part of the process and the paperwork that many bankers don't really think about what it can, and cannot, do for the bank, nor do they think about other options for loss mitigation as early and as often as they should. Let me share some of my beliefs about collateral, repayment, and loss mitigation:
- Collateral is a source of partial repayment at best. It will never make you whole.
- It is easy, and generally wrong, to assume that the value of the collateral at the time you sign the documents will be the value of the collateral when it comes time to liquidate it.
- Bankers overestimate the loss mitigation power of collateral in part because by the time the collateral is seized, it is often someone else's problem. If every banker had to manage liquidation hands-on for every default they brought into the portfolio, they would learn to think about it quite differently.
- Collateral is too often regarded as an element of the credit process, rather than an explicit preparation for dealing with a possible problem loan. Bankers look for collateral because they know it is expected of them, but they do not always think through how useful the collateral will be when it is needed.
- In the vast majority of credit relationships, we can see that the borrower is getting shaky. When you identify in advance the responses you can make to support repayment as the borrower deteriorates, as part of a "problem loan pre-plan," you have a much better chance of applying those responses in a timely enough fashion to prevent or reduce a loss.
- Collateral and guarantees should be just some of the elements in that "problem loan pre-plan." What is needed is a strategy for maintaining repayment as long as possible in the face of failing borrower performance, one that includes some of the alternative sources of repayment I listed in the previous issue.
In general, I recommend a much broader, and much more proactive, approach to repayment. We need to get past "primary and secondary sources of repayment" and recognize that we are "managing loss mitigation." And we can manage loss most effectively if we embrace early detection of borrower problems, and rapid response -- deploying steps we have already identified -- to those early signs of trouble.
Even with that philosophy, however, it is still possible to go astray. In the next issue of Jeff's Thoughts, I'll reinforce priorities that play key roles in effective loss mitigation practices.