Speculative commercial loans – Sloppy commercial loan underwriting

Commercial loan underwriting is a profession where objectivity and subjectivity work hand in hand. While commercial credit analysis relies substantially on ratios and their comparison with industry standards, there is a lot of customization due to the wide range of different traits exhibited by borrowers. For example, a borrower that sells water pipes to South America cannot possibly be compared to a borrower that sells floral baskets locally. Their cash conversion cycles, income statements, and balance sheets should look substantially different.

Given that middle market commercial loans are usually tailored to the borrower, it is important that the underwriter is careful about letting underwriting deficiencies creep into the structure of the loan facility. While the perfect world for a risk management professional would be for a cash secured loan, guaranteed by a cash rich billionaire with the proceeds of the loan kept on a restricted account controlled by the lender; in the real world risks need to be taken and our job is to recognize and minimize those risks when possible.

Today, I am going to discuss a structural weaknesses that is widespread in commercial loans, but most times ignored during the underwriting.

The speculative purpose loan:

Very common in commercial real estate financing when someone buys land without a definite plan to develop it. Chances are that person is buying the land {a non cash producing asset that in fact eats cash} with the intention of holding it for resale at a later date.  This type of deal used to be a lot more common before the recession, and since everything is cyclical it is to be expected that it will be back in fashion in a couple of years.

It is good to remember that the decision to classify a loan as speculative is not taken just because of the lack of an immediate development plan. There are certain situations where the loan would not be necessarily called speculative. If for example, the borrower was a single family home developer that was buying land as part of its strategic inventory to develop in a couple of years, the loan might not be considered speculative.

Speculation can also be present in regular business loans. I guess the best example I could think of is the borrower that decides to buy substantially more inventory because the business expects an increase in prices, and requests a loan to do the purchase. In this case, the underwriter could partially mitigate the speculative nature of the transaction if the borrower has done a similar bulk purchase before, the amounts of inventory could easily be absorbed by the company over a reasonable period of time, and management had enough experience in the industry.

Overall mitigating factors:

If your prospective borrower is requesting a business loan that could be considered speculative, ask yourself the following questions to determine if the issue can be properly mitigated:

How is the borrower’s financial strength and condition?  If the proposed loan request represents a small portion of the borrower’s assets, and the associated debt service can be easily covered by the global cash flow, then these facts can be used to mitigate the speculative nature of the loan. On the other hand, the opposite situation would only increase the concern regarding the proposed facility.

How are the market conditions? When assessing the market conditions the underwriter must look at whether or not the transaction makes sense when looking at the overall environment, by asking specific questions. Example:  Does it make sense to increase the amount of undeveloped land in the inventory of a home developer? If so what is the amount that is normal in the industry?

For more information about corporate credit analysis, you can buy the following books from Amazon: Standard & Poor’s Fundamentals of Corporate Credit Analysis or Financial Statement Analysis: A Practitioner’s Guide (Wiley Finance)

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