Credit Risk Memos (CRM's)
For Small Business Debt and Repayment
Credit Awareness Tools & Insights
CRM #2 – Accrual, Nonaccrual
This is the accounting measure of interest accrual on your loans. Accrued but unpaid interest amounts will be recognized as income to the creditor if the lender expects the loans to be repaid according to the terms. Nonaccrual status is applied to your loan, in part, if the creditor determines that (1) principal or interest has been in default (i.e., non-payment) for 90 days or more, unless the loan is both well-secured and in the process of collection; (2) payment in full of principal or interest is not expected. Such would require the creditor to reverse any accrued interest taken as income, and essentially stop accounting for further accrued interest into their income each month. Well-secured means there is collateral in an amount sufficient to repay the debt and any interest in full, or a guarantee by a party that also supports repayment. In the process of collection means that there is ongoing legal action to pursue collection or collateral liquidation, or some other collection activity that also ensures repayment, or a return to a Pass rated performance.
Loans are often restructured, in the best interests of both the debtor and creditor, to help ensure the prospects of repayment. With a properly restructured loan, it need not remain in nonaccrual status. Generally, sufficient time is given, for example – six months, to document the receipt of payments being paid as agreed to support the decision to return the loan to accrual status. The key is to show repayment is ‘sustainable’. To restore a credit to accrual status, the principal and interest payments need to be current, and the creditor needs documented support to show it fully expects the loan to be repaid under the current terms; it can also apply to when the loan becomes well-secured and in the process of collection.
Keep in mind if your loan is 90 days past due, the ‘system’ will continue to calculate interest payable that you’ll still be required to pay (interest never sleeps); it’s just that the creditor isn’t taking interest into income while in nonaccrual status. At this stage, every effort to bring the loan to a $0 balance will be made unless you’re able to restore the financial performance to acceptable levels (i.e., sufficient cash flow coverage). A creditor does not want to have any non-performing loans laying around.
Also, if you’ve formally restructured your loans to ensure repayment and performance, your loans need not be maintained in nonaccrual status forever. The creditor will need to decide when to return the loans to accruing status based on your successful payment performance that had been sustained for a reasonable time, like six months of regular payments under the new terms. Some restructurings may involve actually splitting your loan into two loans – please see Restructuring; ‘A’ and ‘B’ Notes.
CRM #25 – Loan Structuring
Loan structuring is designed to help ensure a successful borrowing relationship, with appropriate measures that serve the debtor’s needs in the short and long term, and in good and bad economic times . Workout loans may alter the traditional repayment terms and structure, however. Elements of loan structure may include: interest rate pricing and fees, maturity date, payment amount and frequency, secured or unsecured, lien position, collateral type, guarantors, seasonal funding, loan covenants, financial reporting, and down payment. With multiple credit facilities, the creditor should have maturity dates that support the loan purposes and repayment terms.
The key for the creditor is to thoroughly understand the debtor and his business, the loan purpose and borrowing cause. The creditor will have loan policies and procedures to ensure the loan request is structured to conform to policy requirements. Most financial institutions are regulated entities and their underwriting standards, including loan structure, have similar characteristics. Competitive pressures and regulatory changes can affect the elements of loan structure. Loan structure helps ensure the creditor is lending in a safe and sound manner.
Loan structure during economic expansion periods can result in laxed credit underwriting standards. For example, creditors offer ‘light’ covenants with excessive ‘head room’ before the covenant is violated (aka ‘cov. light’), non-recourse or no guarantors, extended maturities, unsecured or no collateral, and low fixed interest rates, and less fees. During an economic downturn, however, all bets are off. The creditor is going to take whatever measures he can to ensure your loan is repaid as soon as possible, or at least get it back to a performing status. Interest rates and fees are likely to be increased; the entire structure will become ‘tighter’ and more controlled by the creditor.
NCARA believes you have a voice in negotiating the loan structuring process whether at loan origination or loan workout . Debtors should be empowered to create debt repayment solutions by better understanding credit risks the way the creditor sees them, and then customizing a better solution, especially during troubled times. Yes, it’s the creditor’s business to know his customer and its business. But the debtor needs to step it up a few notches and know the creditor’s business too. It’s not as if the patient is telling the doctor what treatment he needs, but if he’s aware of and familiar with the treatment options, and knows what works best for his particular needs, why wouldn’t he step forward and make a solid recommendation? NCARA’s credit risk memos highlight key credit risks that are important for the debtor so he realizes where and how he can better negotiate his own debt repayment solutions.
CRM #30 – Pricing: Interest Rates, Fees
The interest rate offered should be based on the credit risk in the deal. All things considered, the stronger the financial statement, the better the interest rate and fees. What goes into determining the interest rate? The established rate will need to be sufficient to cover the creditor’s ‘cost of funds’ used to fund the subject loan, the overhead or the cost to service the loan, as well as potential losses it may incur, and a reasonable level of profit. Financial institutions operate on a very thin margin. Management will have internal pricing criteria, and experienced lenders know the necessary pricing and fee objectives for each loan. Pricing can change as competition and other risk factors are realized. Creditors will not likely seek to offer the lowest interest rates, and may be willing to lose a deal due to underpricing from a competitor.
Creditors will also consider the monetary value of ‘compensating balances’, the deposits a loan customer will bring to the relationship, and adjust down the pricing accordingly. Many loans are granted on a variable interest rate basis, where a certain margin is tied to the prime rate (i.e., base rate), for example, as quoted in the Wall Street Journal. The pricing structure may also have a ‘floor’ rate or a ‘ceiling’ rate that reflects how low or high the interest rate may be adjusted in a given period. As the base rate changes, so will the rate on the loan change when adding the margin percentage. Consumer loans will frequently have a fixed rate structure for the entire loan term, as well as some longer-term commercial loans (i.e., interest rate to be adjusted every five years). Creditors can face strong pricing competition, but will try to win over deals with excellent service.
NCARA believes that small business owners need to immediately and seriously reassess the level of debt on their balance sheets for the sake of their own survival. In too many cases, heavy debt rules the day, and most of the debt is accruing interest on a variable rate basis. Over the past decade or so, because of extraordinary adverse economic conditions, world bankers have maintained a very low interest rate posture. Low rates are evidence that ‘things are not good’; that’s why the monetary stimulus is there in the first place. Government fiscal spending is a whole other topic; it is worth mentioning though, that the whole world has been living off a ‘credit card’, with record high debt levels everywhere – with no end in sight.
All that aside, maybe it’s time for you to look at interest rates from a different perspective. What if, for whatever reason(s), interest rates increased much sooner than you might have expected, and more sharply than you could have imagined? What then? If you’re having a hard time making interest-only payments, or minimal amortizing payments, like much of the world is doing, how well would your business fair if interest rates jumped 300 to 400 basis points (three or four percent), or more? How would that impact the interest expense on your income statement, and what would that do to your bottom line? Have your accountant or Chief Financial Officer stress test your balance sheet and income statement, and see what happens for yourself (i.e., higher interest rates, reduced sales revenue). If interest rates increased more suddenly and sharply than you expected, what effect would those economic conditions have on your operating margins and the value of your assets?
NCARA believes we live in fragile times, and small busines owners who have paid little to no attention to the levels of debt they maintain, may find themselves in serious jeopardy one day. Think of the words ‘modest’, and ‘controlled’, and consider adjusting your strategic plan accordingly.
As you might guess in a workout situation, the creditor is going to offer an interest rate regimen that makes sense for the creditor. If you don’t like it, and you’re able to do something about it, take your business to another lender. If you’re stuck with the creditor, or if the creditor is stuck with you, there’s no reason that you cannot address the interest rate treatment straight up. Look at your pro forma cash flow statement and install the interest expense amount your creditor is expecting you to pay over the next 12 plus months. If you feel the interest rate is fair and equitable, then fine, pay it. If you don’t believe it is fair, equitable, or manageable for your business, then discuss the rate with the creditor and request a rate structure that will meet your needs. But don’t do the latter, just because. There should be a valid reason and financial need or you’ll not likely succeed.
If you know your business and why those pro forma cash flow numbers make sense, recall what changes have to be made in order to reduce expenses and be prepared to document each one. Don’t forget that interest expense is one of those expenses that needs your voice too. A lower interest rate is an option, but you will only get it if it’s absolutely necessary for your survival. And, do you know what? That’s the way it should be. Creditors need to be properly compensated just like you do for your products and services, right? So, be careful. Be thoughtful. Justify your positions. It is what it is, good or bad. Think full disclosure. This includes having a variable or fixed rate. The creditor may be willing to discuss both options, and in a potentially rising interest rate environment, perhaps your interest expense can be locked in at a lower rate. The creditor will, obviously, push for the opposite.
If you propose an interest rate that the creditor considers as being a concession, you’re opening up a whole other discussion (see Credit Risk Memo entitled: Troubled Debt Restructured/TDR). Depending on certain circumstances, having a below market interest rate structure may entail the creditor having to treat your loan as a trouble debt. Talk about it openly with your creditor once you’re familiar with TDR accounting. If you are in a debt restructure posture, then you will look at possibly having to get an interest rate concession. If not, you may push to have at least a more competitive interest rate as you hope to eventually emerge from poor financial performance.
CRM #35 – Repayment Sources: Primary, Secondary, Tertiary
A well-structured loan comes with repayment terms and conditions that satisfy the loan’s original lending purpose and based on a specific borrowing cause. Creditors require there to be well-defined repayment sources in order to help ensure full repayment. Ideally, there would be three sources for repayment should the primary source fail to materialize, etc. The primary source, generally cash flow, will be different depending on the type of loan being underwritten. Secondary sources will likely include the sale or liquidation of collateral or a refinance of the loan. Tertiary sources will often be the financial support from the legal entity(ies) or individual guarantor(s).
Primary Source of Repayment (PSOR) – The PSOR will be directly related to the loan type. For example, for a construction loan, the PSOR will be the take-out or permanent financing, and not rental income or the sale of the property. For an asset-based line of credit, the PSOR will be the conversion of trading assets to cash. The PSOR for a long-term equipment or an owner-occupied commercial real estate (CRE) loan will be the cash flow from business operations generated over multiple operating cycles. For a non-owner occupied CRE investment property, the PSOR would be the tenant rents.
Secondary Source of Repayment (SSOR) – The SSOR will serve as an alternative source of repayment should the PSOR fail to materialize. In most cases, the underlying collateral, a properly documented and pledged lien or interest, will be foreclosed or liquidated and the proceeds will be applied to the remaining outstanding balance.
Tertiary Source of Repayment (TSOR) – The TSOR is typically the final layer of protection to help ensure repayment should the prior sources fail to pay off the outstanding balance. It’s possible the guarantor(s) may, or may not, have the ability or willingness to further support and serve as a repayment source. Guarantors will often step in earlier to shore up any cash flow deficiencies and can become fatigued through the workout process.
NCARA believes you need to be candid and realistic about the repayment sources available to you when you’re experiencing a serious financial setback. The repayment sources are either there or they’re not. There is also the willingness to repay, and the ability to repay factors. It is what it is. And your job is to be completely honest and candid as to what is there and what is not. All of your financial reporting should be complete and accurate. Your root cause analysis to determine the reasons for your financial difficulties, regardless of what they may be (i.e., the result of your decisions), together with the assumptions that support your resolution plan, need to be fully documented. As you do so, the repayment sources will have to take care of themselves. They are what they are.
Just realize too, the creditor does not want to hear any ‘bad news’. He wants to avoid any losses. He wants to avoid having to spend good money trying to pursue liquidation of the collateral, or chasing you down to get a judgment against you. He wants this to be over quickly, the sooner the better. He expects you to keep your end of the bargain and comply with the actual promises and commitments you made when he gave you the money in the first place. He wants to hear only good news. So, why not just do all that? Or, maybe, why not give him false hope and the numbers that he wants to see? And, you’ll just hope to survive and live another day, right? Is that what he wants, and is that what you will give him?
You’ve probably been thinking about this for some time already, or maybe you’ve already had a bad experience. Your initial reaction was, as you thought about it, along with how you imagined other small business owners may have reacted to their creditors, that this was the time to avoid and fight the creditor at all costs. Why? Because that’s what usually happens, right? You now have to protect all your assets because the creditor is coming to seize them; you want to fight him with every tooth and nail. That, indeed, may be your natural reaction when your business, assets, and livelihood are threatened. If you’ve thought that way, you’re probably in good company. It may be that way because, as noted, the creditor wants it all, and he wants it yesterday. And if you give him all that transparent information, he will then know how and where to come and get everything too. You’d be giving him the ‘keys to the vault’, you say. Why on earth would you do something like that?
Well, first off, if you’re financially in trouble, you have a choice to make. You can do it the easy way or the hard way. First, the hard way. If you fail to live up to the promises you made when you signed it all away anyway, in your loan documents, you will have breached your promises. You will have failed. Creditors, just like you when you’re trying to collect one of your accounts receivable, can sense bad-faith. It’s ugly. It’s frustrating. How could they do that? Right? Well, you’re an account debtor too. What does your creditor think of you today? Are you going to fail in your promises to come to the table? Or are you going to acknowledge your problem, and then empower yourself, and fix your problem? It’s not the creditor’s problem. It’s your problem. It’s your responsibility. So, why in the world is it not your repayment solution? Do you see how you need to empower yourself?
Which leads to the easy choice. Empowerment. Yes, empowerment. You know this is your deal, so you have to prepare yourself by gaining any knowledge you need to prepare your debt repayment solutions. And then top it all off with a pro forma cash flow statement that shows what changes you’re making in your business and how that will translate into cash flow for satisfying your debt. Sure, it’s not going to be what the creditor wants to see, but it will be your best shot, and what you expect will honestly be there. It is what it is. When conditions improve, you’ll come back to the table and reset or modify the loan once again.
Question: Do you think this ‘easy’ approach will work if you exhibit any of the values from the ‘hard way’ approach? If you choose that ugly approach, it could have a material negative impact on your overall well-being. Creditors will take appropriate measures to collect and force debt repayment anyway. It’s called justice. It’s their right, and they will exercise it; they have the resources to force their hand. On the other hand, if you do your very best to live up to your agreements, how can you be any less ahead at the end of the game? Do this your way; be empowered, find solutions to your own repayment plan. Creditors are human beings too. They know how to listen, and they’re reasonable people. You may be very surprised how well you fair. But, seriously, do you really want to do this the hard way? No, you don’t. You want to do this the easy way. Your spouse and family will thank you in the end. No alimony and no child support payments here. You can do this. Unless and until the creditors empower you to take the lead in you being responsible for solving your own problems, you empower yourself to do this.