Common sense in commercial lending

Common sense in commercial lending

Now that I am back to sharing my thoughts in this website, it allows me an opportunity to reminisce about the past. One of my old posts that has remained popular all these years is the one about warehouse lending and fraud. I wrote that article nine years ago when I was asked to underwrite a $10 Million participation {a participation is when a bank purchases a portion of a loan originated by another bank} in a $170 Million warehouse line of credit facility. Proceeds of the facility were to be used by the borrower {a top 15 national wholesale lender} to finance its operations as a mortgage banking company. The facility was to be secured by a pool of both conforming and non-conforming loans with sublimits and pricing according to the quality of the collateral pledged.

When I wrote the original article in 2003, my exposure to mortgage banking was limited. However, there is nothing I like more than learning about a new industry, really understanding how they work, and most importantly how they get their money to pay our loans. There is also nothing I dislike more than someone that just regurgitates information in an analysis without understanding what is behind the numbers. Writing the 2003 article helped me figure out where my employer could get hurt.

At the end of the day, my employer did not do the loan mostly because I could not get comfortable with the deal. My concerns prompted people higher up to do some extra due diligence, and ultimately resulted in us walking away from the offer. Since this is a story about common sense in commercial lending, let me walk you through the reasons why I was so uncomfortable.

The warehouse line of credit was referred to us by what would be considered a well-known mid-sized regional bank that at the time was about $16 Billion in assets. My employer was about one-third that size, and with a limited history in commercial lending. In fact, I had only been working at the bank for a couple of months as part of a push to get experienced commercial loan underwriters on board. I am bringing up the difference in sizes to highlight a problem with commercial loan participations between large and smaller banks. The smaller bank is supposed to do its own due diligence, but some people feel that if the larger more experienced bank is ok with the loan, why would the smaller bank be against it. Unfortunately, this leads into a lot of copy/paste jobs that are nothing more than a rubber stamp on the work done by the larger lead bank.

The lead bank provided us a nice package for us to underwrite the warehouse line. As I was going over the financials, I saw that the borrower was experiencing fast growth, was highly leveraged, and was eating up cash like no tomorrow because they were keeping a lot of the originated loans in their portfolio. Although you might think that the reason for my concern was the leverage and the continuous need of cash, that was easily understandable and mitigated. I am not one to penalize a company for its business model as long as it makes economic sense, and it does not deviate from industry standards. If you can make more money by keeping loans in the books instead of selling them to investors then that is fine with me. It just means that I have to take into consideration a new set of risks.

The reason for my concern is that I was asked to underwrite this loan at the end of June 2003, and the borrower was unable or unwilling to provide us with fiscal year ending 12/31/2002 financials. This just did not make sense to me. The lender who was championing the line of credit tried to brush away my worry calling it irrelevant, and telling me that the loan was to one of the best clients of the lead bank and I should not worry about it. When I told him I was not convinced, he set up a meeting with the head of commercial lending. I remember that conversation well, I won the argument by telling him that our borrower was a mortgage banker that is essentially in the same business that we are, and that this business is selling money. I also told him that I just did not feel comfortable lending money to someone in the business of selling money that would take more than five months to produce a set of financial statements specially since I have seen little banks as small as $65 Million  in assets {my very first employer out of college} able to provide a set of financials using the prior day’s numbers.

The head of commercial lending ended up calling the lead bank, and we had a conference call. After the call, we were left without the financials that I wanted, and with a feeling that the lead bank knew something about this borrower that they were not sharing with us.

Six years later the lead bank became one of the top five largest failed banks in the history of the US, and their failure was driven by their close relationship with this borrower. The bank and the mortgage bank borrower became so entangled, that employees of the bank took part in fraud that cost the bank hundreds of millions of dollars. And it all started in 2002, which is probably the reason why the borrower would not share their financials with us.

I always say that lending is a game of numbers and percentages. Sometimes lenders do not understand why their risk management counterparts are against a particular commercial loan when the overwhelming chance is that the loan will perform accordingly. They fail to recognize that the difference between profitability and losses lies between a portfolio with a 1% chance of default, and a portfolio with a 3% chance of default.

There is a lot to be said about gut feelings, but when you can use the term “gut feeling” replace it with “common sense”.

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